Swan's blind bank bashing

Wayne Swan has been warming up for another round of bank bashing next week, pledging that he would continue to provide ‘'frank and fearless'' commentary about interest rates and bank profitability. Already a chorus of like-minded bashers is forming behind him and taking pre-emptive pot shots at the banks even before there is anything to shoot at.

It is widely expected that the Reserve Bank will cut official rates next week by another 25 basis points. It is also widely anticipated that the major banks will cite funding cost pressures as the reason for not fully passing on any rate cut.

It wouldn't be surprising if they retained at least 10 basis points of any RBA move – and the RBA, which has said it factors the likely response of the banks to official rate movements into its decisions, wouldn't be in the least surprised.

The RBA, like most people who have any real understanding of the banks' funding, is well aware that they are experiencing some pressures.

While the majority have, with the help of risk-averse depositors, done a very creditable job since the onset of the global financial crisis of reducing their dependence on offshore sources of funds, and short term funding from offshore in particular, they still have an offshore term funding requirement of about $100 billion this year. About 20 per cent of their overall term funding is sourced offshore.

The relative cost of those funds, where they are available, has spiked since the eurozone tumbled into a fresh crisis.

The banks have responded by taking advantage of their newly acquired ability to issue covered bonds, making issues both offshore and more recently in the domestic market. While the covered bond issues might raise funds more cheaply than issues of conventional bank debt, they haven't provided cheap funds.

Commonwealth Bank raised $3.5 billion of five-year money earlier this month in the first Australian dollar issue of covered bonds – and paid the highest yield premium for a domestic bank issue ever recorded.

And, of course, one of the reasons the banks have been able to lower their proportional exposure to offshore markets has been their success in attracting domestic deposits. Again in relative terms, that has come at a cost as the strong competition for them has driven their cost up.

The relative cost of funding is the key to understanding why banks are under increasing pressure to ignore Wayne Swan. The RBA can, by raising or lowering the cash rate, push the short end of the yield curve around and therefore influence the absolute price of money.

What it can't do is dictate the spreads the banks pay over the cash rate to attract funds and those spreads, indeed the spreads on all their forms of funding, have been blowing out.

If the banks want to maintain profit margins – on average they had a return on assets of 0.93 per cent and their net interest margin averaged 2.27 per cent last financial year – they have to pass some of those increasing costs back either to borrowers in the form of higher mortgage rates or depositors through lower term deposit rates, or a bit of both.

In the past volume growth and efficiencies would have provided some offsetting relief but, as today's credit statistics show, demand for credit is still very anaemic and in any case, with the combination of funding pressures and the proposed new and higher capital and liquidity regimes, there's less incentive for banks to grow their balance sheets today than there has been for about two decades.

The foundation for Swan and others' attacks on the banks is the charge that they are too profitable. Indeed Swan said this week that they were ‘'hugely profitable'' and that ‘'their return on equity is unequalled in the world.'' He's wrong on both counts.

A return on assets of less than one per cent doesn't constitute egregious profitability, nor does an average return on equity last year of 16.7 per cent. These are, after all, highly-leveraged institutions. They either make solid profits – and plenty of other Australian companies generate higher returns – or they would, given the skinniness of their margins for error created by the leverage, lose lots.

Neither are their returns on equity unequalled. They do look good against most other developed world banking systems, but that's a silly comparison given that most other banking systems in developed economies were nearly destroyed by the global financial system. Some are still owned by taxpayers and some in Europe are again close to being owned by taxpayers.

The better comparison is with the only other comparable system that came through the crisis with its reputation for sound practices and supervision intact – Canada.

The five majors in Canada – Royal Bank of Canada, Toronto-Dominion, CIBC, Scotiabank and Bank of Montreal – had an average return on assets of 1.25 per cent and an average return on equity of 18.5 per cent last year. The Canadian majors are clearly more profitable than their Australian counterparts.

The odd aspect of Swan's regular attempts to coerce the banks into shadowing an RBA policy that only indirectly influences their funding costs is that, if they do what he wants and their funding pressures continue to increase, their only obvious responses would be to cut even more jobs and lend even less.

Why the Treasurer and others think that would produce better economic outcomes than borrowers missing out on 10 basis points of a rate cut on their home loans is beyond me.