The myth of excessive bank profitability seems to stay alive in 1995……Banks do not need to be universally loved, but they do need to be universally respected for their financial acumen, strength and vitality. This includes the Big Daddy, the Reserve Bank of Australia…. We cannot run the country on a talk-back radio basis. Given that misinformation flows travel faster than a speeding bullet, bank bashing is becoming hugely counter-productive………Banks are not outrageously profitable in Australia. They also pay enormous fully franked dividends and enormous taxes….. Apart from the employment and other taxes that accrue when about 125,000 people are employed in Australian banking, the banks are the greatest benefactors to fiscal policy among Australian companies. Why any government would want to reduce the profitability of banks is beyond reasonable comprehension. No household should offend such a proven breadwinner……
WE should scold the banks for honest errors, and continue to demand lower charges and insist on competition. but we should concurrently recognise that not much economic good can come from banks that perform below top-sector financial parameters on both a national and international basis. We should not ask that banks become part of the welfare system and have battlers’ rates and charges. Weaken the banks and weaken the nation.
From George Sutton’s weekly column ‘ On Closer Analysis’ , The Australian, 20 January 1995.
In 1984, I think it was a pity bank deregulation took place when it did and/or to the extent it did. Mainstream Australian banks reacted stupidly to the threat of foreign competition. Prudential controls were sacrificed in pursuit of market share, facilitating borrowings and buy-outs by the gaggle of paper entrepreneurs then emerging. Normally conservative bankers lent billions of dollars to corporate cowboys without tangible security, on no more than a negative pledge and without bothering to determine the extent of pre-existing unsecured debt. The takeover merchants bore no relationship to the capitalist entrepreneur of textbook economics or the real world entrepreneurs like Henry Ford – who touched off economic growth by developing new products and better ways of producing products.
Neither I nor, as far as I can remember, anyone else, anticipated that the banks would behave in the reckless manner they did. The Labor left vehemently opposed deregulation, but not for that reason. It wanted to direct lending to favoured borrowers, and also saw deregulation as an obstacle to its ambition to extend public ownership of banks.
Peter Walsh, ‘Confessions of a Failed Finance Minister’, 1995.
Lest we Forget
We should all remember that the Global Financial Crisis was not born out of the Real Economy – the production of goods and services. Rather it was spawned out of the Symbol Economy (that of money and credit) and the Political Economy where increased access to American housing finance offset opposition to the war in Iraq. If households could be beguiled into buying houses that might subsequently prove to be unaffordable and liable to foreclosure then the resulting economic growth at the outset would divert attention away from the difficulties of fighting a war of choice, rather than one of necessity. Also the increase in GDP from the housing boom made it look as though the war and the rapidly escalating oil price were easily affordable. The politics overrode the economics as Fannie, Freddie and Mr Greenspan were there to assist the madness of crowds, both bankers and borrowers. Also we were paying the bankers as though they were commission salesmen who were engaged in financial engineering to enable the ticket to be clipped more than once, and on the way down as well as up.
The ‘Made in America’ global recession came directly from the bankers to whom easy profits were irresistible..
The beginnings and the ends of the bankers’ madness is neatly summarised by Robert Murphy’s article of October, 2010 "Putting Austrian Business-Cycle theory to the Test" : "…the government seized Fannie and Freddie, thereby effectively nationalizing a large portion of the entire US housing market; the Fed nationalized AIG; the treasury secretary told everybody that he needed $700 billion pronto to patch up the financial sector or the world would end; the treasury secretary then proceeded to partially nationalize the US financial sector; the federal government took over two of the Big Three car companies and threw traditional creditor rights out the window; the Fed more than doubled the monetary base in six months’ time; the new Obama administration borrowed almost $800 billion to spend on "stimulus"; the federal government has taken a giant leap forward to socialized medicine; and just for kicks, the federal government also banned offshore drilling (though the rules are yet again undergoing revision)."
We should remember that big banks earn big profits because they have large asset bases and large shareholders’ funds. But ‘large’ must be measured accurately and ‘outrageous’ should have some perspective beyond populist pap. Joseph Hockey’s Nine-Point Plan does not seem to contain anything too extreme, but when coupled with his television and radio appearances carry with it the presumption of guilt, and certainly a certain imbalance and lack of attention to relative and relevant facts.
This Insight article focuses on the 4 Pillars – ANZ Bank Group, Commonwealth Bank, National Australia Bank, and Westpac Banking Corporation.
What do banks do? What role do they play? Why is sound banking important?
Banks are primarily intermediaries between depositors and borrowers. Their product is money, a loan, and their price is the rate of interest. Peripheral activities such as transactions processing and wealth management are also carried out.
The primary functions of banks are –
- To protect depositors’ funds.
- To make and administer prudent loans.
- To use their experience to know when and how to lend to an innovative borrower.
- To know when and how to foreclose.
- To price risk at appropriate levels and thus distinguish between different classes of borrowers.
- To report transparently and honestly to authorities and shareholders.
- To use leverage prudently by borrowing themselves as principal.
- To employ lots of people.
- To pay large amounts of federal and state taxes.
- To pay large quantums of dividends.
- To be a vibrant part of the community.
Do banks earn ‘outrageous’ profits?
We think not. Statistics can be manipulated but the following tables prepared from Morningstar and Ecinya data suggest that banks earn appropriate levels of profits.
Over the past 14 years the 4 pillars have earned aggregate profits of $164.7 billion on total assets of $18 trillion and from aggregate shareholders’ funds of $1.1 trillion. The return on assets has been less than 1% and the return on shareholders’ funds has been 14.9%. These ratios, though robust over such a long period, do not appear to us to be excessive if one thinks of nominal economic growth over the period and the necessity for depositors’ funds to be protected from a strong sector performance.
The reason that the 4 pillars had such a strong 2010 fiscal year was because they had charged large provisions against profits in 2009 when the GFC was in full bloom. Also Westpac had an extraordinary $600 million gain on a tax write-back. But even then when compared with the top 20 companies by market capitalisation their returns on shareholders’ funds do not appear to be excessive.
Using annual averages, profits have grown over 13 years at 12.2% while assets have grown at 12.1%. This seems harmonic though it also reflects the fact that the sector could probably do with more viable competition BUT in full awareness of the 1995 experience of Peter Walsh as quoted above where he says competition under poor management can lead to reckless quests for market share. Over 5 years, profits have fallen behind asset growth as loan losses were charged against profits. In 2009 profits actually fell due to the GFC while assets continued to rise. In 2010 coming off a lower base the percentage increases were abnormally high. In Earnings-per-Share terms banks do not appear to be a good bet over the long term and this probably means they are more cyclical than growth stocks. So there is a time to buy the banks and a time not to hold them.
INTEREST RATES
When interest rates are going up it is never the fault of fiscal policy .Waste and extravagance at federal and state government levels is not a problem because the waste and extravagance saved us from the GFC ! If only economics were that simple and a false construction of Maynard Keynes theories solved all economic problems.
When interest rates are rising look at where government largesse and profligacy is positioned. Do not look at commercial bankers and the Reserve Bank of Australia for they are mostly right in their interest rate settings. If governments are not truly cognisant of the fact that they generally spend money unwisely and do not know the value of lower taxes and lower interest rates and their impact on the small business sector, then the inescapable conclusion is that shifting the blame is their aim.
There are many emminent and not-so emminent economists, including ourselves in the latter category, that believe in the Austrian school of economics dictum that says sub-optimal outcomes in all areas of an economy are primarily caused by mis-allocation of resources. Over the past few days we came across an article by John P Hussman of HussmanFunds supporting this propostion by saying –
"One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers)."
When populist pap takes over from a reasoned analysis of the facts we run the risk of damaging our banking system, threatening the safety of depositors’ funds, and preventing banks going about their useful business. Just as Jesus flogged the money-lenders in The Temple, politicians leading frrom a presumption of guilt, are flogging the money lenders in today’s market-place, and once again, without consultation.
Ecinya does not believe that banks should not be routinely examined. They do benefit in significant measure from their quasi-monopoly position though we should not forget that many foreign banks operate in Australia and competition is not as absent as some would have you believe. The main problem is that we trust our bankers and many have been burned from easy loans from foreign bankers who foreclose as quickly as they lend. Exit fees are generally wrong. Some of the small business charges on Eftpos and merchants fees generally seem excessive and close to ‘outrageous’.