The rate of profit, borrowing, return on equity and leverage

Section 3.1 concluded with an equation that represented the rate of profit for the capitalist system as a whole, allowing both for the unproductive costs of commerce, MDC and IBC operations and for the lending of investment capital. This differed from Marx's presentation of the rate of profit, where he only considered IBC from the point of view of it receiving a part of the total surplus value in the form of interest (Marx, 1974c, Chapter 21). In this section, I will examine some important relationships using the previous formulae, showing that once the issue of borrowed capital is taken into account, as Marx does in his determination of 'profit of enterprise', the question of capitalist profitability should also be examined in a different context. IBC operations are included in my system rate of profit formula, but, following points made in the previous section, I will argue that this does not imply that banks will tend to earn the same rate of profit as the industrial and commercial companies.²³ This will also show that what may look like a comparable measure of profitability only serves to highlight the different status of banks.

Surplus value, profit of enterprise and interest

Marx divided the total surplus value into 'profit of enterprise' and interest. However, in this analysis he gives the impression that the only deduction to be made from the total surplus value accruing to the productive, commercial and money-dealing capitalists is the interest paid to 'the owner and lender of money capital' (Marx, 1974c, Chapter 23, p. 371). As already

23 To simplify the exposition, from here on my reference to 'industrial and commercial' capital or companies will include the advance of productive capital, commercial capital and MDC.

shown, however, the total surplus value must also cover the costs of commercial capital, MDC and IBC. This implies that the correct formula for the profit of enterprise is:

(iv) S – X – Z – D2iA

where the final term is the total interest paid on the funds that productive, commercial and MDC companies borrow, D2, multiplied by an average interest rate of iA. If the former companies lent funds to the banks, then they would also receive a portion of the total deposit interest paid by banks, but that is ignored here.

As shown in Section 3.2, banks are able to create fictitious deposits in addition to the 'original' deposits arising from the circuit of industrial and commercial capital or from other sources. Not all of these deposits will be lent to industrial and commercial capitalists, and some of the total bank deposits will also be lent to capitalists who invest in financial assets of various kinds. These factors have an important effect on how profitability appears for

industrial and commercial capitalists versus those capitalists advancing IBC, an effect best explained by using a common measure of profitability used by all large, publicly quoted capitalist companies: the return on equity (RoE).

Marxist analysis has focused almost exclusively on the simplified expression for the rate of profit in the S/(C + V) formula. However, it is not often that capitalist companies pay much attention to this kind of measure. Some companies will report a figure for 'return on capital employed', which broadly represents the same concepts, but the overwhelming focus of large capitalist companies quoted on the stock market is the return on equity. This

measures the net profit of the company compared to the value of its equity capital (measured according to the value of the equity when issued, plus retained earnings), and so is a good indicator of the return to the owners of the company of the money capital that they have invested in it. The RoE measure is not used in isolation from other indicators, however. For example, a company with a high RoE combined with high levels of debt may not be considered to be in a better position that a company with a lower RoE but much lower debt.

The following analysis shows how the capitalist system's rate of profit is linked directly to the RoE calculation for industrial and commercial capital. However, there is a far more tenuous link between the system rate of profit and the profitability of banks, who are used here as the main representatives of capitalist companies advancing IBC. The exercise will indicate how closely one empirical form of the rate of profit is related to the underlying process of surplus value production.

Return on equity: industrial, commercial and financial capitalists

The owners of capitalist companies must usually advance some of their own capital to begin operations, or to continue to operate. However, they will normally also borrow investment funds (IBC) from the financial system. When this occurs, while they are concerned about the returns they get on the total advance of capital, they are more particularly focused on the return on the investors' ownership stake, or the RoE.

The return on equity for the industrial and commercial capitalists is their profit of enterprise (leaving aside any deposit interest received from banks), divided by their own advance of capital, or:

This return on equity formula indicates how profitability can be boosted from the point of view of equity investors without them necessarily providing any more funds for investment. If they use borrowed funds, then, depending on the interest costs, the numerator may increase while the denominator – their own invested capital – stays the same. Within limits, this means that it is possible for the RoE to rise even if the rate of profit on total investment falls.

Nevertheless, there will be a general, positive correlation between the system rate of profit, r, and the return on equity for industrial and commercial capitalists. This can be seen by rearranging equation (iii) to make the total capital advanced the subject. The result is:

2 r

After moving the W and D2 terms to the right hand side, noting that the result is equal to the denominator in equation (v), substituting into equation (v) and then multiplying the top and bottom of the fraction on the right hand side by r, the RoE formula becomes:

)

This shows that the return on equity for industrial and commercial companies will tend to decline as r falls, since the numerator falls and the denominator increases. If the rate of interest fell, then there could be a rise in the return on equity despite a fall in r, but a fall in interest rates (for borrowing) has a limit above zero. The broadly positive correlation will tend to hold.

By contrast, the return on equity for the banks has a far less clear relationship to the system rate of profit. This sector of capital's RoE is its net interest income, after deducting other costs (assumed to be equal to Z), divided by the total advance of capital, W. Making the simplification that the total loans equal total deposits, D, the net interest income is the total

interest received on assets, DiA, minus the interest rate paid on total deposits, DiD. This gives the following expression for the return on equity for the banks:

(vi)

W Z i i

RoE_Banks = D( ^A − ^D)−

In this case, the trend in the system rate of profit, r, has a far less direct impact on the RoE for banks. If there is a trend of falling profitability, then RoEICC will fall, as previously indicated.

This will reduce these companies' ability to meet interest payments on borrowed funds, so there is likely to be downward pressure on iA (considered as a percentage return on bank assets, not simply as an interest rate) through a lower demand for investment funds and also due to potential loan losses. That should eventually feed into a lower figure for ROEBanks. Nevertheless, there are some important degrees of freedom on this measure that could make the banks still look profitable, despite lower returns elsewhere.

Firstly, it is evidently the gap between borrowing and investing (or lending) rates that is critical for the banks. In a 'credit crunch', banks can often charge higher interest rates on their loans, even if the interest rates they pay to depositors fall. Secondly, the banks are able to expand their deposits and loans via credit creation (depending on bank reserve ratios, together with bank credit risk and capital adequacy measures). Hence, the volume of interest earnings, and the return on equity for banks, can move quite differently from the return on equity for other capitalist companies.

The upshot is that the ability to expand borrowing and assets is a key driver of profitability for the banking system. This creates a different dynamic for the return on equity for banks compared to that for industrial and commercial companies. There is clearly no direct relationship between the two calculations of return on equity and they are liable to be different.

Profit of enterprise and equity dividends

Before continuing, it is worth commenting on the profit of enterprise equation for industrial and commercial companies – equation (iv). This equation represents the profit available for distribution to the latter group of capitalists. They need have no knowledge that it includes the total surplus value, S, and deductions X and Z for the depreciation and other costs of the commercial and financial capitalists, although they will be aware of the interest paid on borrowing from banks. For them, profit of enterprise is just the residual profit they have left after paying interest. Marx introduced this term to distinguish the functioning capitalist from the mere lender of money capital as interest bearing capital. However, virtually all the capital advanced by today's major industrial and commercial companies is made up from equity

capital issues on the stock market, retained profits, loans from banks and bond issues, with very little originating from the functioning capitalists.

There is probably no 'profit of enterprise' received by capitalist owners as a separate payment from dividends, except in the case of privately owned (not listed) companies and the latter companies account for only a small fraction of the total assets of capitalist corporations.

Even retained profits, after payment of interest and dividends, are attributable to all the company's equity holders, not to a separate group of owning/functioning capitalists. This makes the RoE-type calculations compelling as alternatives to the traditional rate of profit calculation, in addition to the way they facilitate understanding of the different dynamic for companies in the financial sector. But it also suggests a diminished importance of 'profit of enterprise' as an economic category in modern capitalism. At the same time this reflects the much greater prominence of interest-bearing capital and the form it takes as fictitious capital in equity and debt securities. This point is consistent with Fine's argument that

'financialisation' should be viewed as being 'underpinned by the quantitative expansion of interest-bearing capital and its extension across the economy' (Fine, 2010, p. 113). One area for investigation emerges from this topic, although it is outside the scope of this thesis. This would be to examine whether privileged control of a company, through holding voting shares, and the privileged payment of returns that results from the ownership of certain types of equity, tends to reside with the founding capitalists. In the case of the Facebook IPO, for example, one of the founders, Mark Zuckerberg was reported to own only 18% of the shares but he had 57% of the voting rights (Surowiecki, 2012).

Rates of return and leverage: banks and non-financial companies

Given the previous discussion, it comes as no surprise that industrial and commercial

companies borrow far less as a proportion of the equity held by the company's owners than do banks and other financial companies. This ratio of borrowing to shareholders' equity is a common definition of leverage. The ratio will change according to economic conditions, growing rapidly when times look good and falling when times are bad. Nevertheless, at all times banks borrow far more than do other capitalist companies compared to the size of their capital or equity base.

As an indication of the divergence, it is considered normal in major capitalist

countries for banks to have a leverage ratio of around 20 – in other words, when borrowing is 20 times the size of equity (Haldane, 2011). Industrial and commercial companies, by

contrast, are looked upon questioningly by the stock market if their borrowing ratios are high.

Data for the aggregate of US manufacturing companies' debt holdings showed that they were less than the value of the company's equity capital in each year from 2001 to 2010. Their

average leverage ratio stayed at less than 1 despite the sharp rise in borrowing elsewhere in the US economy during this period. This was also true for the aggregate measures of mining and wholesale trading companies (US Census Bureau, 2012, Table 794). Another divergence with the banks is that when industrial and commercial companies borrow funds they are very likely to use these funds for investment in their own productive and commercial operations.

Banks normally borrow funds to lend to others, or to invest elsewhere.

Higher leverage usually implies higher volatility of returns on equity. If the investment turns out badly, the interest on the borrowed funds must still be paid, reducing returns further. If investment returns are good, a low cost of borrowed funds relative to the investment returns will magnify the return on equity. Standard portfolio investment theory makes an adjustment for this, deflating the higher returns by the higher volatility when calculating a 'Sharpe ratio' on investment performance (CFA, 2012, pp. 408-409).

Data on the leverage ratios of banks reveal an important dimension of what happened in the run up to the 2007-08 global crisis. From the 1990s, bank profitability had been coming under pressure from narrowing interest rate margins, which had tended to fall in line with the trend of lower money market interest rates.²⁴ For US banks, net interest margins fell from around 4.0-4.5% in the 1990s to below 3.5% by 2006 (Federal Reserve, 2009, p. A76). This encouraged banks to step up their lending operations in order to compensate with a higher volume of assets. The result was much higher bank leverage. At the same time, the banks also boosted the volume of their trading in foreign exchange, financial securities and derivatives, something that was assisted by their 'financial innovation' and the boom in financial

markets.²⁵ These moves increased both bank interest income and their trading income from dealing spreads and commissions.

In the early 2000s, a relatively stable rate of economic growth in major capitalist countries made the higher leverage not seem so risky. Ahead of the crisis, leverage ratios for some major institutions hit levels in excess of 100 in the US and more than 80 in Europe, four or five times 'normal' levels (see Chart 3.1). Once the credit-fuelled bubble burst, however, this gave a particular 'financial' form to the crisis that broke in 2007-2008. The percentage loss incurred on a huge asset base did not have to be high to wipe out the equity capital of

24 Lower interest rates in major countries were often seen as a result of the success of economic policy in reducing inflation rates. However, this overlooks the impact both from the growing supplies of low-cost imports from China and other producers from the 1990s and of the (mainly Asian) central bank purchases of government bonds in the US, and other major markets, from around 2000.

25 See Crotty 2007 for an interesting analysis of bank returns and financial innovation. However, he pays too little attention to the broader issue of bank leverage, noting only the implied leverage from credit derivatives and other derivatives.

many institutions, leading to state-supervised mergers and bailouts in the US, the UK and a number of other European countries.²⁶

Chart 3.1: Leverage ratios for major international banks, 2007–2011 (Total assets divided by bank capital. High-low range in each year)

Notes: LCFI stands for 'large complex financial institution'. UK banks are not included in the European LCFI columns. In 2007 and 2008, the weighted average numbers for leverage ratios were about two-thirds down the relevant bars.

Source: Adapted from BoE, 2012, Chart 1.19, p. 14.

The financial system can obviously develop a destructive dynamic in the search for extra profit. This can be looked upon as one consequence of the way in which banks can expand their assets by credit creation. From the perspective of the money-dealing aspects of bank operations, they also have a clear incentive to boost the volume of financial

transactions. The financial system grows alongside and is intertwined with the accumulation of capital. However, as indicated, weak economic growth and profitability can often prompt accelerated growth of different types of financial business, especially if there is a decline in returns on financial investments in an environment of low interest rates. It was this that prompted the extra leverage and the explosion of derivatives markets in the 2000s, as

financial institutions could not maintain the returns that they needed from loans or from bond and equity investments (Norfield, 2012). The relationship of these financial returns to the rate

26 Appendix 2 to this chapter gives the leverage data for major UK banks since 1960, confirming that the 2000s were years of exceptionally high leverage.

of profit is complex. However, the lower is the system rate of profit, the more likely it is that what takes the form of a 'financial' crisis has its roots in weak profitability. In turn, the lower is the system rate of profit, the greater is the economic damage wreaked by a financial crisis.²⁷ 3.4 Financial revenues, surplus value and fictitious capital

Marx's theory of value treats the 'financial sector' (MDC and IBC operations) as unproductive.

It neither produces new (surplus) value, nor transfers value to commodities, and all of its costs, not just its profits, are a deduction from the total surplus value produced. Even when financial sector revenues flow directly from workers' wages, as in the case of interest

payments on loans, the ultimate source of these payments is from surplus value, given that the regular wage paid would need to adjust to make allowance for such deductions and to

maintain a particular value of labour power. However, if one simply stated that financial sector revenues were a redistribution of existing surplus value, this would overlook some important issues. These can be explored by examining the links between surplus value and the price of financial securities or fictitious capital.

Sections 2.4 and 2.5 of Chapter 2 noted the basic mechanism through which the price of financial securities is determined. This price is essentially the discounted value of the future cash flows expected - dividends for equities, and coupon and principal repayments for bonds. The security's price therefore does not represent existing value, but there is a minimum price of the security that reflects the taxable capacity (or creditworthiness) of the state or the value of a company's remaining assets. Instead, the price is largely driven by interest rates in the market, influencing the discount rate and, in the case of equities, expectations about future company profits. Therefore the security's price does not have a direct relationship to the surplus value currently being exploited from the productive workforce. Its price could rise sharply if interest rates fell or if expectations about future coupons/dividends/repayments

Sections 2.4 and 2.5 of Chapter 2 noted the basic mechanism through which the price of financial securities is determined. This price is essentially the discounted value of the future cash flows expected - dividends for equities, and coupon and principal repayments for bonds. The security's price therefore does not represent existing value, but there is a minimum price of the security that reflects the taxable capacity (or creditworthiness) of the state or the value of a company's remaining assets. Instead, the price is largely driven by interest rates in the market, influencing the discount rate and, in the case of equities, expectations about future company profits. Therefore the security's price does not have a direct relationship to the surplus value currently being exploited from the productive workforce. Its price could rise sharply if interest rates fell or if expectations about future coupons/dividends/repayments