Dinner Party Banter - Banks

Bank Funding – Liven up your Dinner Party!
In today’s article I will attempt to do the seemingly impossible. I am going to try and make an article on Bank Funding Costs interesting..........stay with me here. Today the Reserve Bank of Australia made their monthly (except January) decision to set the official cash rate. This decision results in a frenzy of media speculation and political bank bashing from both sides of politics – although we have been spared this time round as the RBA has kept rates steady. Regardless, my attempt today, may not win you friends at dinner parties, but may give you a better understanding of how our financial system works, and consequently, the small mindedness of the political point scoring.
So here goes.......firstly, I want to provide some context about what occurred during the Global Financial Crisis.
Do you remember a company called RAMS Home Loans? Sure, it still exists today, but certainly not in the same form it did back then (indeed, the franchise is now owned by Westpac). RAMS was part of the Home Lending revolution in the late 1990’s that really saw the Non Bank Lenders (Aussie Home Loans being another) stick it to the major banks. They did this by introducing a new form of home loans that was financed by Mortgage Backed Securities (MBS). The new kids on the block were able to slash the interest rates that were being offered by the major banks and they took a reasonable chunk of market share. This was achieved via the plentiful and cheap funding of the MBS market plus the low cost base of their business model – fewer branches and no transactional banking. Times were good, good enough in fact for John Kinghorn, the founder of RAMS Home Loans, to pocket $650 million when he floated RAMS in July 2007 (with hindsight, a brilliant decision given what happened next!).
You see, because RAMS was not a deposit taking institution it was therefore not regulated by the Australian Prudential Regulation Authority (APRA). Without this prudential oversight, RAMS was able to raise much of its funding by issuing short term bonds in the MBS market.Unfortunately for them, much of this funding matured just as the Sub Prime crisis began to blow up in July 2007, not long after RAMS listed on the Australian Stock Exchange. The consequence? Bond investors either wanted their money back or rolled over at a much higher rate. And that was that. In Australia the MBS market pretty much died overnight and RAMS ceased to exist in its original form.
Now the reason I thought I would tell you about this is that it puts into context that our “Banks” in Australia simply cannot do this. This is because part of the conditions of being a licensed deposit taking institution in Australia is that you allow APRA to monitor your activities in your day to day banking duties. Put simply, Australian Banks are not allowed to borrow (take deposits) short term and invest (lend) long term. Australian Banks are required to match the “duration risk” of their deposits against their loans to borrowers. APRA oversees this.
So when we hear about the reserve Bank setting the “Official Cash rate” this is simply the overnight rate used by banks to settle their outstanding credits or debits in the banking system for that day. This has indeed become a de facto indicator of what sets the banks’ interest rates, even though it has little bearing on the overall pricing of a single bank’s loan book. Put simply, a bank cannot ask for an unlimited line of credit from the RBA at the current overnight cash rate, and, even if it could (interestingly, the European Central Bank has recently done exactly that....), APRA would not allow this to occur as it would shorten the duration of the bank’s liabilities, putting it at risk much like RAMS.
Adding to the cost pressures, the Banks also are required to finance part of their loan book by issuing Bonds overseas. The global credit crunch is also impacting the Banks ability to do this successfully. International investors are demanding higher returns when lending to Australian Banks, despite their sound credit ratings and seemingly safe location. Australia is a country that relies heavily on Foreign investment and as a result we are beholden to the mood of Global Credit markets. So this is why we have to be very wary of media reporting and political point scoring that demands that our financial institutions set their variable rates based on the official cash rate. It simply does not work like that.
(BTW, there is a lot more to the make up of funding for banks, but to go into more detail would risk your dinner party guests walking out).
At this stage of your dinner party, you might have upset some of your guests by defending the Banks, but why not further incite them by discussing the Banks “obscene” profits? Firstly I think it is important to point out that having a profitable local banking sector sure beats having the European version..... a collapsing, bail out ready banking sector. Warren Buffett put it beautifully in one of his Annual Reports a few years back when he stated.
“Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed”.
So having a well functioning banking sector is vital for the growth of our economy. Have they made mistakes? Yes. Have they been allowed to swallow up their competition? Yes. Do they pay their executives too much? Yes. But are we lucky to have the banks we do in Australia? Yes!
But let’s look at the alternative? A shrinking banking sector results in contracting credit that would inevitably lead to falling housing prices.....not an ideal outcome. We must also consider the wider implications of the political bank bashing because there are a few other unintended consequences. Pressure on bank profits will result in lower dividends to retirees, superannuation funds and personal investors. These lower dividends are also likely to result in lower share prices. Keep in mind also that the political pressure is on home loan rates – so banks may cave in to this pressure but leave business banking rates unchanged. It is no consolation if your home loan rate falls but you lose your job because your employer can’t obtain reasonably priced credit. So Wayne Swan et al, be very careful what you wish for.
But putting it in perspective, the Big 4 Australian Banks are VERY BIG. The balance sheet for the Commonwealth Bank (CBA) alone lists $668 billion in Assets for a profit of almost $10 billion before tax (2011 Annual Report). That makes for a return of just 1.5% on assets which is actually pretty poor. The Banks, however, are a little different to most Industrial Companies. This is because they are highly leveraged operations. The balance sheet for CBA also shows liabilities of $630 billion resulting in net assets or “book” equity of just $38 billion. The before tax profit return on this “book” equity is much better at 26%. Unfortunately for potential investors, the share market has valued the “book” equity in the CBA differently as its market capitalisation (share price multiplied by number of shares on issue) is almost $80 billion – twice its book value!!! So the profit is not as attractive at 12.5% (before tax) if you buy the shares on market today.
But think about that, buying shares in a company which has geared its “book” equity 17 times – I would want to be handsomely rewarded for taking on that risk, wouldn’t you?[Footnote: Banks profits are currently circa $30 billion per annum which results in tax revenue of around $9 billion. If the Federal Government really wants to achieve its budget surplus in 2012/13, it had better be careful not to bite the hand that feeds it!!!!]