Here's why big banks will make lower returns during the next upturn...
Earlier this week, news broke that Lloyds Banking Group (LSE: LLOY) is to stop selling payment protection insurance (PPI).
Good riddance to bad rubbish
Banks and building societies sell PPI alongside credit agreements, largely mortgages, personal loans and credit cards. If policyholders are unable to work because of accident, sickness or unemployment, then PPI meets their monthly repayments until they're back at work, for up to a year.
Although PPI seems to offer valuable benefits, it's rarely worth getting. That's because these policies are hugely over-priced, widely mis-sold and packed with loopholes and get-out clauses. Hence, since joining the Fool in 2003, I've waged a 7½-year vendetta against payment protection insurance, which I believe to be the world's worst protection.
Great news for borrowers...
PPI has been under close regulatory scrutiny in recent years, leading to crackdowns by the Financial Services Authority and the Competition Commission. Even so, problems with PPI now account for a third of all complaints to the Financial Ombudsman Service.
Taxpayers own 41% of Lloyds, so it's possible that the powers-that-be pressurised the bailed-out bank to stop selling this poor-value protection. If so, then 84% taxpayer-owned Royal Bank of Scotland (LSE: RBS) may soon follow Lloyds' lead and scrap PPI completely.
What's more, other major lenders have also taken steps to tackle deep-rooted problems with PPI.
HSBC (LSE: HSBA) stopped selling stand-alone PPI in 2007; Santander pulled its non-mortgage policies in 2009; Nationwide BS sells PPI only alongside mortgages; NatWest and RBS offer PPI only for mortgages and unsecured loans over £25,000; and Barclays (LSE: BARC) is in the process of withdrawing its PPI range.
But bad news for shareholders
Though this seems to be the beginning of the end for payment protection insurance, its loss won't hit banks as hard as it would have, say, three years ago. This is because both levels of secured and unsecured lending have collapsed, thanks to the credit crunch and economic recession.
Had PPI been reined in during the boom years, then its loss would have been far, far greater. For example, thanks to the twin booms in housing and credit, the UK's big banks made a combined profit of around £40 billion at the market peak in 2007.
Based on my experience as a former PPI insider, I reckon that as much as £5 billion of this total came from PPI sales. Hence, PPI accounted for around an eighth (12.5%) of total bank profits during the boom. Today, given falling PPI sales and low levels of lending, this ratio has probably fallen to a low single-figure percentage.
Nevertheless, a mass withdrawal by lenders from selling PPI will have a significant effect on their present and future profits. Indeed, as PPI dwindles and dies, the next boom in house prices and credit will be much less profitable for lenders. In particular, shareholders in the Big Four banks -- Barclays, HSBC, Lloyds and RBS -- should bear this in mind when predicting profits in the next upswing.
Then again, given that the UK's most profitable banks once raked in nearly £1 billion a year apiece from PPI, it's highly likely that they will act to replace these lost profits. Therefore, the cost of credit for both individuals and companies may well rise to make up this shortfall. Indeed, you could argue that this has happened already.
Half-year results from both Lloyds Banking and RBS are due out next week (on 4 August and 6 August respectively). It will be interesting to see what they have to say about the impact of this on their profitability.
More from Cliff D'Arcy:
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