Understanding a banking furore

The furore developing around bank interest rates and job losses ought to be seen in at least two dimensions. One is the state of the banking sector itself and the other, which is related, is what it says about the wider economy.

The banks, and the economy, entered the global financial crisis after nearly a decade and a half of solid growth and prosperity and on the back of years of credit growth in the mid-teens as households and businesses gorged on historically (and unsustainably) cheap credit.

The crisis almost instantly blew up a few fragile business models, caused a spike in bad and doubtful debts and cut off, temporarily, the big banks' access to wholesale funding markets. The Rudd Government, however, soaked the economy with stimulus, including the cash splash and the first home buyers' grant, the mining boom continued unabated and it appeared the Australian system and economy had escaped largely untouched.

What wasn't initially evident, however, was that the psychology of households and business had been scarred by the experience and shifted into a deeply defensive mode. Both sectors started deleveraging as fast as they could and credit growth slowed to levels that bore no resemblance to the pre-crisis experience.

Despite that, the economy remained stable and the banks carried on business more or less as usual, although the structure of the banking system had been changed by the crisis – there were fewer banks, and bigger banks and those that remained had raised lots more capital and liquidity.

There was a brief and steep drop in profitability and a reduction in margins as the impact of impairment charges was reflected in their results, but as those faded and with the help of some retention of the Reserve Bank's cuts to the cash rate, margins gradually crept back to their pre-crisis levels, much to the displeasure of Wayne Swan.

Then, of course, towards the end of last year it became obvious that the eurozone was threatening to be the epicentre of another crisis, potentially more damaging to the global financial system and economy than the 2008-09 experience.

That did further damage to consumer and business confidence and helped turbo-charge the Australian dollar as a global scramble for safe havens with positive returns developed, fuelled by the near costless money being pumped into the US and European systems by central banks.

Last week, ANZ created a little piece of history when it increased its home loan rate independently of any change to the cash rate by the RBA, by a mere six basis points. Westpac immediately hiked its home loan rate 10 basis points and today Commonwealth followed suit. National Australia Bank raised its rate by nine basis points and Bendigo and Adelaide lifted its by 15 basis points.

ANZ also foreshadowed a reduction in jobs of about 1000 permanent employees by the end of this financial year. That follows suggestions that the majors could shed as many as 7000 jobs in a massive wave of cost cutting.

The rate increases and the job losses are related.

Across their range of funding sources – deposits, domestic and offshore wholesale funding – the relative cost of funds has been creeping up and putting pressure on margins no longer benefitting from the subsidence of impairments, which now appear likely to creep back up within a slowing economy. The banks are now sharing some – but not all – of that increased cost with their customers.

Bank profitability is a complex mixture of margins and volumes and their relationship with the particular bank's balance sheet.

In an environment in which margins are being squeezed, where there is only low single-digit volume growth in credit within the system, where the banks are holding significantly more capital and costly liquidity than they were pre-crisis and where the resources boom and soaring dollar is ravaging the banks' non-resource sector industrial heartland of small and medium-sized enterprises, something had to give.

In a sense, what ANZ plans to do, and its peers will also do, is a delayed response to the impact of the original crisis – a response delayed until it became clear as a result of the eurozone's wobbles and their flow-on effects here that there were changes occurring to the context in which they operate that had to be regarded as potentially permanent.

Pre-crisis, for instance, ANZ had just under 20,000 employees in its Australian business. Today it has about 24,000. Even if one sets aside the 3000 people it added when it acquired ING's share of their wealth management joint venture, ANZ has added people over the course of the crisis.

Workforces and infrastructure built to service a sector which was experiencing growth rates in the mid-teens will clearly have considerable over-capacity when that growth rate slows to a crawl.

What we are about to see is a structural shift – a down-sizing – in the capacity of the banks to bring them more into line with the demand they are now experiencing and likely to experience in the medium to longer term.

In a sense that is the story of the wider economy.

The capacity of whole industries – the broader financial services sector and retail are other obvious examples – was geared to that lengthy era of historically high levels of consumption driven by an assumption of indefinite prosperity that has now been shattered and a tide of cheap credit that has now receded.

The strength of the dollar has exacerbated the impact of the downturn in demand and will amplify the degree of restructuring of the non-resource side of the economy required to bring supply and demand into a better and more sustainable balance. For some sectors, the overlay of the impact of the internet adds another layer of pressure for change.

The banks, as the intermediaries for capital flows within the economy, provide a kind of early warning signal for what is happening in the broader economy. The warning lights are now flashing brightly.

It will be convenient for some to make out that the rate increases and job losses are about greedy banks behaving badly. In fact, they are behaving rationally to protect their stability and preserve their profitability in the face of the wholesale and painful structural changes to the broader Australian economy that are already underway.