–That great disturber of peace of mind—the Internet—happens to be off-line at your editor’s office this morning. The technicians are busy fixing it up. In the meantime, there’s always the newspaper…and some time to think about whether large bank profits are unnatural, or at least subject to mean reversion like everything else.
–Mind you, we’re not claiming that Australian banks are too profitable in some moral or ethical sense. Profits are what they are. Only the government seems willing to determine what level of profit is too high for a given industry.
–Making that kind of determination is absurd, by the way, given that most of the people in government have never run a business in their life and wouldn’t know a profit if it slapped them in the face. Of course, profit may not be the most important thing to everyone in a qualitative sense. But if you’re running a business, it’s hard to do without, in a quantitative sense. And surely it’s better to have profitable and solvent banks than weak ones.
–No, it’s not outrageous bank profits that are the issue. It’s the risk taken by bankers to get them. When credit is cheap and credit growth expands—as it has been for most of the last 20 years—banks can grow profits simply by making more loans. This is how it came to pass that Australia’s retail banks own $1 trillion in mortgages.
–Where is the risk in this? Well, the profitability of the banks is driven mainly by one single asset class. The risk is that all the price gains in that asset class are simply a function of credit growth. When the credit growth slows down or reverses, asset values will fall while liabilities (what you owe on the mortgage) will not.
–“More than any other factor,” reports Matthew Drummond in today’s Australian Financial Review, “a series of housing booms is what has fuelled the growth in banks’ profits. Mortgages are banks’ single biggest asset class (including mortgages offshore they make up 65 per cent of total assets at Commonwealth Bank and Westpac, 55 per cent at ANZ and 50 per cent at National Australia Bank.)”
—-“House prices are now either falling or going nowhere,” Drummond adds. “The effect on Australia’s banks will be profound.”
–That’s an understatement. But is it a surprise? The banks make more money making home loans and appear to take less risk than making business loans. After all, many small- and medium-sized businesses fail. Loaning money to losers is bad business. Besides, in a non-recourse mortgage market, a home loan is forever. The mortgage borrower can’t “fail” in the same way a business can.
–Given the higher profitability and lower risk in lending to house buyers, why wouldn’t the banks load up on mortgage loans? It’s the best way to grow profits. And why should shareholders worry? Australian banks have managed to generate high returns on equity through home-loan growth. If investors in banks stocks are happy—and that includes super funds that own the banks—isn’t everybody winning?
–When you live in a culture and an economy that’s been “financialised”, it’s normal to expect high returns on equity from banks. But in a non-finacialised world (where growth isn’t stolen from the future through relentless credit expansion), banking ought to be a low-risk, boring, conservative, low-profit business. Why?
–In an economy where credit growth is constrained by available savings (actual incomes on deposit with banks), lenders have to be prudent about the risks they take. They “own” each and every risk to the extent it’s a loan that resides on the balance sheet of the bank making it. It has a sobering effect.
— Ownership tends to promote the qualities of good stewardship. In times gone by, local and regional lenders would scrutinise borrowers, demand sizeable down payments, and, because the labour market hadn’t yet been globalised, lenders would have a pretty good idea of what the borrower’s income would be over time, and what size loan he’d be able to service without too much stress.
–But with globalisation and securitisation, smaller lenders have been swallowed up by larger ones. We now have a handful of massive firms that dominate the mortgage market. And they finance their lending through borrowing overseas and securitisation (although this form of financing has not fully recovered from the events of 2008).
–In other words, the big four Aussie banks have concluded nearly two decades of double-digit credit expansion in Australia by gathering unto themselves nearly all the mortgage market. They have convinced a whole new generation of borrowers that houses are investments with rich capital gains on offer year after year. They have not informed borrowers that most house price gains are simply the result of expanding credit.
–But wait, you say! Credit is expanding because demand for it is robust! Australians want to borrow because they can and because houses are good long-term investments. The growth in credit is driven by genuine consumer demand, the argument goes. Market forces at work. Nothing to see here.
–That would be true if the price of credit wasn’t artificially set by global central banks. Demand for credit was high globally up to 2007 because the price was so low. Most people think the price of free beer is more than reasonable. Free beer can even turn non drinkers into accomplished alcoholics.
–During eras where there is not a once-in-a-lifetime expansion in credit, bank profits tend to be low because banks tend to be prudent. But we are not in a prudent era. We are in the tail end of a vast global credit expansion that has put credit growth and high asset values ahead of every other economic virtue.
–Around the world, asset values are levitating, supported by relatively easy monetary policy. But for how much longer? “We’ve had systemic level failures over and over and over again, and we will in the future,” says Stefan Walter, the secretary-general of the Basel Committee for Banking Supervision, also in today’s AFR.
–“So when it comes to capital and liquidity, we shouldn’t sail as close to the wind as in the past…I think all would agree that it would have been desirable to trade off somewhat less credit growth for a less dramatic downturn.”
–Walter is writing new global banking rules designed to prevent the next crisis. But he may be wrong about everyone agreeing that less credit growth was desirable. There are plenty of people who benefit in the short term from the unsustainable expansion of bank balance sheets. Nearly everyone suffers, though, in the long term, when the expansion turns into a contraction.
Markets and Money Australia