Australia’s true competitive advantage: banking

Banking, not mining, is where the future of Australia's economy really rests. And questions about sustainability of the banks' globally aberrant return on equity are more important than ever.

The banks will be big winners from the Reserve Bank’s decision to buffer the Australian economy from the end of the mining boom and to try to bring down the dollar, by bringing interest rates down to GFC lows, and probably lower – because for that plan to work, credit growth needs to resume.

And if Governor Glenn Stevens, like Mario Draghi in Europe and Ben Bernanke in the US, is in a "whatever it takes” frame of mind, he will presumably keep cutting rates until the banks lead the economy out of trouble.

Already in the past week bank share prices have gone up 3 per cent while global stocks have been flat – it’s as if they operate in a parallel universe to the one inhabited by their counterparts in Europe and America.

In fact it’s probably not going too far to say that the industry in which Australia is truly the world leader is not resources, it’s banking – not the sort that caused the GFC, but old-fashioned deposit-taking and lending, the business that Wall Street banks are trying to get back to.

What’s more, it’s this business on which the future of our economy really rests, not on mining and energy, where our only competitive advantage lies in the providence of having the stuff

But yesterday the chief executive of Morgan Stanley, Australian James Gorman, made a statement in an interview with the Financial Times that should ring some alarm bells. He said: "We’re generating 5 per cent, can we get back to 10 per cent? That’s much more interesting to me than can we get back to 15 per cent or will we ever get back to the glory days – those are completely flawed anyway.”

Australia’s banks are averaging 16 per cent return on equity; for them the glory days are still here, at least by comparison with banks in the US and Europe, if not compared with the 20 per cent they used to make. In any case, the market capitalisation of the big four Australia banks is now greater than the total of all European banks.

In a way Australian banking does operate in a parallel universe: there’s just enough competition to keep the regulators off their backs, but not too much that margins can’t be expanded, as they are now. Tight regulation and a better culture kept them out of derivatives and the excessive leverage that goes with them, so their books are clean.

Unemployment is near 5 per cent and the housing market has only fallen about 6 per cent and appears to have bottomed, which means impaired loans are negligible – 1 per cent of all advances.

In fact borrowers are using the rate cuts to pay off loans faster rather than reduce repayments; 40 per cent of borrowers who are ahead on their repayments have a buffer of more than a year.

Bottom line: in the year just finished, the big four made $25 billion in cash profits, or 16 per cent return on equity.

So is James Gorman right that 15 per cent ROE for banks is "completely flawed”?

It’s a crucial question for Australia because as the mining boom deflates the banks need to step up and fund domestic investment and growth by recycling domestic deposits, and not relying on foreign debt.

So far so good. In the 12 months to August, deposits rose 12 per cent and thanks to the demand for term deposits among self managed super funds, the banks are rapidly reducing their reliance on wholesale funding.

At the same time the banks are now investing billions updating their 30-year technologies and, more importantly, preparing for a cashless world in which we all use mobile phones as credit and debit cards.

This week ANZ Bank launched its plan, which seems more focused on the front end than CBA’s renovation of its core banking systems. But broadly, it’s fair to say that Australia’s banks are in a much better position to respond to the challenges of digital banking than their beleaguered counterparts in Europe and the US.

For investors, Australian bank yields are compelling: 6-6.5 per cent, fully franked. As a result their shares are selling at price to book ratios of close to 2 times – double the price to book ratios of European and US banks – and commanding PE ratios of 12-13 times.

And right now it is hard to see what is going to bring these glory days to an end, short of a property collapse or recession, or both.

Follow @AlanKohler on Twitter

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