The delicate balancing act of Australia's big four banks

It would be easy to conclude from the Bank for International Settlements' analysis of the profitability of the world’s major banks that the Australian majors are too profitable and that 'something' needs to be done about that.

The BIS analysis showed that the pre-tax profits of the Australian majors in 2013 were 1.28 per cent of their total assets. That compared with Canadian banks’ 1.06 per cent, the US majors’ 1.24 per cent, the UK’s 0.23 per cent, France’s 0.32 per cent and Germany’s 0.1 per cent. Only the big banks in developing countries produced higher returns on assets.

The picture provided by net interest margins wasn’t quite as clear-cut. At 1.79 per cent, the Australian banks’ margins were ahead of Canada (1.65 per cent) and most of the European systems, but skinnier than the US’s 2.32 per cent and much tighter than the developing world’s banks.

Statistics without context can be misleading.

There are five major levers that drive bank profitability. Lending volumes, margins, credit quality, costs and leverage are all crucial influences on bank bottom lines.

Given that the Australian economy has been arguably the strongest in the developed world since the financial crisis erupted in 2008, it would be surprising if any other system had the levels of volume growth that the Australian system has experienced, even though demand for credit has been weak by historical levels.

The relative performance of economies also flows through to margins. While the net interest margins of the Australian banks appear fat when compared with the rest of the developed world, they are actually materially lower than they were before the crisis. In 2007 the majors had net interest margins of 1.95 per cent.

Given what has happened in other developed world economies and their banking systems -- Europe, the UK and the US had to bail their banks out while experiencing recession -- it’s not surprising that the credit quality of the Australian banks is superior.

At 17 basis points as a percentage of total assets, their loan loss provisions are the same as Canada’s banks but less than half those of the UK banks, smaller than the US banks (21 basis points) and much smaller than those of the banks in the developing world.

Pre-crisis levels of loan loss provisioning in the Australian system were 19 basis points, which rose to 30 basis points in 2008 before continuously edging down in recent years to historically low levels.

On costs, at 1.11 per cent the Australian system is one of the most efficient in the world. This is much more efficient than in 2007, ahead of the crisis, when operating costs were 1.99 per cent of total assets. Canadian banks’ operating costs relative to total assets were 1.78 per cent last year, Germany’s 1.55 per cent, the UK’s 1.55 per cent and the US’ 3.03 per cent.

The BIS data doesn’t compare the leverage within the individual systems. We know that using the Basel Committee’s approach to capital adequacy, the Australian system is (with Canada’s) the best-capitalised in the developed world.

The committee’s system of risk-weighting various types of lending, however, disguises the levels of leverage within systems.

The Australian banks’ lending and balance sheets are heavily weighted towards residential mortgage lending, which attracts a very low risk-weighting under the Basel Committee approach. That means the real levels of leverage in the Australian banks are high compared to systems with greater proportions of commercial lending and/or investment banking activities.

That leverage amplifies their profitability. It also provides fuel for the debate about whether the extent of the banks’ exposure to a residential property market where prices have been surging is a point of vulnerability for the financial system, but that’s a separate issue.

It is also worth noting that pre-tax profits as a percentage of assets have been falling. In 2007 the Australian banks’ earnings represented 1.58 per cent of their total assets, so they’ve 'lost' 30 basis points of profitability in the post-crisis period.

The inquiry into the financial system chaired by David Murray is looking at the question of whether the Australian system, dominated as it is by the four major banks, is sufficiently competitive. It will no doubt come up with some recommendations for making it more competitive, or at least creating the potential for more competition at the margin.

There’s a delicate balance between the intensity of competition and the stability of the system. While no-one wants an uncompetitive system -- an oligopoly -- even less desirable is an unstable system.

A key reason as to why Australia didn’t suffer the kind of trauma experienced by Europe and the US during the financial crisis – and they are still suffering the after-effects today – was the strength and stability of the major Australian banks. This is a tribute both to their management and the quality of their regulation by the Australian Prudential Regulation Authority.

As the developed world eventually tries to normalise and wean itself off the massive unconventional monetary settings that are in place in the US, Europe and Japan, the potential for fresh bouts of global financial instability is significant.

While it is important that APRA continues to pressure the banks to maintain lending standards and pursues conservative regulatory minimum capital and liquidity settings, it is also important that the always controversial profitability of the major banks doesn’t lead to changes to the system, which could eventually undermine its stability.

Banking systems that are too profitable create a challenge for competition policymakers. Systems that aren’t profitable constitute a threat to overall financial and economic stability, as governments and their citizens in Europe and the US have learned at traumatic economic and social cost.