Lloyds Banking Group Made a (Tiny) Profit!

LONDON -- Earlier this morning, Lloyds Banking Group (NYSE: LYG  ) issued a trading statement in respect of the first quarter of 2012. For once, it made a profit, albeit a mere 2 million pounds after tax, which works out to be just more than 0 pence per share. Naturally, the bank isn't paying a dividend.

Lloyds' shares have been an awful investment in the last few years, but these results show that there is a sliver of light at the end of the tunnel. It's often the case that when an economy eventually recovers from a lengthy downturn, its banks' profits rebound quite spectacularly. Long-suffering Lloyds' shareholders hope this will happen sooner rather than later.

1.5 billion pounds. Really?
Lloyds Banking Group was formed back in 2009 after Lloyds TSB was persuaded by the Treasury to buy HBOS -- a decision that ranks on par with using a chainsaw to cut your toenails while blindfolded.

The sheer awfulness of HBOS' loan book has dogged the bank ever since, but if you'd only been looking at the headlines, then you may think Lloyds has been doing quite well. That's because it prefers to define profit on a "combined business basis," which ignores most of the bad stuff that the rest of us have to deal with.

This quarter's combined business-basis "profit" turned out to be more than 1.5 billion pounds before tax. Yet after various adjustments, such as the 375 million pound provision for compensation payments in respect to claims against mis-sold payment protection insurance policies, this falls to 2 million pounds of statutory profit after tax.

A business that can't be run by idiots
Peter Lynch says investors should look for a business that's so good it can be run by an idiot, because one day it will be. Banking is not an idiot-proof business, because a bank can easily be ruined if it makes too many bad loans relative to its capital base.

HBOS was a prime example of this, having encouraged reckless lending by basing the bonuses for some of its senior managers and directors upon the amount lent, rather than the quality of the loans. Any idiot can lend money; the important thing is to get it back.

However, despite the best efforts of its former directors, Lloyds is still a constituent of the FTSE 100 (INDEX: ^FTSE  ) index. That said, this is in large part because of a government bailout and a massive rights issue in 2009 that means the British state now owns 41% of the company.

There but for the grace of God
One British bank that has attracted a fair bit of praise because it didn't need a bailout is Barclays (NYSE: BCS  ) . But this had little to do with the skill of its managers; rather, Barclays was lucky enough to be outbid for ABN AMRO in 2007 by a consortium led by Royal Bank of Scotland (NYSE: RBS  ) .

ABN AMRO was an acquisition so bad that it made Lloyds' purchase of HBOS seem like a good piece of business. Had Barclays won the bidding war, then it, not RBS, would have needed the mother of all bailouts, and Fred Goodwin would probably still be a knight.

Bad incentives
The recent banking crisis was largely caused by faulty incentive schemes. Banks issued lots of share options to their senior directors, giving them all of the upside with none of the downside, thus encouraging them to make big bets with other people's money. They chose to make lots of risky loans and eventually ended up speculating in securitized mortgages, which had been taken out by people who couldn't repay them even in the good times.

Another thing that contributed to the banking crisis was the depositors' compensation scheme. This caused many people to chase the highest interest rates, instead of depositing their money with the more secure banks. This guarantee was the main reason why so many people piled into the Icelandic banks, and the British taxpayer ended up having to help bail them out in 2008.

How to fix the banks
Berkshire Hathaway
(NYSE: BRK-B  ) legend Warren Buffett has an excellent idea as to how to stop banks from getting into serious trouble. If any financial institution requires a bailout, then its chief executive officer and his or her spouse (or partner) should be bankrupted. That should concentrate the mind wonderfully!

The risk of personal bankruptcy is a powerful incentive, and it's no surprise that the investment banks and private banks that remained as partnerships, wherein the partners' own money was at stake, didn't get caught up in the practices that led to the recent banking crisis.

Another alternative is to do what America did during the middle of the 19th century when a bank went bust. Back then, every director was on the hook for several years' salary if his bank went under, while the shareholders had to pay the par value of their shares to the receiver.

One way to curb the banks' tendency toward reckless lending is to increase their capital requirements to prevent them from lending so much. A major cause of the credit crunch was that some banks were using leverage greater than 30-to-1, so 1 billion pounds of capital was used to back 30 billion pounds of loans, which is way above the ratios used by most banks throughout history.

The future for Lloyds
As the trading statement shows, while things are improving, Lloyds Banking Group still has major problems, particularly regarding the payment protection insurance scandal where it routinely sold policies to people who were not allowed to claim against them.

That said, the market was fairly pleased, marking up Lloyds Banking Group's shares in early trading by more than 2%.

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Further investment opportunities:

Tony owns shares in Lloyds Banking Group (it's a punt on the recovery!). The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.
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