Why bank profits defy hard times

Ever wondered how the banks manage to churn out ever-higher profits when the economy's weak and credit growth is near record lows?

To the casual observer it may seem puzzling, to say the least.

Despite constant talk of a soft economy, the big four racked up $27.4 billion in cash earnings between them this year, an average yearly increase of 9.5 per cent.

Bank chiefs repeatedly trotted out phrases such as "subdued". And yet their earnings seemed to defy gravity.

So what's going on? If the economy is weakening and banks are highly exposed to the country's ups and downs, how do earnings keep growing so strongly?

Greens MP Adam Bandt summed up the suspicions many of us have that we are being gouged.

"It is no wonder so many Australians see the big four as vampires," he said after ANZ's $6.5 billion full-year profit.

It may be easy to jump to a conclusion such as this. But if you look at what the numbers show, things are much more complicated in terms of what is driving profit growth.

I'm not writing to defend the big banks, which make far better returns than most of their peers overseas - more on that later. But simply quoting big profit numbers as proof we're being ripped off doesn't make sense.

Of course, banks' raw profits are enormous - they are enormous companies. Commonwealth, Westpac, ANZ and NAB are all among the world's 20 biggest lenders. With a combined market capitalisation of more than $390 billion, they make up 26 per cent of the ASX 200.

And, of course, most of their profits come from charging interest to consumers and businesses and levying various fees - that's what banks do.

But understanding the recent growth in profits is a different matter.

Indeed, the latest results showed the biggest source of growth has been lower provisions for bad debts.

This is basically a bucket of money that banks take out of their bottom line and set aside to cover loans that are likely to go bad. So when provisions fall sharply, as they have lately, it boosts profits.

At Westpac, for example, the bottom line benefited from impaired loans plunging 30 per cent in the latest half, to just 0.16 per cent of total loans, the lowest share since the mid 1990s.

Without getting caught up in a highly technical debate, provisioning levels are now very low, raising legitimate questions about the sustainability of earnings growth near 10 per cent.

UBS analyst Jonathan Mott calculates that all growth in the banks' earnings per share in the latest half came from lower provisions and a slightly lower tax expense, and that pre-provision profit growth per share was -0.2 per cent in the same period.

The main reason bad debts are so low is because default rates by businesses are far lower than average, after many companies sharply reduced their leverage.

No one knows how much further bad and doubtful debts can fall. The point is that recent falls in provisions are "pro-cyclical" - they enhance profits today, but the same forces will dent profits when things eventually turn bad.

So the shift to more cautious behaviour by businesses can explain much of the recent profit growth by banks because it has led to unusually low default rates.

The fact Australia avoided the worst of the global financial crisis also helps explain why our banks are so much healthier than many of their peers overseas.

But the state of the economy can't explain all of the big four's longer-term outperformance, and here is where bank critics have a stronger case.

Figures from the Bank for International Settlements show Australia's big banks have been the most profitable in the developed world for the past three years, with pre-tax profits equal to 1.18 per cent of their total assets.

Even before the financial crisis, Australian banking was highly profitable. Among 10 developed countries ranked by the BIS, only the US had more profitable banks between 2000 and 2007.

The big four's average return on equity - which takes into account that banks' assets are highly leveraged - was a healthy 15.9 per cent in 2012-13, up 40 basis points. Commonwealth Bank's is a whopping 18.4 per cent.

Banks point out that many companies make higher returns than this, which is true. But rates of return should reflect risk - the riskier the business, the more investors are compensated.

For an industry that's implicitly supported by the government, as we saw during the financial crisis, the banks' returns are very strong.

To an economist it suggests banks are probably not competing on price as ferociously as they could be. The economic term for this is pricing power - the ability of a company to be a "price-maker", rather than accepting the prices set in a competitive market.

So, if you're a bit suspicious about our very profitable banks, fair enough. But it's the consistently high returns and implicit government support we should be discussing rather than the fact their raw profit numbers are huge.