Four fragile A-pluses

So, the big four Australian banks have again been ranked the most profitable among their international big bank peers by the Bank of International Settlements. It would be a concern if they weren't.

Given that about half of the 55 major banks included in the BIS survey, published in its annual report, were European, you'd expect the Australian banks to do well in any comparison. With another six from the UK and nine from the US, about 80 per cent of the banks BIS looked at are from jurisdictions that have had banking system issues and economies that are struggling.

The more interesting insight provided by the analysis is to look at the big four's performance in 2011 relative to their own recent performances, which tends to reinforce the conclusion of recent bank results that, with net interest margins being squeezed by funding pressures and only modest volume growth, it is only the improvement in asset quality in the past couple of years and their own cost-cutting that has enabled them. In the latest half-year their combined cash earnings were up less than 2.5 per cent.

The BIS numbers do show that pre-tax earnings as a percentage of total assets have improved from 93 basis points in 2009 to 119 basis points in 2011, despite losing 5 basis points of net interest margin (as a percentage of total assets) from 1.88 per cent to 1.83 per cent.

The drivers of their improved profitability were a 35 basis point reduction in loan loss provisions, from 54 basis points to 19 basis points, and a 3 basis point fall in operating costs, from 1.2 per cent to 1.17 per cent (and 7 basis points from 1.24 per cent in 2010).

Somewhere in the mix there is a missing 7 basis points – the banks improved their impairments and costs by 38 basis points, lost 5 basis points due to net interest margin shrinkage but ended up with only a 26 basis point improvement in pre-tax profits as a percentage of total assets.

Those 7 basis points probably relates to fees and other charges – a Reserve Bank study last week showed bank fees had fallen for two years in a row. Lower margins and fees aren't consistent with the common accusation that the major banks are gouging their customers.

The best comparison with an international peer is with Canada, which has similarly conservative banking regulation and a resources-oriented economy.

Its banks' pre-tax profit margin was 1.08 per cent (a bigger lift on the 0.73 per cent they were generating in 2009 than experienced by the Australians) but they suffered a 12 basis point reduction in net interest margin, from 1.72 per cent to 1.6 per cent. Loan losses improved from 44 basis points to 18 basis points and operating costs from 2.04 per cent to 1.87 per cent. It would appear the Canadians got a benefit of about 4 basis points from other areas, presumably increases in fees and other income.

The Australian Bankers' Association was quick to point out that the BIS data was presented on a pre-tax basis and that Canada's corporate tax rate was 26 per cent against Australia's 30 per cent. On an after-tax basis it would have been a close-run contest to claim the mantle of the world's most profitable system.

The Australians were, however, markedly more efficient than their Canadian counterparts and had better asset quality and compared favourably with almost all the other systems on those criteria.

(The least profitable system in the BIS analysis, incidentally, was Italy's, with a negative pre-tax profit margin of 1.22 per cent, although Spain might challenge for that title this year).

Given the continuing instability and stress within the European banking system, and in the wake of last week's downgrading of 15 of the world's largest banks by Moody's last week, being effectively labelled the world's most profitable system and one of its soundest in terms of loan loss provisioning by the BIS is a significant positive for the Australian banks. While they've reduced the extent of their reliance on wholesale funding markets they still need access to them.

The other aspect of the BIS analysis is that it is a reminder of how skinny are the margins – and the margins for error – banks operate on. A movement of just over one percentage point in the value of their assets – their loan portfolios – and they would be unprofitable. With about $2.7 trillion of assets between them, minor movements in impairment experiences can have very large impacts on their bottom lines.