Why Central Banks Are Not Printing Money

It really pays to set up shop in close proximity to a central bank. Australian banks, who have surrounded the Reserve Bank of Australia (the bank in the centre), are raking it in. Yesterday the Commonwealth Bank announced a first quarter profit of $2.1 billion, up 14% on the same quarter last year.

When times are good and you have a highly leveraged balance sheet, 14% growth is not that difficult to generate. Keeping costs down is essential, which the banks are pretty good at.

And when you’re right next door to the nation’s money creating machine, escaping inflation is not that difficult either. That’s because you get first use of the money. It hasn’t yet had a chance to flow through the economy and morph from ‘wealth’ into inflation.

Right now, the ‘wealth effect’ is certainly benefiting the CBA and its shareholders. The Australian reports that the bank is now the 10th largest in the world by market capitalisation.

Ahead of it are only the big banks from the US and China, and HSBC, a UK bank. As an aside, we remember back during the days of the Japanese boom when the biggest banks in the world were all from Japan. Thanks to China’s credit boom and a total credit to GDP ratio of over 200%, China has four banks in the global top ten. Hmmm…

CBA, with a market cap of $120 billion, is moving in on the Bank of China at $129 billion. Westpac is number 11 on the global table with a market cap of $100 billion. Both ANZ and NAB make it into the top 20.

Funnily enough, our two largest banks are firmly focussed on the domestic market. Foreign expansion (although in NAB’s case you could hardly call it expansion) isn’t particularly great for growth. It subjects you to local competition, which is invariably a tad tougher than the oligopolistic conditions here at home.

To think that just 12 months ago these banks were complaining to anyone who wanted to listen about how tough business was. How offshore funding markets were expensive and it was thwarting their attempts to lower interest rates.

But now, thanks to the inherent leverage built into bank balance sheets and the RBA’s rate cutting cycle, Australian banks are amongst the most profitable in the world.

For example, in 2013, including the value of franking credits, CBA generated a return on equity (shareholder funds) of 27%. If 2014 continues in the way it started, it will beat that number again.

Compare that to the return on equity (ROE) achieved by Wells Fargo, the second largest bank in the world, or JP Morgan, the fourth largest. These banks churn out a ROE of around 12-13%. They are half as profitable as the CBA. Anything over 20% ROE for a big bank is spectacular.

CBA’s profitability tells you something about the level of competition here in Australia. There is none.

It also tells you something about the share price. Buying CBA shares here means you’re confident that this phenomenal rate of profitability will be sustained.

And by implication, it means you believe that the demand for mortgages and ever increasing average loan sizes will remain unabated. That’s because mortgages are what drives profitability.

Business lending doesn’t cut it. The rules state that banks have to set aside ‘risk capital’ for 100% of a business loan, which makes them less profitable. Lending against residential property, on the one hand, is considered much less risky, and the ‘risk weighted capital’ of a residential property loan is only 50% of its actual value.

So by lending against property, banks can really leverage their balance sheets…but from a regulatory perspective their leverage isn’t so bad because it’s measured in terms of ‘risk-weighted assets’, and residential property is considered low risk.

My mate over at Money Morning, Kris Sayce, has turned to castigating anyone who dares to question the viability of property as an investment. ‘Woah, woah,’ says Sayce, ‘you’re forgetting that property always goes up. There is no risk.

When his tongue isn’t in his cheek, Saycey likes to play in the real world, where risk and return matter. In fact, he’s just found what he considers to be a high risk/high return opportunity in the neglected resources sector. You can check out the details here.

We said earlier that central banks are money creation machines. That’s not entirely true. And contrary to popular wisdom, central banks don’t print money. More accurately, they create liquidity.

Central banks provide the fuel for money creation, but it’s the banks that carry out the actual money creation process. That’s because banks loan money into existence.

If you go to a bank and borrow whatever amount, they are lending you money that didn’t previously exist. You’re drawing on your credit to get a loan. That’s how the ‘credit creation’ process works.

But the process is a double-sided one. When a bank creates a loan, it’s both an asset and a liability. That is, on the bank balance sheet (in the case of a property) the physical house is the asset while the liability is financial, either a long or short term loan.

So you have an illiquid property asset matched by a more liquid financial liability. That’s why banks are prone to crisis. It’s because lenders to a bank can request their money back much faster than a bank is able to ‘liquidate’ its assets to repay them.

That’s where central banks come into it. In times of stress, a central bank will lend to a bank using, say, its illiquid property as collateral. So central banks in this instance monetise previously created credit. They create liquidity, not money.

In the case of the Fed and all the other major central banks ‘printing money’, it’s a similar situation. Although in this case they are liquidating/monetising previously created government debt. They are simply changing the structure of the debt market from long term to short term. They are making it ‘more liquid’.

So it’s no wonder this whole QE business is doing nothing for the economy. It has nothing to do with the real economy. They’re not printing money, they’re creating liquidity…liquidity which is entirely contained within financial markets.

It would only turn into real money in the economy if everyone decided to go to a bank and max out their credit by borrowing as much as they could. But most people have already done this, which is why the strategy of QE, if you could call it that, isn’t working.

The only way it could work is by gifting the masses shares in the S&P500 or the Dow, and using this as collateral to borrow more money into existence, or something similarly stupid.

But with no one taking central bankers to task, this madness will continue. Everyday we’ll sit around waiting for the data to confirm whether QE is working or not. And when it doesn’t, we’ll try just a little more, and then a little more again. We’ll keep going, until something forces us to stop.

Regards,

Greg Canavan+
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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