A good first attempt by Anthony, which I might return to later...
Business Review Weekly
BANKS ON SHIFTING SANDS
Anthony Sibillin
Thursday 17th of June 2010
The big banks may have steered a steady course through the global financial crisis but are they really as safe as houses? Report: Anthony Sibillin
"Pride goeth before destruction and a haughty spirit before a fall," warns the Bible. Australia's big banks are certainly proud and haughty after emerging in profit from the global financial crisis and in credit for not magnifying the downturn in the way United States and European banks did.
However, must it lead one day to the destruction and fall of one or more of the big banks?
Until very recently, the thought was preposterous. In the first half of 2010, Commonwealth Bank of Australia, Westpac Banking Corp, ANZ Banking Group and National Australia Bank made $14 billion in pre-tax profits between them, up from $9.7 billion in the second half of 2009.
Bumper profits reflect the wisdom of local rules and sagacity of local bankers, according to the politicians and bureaucrats watching over them. A "sound financial system" is a big reason Australia had one of its "mildest" recessions in the post-War period while the US and several European countries had one of their "most serious", Reserve Bank of Australia governor Glenn Stevens said in April.
Yet two developments make the thought of a leading bank failure less preposterous than it seemed a few months ago.
One is a cooling housing market. After rising for 16 consecutive months, capital city house prices were virtually unchanged in April, according to the RP Data-Rismark Hedonic Home Value Index. Weak demand for home loans – the number approved in April was the lowest since March 2001 – suggests other capital cities might soon follow Brisbane, Perth and Darwin, where prices are already falling.
If this happens, bank profits are sure to follow. Why? Because the share of home loans in banks' total lending stands at 58 per cent, according the RBA. Falling house prices spell fewer buyers, borrowing less and paying banks less interest.
If they fall enough, house prices can drag down an entire economy. This is what happened in the US in 2006 when falling prices led to a jump in the number of Americans unable to pay their mortgages and, a year later, a sharp rise in unemployment. The newly jobless swelled the ranks of defaulters until the losses tipped thousands of US banks and mortgage firms into bankruptcy and the global financial system into crisis.
University of Western Sydney economist Steve Keen can see something similar happening in Australia. He says households are so indebted – the ratio of mortgage debt to gross domestic product has quintupled to 85.7 per cent over the past two decades – they can borrow no more.
"Our current level of economic performance is dependent on an increasing level of debt to GDP," Keen says. "As soon as you have a stabilising, which we are seeing now, then you are in trouble."
The head of the RBA's financial stability department, Dr Luci Ellis, counters that the recent US experience is historically anomalous. "Financial crises are normally sparked by other sources," she told a conference in May. "These [sources] include commercial property, property development, leverage buyouts, sovereign debt and so on."
Which is why the developing sovereign debt crisis in Europe provides a second reason to worry about local banks. While the big banks have little exposure to European governments in difficulty, the RBA's Stevens concedes the most important effects in Australia will come through "the impact on world and Asian growth, on resource prices and on the cost and availability of global capital".
In the event, unemployment might rise sharply, souring a big chunk of the housing loans that dominate the big banks' balance sheets.
"A collapse in China – or even a global slowdown – will have an impact on the economy, Australian income growth, and that would certainly feed into house prices," Australian School of Business researcher Glenn Otto says. "The impact of unemployment is also crucially important for house prices; an economic shock pushing up unemployment would have even more consequences for house prices."
While few economists are as pessimistic, most agree the big banks are now too big for any government to let fail. "They are all too systematically important to fail," real estate funds manager Rismark's managing director, Christopher Joye, says. "That is one reason why taxpayers offered the major banks deposit and liability guarantees during the GFC."
Fortunately, they did not have to draw on those guarantees. But what if they do in the future? Is the government's balance sheet big enough to cover the big banks' deposits and liabilities?
"The Armageddon outcome would be the complete implosion of the banking system if taxpayers were not there to backstop institutions in the case of a crisis, which could cause extreme credit rationing and precipitous price falls," Joye says.
According to a former chief economist of the International Monetary Fund, Simon Johnson, Australia's big banks pose a bigger risk to the economy than the biggest US banks do (see table). Johnson thinks no single bank should own assets (mainly housing, small business and corporate loans but also derivatives and other investments) worth more than 4 per cent of a country's economic output.
Yet NAB owns assets equal to 54 per cent of Australia's GDP, followed closely by CBA (51 per cent) and Westpac (49 per cent).
Even the bank with the fewest assets, ANZ (42 per cent) is almost three times the size, in relative terms, of the biggest US bank, Bank of America (which owns assets worth 15.6 per cent of US GDP).
Australian School of Business banking and finance lecturer Ning Gong says a hard cap on the size of Australian banks would need to be higher than 4 per cent to take account of a comparatively smaller market. "We [would] need another 45 banks to manage the assets under the current big four," Gong says.
Yet as Johnson and co-author James Kwak note in 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, there is "little vidence" that big banks are more efficient than small ones.
"A review of multiple empirical studies found that economies of scale vanish at some point below $10 billion in assets," they write.
In other words, even smaller Australian-owned banks Bendigo and Adelaide Bank ($51 billion) and Bank of Queensland ($36 billion) are already as efficient as they can be.
At the very least, CBA's purchase of BankWest during the global financial crisis should be the last big bank acquisition regulators approve, competition expert and associate professor at the Australian School of Business Frank Zumbo says.
"The current law dealing with mergers is weak and ineffective," he says. He wants it changed to allow the big banks to be broken up for competition as well as financial stability reasons.
Few dispute that the big banks borrow more cheaply on international markets than smaller rivals because investors assume the government will not let them fail. For Louise Petschler, chief executive of Abacus, the industry body for credit unions and building societies, this is one reason the government should level the playing field for deposit funding, by continuing to guarantee bank deposits indefinitely.
"One of the lessons of the global financial upheaval was that sometimes simple is best – and mutuals are very sound, with straightforward balance sheets, conservative funding, high-quality assets and high capital," she says. "Global collapses and bail-outs were about very big, very complex, aggressive and 'creative' institutions."
For this reason, Rismark's Joye is more concerned about the overseas expansion of ANZ and NAB than he is about a collapse in house prices.
"The major banks' peers in the UK and Europe had far greater direct exposures to the US sub-prime crisis through their overseas expansion strategies," he says.
"My single greatest concern with the major banks right now is their offshore expansion plans, which directly undermine their greatest source of strength during the GFC."
Like Joye, Keen is also cool on a size cap, believing banks would successfully lobby it away during stretches of economic and political stability. He favours a cap on the size of home loans instead – equal to 10 times the rental income from a property – and other measures to reduce demand for credit in the first place.
Of course, the failure of a big bank is still an unlikely, if no longer a preposterous, idea. According to John Laker, chairman of the Australian Prudential Regulation Authority (APRA), the main bank regulator, the big banks would survive a Chinese and global economic downturn severe enough to raise unemployment to 11 per cent and lower house prices by 25 per cent.
However, as Laker admits, a future downturn will "not play out as specified" in APRA's so-called "stress-test". "It is just one of a myriad of future possible outcomes," he said in early June.
Among clear lesson of the global financial crisis is that the unlikeliest outcomes become possible in a crisis. After all, the best computer models said US house prices would fall by 20 per cent only once every 10,000 years.
Table:
HOW THE BIGGER BANKS RANK
Bank Total Total
assets $m assets/GDP %
National Australia Bank 650,360 54
Commonwealth Bank of Australia 625,426 51
Westpac Banking Corporation 600,775 49
Australia and New Zealand Banking Group 506,708 42
Bank of America (US) 2,817,711 16
JPMorgan Chase (US) 2,573,248 15
Citigroup (US) 2,412,305 14
Wells Fargo (US) 1,474,253 8
Source: Company reports, Yahoo! Finance, ABS
