“The Importance of Bank Capital and Economic Cycles: Lessons from Frosts in Early May”

Frosts in early May are not unusual, but no one knows exactly when they are expected and how long they will last. Rapid temperature fluctuations during spring can be compared to developments in the economy, which we call cycles. There is a larger cycle of development (change of seasons) within which there are noticeable fluctuations (frosts).

The end of a larger development cycle was, for example, 2008, which was gradually followed by an economic “spring”, and now we are likely to be at the end of this larger development cycle. It is wise to prepare for this in time – healthy bank capital is one of the stabilizing mechanisms that allow the financial sector not only to protect itself, but to stabilize the economy when we are in crisis or recession stages.

Historical experience and the impact of the economic cycle

Banks are an organic part of economic developments, they plan their operations within the framework of economic cycles and take into account the historical experience in the specific country. During boom times, banks provide better returns on capital knowing that an economic ‘winter’ period will follow later. Also aware that unexpected developments may happen from time to time. Wintering requires proper preparation, so speculating that banks are “earning too much” is quite short-sighted for two reasons. Firstly, it is an assessment without seeing what stage of the development cycle the economy is currently in and, secondly, it means that banks with small profits or losses and a thin layer of capital would become weak, quickly freezing “seedlings” during unexpected frosts.

The financial sector is one of those that is strongly related to economic cyclicality. If business and individuals are doing well, both want to promote their well-being, they borrow money from banks, invest, earn new money, repay loans, and everyone becomes a winner. And vice versa. In the years 2009, 2010 and 2011, which we remember as the times of economic crisis, the losses of the banking industry exceeded 1.8 billion euros, which is much more than the banks earned during the previous economic cycle (after Latvia joined the European Union in 2004). These losses of a few years were later compensated in about six years – until 2017. At that time – ten years ago – did anyone think that the banks were “making too much money”? It should be reminded that Latvia was then preparing to join the eurozone and a stable financial sector was one of the essential conditions for our country to join the club of euro countries.

Return on capital of banks among other industries and the importance of capital

If we look at the Latvian banking industry over a period of 23 years, the average profit of banks has been around 125 million euros per year, while the average return on capital (ROE) has been 5.7%, which can be considered a lower indicator compared to other industries. In addition, when assessing the profitability of banks in a historical section, it should be taken into account that for a long time there were so-called non-resident banks operating in Latvia, whose return on capital was incomparably higher than the industry average or neighboring countries.

The average five-year ROE in the banking sector in Europe ranges from negative in, for example, Cyprus and Greece (data for the period 2017-2021) to almost 13% in Hungary and just under 12% in Romania. As you can see, the return on capital depends on the specific region and country. The ROE of Latvian banks in this period (2017–2021) was 7.2%, which is noticeably behind Estonia (8.8%) and Lithuania (11.3%) ¹. This indicator has been relatively higher in the last two years, when the volume of loans issued in Latvia also increased. If you compare the bank capital return data with other sectors – the average rate of return from 2017 to 2021 for all sectors of the Latvian economy was 12.7% ².

Banks’ return on capital (and not just profit) is one of the most important indicators that show the ability to develop, invest in new services and technologies, becoming an important support point for citizens and business. Here we can mention the recent Swiss Credit Suisse, which failed to reorient itself in time, and also experienced management problems and operated at a loss for several years, resulting in the bank’s inability to continue operations. Banks with thin capital cannot invest in development and become weaker in the long run. This is bad for the economy, as banks are no longer able to lend, companies are not developing, new jobs are not being created, etc. Speaking of lending, contrary to the widely expressed opinion that banks do not lend in Latvia, it should be emphasized that the volume of loans issued in the last two years (2021 and 2022) increased by 19% (comparing 2020 and 2022).

When it comes to the importance of bank capital, we should return to the planning factor. Let’s remember that until very recently – in 2021 and at the beginning of 2022 – the situation of so-called negative rates was relevant. The rate hike by the European Central Bank is a current issue this year, and banks are adapting to this situation, taking into account both their operational strategy, risk considerations and industry regulatory requirements. It should be emphasized that in the case of Latvia, the losses caused by negative rates were compensated by the banks themselves in most cases, they were not applied to our clients. In less than a year, the situation has changed radically, and the financial sector is in a qualitatively new situation, which neither the central banks of EU countries nor prominent economists could have foreseen. This example vividly shows how rapidly the situation is changing and how little we know about it in advance. The financial industry cannot rely on the fact that it will “somehow” overcome sudden, unforeseeable “freezes”. Bank capital is a guarantor that allows the industry to survive various situations and periods in the economy. Therefore, we can listen to economists’ assessments of what and how should be done differently, but we must not give up the basic principle of banking – act by evaluating all risks, prepare for economic “winter” periods that always follow development stages, as well as be ready for unexpected “frosts” , which hits us even in the warm spring months.

¹ Data source: European Central Bank

² Data source: Central Bureau of Statistics