If Piketty is right about rich people getting high returns, why do banks lend at low rates?

A critical assumption in Thomas Piketty’s Capital in the Twenty-First Century is that rich people get a better return on investment than average S&P 500 buy-and-hold idiots. This assumption leads to runaway wealth inequality and the necessity for a new worldwide tax on wealth.

Why do rich people get such a great return, according to Piketty? They have access to brilliant financial managers and investments that the rest of us can’t find.

What about big banks then? With billions in assets they are unarguably rich. Their office towers are stuffed full of the best financial managers that $500k-$20 million/year salaries can buy. They sit in the biggest cities and have access to every conceivable business idea. Big Banks should have ever better investment opportunities than Mr. Generic Rich Bastard. Yet they are happy to lend out money right now for a return of about 2 percent (e.g., margin interest on stock holdings, best adjustable mortgage rates for the first five years). If there are such great investment opportunities out there for the sufficiently rich and sufficiently connected, why would a big international bank want to lend out money at 2%?

14 thoughts on “If Piketty is right about rich people getting high returns, why do banks lend at low rates?

  1. Disclosure: I’m not an expert on bank finances. However, it occurs to me that a bank can lend money thousands of times, sell the right to collect interest to a third party, and pocket a profit only limited by the number of mortgages they manage to offers and sell. That profit, I believe, is somehow independent of the lending rate. They de facto act as mortgage brokers. The parties “holding the bag” may not be the mortgage originators. I think we have seen that movie before…

  2. Stephen: All banks will lend at 2%! Actually current rates are even lower for borrowing that is secured, for example, by a portfolio of marketable securities. Rates are about 2.5% right now for five-year jumbo ARM mortgages (so the 2.5% rate is locked for 5 years with no prepayment penalty).

    If you’re not seeing rates like this it is probably because you’re not looking to borrow enough so the bank has to put the cost of marketing and setting things up into the rate. When a bank is lending out $100,000 they need the same paperwork as when they are lending $1 million or $10 million.

  3. Phil, first I don’t think exotic investments outperforming the S&P is the critical assumption of Piketty. And it’s not that some supercapitalists outperform average capitalists/investors, it’s that all capitalists together outperform. The critical observation is that return on capital exceeds economic growth (i.e. it also exceeds Income from production GDI=GDP).
    In particular you should expect some extra return on risk taking, so it shouldn’t be too surprising that some people get more return from capital than from income, but his observation is that in total aggregate, return on capital has been higher than growth on a sustained basis, which leads to wealth concentration.

    Now S&P itself is not even representative of capital, since much of capital is debt/fixed income, and banks aren’t investment managers who are supposed to grow capital (traditionally they’re intermediaries, though you could make a spectrum of banks from most traditional to much closer to asset managers and other investment services).

    So if you look at some bank rate as a stand-in for return on capital, say Prime/Libor/Swap and compare it to GDP growth, or wage/income growth it has generally been higher in US since 1980. Piketty argues also that in the longer view of history the period of 1940’s to 1980 or so has been an outlier in terms of gains for wages and growth of middle class.

  4. I’m not a Piketty fan [I think the argument is way overblown], but your observation is very weak. The fact that banks are willing to lend at 2% indicates that at the margin, they have no better investments to make. However, this says nothing about the average rate of return of deployed capital.

  5. Rif: What stops the banks from getting a return on “deployed capital” as you put it? Why can’t they deploy capital since they are very rich and very connected?

  6. I have not read the article in question, so I will not comment on it. To directly answer your question.. banks can borrow at near zero rates from the fed on an average. Therefore, given an opportunity to lend money that has either very low risk of default or an acceptable level of certainty of recovery (secured loans, mortgages, cars, etc, etc) in case of default, the more they lend, the more money they can make. Simply put, there is no reason not to.

    If your question is sincere and not rhetorical… you are probably assuming a finite availability of capital to deploy. For all practical purposes (not entirely correct, but outside of the scope of this discussion) banks have

  7. I have no idea if the rich get a higher rate of return on their investments. I’m sure they have more resources to investigate thoroughly so it wouldn’t surprise me if there is some edge there.

    However in the US many of the rich do get a substantial break on their taxes through capital gains loopholes (e.g. investment bankers), or just having the resources to shift money through the numerous loopholes that exist in the tax code. This seems a much more likely scenario for why they seem to get to eat a bigger piece of the pie than just simply getting a slightly bigger piece of the pie to begin with. I haven’t read the Piketty book, so maybe her covers this as well.

    As far as banks go, I thought they were able to borrow money from the Fed at even lower rates. How much they can borrow is governed by leverage ratio rules, but the effect is they use their assets to borrow so they can loan many times the amount of their assets. So the 2% rate is really much higher in terms of how much they take in based on their original assets, if I understand it correctly.

  8. Although Piketty is largely clueless, banks, on average, cannot generate larger returns on their held assets than the growth in overall economic activity. If banks were suddenly freed of both regulatory constraints and common sense, they might choose to funnel their assets into the private equity market in order to realize those unseemly gains to which Piketty so feverishly objects. The result would be instantly inflated prices and evaporating returns.

    What his argument misses is the law of large numbers. If, in fact, the rich continue to get richer, eventually they will see their investment returns revert to the mean. In other words, if the rich were as rich as banks, they would be looking at 2% CAGR.

    The very fact that some wealthy people are able to enjoy outsized gains suggests that wealth accretion is NOT the problem that Piketty suggests. It is the opposite. The enormous fortunes that have been acquired by a relatively few are, in most cases, the direct or indirect result of innovation or invention that has provided benefits to the greatest number of people. Piketty suffers from the common myopia that suggests that the division of wealth is a zero sum game.

  9. >If there are such great investment opportunities out there for the sufficiently rich and sufficiently connected, why would a big international bank want to lend out money at 2%?

    Uh, because the Fed will lend to them at 0.75%?

    In the old days, the banking business operated according to the “3-6-3 rule”. Borrow at 3%, lend at 6%, tee time is 3PM. Now it is the .75-2-3 rule but if you notice, the ratio of borrowing to lending cost is now even more favorable (tee time is still the same).

  10. P.S. I have often wondered why banks give out money so cheaply. In my line of work (private equity), the interest rates for subordinated debt (which is only marginally more risky than bank debt in reality if not in theory) start at 12% plus a substantial warrant (piece of equity) but banks are content to play the spread on LIBOR. If you want to see what kind of returns “smart money” (which is not banks) demands and gets, look at, for example, the rate of return on the Harvard endowment fund.

  11. DP: “… banks, on average, cannot generate larger returns on their held assets than the growth in overall economic activity.”

    Incorrect. Your underlying assumptions must be wrong. A quick Google search shows that the Return on Equity for big banks is 9%.

  12. Consumer mortgage lending is a highly regulated and not terribly strategic part of the banking business. The interesting number is not what those mortgage rates are, but the effective return on back equity.

    I am repeatedly annoyed by people saying this or that Piketty conclusion can’t be true because of X, because most of his findings are of the form “by crunching the historical numbers, we observe that A is the case.” People claiming “theory says that shouldn’t happen” deserve little attention.

Comments are closed.