Banks May Generate Big Profits, But They Are Highly Geared And Vulnerable

The Age

Friday October 3, 2008

Malcolm Maiden

The best we should hope for is they pass on about half the RBA's interest rate cut on Tuesday.

YOU have to wonder what Malcolm Turnbull has been smoking after his calls for the banks to pass on 100% of the interest rate cut the Reserve Bank will announce on Tuesday, and his suggestion that Prime Minister Kevin Rudd and Treasurer Wayne Swan have wimped it by not demanding the same thing.

Swan and Rudd have said the banks should pass on as much of the cut as they can, but that while the credit crisis rages, the stability of the banks and Australia's financial system is paramount; and they are right.

The Reserve is probably going to respond to the sudden intensification of the crisis last month by cutting rates by half a percentage point and, if the Australian banks pass the lot on, their profitability will be eroded in the middle of what is, in effect, a global crisis of confidence about the quality and sustainability of bank earnings: that coincidence is best avoided.

The banks source about half the money they lend to their customers from their own bank deposits, another 20% from medium-term wholesale borrowings, and the balance from short-term money markets. Last month, the cost of both debt portions soared.

Before this crisis hit in August last year, the banks were sourcing 90-day funds from bank bills priced at about 10 basis points (one-10th of apercentage point) above the effective cash rate, which is the official cash rate adjusted for likely moves in that rate over the 90-day term of the bill.

In the first full flood of the crisis in March this year, when the US Federal Reserve stepped in to save Bear Stearns, the premium blew out to 77 basis points, or just over 0.75 of a percentage point.

It fell back to about 50 basis points by the end of August, and to a low of just under 30basis points early in September, as the debt markets priced in the Reserve Bank's decision to cut the official cash rate from 7.25% to 7%.

But then, all hell broke loose. Fannie Mae and Freddie Mac were nationalised, Lehman Bros was allowed to collapse, and banks started toppling like dominoes, forcing nationalisations, enormous liquidity washes from the Western world's central banks, and unprecedented direct government bail-out moves. These include the $US700 billion package that has struggled to win congressional approval and may or may not get banks lending again, a virtual blanket guarantee of Irish bank loans and deposits from Ireland's Government, and moves in Europe now, led by French President Nicolas Sarkozy, for a $US500 billion US-style bad-debt bank support package to move troubled debt out of Europe's banks and replace them with cash.

The bank bill margin blew out to just under 100 points last Monday, a record high

that has been alleviated only partially by a subsequent subsidence to about 70 basis points yesterday. Three-year debt that fills an extra 20% of the funding base for the banks on top of the 30% sourced from bank bills is meanwhile being priced at about 130 basis points above cash, compared with about 10 basis points before the crisis began.

The banks are, therefore, in a position to argue that their profits will be pressured if they pass on next week's Reserve Bank official cash rate cut in its entirety, even though they have already unilaterally raised their lending rates by about

0.5 of a percentage point during the crisis.

It is true that over the years the Australian banks have been more profitable than their overseas peers. Their absolute profits are always targeted for criticism, but are irrelevant: they are very big, highly geared enterprises, and their profits are correspondingly large.

The better measure is the return on equity they generate; and, at between 15% and 22% currently, the ROEs are solid, but not spectacular.

But there is a circular, corrosive relationship between the collapses that have been occurring and the fear that is rampant in the markets, so intensely rampant inside the banks themselves that they have to all intents and purposes stopped lending beyond 24 hours to each other, let alone to their customers.

Our banks remain well capitalised and are relatively well insulated from the chaos. But their loan losses are rising as the financial shock works its way into the real economy: they don't need, and nor do the markets and economy need, an additional, self-inflicted shock.

A cut in official rates of 0.5 of a percentage point will give the banks room to repair their margins and pass on a useful cut, perhaps a touch more than half the total.

And when the crisis is resolved, Malcolm Turnbull

will have an issue to explore. The power of the big banks is rising in this crisis as non-bank competitors are squeezed out; and when the markets settle, they will be in position to increase their power further, by building lending market share. The risk is that they use that power to lock in margins that would have been competed away before the credit crisis changed the competitive landscape.

But in the context of the biggest banking crisis in living memory, it's a lower order issue - and a slightly bizarre one for Turnbull to be pushing, given the Coalition's traditional pro-business roots.

Passage of the US package is crucial, but unlikely to unwind the tension immediately. The markets will want evidence that it is working to free up liquidity locked in the banking system, and need to see key restructuring deals concluded.

Concerns in credit markets about Morgan Stanley have eased since Japan's Mitsubishi bank's confirmation this week that it will buy in as a new cornerstone investor.

But other rescue deals including Bank of America's acquisition of Merrill Lynch still await confirmation.

mmaiden@theage.com.au

© 2008 The Age

Back to News Index | Back to Home