Bank-bashing is bipartisan policy, but this time it looks like the pollies will go beyond jumping up and down and might actually do something. Here is Joe Hockey
Opposition treasury spokesman Joe Hockey says it shows the Government is powerless to act.
“This is further evidence that the Gillard government just has lost control of the banking system, and quite obviously they’re being treated as a laughing-stock by the banks,” he said.
“Even after all the outrage about the Commonwealth Bank’s increase the ANZ decided to go [to] nearly the same level.”
…
“For the 34 warnings Wayne Swan has issued to the banks not to go beyond the Reserve Bank, today the ANZ kicked sand in his eyes and in the eyes of the Gillard Government,” he said.
Fancy that – a private organisation changing its prices without first getting government permission. Those silly banks obviously think they’re trading in a liberal democracy with a capitalist economy.
Increasing prices isn’t evidence of monopoly power nor is charging a high price evidence of monopoly power either. People look at bank profits and suggest that high profit levels are evidence of monopoly – the argument being that banks are really utilities and should be regulated as such and earn contrained profits. Tony Harris makes that argument in the AFR this morning (subscription required).
The business of banking revolves around maturity intermediation. Banks borrow short and lend long. Their short-term borrowing tends to be more liquid than their long-term lending so there is substantial risk in this activity. But banks are also conglomerates – they provide a whole bunch of other services to their customers that involve wealth and property management. These services are not banking services per se and can be, and often are, provided by non-banking competitors. But when people propose that banks be considered as utilities I suspect they are referring to the maturity intermediation aspects of the business.
Looking at APRA data for the major banks (pg. 14), it isn’t clear to me that they are earning high profits on the banking business. Net Interest Income to Assets is 1.9 percent, while Operating Income to Assets is 2.7 percent. The Return on Equity at 10.6 percent after tax looks to be high, but remember that banks are highly leveraged (the equity to deposits ratio is 10 percent) so that number is upwardly biased.
Over at Club Troppo Ken Parish raises two issues about banks. First that the majors are all raised their interest rates by a similar amount in excess of the RBA rise. To my mind that doesn’t suggest monopoly power. The majors all have more or less the same business model, face more or less the same market for customers and raise finance in more or less the same financial markets. On that basis I expect them to behave more or less in the same way. That behaviour is due to them facing more or less the same competitive pressures. Why do they raise their rates at more or less the same time? Because they get their cue from the RBA. So what looks like coordinated behaviour is, to my mind, competitive behaviour. (Think of the Hotelling theorem – two icecream sellers on a beach will locate at the centre standing back-to-back rather than locate at the quarter and three-quarter mark).
The other point Ken raises is the profitability of banks at this stage of the business cycle. That is due to the nature of the GFC and how it impacted Australia. Right now deposit taking institutions (banks) have a cost of capital advantage over non-deposit taking institutions and have grown their market share due, in part, to the small impact the GFC had on the local economy. Of course, the question is whether the cost of capital advantage is due to the guarantee. Perhaps some of the advantage is due to the guarantee but I’m not convinced on this score and this is an empirical question. (Part of the problem is that loan originators had the pools of liquidity that they access dry up – so their cost of capital rose and would have risen irrespective of the guarantee).
Tony Harris raises a related issue in his AFR piece – the fact that banks can raise their rates to cover costs indicates some market power that other firms do not have (at least at present). Bear in mind that a firm that cannot cover costs in the long run must exit the industry. The ability to pass on costs is a function of market conditions – the fact that the banks can but steel makers can’t currently pass on costs tells us about those industries and relative competition between markets not within markets. Nobody is suggesting that steel makers start banking in order to raise their prices.
So how should we think about competition? Rather than second-guessing entrepreneurs and consumer choices I prefer to think about barriers to entry (subscription required) and exit. There are regulatory barriers to entry into banking and the four-pillars policy is a barrier to exit. Banks maximise their profits within those constraints. The net impact regulation has on banking industry profits is an empirical question. I don’t know the answer to that question. The question that policy makers should asking themselves is whether they want to change any of the current barriers to entry or exit? There may well be good arguments for doing so, but then let’s hear them and evaluate those argument very carefully. We know what a poorly regulated banking system looks like – the current US system – and we know what we’ve already got.
My first point was not just that the banks raised their rates by roughly the same amount (as they generally do). That is certainly explained as Sinclair does (similar cost pressures and similar business models), and so would not without more provide evidence for lack of competition.
However, as you know, Treasury has calculated that the banks’ cost of funds does not currently justify or explain raising mortgage rates by more than the cash rate increase. Now, unless one simply dismisses Treasury as a captive of the government of the day willing to prostitute its analyses (and that manifestly isn’t true – e.g. where do you think the just-released OECD critique of aspects of ALP policy originated), this additional factor means that we most find some other explanation than cost pressures for the Big 4 rate rise decision/s. I can’t instantly think of one other than what I posited at Troppo:
Is there another plausible explanation other than lack of competitive pressure?
Ken Parish
16 Nov 10 at 9:53 am
We also need to think about the maturity structure of the banks’ balance sheets. They are rolling over a whole bunch of bonds of various maturities. Now the RBA came out recently and said that financing costs have been stable over the past few months and that’s fine, but the debt being rolled over is at pre-GFC rates and is being rolled over the post-GFC rates. That increase in the cost of medium term debt is now being passed onto customers. So the past few months isn’t enough to make that determination. Now I think the Treasury argument is very similar to the RBA argument.
On the trade-off between stealing market share and increasing prices – this is harder than it looks. How much market share do individual banks want? They have a portfolio of loans and does any one individual bank want to be very exposed to residential property? So they have to manage the temptations to discount themselves into financial distress, gaining business at the expense of their competitors, earning a profit and so on. As Nick suggested on Insider Business – these are complex and difficult issues and a whole range of trade-offs exist. Including regulatory trade-offs – some prudential regulations may conflict with consumer protection regulations.
Sinclair Davidson
16 Nov 10 at 10:34 am
Just to add – the majors are facing less competition in the consumer market at the moment due in part to the financing difficulties faced by their smaller competitors. That is true. I’m not convinced there is much that government can actually do about that. They can look at barriers to entry but trying to lower or subsidise the cost of capital to bank competitors isn’t likely to be good policy.
Sinclair Davidson
16 Nov 10 at 10:44 am
It’s lamentable the man on the street doesn’t know about maturity, duration and rolling over of short dated financing.
We do have competition. I bank with a large bank and a credit union and I pay bugger all fees. If I went with the large one alone, I’d pay none.
You can get mortgages for about 1.88% above the OCR.
.
16 Nov 10 at 10:44 am
Currently, interest rates on deposits are considerably higher than the RBA cash rate, normally they are less than the cash rate. So it appears the banks are charging higher mortgage rates to pay for their term-deposits. If so, why?
Is it because (as implied above) they are concerned about over-exposure in the residential sector?
Capitalist Piggy
16 Nov 10 at 11:52 am
The banks may be making monopoly profits, but the real question in many ways is, are they making excessive monopoly profits? Sinclair’s quick look at the APRA data suggests not.
Mother Hubbard's Dog
16 Nov 10 at 11:59 am
The Return on Equity at 10.6 percent after tax looks to be high,
Why do you think that, Sinc? BHP’s return on equity is 28.5%. To be perfectly honest a return on equity of 10% seems to be just adequate based on assessing duration and credit risk these balance sheets take..
The best bank in the US that sorta resembles ours would be JPMorgan and their latest return on equity is 9.41. They were still provisioning, writing off GFC losses and top line revenue line was flat, so that return on equity is likely to normalize higher. Higher than the Australian banks that are taking as big a hit as their American cousins.
Another Bank which is also still provisioning and looks more like our banks in terms of range of services and little capital markets activity to speak of is Wells Fargo. Their return on equity is 9.59%. Their normalized earnings would be higher too once the stop elevated provisioning.
Anecdotally I continue to hear banks are reaching to the top end of their sector limits in certain areas of their lending books and higher prices may be indicative of this, which also stands to reason seeing the shadow banking system was wiped out in the GFC.
JC
16 Nov 10 at 1:07 pm
That wasn’t meant to sound snarky or anything like that as I’m genuinely interested.
JC
16 Nov 10 at 1:08 pm
oops Higher than the Australian banks that aren’t
JC
16 Nov 10 at 1:09 pm
JC – right now people would imagine that banks should be making losses, so a double digit after tax profit looks high.
Sinclair Davidson
16 Nov 10 at 1:47 pm
Yea, I take your point.
I hadn’t thought of a comparison by return on equity between the Aussie and the US banks. Our banks aren’t hobbled with continual elevated provisioning like the US banks and their two best (even with provisioning) have a return on equity at about the same rate as ours. In terms of normalized return on equity US banks are aiming for 15%. So given the state of both banking system it’s startling just how mediocre our banks are in terms of profitability potential (earning power)
And there is another argument too, why compare with US banks why not compare with the best in the Asian region which is closer to our economic cycle. Singaporean banks seem to trade on a lower multiple than ours.
JC
16 Nov 10 at 2:02 pm
The market return over the past 30 years was 13.8%.It appears that banks have not exceeded that.There is no evidence that the banking industry is uncompetitive.
Given the RBA’s announcement today,can we expect Hockey’s resignation and grovelling apologies from the media?Probably not.
Tom Valentine
16 Nov 10 at 6:35 pm
What am I missing here?
If a bank suddenly has to pay an extra one percent to borrow from the RBA, isn’t that an increase of 1/x – say, the 5 (%) it was borrowing at the day before – meaning it’s costs just jumped 1/5 = 20%? And if so – ceteris paribus the charge to the retail mortgage holder should increase by 20%. So, if they were borrowing at 10%, an increase to 12%, would be required for the bank to come out profit/return neutral.
Now, of course as folks have discussed above, in reality, the impact on profitability of retail mortgages is nowhere near that simple, but surely it is a reasonable place to start the discussion?
Peter Patton
16 Nov 10 at 7:08 pm
YOu are exactly correct Sinclair, if it appears that there might be monopoly or cartel like profits, first ask what might be limiting an increase in competition.
Also, I should have thought that sustained highish profits are the first sign of likely increases in competition where barriers to entry are not a relevant factor. If you were a foreign bank looking at 4 pillar profits you might think this a good place to expand.
pedro
16 Nov 10 at 9:29 pm
10.6% is actually a bit low, the APRA umbers are out of date, it’s been rising nicely in the last year as impairments come off. The lowest ROE is NAB a bit under 12% the rest are up around and over 15%.
But it compares very nicely to the overseas banks, often less than 10%.
Mostly reflects impairment charges. And it’s not coming through the AU banks lowballing on core equity and bulking up on hybrids and sub-debt like in Europe. There are solid-earning, well capitalized banks.
But all this is missing some important points.
1) Banks with crappy earnings cannot sustain massive impairments. You want a structurally sound finance system? You want AA credit ratings without relying on government support? You’ve got to let banks earn.
2) The Australian majors debt fund a lot of the economy with reasonable-to-good capitalization, and spit it back out to investors in 70%+ payout ratios while keeping cost/income ratios in the 40-50% range. A big portion goes into superannuation.
PSC
16 Nov 10 at 9:38 pm
10.6% is actually a bit low, the APRA umbers are out of date,
Like June 30 2010 year ending.
JC
16 Nov 10 at 9:42 pm
Peter,banks do not brrow from the RBA.The cash rate is the interbank rate.It is the margin between bank lending rates and their cost of funds which affects their profits.The statement by the RBA today indicates that this margin has not increased. Pedro,the CAPM suggests that banks are not making above normal profits.Nevertheless,they are sounder than most banks around the world and this would create international interest-but would the government allow a takeover?
Tom Valentine
16 Nov 10 at 9:47 pm
The aussie banks use a sept-sept financial year JC. Except CBA (June-june).
PSC
16 Nov 10 at 9:57 pm
So APRA’s June 30th year end was notional then? huh.
15% return is the expected return by most major banks in the world in terms of normalized earnings SDFC. it doesn’t suggest that are earning ‘super profits”- to use a well known leftist term.
JC
16 Nov 10 at 10:15 pm
Actually just looked at the APRA numbers – they’re March 2009 -> March 2010 so definitely out-of-date. This was the banks under stress sustaining largish impairment charges.
PSC
16 Nov 10 at 10:29 pm
Here: page 11. It’s not 2009. You’re looking at an out of date report.
JC
16 Nov 10 at 10:32 pm
Damn straight. And one of the tricks HBoS/BankWest learned the hard way is that there are a few tricks to running a bank.
One of those tricks is only lending money to people who are likely to pay you back.
It might just be that our banks charge reasonable rates which compensate them and shareholders for bearing the costs of working out who will pay you back and the risks of getting it wrong.
PSC
16 Nov 10 at 10:37 pm
JC – The APRA numbers in your link are year end March 2010. Here’s Westpac’s annual report:
http://www.westpac.com.au/docs/pdf/aw/ic/WBC2010_Annual_Report_ASX.pdf
ROE = 6124 Income /38189 Equity ex. non-controlling interest = 16.0%
The other majors are similar.
PSC
16 Nov 10 at 10:42 pm
yea , you’re right. I think i was looking at another column of numbers on another site the time.
So they take in the GFC writedowns.
That sort of return is not hugely out of line and is basically what you would expect from a well run bank with normalized earnings.
JC
16 Nov 10 at 10:47 pm