ANZ chief executive Mike Smith talks to Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz about how the sub-prime crisis will lead to credit rationing in Australia.

Alan Kohler: Mike Smith, thanks for joining us.

Mike Smith: I grew up with James Bond films and look forward a Friday afternoon KGB interrogation.

AK: Well we’ve all got our sunglasses on. It’s a bit more like Get Smart actually.

Stephen Bartholomeusz: Hi Mike, let’s start with a somewhat open ended question. You’re a veteran banker. Can you put the sub-prime crisis into perspective? How serious a threat is it to the global financial system and what do you think it means for our banks, our financial system and our economy?

MS: The sub-prime crisis is basically the catalyst which has created a somewhat bigger crisis in the financial markets. In terms of its magnitude, I would think it will probably finish up at around the $1 trillion mark. Is that a significant amount of money in terms of the global economy? Well, no it isn’t. But it is a very significant impact on the financial services industry.

To put it into perspective, if you think of how housing prices have reduced in value in the United States in the last year or 18 months, almost $4 trillion of value has been eroded. So whilst it’s significant, of course it’s not fatal.

As I said earlier, the sub-prime crisis has been a catalyst which has then created a huge amount of investor unease in related instruments and has created a lack of confidence, not only in the debt markets, which is where this all started, but that has knocked on to equity markets and various other secondary markets.

Have we seen the end of it? No, I don’t think we have. I think that the surprises that continue to come out of the US and Europe every night are likely to continue for a bit and frankly I suspect until we get two clear quarters without no surprises people are not going to believe that this is finished. I would say realistically this is going to run until about June next year.

SB: And the impact on our banks and our economy, Mike?

MS: Frankly, the Australian banking system has been able to handle this remarkably well, in that its direct exposure to these markets and into these products has been virtually nil.

Of course, the effects we have seen have been on the structures that have been in place with a number of corporates in particular, and they’re all sort of high profile names that we all know and love. They have basically been affected in terms of their refinancing by a lack of appetite, which is a contagion which has emanated from sub-prime.

In terms of the Aussie banks, they’re in pretty good shape. The issue with the Australian banks, like in most other OECD countries, is that their asset-to-deposit ratios are high and therefore there is a need to rely on wholesale funding for a proportion of their balance sheets. That’s the part that has hurt them. Not that there isn’t liquidity, it’s just that the cost of raising that money has significantly increased.

Robert Gottliebsen: Mike, do you think we’re going to see some US banking failures? And are we likely to see Middle East and Chinese funds taking control of some US banks?

MS: I think we are likely to see consolidation in the US. I suspect a number of smaller banks will fail. I don’t think you will see any of the big names fail.

You have seen sovereign funds move into the US banks and into the European banks. The fact that the sovereign funds are available to put this sort of money in is actually fortuitous and indeed had it happened a few years ago then maybe things would be looking very different. It is absolutely vital that these banks have had access to primary capital and of course that’s going to be in the guise of the sovereign funds.

RG: But if we say the losses revealed so far are say, $300 billion, if we’ve got another $700 billion to go, the amounts of money that are going to be required for capitalisation are just enormous.

MS: Yeah, but this isn’t all in the banking system you know, there will be other investors who will actually no longer have the value of securities they’ve invested in. I mean that includes pension funds, insurance companies, any number of investors. Because this stuff is spread out all over the place.

AK: But the capital still has to be raised. I mean, even though it’s spread out, where do you think this capital is going to come from?

MS: Well no, the capital will have to be raised in the banks, insofar as the banks have this stuff on their balance sheet. And of course, you saw in the first round of the problem that a number of the SIVs came back onto balance sheet. That was I think probably quite responsible of the banks concerned. Now you’re seeing banks walking away from the SIVs, apart from their equity interests in them. That’s a very different sort of behaviour.

So if you were running an investment fund and were buying these things, then you’ve just lost your investors’ money. But as to the banks, on the whole I think that we’re gradually getting to the end of where they are in terms of their own exposure which is sitting on their balance sheet.

But there is still a lot of liquidity around for the right price and right asset and what is happening now is that people are waiting and looking at buying into distressed assets. There will be quite a big industry in that going forward, I suspect.

AK: How do you go about conducting the business of banking now? Are you quite risk averse? What’s the sort of term of commercial loans that you’re making? Are you making five-year loans at all or it is all seven-year loans now?

MS: Business goes on. Coming back to Australia, if you look over the last ten years, what has happened is people have got used to operating in an extremely benign credit environment. The actual credit losses in the banks have been unrealistically low and that’s a phenomenon that has worked through the world. Basically, there was too much liquidity chasing too few good assets.

But business goes on. We continue to support our customers. Yeah, the issue is that the timing of liquidity means that the cost of raising money is going up on one side. If we can’t pass that cost on, then we have to restrict the amount that we lend. That’s the impact that the government hasn’t seemed to understand properly yet.

AK: Do you think Australia will come out the other end of this with the same number of banks as it currently has?

MS: Oh yeah, I don’t think there will be any problem there, certainly from the major trading banks. I think they’re incredibly well placed.

AK: I’m talking about takeovers really, not collapses.

MS: There may be. If you look at some of the smaller players then obviously some of their funding is going to get tighter. But as they say, as long as they can pass on that pricing they’ll be alright.

SB: Mike, you referred a moment ago to the inability to fully pass on the increase in funding costs. It appears ANZ’s business lending growth is running at something above 20 per cent. The non-bank sector has imploded. Your share price is down by about a third. Is there a possibility of credit rationing in this kind of environment?

MS: Yes.

SB: How severe?

MS: It’s going to be driven by a number of factors. One is what I would call the re-intermediation. If you look at the securitisation market, that has basically dried up at the moment, so that has to be refinanced somewhere – basically the stuff comes back to the bank’s balance sheet – if there is the capability, if they have the room.

There is no way at present you’ll be able to kick-start the securitisation market, because the underlying assets at the moment aren’t producing sufficient returns for any investor to buy the stuff whilst interest rates are being held down on mortgages at unrealistic levels. There just won’t be a means to take them to market. So the only alternative is to come back to the banks and that’s going to be difficult.

You’ve also got a number of other players coming out of the market. You see Macquarie’s stopped lending this week into the mortgage market and that’s going to create further angst. So yeah, we’re definitely moving to a squeeze and as I say, if we can’t pass on the increased cost of the funds then we have to constrain our lending.

RG: But Mike, why can’t you pass it on? The government makes noises and stuff like that, but there’s nothing to stop you doing it.

MS: No, but we do work within a fairly highly charged political environment here. I don’t have such an issue with business banking and the corporate world, although of course people are squealing.

But people don’t really understand how the global market operates. When you operate in a global economy – particularly in an economy which is so driven by global prices, such as in commodities – you can’t suddenly say ‘we are purely domestic and we don’t rely on the international market to provide the financing of that’.

RG: Is it going to be houses that will be most affected because that’s where you can’t pass the higher funding costs on?

MS: It’s the mortgages that are obviously the classic political hot potato and there has been a huge amount of pressure to keep rates down as you know.

AK: Are you therefore saying that that the politicians will be responsible for credit rationing?

MS: Well, at present they are looking at using interest rates as a mean to adjust or slow the economy. I think it would be actually easier to allow the natural market forces to work through the banking system, which will have exactly the same impact.

AK: Just on ANZ itself for a moment, in February you put out a trading update and revealed some monoline insurance exposures of your own of $US200 million. How surprised were you about that? Did you get any assurances before you took over as CEO that there weren’t such things going on in ANZ?

MS: Well, those sort of trades were in many banks. I would have expected ANZ would have been in that sort of business. It was just a credit intermediation trade and I could understand how we would have done that. What I wasn’t very comfortable with was the fact that it was completely unrelated to our core business. It wasn’t relationship driven and it wasn’t anything to do with Australia, so in terms of a stand alone business like that in the US, no, I didn’t know about that.

But you have to remember that these deals were written at a time when the world was absolutely flush with liquidity. Banks were under pressure to increase earnings and this was a matched trade which was sold as having no credit risk and no market risk. I can understand how it looked attractive at the time. We can all be very smart in retrospect.

AK: But these things very rarely come in ones, do they Mike? Are you absolutely confident there’s no more of that sort of thing?

MS: Well no, as we said, there were a number of trades but the only one that actually had the reinsurance with ACA was this particular deal. It was a series of three baskets but one effective trade.

AK: The day after that trading update you spent $1 million of your own money buying ANZ shares. You’ve lost over $100,000 on that now, so how do you feel about that?

MS: Well you know, I’m there for the long term. Well, hopefully. [Laughs]

RG: Mike do you think this credit squeeze will affect the value of properties in Australia if it is sustained over 12 months?

MS: Inevitably it will if this continues and rates continue to be so high.

But the big difference between the Australian residential property market and the US property market is there is still more demand than supply and the supply problem that we have here is going to maintain values.

RG: What about commercial properties, like warehouses and shops and small offices, are they likely to be affected by this?

MS: It’s a question of where the retail industry goes – if spending is curtailed it will come under pressure. I think we have to carefully watch what happens. But inevitably when you’re trying to cool demand the impact is that there is a downturn in retail sales.

SB: Mike, can I go back to that question that Alan asked a moment ago and broaden it slightly. At [former CEO] John McFarlane's farewell last year you appeared really comfortable with the financial and the cultural state of the bank that you’ve inherited. Now you’ve had time to come to closer grips with what it is that you have inherited, do you still feel the same?

MS: I’m still pretty relaxed. Do I sound it? [Laughs]

It’s still a great bank, we’ve got a great business. People tend to say ‘did you know about this skeleton...did you know about this one’. The fact is that it’s a very big organisation and we are in very different times than we were a few months ago. This is a global financial services crisis the like of which we haven’t seen for very many years. The fact that I’ve been through about five of these in my career actually leaves me quite comfortable we can steer the ship through this one without too much trouble. There are going to be a few rocky moments along the way but am I too worried about it? No, I’m not.

RG: Mike are you likely to make a drive on Australian bank deposits to lessen the reliance on overseas funding?

MS: Yes I am. I’ve been doing that since I got here actually.

RG: How are you doing it? Higher marketing or higher deposit rates?

MS: Basically it’s about changing people’s incentive schemes. One of the characteristics of Australian bankers was that real bankers lend money. You really have to change that mindset and that takes a bit of doing. But having been here for some time I think we are actually getting some traction on that.

We’re also lucky to have the platform into Asia. Asian growth and deposits is continuing to be very high. As you know the savings rates in most of the Asian countries are high and we are looking to increase our deposits base from there as well.

SB: Mike, you’ve raised Asia. I’m sure you’re very aware that the markets are somewhat wary of the prospect of you doing large scale expansion through Asia. Can you convince the shareholders that the risk/reward equation is attractive?

MS: Well, it’s for them to vote on that. I believe that our strategy is going to become somewhat different from the other banks in that respect. I actually feel that we are totally aligned with what corporate Australia is doing and in fact what the whole of Australia is doing. Australia is intrinsically linked in terms of its economy with the economies of Asia right now and frankly, any bank has to follow its customers. All our customers are now doing business in the region and we have to be there too.

So I don’t actually see it as a high risk strategy. I see it as a sensible one and in fact I’m amazed that we haven’t or an Aussie bank hasn’t made further traction down this route before.

RG: Is this the right time to thrust into Asia?

MS: Indeed. That’s where the liquidity is. This is where it’s happening. The alternative of course would be to bunker down here or go to markets like the US. I suppose there’d be a few bargains there. Or into Europe. I suppose you could try having a go at France or something, but no, thank you. I would rather go into Asia.

RG: And you would raise deposits there.

MS: Oh, indeed. It would be a strategy led by deposits and then you lend the money.

RG: But you’d buy an Asian bank to attract Australian deposits?

MS: We will look at some potential acquisitions and of course, prices have reduced throughout the world. Whilst the price-to-earnings ratios of the Aussie banks have gone down, in US dollar terms – which most Asian banks are priced in – it’s not looking quite as expensive as it was.

AK: I think on that note we’ve probably outstayed our welcome. Thanks very much Mike.

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