Canadian banks reported record profits in the most recent quarter despite an interest rate environment that is crippling the core business of lending across the globe.
Traditionally, banks have made the majority of their profits by "borrowing short and lending long." In 1995, for example, the major banks would borrow money in the market at levels close to the three month T-Bill rate of seven per cent and then lend it to clients at the ten year rate of 9.1 per cent. The accounting term for these profits is Net Interest Income.
In 1995, the 2.1 per cent difference (9.1 minus 7.0) between the short and long term rates resulted in significant returns. Currently, the spread has fallen to below 90 basis points and Net Interest Income has declined markedly as a component of total profits.
The chart above shows the relationship between interest rates and Net Interest Income for the domestic banking sector. Periods where the spread between short and long rates is larger correspond with high Net Income for the Banking sector.
It is no surprise that Canadian banks are increasingly diversifying away from the core lending business into underwriting, brokerage, real estate, insurance and other sources of revenue – the returns from basic lending are falling quickly. The longer interest rates and economic growth continue at current low levels, the more likely this trend will continue.
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