Balancing the banks

One of the more significant and complex tussles in 2010 will be the tension between the shareholders and customers of the major banks over the excess returns the banks could generate as their bad debts plateau and start to drift back to more normal levels.

Over the two financial crisis-affected years, the big banks have racked up impairment charges of about $20 billion – $12.8 billion of them in their last financial year. That compares with the $16 billion of charges they made against profits for the preceding eight years.

Those loan losses and the $20 billion of new capital raised last year, led to modest declines in reported earnings and a steep decline in returns on equity. Two years ago the majors had returns on equity above 20 per cent. That slid to just below 18 per cent in 2008 and then tumbled to about 13.5 per cent in their last financial year.

The losses also disguised a significant increase in their underlying profitability. Their aggregate profits before tax and provisions increased by more than 20 per cent last year, with increased volumes and the re-pricing of their business loan books in particular (along with the controversial claw-backs of most of the interest margin foregone on their home loans) enabling them to grow their net interest margins and net interest income solidly.

With reduced competition/increased dominance, if there is no further deterioration in their loans books the underlying strength in their profitability ought to show through this year and their returns, despite the expanded capital bases, ought to bounce back to the high teens or even early 20 per cent range.

A sharp rebound in profitability would be contentious and politically sensitive.  There are already calls for federal government intervention to create more competition for the majors. The appointment of former senior National Australia Bank executive Ahmed Fahour to head up Australia Post has sparked urgings for the creation of a post office bank.

While it is vital that the majors remain solidly profitable – the wreckage in financial sectors and fiscal settings elsewhere illustrates how destabilising and destructive an unprofitable system can be – it would be a sign of an unhealthily concentrated and uncompetitive system if the majors were too profitable. It would also almost inevitably lead to government intervention.

There are some complex overlays.  The average cost of funding for the banks will continue to rise over the next three years as longer-term wholesale funding arranged pre-crisis continues to mature and the banks continue to wage a price war for retail deposits.

Also, while the Australian Prudential Regulation Authority has now pushed back the start date for its proposed new liquidity requirements into 2011 to bring them more closely into line with the international regulators' timelines, the banks know that new liquidity and capital requirements are in the pipeline.

There will be a cost for more and higher quality liquidity – somewhere between about five and eight basis points is the estimated cost – and capital has to be serviced.

The majors are already holding about 200 basis points more Tier 1 capital than they were a year ago and know that the minimum levels and quality of their core capital will be permanently higher in future than it was pre-crisis.

There have already been public indications that the majors envisage simply passing on the cost of the proposed new liquidity regime onto customers. They would no doubt regard the cost of holding significantly more capital as just another cost of doing business that customers should fund and they have the market power to recover it.

One would expect the banks to transition towards the new liquidity and capital adequacy regimes gradually and pre-emptively to avoid a deadline-inspired global scramble to conform when those changes are imminent. If the economy and financial system remain relatively stable in 2010, it would be sensible to start making that shift next year.

There is an argument against the majors simply passing on the costs associated with the more conservative prudential regime.

The majors, with their higher quality capital and liquidity and lowered leverage, their focus on mortgage lending, their crisis-enhanced aversion to riskier business lending and their re-pricing of their existing business loans to properly reflect the increased risk, are themselves fundamentally less risky than they were and will be even less risky in future.

New accounting rules that will enable them to provide for future loan losses counter-cyclically will also provide an extra layer of protection against future shocks.

Logically, if the majors are less risky, the returns demanded by investors ought to be lower in future than they were in the past. Markets ought to be able to risk-adjust those returns.

That suggests the banks should be able to share the increased costs of the tougher prudential regime between customers and shareholders rather than simply passing them through to customers alone.

If they don't – if they are seen to be generating excessive returns as the strength of their underlying profitability starts to show up as impairment charges begin declining – the already loud calls for government intervention in the sector will become deafening.

The majors may have taken advantage of the crisis to strengthen their dominance, but they'd be foolish to exploit it too carelessly or obviously.