A couple of weeks ago I talked about the huge profits made in the banking sector in 2012. The largest Kenyan banks like Equity, Cooperative and CFC have recorded impressive figures, with profits growing up to 58 percent compared to the previous year. Is that normal? And is that good for the economy?

One of the criticisms that people make is that the banking sector squeezes profits out of firms, affecting more or less indirectly investments, job creation and the overall growth of the rest of the economy. Is that true?

Photo credit: Business Daily

What is definitely true is that macroeconomic volatility advantaged Kenyan banks last year. When the Central Bank of Kenya increased its main lending rate by a massive 12 percent in three months, banks were forced to increase interests on loans from an average of 14 percent  to an awfully high 26 percent. Interest rates on deposits however remained untouched at around 5 percent. The huge spread between loans and deposits rates was an important factor behind the growth of bank profits last year.

This prompted consumer associations to ask for government controls on interest rates:

Unless there is some sort of control they will always make abnormal profits at the expense of the economy. We thought they would self-regulate but this seems not to be the case […] All indicators show that they shouldn’t be charging what they are currently charging.

I think that encouraging competition among banks is a better solution than having government controls. Although the Kenyan financial sector is relatively more developed compared to most African countries, the banking sector is still highly concentrated. 6 out 44 banks in Kenya control 56 percent of the market. Plus, the government is still very much involved in the market, having shares in a variety of institutions.

But anyway, if we go beyond the Kenyan specific case we have to realize another important aspect: the financial sector tends to be extremely profitable all over the world. Why? Talking about the US financial sector, the excellent Noah Smith points to two factors: socialization of risk and natural monopoly of the financial market:

Why is finance so profitable? One possibility is socialization of risk: in other words, the government implicitly guarantees that big banks won’t fail, which allows banks to make profit in good times and shift losses onto the taxpayer when things go bad.

… Another possibility is that finance is a natural monopoly. This is weird, since finance has few network effects like Facebook or Google, and doesn’t require exclusive local land access like a public utility. But in economics, any industry where economies of scale are large will gain monopoly power, and hence high profits. And banks may benefit a lot from economies of scale. Why? My intuition says that it’s part of the definition of what a bank is. A bank – or any financial institution that acts like a bank, which is most of them – makes its profits by borrowing short and lending long, and this makes it fundamentally vulnerable to a bank run

Over at NPR Jacob Goldstein develops the issue further:

Even the most boring, safe, neighborhood bank is in a crazy, risky business. A bank takes money people put in checking and savings accounts — money those people are allowed to withdraw at any time — and lends it out to other people, who don’t have to pay it back for 30 years.

Yet most people assume their money is safe in the bank. They assume that somehow, even if a bank takes all the money in its checking accounts and lends it out to people who don’t pay it back, the people with checking accounts will still be able to get their money.