As I first noted here (well worth a read), the commentariat’s mistaken fixation with net interest margins belies the fact that it is return on equity that drives profitability. Net interest margins tell us nothing about the cost of selling and servicing loans, nor the non-interest revenue lines, such as fees.
And so while funding cost challenges did temporarily compress net interest margins on residential loans during the GFC (but notably not business lending margins), this was at least partly offset by dramatic reductions in costs—namely, a one-third decline in the costs of distribution, scale economy benefits as the oligarchs’ market share rocketed through the roof (home loans are highly scalable), and the diminution of many of their expenses—think advertising and heavily discounted rates—that were required during the pre-GFC days to effectively compete against smaller banks, building societies and non-banks.
And then there were the newly invigorated top-line opportunities—the well-worn banking diet of product and transaction fees—that no longer needed to be waived given the cartel’s control of the market.
So my first criticism of the commentariat was that you can easily have a decline in net interest margins while still experiencing a stable or increasing return on equity given that the latter is influenced by many other variables over and above funding costs. And this helps explain why the major banks remained highly profitable during the worst credit crisis in nearly a century.
The RBA responded in kind to my arguments with Ric Battellino’s subsequent speech on the 16th of December last year. Ric explicitly sought to analyse, for the first time, the relationship between funding costs and bank profitability.
In the chart below we want to first focus on the top blue line, which represents the oligarchs’ reported profits. Observe how they were able to remarkably maintain their earnings beyond 2005 levels throughout this calamity. Remember these are institutions promising shareholders very high, double-digit equity returns in exchange for some degree of purported cyclicality (viz., risk) in those earnings. But not the Antipodean oligarchs. They hardly registered a cyclical blip during the worst crisis since the Great Depression. It was an amazing outcome. Indeed, one might venture that they look uncannily similar to government-guaranteed utilities. Hey, wait a second…No, I won’t bother going there.
Now shift your eyes to the grey line. This shows what the major banks’ earnings would have looked like had they kept their net interest margins constant at pre-GFC levels. Yes, commentariat, let’s put this in really plain english: the cartel’s actual profits are higher than those associated with static margins according to the RBA. Ipso facto, margins increased, not decreased, during the crisis, as many would otherwise have us believe. The final line is an irrelevancy, and simply depicts what would have happened to profits had the oligarchs not sought to maintain margins at all—ie, had they absorbed all of the funding cost increases. But that was never going to happen as it would have eviscerated any hope of senior management paying themselves bonuses.
Now let’s correct a few factual errors. First to our Treasurer, Wayne Swan, who informed voters yesterday that:
“The banks' interest rate margins are back to pre-crisis levels. They have as profitable margins now as they had before the crisis. The Australian people were bitterly disappointed with the behaviour of some of our banks at the end of last year. If any major bank were to attribute some move above the Reserve Bank's to this decision they would be wrong and would incur the wrath, not just of the Australian people, but of the Australian government."
Technically speaking, this is not accurate. That is to say, the banks’ net interest margins are not ‘back to pre-crisis levels’. According to Ric Battellino they have, in fact, expanded beyond that threshold: “Over the past year or so, however, margins have widened again, and they are now about 20 basis points above pre-crisis levels.”
Yet it is the ordinarily affable Andrew Main at The Australian who makes the most intellectually grievous of mis-steps, erroneously advising his readers that our oligarchs are actually much worse off today:
“There's the incorrect belief that the major banks have been making out like bandits on lending since the guarantee came in in October 2008. Even the Reserve Bank concedes their lending margins, at about 2.53 per cent, are way below where they were before 2002, when they fell below 3 per cent thanks to competition from the non-bank lenders in particular. In essence, they've had the unfamiliar experience more recently of being squeezed by a cost of funding that's been rising much faster than official interest rates and also faster than their own rising slugs on borrowers.”
While the overall thrust of Main’s argument is hard to understand given the oligarchs’ profitability has increased robustly since 2002, the final sentence in particular is categorically incorrect. Earth to Andrew: the banks’ cost of funding has not been ‘rising much faster…than their own rising slugs on borrowers’. More specifically, to quote his source, the RBA as at the 16th of December (with my emphasis added):
“The margin on variable housing loans is much the same today as it was at the start of the crisis… Margins on business loans, however, are now substantially higher than they were immediately before the crisis.”
As I’ve noted before, the pugnacious Battelino delivered a rarely referenced upper-cut to the oligarchs in December. He was basically telling them that they (and their faithful apoligistas) should no longer use RBA analysis as a scapegoat for justifying out-of-cycle rate hikes (aka margin expansion), as Gail Kelly had done in the weeks preceding Battelino’s speech. And rest assured, the RBA’s words are as strong as they come in the parallel universe that is central banking land (emphasis added):
“With the economy and business climate now improving, the economic justification for wider margins on loans is becoming less compelling, so it would be reasonable to assume that, in a competitive banking sector, we should see margins level out soon. Over the past couple of months, there have been some signs that this is starting to occur.”
