No proof of a CBA spectacular

The headline numbers in Commonwealth Bank's December half results will inevitably be looked at in the context of its 10 basis point increase in its home loan interest rate and will trigger another bout of charges that bank profits are too high and something should be done about it.

At face value that case can be made. A 19 per cent increase in statutory earnings and a return on equity of 19.2 per cent is, in the current economic climate, an impressive performance by the sector-leading institution.

On closer scrutiny, however, while still very respectable, the result is more solid than spectacular and the rationale for that increase in home loan rates becomes somewhat clearer.

On a cash basis the result was a less provocative seven per cent increase on the same half of last year, but even that number overstates the outcome.

It has been evident for the past 18 months that the initial post-crisis momentum provided by the various stimulus packages, and the first home buyers' grant in particular, was fading steadily. If the latest half-year is compared to the June half that preceded it, CBA increased earnings by only two per cent. In its politically sensitive retail bank, earnings actually fell one per cent on the same basis.

That really shouldn't surprise anyone. Bank profitability is broadly determined by the relationships between volumes and margins. Historically weak demand for credit means there isn't much volume growth and, as the banks and the Reserve Bank keep trying to tell everyone, margins have been under pressure from increased funding costs.

CBA did manage some growth in average interest earnings assets – four per cent – while largely just maintaining its market shares. But the bank lost 10 basis points of net interest margin between the June and December halves and it would appear that as the latest half wore on the pressure on margins intensified.

Reserve Bank assistant governor Guy Debelle gave a speech this week where he chronicled the changes in bank funding costs relative to the bank bills swap rate. The banks were able to issue senior unsecured bonds at a margin of 127 basis points in June last year. The margin peaked at 223 basis points in January before falling back to 185 basis points this month – it is still about 46 per cent wider than it was in June.

CBA made the point in today's presentation that since June 2007 the weighted average cost of the blend (60:40) of deposits and wholesale debt that provide its retail funding had risen 1.64 per cent but the standard variable rate on its home loans had risen 1.34 per cent. That's not reflective of oligopolistic gouging.

It is also worth noting that the bank's return on assets is one per cent – a 1.1 per cent movement in the value of its assets would wipe outs its profits.

That group of academic economists whose letters to the editors of the major newspapers called for an excess profits tax on banks today presumably don't understand the role of leverage in bank profitability and can't remember what happened in the early 1990s when there were falls in the value of bank assets that not only wiped out bank earnings but went perilously close to wiping out two of the major banks and cut a swathe through the state-owned sector.

CBA attempted to counter the claims of super profitability by pointing out in its presentation that the Australian banks are only fifth among the world's most profitable systems on the basis of their returns on equity and that CBA itself, despite being the second-largest company by market capitalisation on the ASX, is ranked only 32nd by ROE and 77th by return on assets. That makes it hard to sustain the view that the banks are excessively profitable.

CBA, with its peers, is in a good defensive posture in circumstances where, because of the continuing crisis in Europe, access to wholesale funding isn't a given.

It is now 62 per cent funded by customer deposits, has $133 billion of liquidity – $43 billion more than it held a year ago – and has a tier-one capital adequacy ratio of 9.9 per cent (which would equate to more than 13 per cent if the UK approach to calculating the ratio were adopted).

The balance sheets, and the profitability, of the major banks are critically important to the stability of the Australian financial system and economy in the event the efforts by the eurozone to manage its crisis by drenching its banking system with near-costless liquidity are unsuccessful.