Europe’s woes reveal the benefits of having profitable banks

NAB CEO Andrew Thorburn speaks during the House of Representatives Standing Committee on Economics annual public hearing at Parliament House in Canberra. (AAP Image/Lukas Coch)

There’s an interesting contrast between the International Monetary Fund’s latest global financial stability report and the questioning of bank chief executives about the profitability of their businesses occurring in Canberra this week.

While the focus of the committee’s questions so far has largely been on bank cultures and legacy issues, there’s also been a sub-current of questioning related to the banks’ profitability, returns on equity and the pricing of their loans.

The four major banks’ returns on equity have averaged around 15 per cent for the past decade, although they have tumbled from around the 20 per cent level ahead of the financial crisis to, in the first half of this financial year, just under 14 per cent. That still makes them, along with the major Canadian banks, among the most profitable banks in the world.

The committee appears to see that as evidence of gouging of customers and a lack of sufficient competition — its general perspective seems to be that the level of profitability of the banks isn’t a positive for the community or economy.

The IMF report referred to financial institutions in advanced economies facing a number of cyclical and structural challenges and the need for them to adapt to the new era of low growth and low interest rates as well as evolving market and regulatory environments.

“These are significant challenges that affect large parts of the financial system and, if unaddressed, could undermine financial soundness,’’ it said.

“Weak profitability could erode banks’ buffers over time and undermine their ability to support growth.”

Even with a cyclical economic recovery, the “problem” of low profitability would not be resolved and more than 25 per cent of banks in advanced economies — with about $US11.7 trillion in assets — would remain weak and face significant structural challenges.

The IMF referred specifically to European and Japanese banks, as well as to the threats to the solvency of life insurance companies and pension funds generated by the protracted period, post-crisis, of low interest rates.

Comparing the returns on equity of the major Australian banks with those in Europe, Britain or the US — where there were massive taxpayer-funded bailouts after the crisis and where, unlike the Australian economy with its quarter of a century of recession-free growth, they have struggled to generate growth since the crisis — is a meaningless and potentially dangerous exercise.

No-one in their right minds would want a banking system that looked like Europe’s.

Labor and the Green’s clamour for a Royal Commission into the banks intensified when the banks didn’t fully pass on the Reserve Bank’s last reduction in the cash rate, which led to Malcolm Turnbull’s instigation of at least annual CEO appearances before the House of Representatives’ economics committee.

Apart from the obsession among politicians with mortgage rates, and an apparent inability to make the connection between historically low rates and historically low housing affordability as a result of soaring house prices, the focus on the banks’ divergence from the cash rate betrays a lack of understanding of the banks and their funding that the CEOs have been trying to remedy.

As National Australia Bank’s Andrew Thorburn said today, there have been significant changes to the banks’ funding mix since the crisis, when the freezing of offshore wholesale debt markets created a threat to a system that has always had to borrow offshore to fund the gap between Australian savings and investment.

The proportion of customer deposits has gone up significantly, as has the amount of equity in the banks. Most of the majors have deposits that represent something approaching 60 per cent of their funding requirements.

That reflects both their own experience during the crisis and post-crisis regulatory requirements for more capital — NAB has added $20 billion of capital since the crisis — and more stable funding.

The proportion of short-term wholesale funding has gone down significantly and the levels of longer term funding have gone up.

The competition to attract the extra deposits, the shift towards borrowings with longer maturities and the big increases in their equity bases add to the banks’ cost of funds — and mean that a very significant portion of their funding base isn’t directly or, in the case of term deposits, immediately impacted by movements in the cash rate.

Since the mid-1990s (when Aussie Home Loans gained traction) the banks’ net interest margins have halved, although they have been relatively stable at around the two percentage points level in recent years. Their return on assets is around, or slightly less, than the long-term level of one per cent.

The growth in their profitability, once the system stabilised after the crisis, has been driven by volume growth, particularly in housing, cost reductions and a historically low level of bad debts. This year the rate of growth in lending has shrivelled, there isn’t seen to be the capacity for further major cost reductions and the bad debt cycle appears to have turned up.

Given the increased scale of their capital base — the majors raised more than $20bn last year in response to the introduction, by the Australian Prudential Regulation Authority, of a floor under their mortgage risk-weights — unless there are unexpectedly strong surges in economic activity and in demand for credit their returns on equity will continue to edge down.

They will, provided there is no explosion of bad debts, still look to be in a different league to most of their overseas counterparts. That’s a good thing, not something to ask a Royal Commission to inquire into.

As the IMF noted, financial institutions that struggle to sustain healthy balance sheets (and profitability is the key to maintaining a strong balance sheet) weaken economic growth and financial stability.