Why Australian banks earn so much profit

Australia’s big four banks are among the most profitable on earth. This is how they do it.

It is a well-worn argument: Australia’s Big Four banks are over-earning and the proof is in their profits. The unsophisticated simply point to the profit number and declare it too large, ignoring the big pile of capital it takes to generate a big pile of profits.

Even if we take a more nuanced approach to measure bank profits – return on equity (ROE) – it seems self-evident that Australian banks over-earn.

ROEs for Australian banks range from over 16% for CBA (ASX:CBA) down to 12% for ANZ (ASX:ANZ). CBA’s ROE is one of the highest in the world and even ANZ, considered the bad boy of Aussie banking, is better than decent.

In comparison, Bank of America (NYSE:BAC) earns less than 6%, Wells Fargo (NYSE:WFC), a key Buffett holding, earns less than 12%; Lloyds (LSE:LLOY) earns 4%. In the rich world, only Canadian banks come close to Australian level returns on equity and they too, operate a cosy oligopoly.

Proof, some say, that banks needs more competition. That might be true but high ROEs alone aren’t enough to make the case.

ROE is made of two metrics, the return on assets (ROA) and the amount of leverage carried by banks. Australian banks earn ROA of about 1%, maybe a little higher than most international peers but nothing that screams outright theft.

The key to higher ROE isn’t higher interest margins or scandalous fees but the liberal use of leverage. Aussie banks earn more because they are more leveraged than international peers.

Does that make them inherently riskier? Not necessarily.

A key feature of Australian banks is the high proportion of loans made to the residential mortgage sector. Mortgages account for about 60% of CBA's loan book at the top end and about 40% of ANZ's at the bottom. Nowhere else in the world are banks as heavily exposed to residential property.

Less capital needs to be put aside against a relatively safe asset like residential property and higher property prices mean that this is a reliable source – perhaps the sole source – of credit growth. This could be a source of risk in future but, for now at least, residential property is the cash cow of the banking sector.

Because Aussie banks have such large mortgage books they can afford to be more leveraged than just about any bank anywhere. And it is leverage, not scandalous charges, that is the true source of bank profits.