Australia's big four banks aren't as profitable as we think they are

You’ve read the headline, and you’re confused. How can our banks not be the most profitable companies in Australia?

The facts appear to line up: our big four were recently named as some of the most profitable in the developed world. And it’s not like they are poor: the biggest of the big four, Commonwealth Bank, turned over a cool net profit after tax of $4.2 billion (close to the total GDP of Montenegro) in the six months to December 31 2013. With figures like this, how can they not be literally rolling in money?

It’s easy to get jaded by big numbers and bold claims. As always, the reality is more complex.

To explain, let’s first go back to the Bank for International Settlements (BIS) report -- the document that named Australia’s banks as the 'most profitable in the developed world'.

Every year, the central bank of banks, the BIS, ranks around ten of the world’s top banking nations on their pre-tax profits. It expresses this ranking as a percentage of their total asset pool, also known as return on assets. Australia ranks quite favourably in the figures. This is the fourth consecutive year that we have led the ranking among developed nations. 

But this might not be the best measure of their profitability. According to former CBA executive and Monash University adjunct professor of economics Rodney Maddock, the structure of Australia’s banking system means that it will always rate well in the BIS’ rankings. This is because the asset pool of our major banks consists of high-return and low-risk residential property mortgages, according to the BIS. Australia’s disposition towards property and home-ownership has allowed them to tailor their portfolio in this manner.

Overseas banks are structured differently. While they still hold property mortgages, their investment portfolio is weighted more towards the securities market. This strategy delivers lower, riskier returns than our banks’ mortgages set-up.  

“When you do what the BIS did, and divide their profit by their assets, I’m not sure it’s a clear way to measure or compare profitability, because their asset composition differs,” Maddock says.

"Whether they [Australia’s banks] are too profitable or not profitable enough is hard to say."

There is another way of measuring profit -- through a metric called return on equity. This figure indicates the rate of return on shareholders' investment in the company 

The bank’s peak body, the Australian Bankers' Association, has already argued how Australia stacks up compared to the rest of the world’s banks in ROE in the past. To put it to a new test, we looked at how our banks' ROE compares as part of the ASX 200.

Bloomberg reports ROE twice a year, tying it to each company's half-year and annual reports. To get a fairer comparison, we looked at average ROE for Australia’s major companies over the past five years. 

Here’s how Australia’s top ten listed companies (in terms of market cap) ranked with ROE. As you can see, all of the big four banks are included in Australia’s top ten companies.

So, Australia’s banks hold their own in competing with Australia’s top companies. But look what happens when we rank the ASX 200 by ROE: Australia’s banks don’t even come close to the top ten.

So what about those big profit numbers? Surely earning as much as the total GDP of Montenegro in six months means something?

ABA’s chief executive Steven Münchenberg argues that big numbers are indicative of the fact that our major banks are big, multinational companies. The rest of Australia’s largest companies produce similar figures. BHP Billiton for example, reported a net profit after tax of nearly $US9 billion earlier this year. Considering that according to the latest KPMG banking survey, our big four banks have a combined asset pool of $3.1 trillion, reported profits in the billions don’t seem as extravagant. ROE takes company size out of the equation and as a result is a better measure of true profitability.

The reason why we all care about the profits of the banking sector (as opposed to other industries) is that we assume that if the banks are making a killing, it’s at our expense. After all, no other industry charges consumers for accessing their own money. And as Stephen Bartholomeusz pointed out earlier this week, there’s also the risk the high profits are indicative of a lack of competition in the sector.

Read more: The delicate balancing act of Australia's big four banks

Münchenberg admits the banking sector still has a way to go in winning the affection of everyday Australians. He argues that they are reducing fees and providing more education to consumers to ensure they choose the right financial product. The recent revelations from the ongoing CBA financial planning debacle doesn’t bode well for this cause.

But this story isn’t about the behaviour of the banks; it’s about the interpretation of their data. Australia’s banks are making money, just not as much as we think they are. 

Got a question? Let us know in the comments below or contact the reporter @HarrisonPolites on Twitter.