Let’s think logically about the facts. According to Bartho, the RBA and most other journo’s, the major banks have been given an awfully raw deal by our politicians. You see, in this little fairy tale, the major banks’ residential mortgage ‘net interest margins’—that is, the difference between the cost of funding a home loan and the interest rate they charge—has fallen a bit since the dawn of the GFC.
On the other hand, the major banks’ net interest margins on their business lending books have increased. So the fiction being peddled by Bartho et al is that, ipso facto, the banks’ business lending area is subsidising the profitability of their residential mortgage lending activities. As we shall see, the opposite is actually true.
Applying this logic, commentators then cast shame on anyone who dares question the major banks scraping back some of their profit losses via mortgage rate hikes that are greater than the RBA’s cash rate change, such as the 45bps that Westpac slugged borrowers with this week.
Unfortunately, there are several ‘inconvenient truths’ that eviscerate the integrity of this analysis.
First, the major banks’ profitability, or, stated slightly differently, ‘return on equity’, is not exclusively determined by net interest margins. There are a range of other essential inputs that drive return on equity, including the cost of selling home loans, a key component of which is upfront and trailing broker commissions, advertising and marketing expenditure, the expected losses on these loans (realised when borrowers go into default), the variable or unit costs of processing loans, other direct top-line revenue opportunities generated by associated fees and charges, and finally, the projected cross-selling opportunities. By only focusing on net interest margins, the commentariat completely ignores these vital inputs.
Second, the major banks capital-allocation decisions are not determined by net interest margins, but rather, quite rationally, by their forecast return on equity.
Third, and most importantly, the overall profitability of their residential mortgage books has been rising not falling. This is precisely why the major banks have redirected their scarce capital into home loans to the detriment of business lending throughout the GFC: ie, because they are rationally allocating their capital to the highest returning areas. And it is exactly why the commentariat’s logic is so asinine.
Taking a step back, we know that the profitability of the major banks’ business lending activities has fallen through the floor during the GFC due to large expected losses. Yet we also know that the overall profitability of the major banks has hardly moved (and in some cases actually increased). So it should be pretty clear that if the banks are taking massive losses on business lending, they must be making it up somewhere else…And you don’t need to have a full frontal lobe to work out where: residential mortgages, which account for 60 per cent of their assets.
There are several reasons why the profitability of residential lending has actually risen notwithstanding that net interest margins have fallen. And to the banks’ credit, they have been upfront in revealing some of this information.
First, their cost of sales have fallen significantly as broker commissions, which is one of their single biggest expenses, have declined by more than 30%.
Second, with the evaporation (or acquisition) of most of the major banks’ competition, they no longer need to waive lucrative fees and charges, or offer lower discounted home loans, in order to attract customers.
Third, the enormous increase in the major banks’ market share and the size of their mortgage books has reduced unit costs given that home loans are highly scalable assets (ie, serviced by large mainframe computers).
Fourth, the effective death of competition outside of the majors has alleviated pressure on the need to spend large amounts of money on advertising and marketing to drive volume growth.
Finally, and most critically, the expected losses on residential mortgages are a tiny fraction of the impairments on business lending.
To objectively prove all of this, one only has to cast an eye over the major banks’ financial results. The three diagrams below are excerpts from CBA’s 2009 full year analyst presentation.
The first figure shows the impact of the GFC on CBA’s product profits. Observe in the ‘home loan’ area, volume growth (gold bar) has driven a large increase in profitability. On the other hand, the cost to profitability from (i) residential mortgage margin declines, which is all that Bartho et al focus on, and (ii) impairment expenses (ie, expected losses) have been relatively minor.
Now shift your eyes right-wards to examine CBA’s ‘business lending’ profitability. Here we again see that volume growth has helped support profitability. Margin expansion, on the other hand, has been just a rounding error. The most important factor at play here is represented in the long red bar pouring down the page. That shows the expected losses, or impairment expenses, on CBA’s business lending activities. As you can see, the profitability of CBA’s business lending has been dragged down due to the much higher risks associated with providing finance to companies.
Now if you were a treasury guy at a major bank with scarce capital to allocate, and had this diagram sitting in front of you, where would you be putting your money?
(Click to enlarge)To reinforce these points, CBA was kind enough to show the historical loss rates across their lending portfolios during the last recession (refer to the next diagram). The tiny red line at the bottom represents residential mortgages. It is evident that the losses were minuscule. In comparison, the small business, institutional banking, and, to a slightly lesser extent, business banking losses are quite literally orders of magnitude higher.
(Click to enlarge)The final diagram shows CBA’s business unit profitability. Here it is also clear that by far the most profitable area of the bank (in absolute terms) has been the first line—retail banking, which is responsible for residential mortgage lending. Even on a growth basis, this group has outperformed most others.
(Click to enlarge)The key message here is simply that commentators, and the central bank, need to set aside their meaningless rhetoric around net interest margins, and start focusing on profitability and return on equity. If the commentators want to argue the case that the major banks’ are justified in raising rates beyond RBA rate changes, they need to support these statements with hard evidence illustrating a decline in the profitability associated with these activities. This is not the same as examining one particular input, such as net interest margins.
Some folks like Mark Bouris have proposed developing a ‘cost of funding benchmark’ against which we can dispassionately evaluate the banks’ decision-making. But this suffers from the same problem. What we really need is a public ‘return on equity benchmark’. Only then will we be able to determine whether events like the GFC have driven lower profitability, which in turn justify margin expansion.
