Hockey's flawed rates reasoning

Joe Hockey is taking a risk blundering into the debate about bank margins and profits and raising the prospect of using the threat of regulatory interventions to prevent banks raising mortgage rates out of synch with the Reserve Bank.

The problem with analysis of bank profitability is that it is never as straightforward nor as static as it might appear, or be presented.

With combined market capitalisations of almost $260 billion, the aggregate profits of the four majors will inevitably appear massive but, according to the Reserve Bank, the major banks' return of equity was 14 per cent in the 2010 financial year – which for institutions as leveraged as banks is quite modest. As bad and doubtful debt charges continue to run down, of course, returns should continue to recover, albeit probably not to the 20 per cent-plus levels the banks once enjoyed.

Hockey wasn't, however, as unsophisticated as to focus on simple size. Instead he cited comments in the recent RBA board minutes that the bank's staff estimated bank funding costs had been "relatively flat" over recent months and that while the spread between lending rates and funding costs was below its 2009 peak it remained well above pre-crisis levels.

Those comments were, as discussed previously (Is the RBA losing control, 19 October), quite pointed and have been interpreted as an attempt to undermine any justification for an out-of-cycle rate hike by the banks.

There is no doubt that the majors want to lift their mortgage rates and, had the RBA increased official rates this month, would have added 15 or 20 basis points to whatever the RBA did. Both the RBA and Treasury don't appear to believe there is justification for any rise beyond official rate increases.

The RBA is broadly correct. In 2007 the biggest of the local majors, Commonwealth, reported a spread (the difference between the average rate earned on its lending assets and the average rate paid on the liabilities supporting them) of 1.83 per cent. At the end of June this year it was 1.91 per cent. The spread for CBA's Australian operations was unchanged, relative to pre-crisis levels, at 2.04 per cent.

That is, however, a static picture. In fact the banks are still rolling over wholesale debt (about a third of their funding is wholesale money raised offshore) that was raised in the pre-crisis environment, when debt was a lot cheaper. Not only are they replacing the maturing borrowings with more expensive funds but they are also borrowing longer term – mostly five-year money – which is more expensive again.

The average maturity of the pre-crisis debt would have been around 3.5 years, which would suggests the process of replacing cheap money with expensive money will end later this financial year. In the meantime CBA has said its average funding cost has been rising by 2 basis points a month and it has been noticeable that as this financial year has progressed there has been a significant and continuing compression in spreads.

Frankly, it is logical – even though it doesn't appear that the RBA or Treasury accept it – that if the banks don't pass on the steadily rising average cost of their wholesale borrowings as their cheapest wholesale funding matures their spreads have to be under pressure.

Some of that pressure was alleviated by the repricing of their business lending, which has now stopped, but their ability to fully recover the cost of funding their mortgage books – up to half their balance sheets – has been constrained by the politics.

Spreads are a relatively crude measure. Of more concern to the banks are their net interest margins – the spreads after including the impact of their free deposits, provisions and shareholder equity.

In its most recent financial stability report the RBA said net interest margins for the banks had increased by about 20 basis points since their trough in 2008 but levelled off "a little" recently. That's for the bank's entire operations. In their Australian operations, over the same period, margins were around 35 basis points higher.

In June 2007 CBA's overall net interest margin was 2.19 per cent. In June this year it was 2.13 per cent. That can be explained by its inability to recover as much of the increase in the funding costs offshore as it has been able to in its domestic businesses.

The net interest margin in CBA's Australian operations in 2007, however, was 2.30 per cent. In June it was 2.23 per cent – there has been some loss of margin compared with the pre-crisis level.

So, the spread for the Australian operations was the same as pre-crisis – when there was plenty of competition for the majors – but there was some loss of margin.

That is a function of the lower yields available on free deposits, bigger holdings of lower-yielding government rather than bank securities as the bank improved the quality of its liquidity, and the reality that the banks are holding a lot more capital that would have been lent rather than retained pre-crisis and which would have generated far higher returns.

In the context of the debate about bank profitability the most politically sensitive issue is the profitability of their mortgage lending. The closest guide available at this point is the net interest margin of CBA's retail banking business, which would be predominantly driven by mortgage lending.

In June 2007 the retail bank had a net interest margin of 2.5 per cent. In June this year it was 219 basis points, with 14 basis points of margin disappearing in the second half. That doesn't suggest profiteering.

It is also instructive to note that the two dominant mortgage lenders – CBA and Westpac – having dominated mortgage lending during the crisis, severely curtailed home lending this year to levels well below system growth. If home lending was excessively profitable one would expect them to be still gorging on it rather than effectively rationing credit.

The silliness of effectively calling for regulation of bank profitability is that to some extent the banks are already experiencing it and they know a tide of further regulation is heading towards them.

They are holding a lot more capital and liquidity – and higher quality capital and liquidity – than they were pre-crisis. As the Basel III reforms are implemented, they will be required to do so permanently and, to retain their rating as among the world's safest banks and secure their access to wholesale debt markets, they will inevitably have to be more conservative than their international peers.

Hockey did make one pertinent point. If the market is going to be left to determine the absolute profitability of the banks, it would be preferable if there were greater depth of competition and differentiated competitors.

Finding ways to make it easier for non-banks and the remaining regional banks to fund themselves and compete would be a constructive approach to creating external disciplines on the majors.

The other problem with Hockey's approach to a problem that doesn't appear to exist at this point is that using a government's "range of levers" to try to control bank profitability would, if it were effective, distort bank decision-making.

If their ability to generate sufficient returns to satisfy their shareholders in this market were constrained, the natural response would be to redirect their balance sheets either into higher-risk and less politically-sensitive activities or simply devote a lot more of their balance sheets to lending offshore.

The politics of denying home buyers loans as a consequence of government intervention would be interesting, as anyone who tried to get a home loan in the days when mortgages rates were regulated could testify.