An interesting take on the Australian banking sector from InvestSMART.
Over the last 20 years the ASX All Ords has returned an average of 4.4 per cent a year. The major banks have beaten that hands down, delivering an average return of 7.5 per cent pa.
Things were wobbly during the GFC but the comeback, assisted by government guarantees, was stupendous. Investors that held on through thick and thin (there’s a lesson there) have done remarkably well. Even compared with their international equivalents, Australian banks are top of the class:
Since the GFC, when interest rates have slowly headed towards zero, Australian and Canadian banks have been the only ones with ROEs in double figures – well into double figures in fact. How have they done it? Well, our banking sector isn’t especially competitive. They all work pretty much the same way, do pretty much the same thing and charge a pretty penny for it. That’s part of it. But this chart showing real interest rates for cash, housing (mortgages) and business loans over the past 20 years is a better explanation.
A bank makes most of its money from borrowing out at one rate (the cash rate, more or less, shown as the blue line) and lending it out at a higher rate (the red, green and purple lines, showing different forms of lending). In banking this is called the interest rate spread and the higher it is, the more money it makes.
Since the GFC the cost of bank borrowing has fallen substantially but in real terms what we’re charged on our loans hasn’t fallen as much. A mortgage rate of four per cent might sound low to those of us that can remember rates of 15 per cent but compared to what a bank pays to borrow the money, it’s pretty high. The banks call it a ‘repricing’ of home loans, which the RBA has said puts the implied spread on housing lending “higher than the previous peak in 2009”. This chart shows what that means:
See that gap between the red and purple lines in 2009, when the interest rate spread was about two per cent? There was some compression after the GFC but now look at the gap for 2016: it’s even higher. The banks are making a killing on mortgages, and that’s the primary reason for their growing profitability. This chart shows the dividend payout ratios of the big four banks over the past 20 years:
While there’s a fair bit of volatility from year-to-year, bank dividend payout ratios are pretty high. That’s bank boards succumbing to investor demands for yield but also having the profits to be able to do so. More recently, we’ve had the odd situation where banks are paying out huge dividends and then asking for it back via capital injections to support a massive growth in mortgage lending (and comply with new regulations, which we’ll get to). Here’s the chart:
Incredible isn’t it? Our banking system has become addicted to mortgage lending. But why wouldn’t it be? Mortgages are hugely profitable and the source of returns on equity that are pushing 20 per cent in some cases. Here’s resident economist Callam Pickering on the issue:
“By focusing on mortgages, banks have the ability to leverage themselves higher which boosts profitability and return on equity. During good times, the key to greater profitability for banks is to write as many new mortgages as possible; those banks that focus on business loans are likely to suffer by comparison. For the most part, the majors are holding just a few cents for each dollar of mortgages they hold on their books.”
Are the regulators worried? Sure they are. A bank must hold a certain level of capital for each loan it writes. The amount depends on the perceived risk of a loan. In the past, mortgage assets have been ascribed a very low weighting – that ‘few cents for each dollar of mortgages’ is no exaggeration – but last year’s Financial System Inquiry concluded banks needed to hold more. Last year, the four largest lenders raised a record $20 billion in equity capital to comply with these new regulations. And they may need a similar amount over the next two years.
Even so, bank system leverage, which some claim is as high as 41 times, is higher than I’d imagine most bank shareholders suspect. And mortgages are the reason for it.
By their nature banks are leveraged. But to achieve such high returns on equity banks are using even more of it. This chart shows where most of that funding comes from:
On the past 20 years bank there’s been a big shift away from domestic deposits towards offshore financing of loans. That makes sense: you can’t sustain a huge increase in mortgage lending from domestic deposits alone. That money has to come from somewhere. Let’s put all this together and see what it means for the local economy.
First, that huge growth in mortgage lending shows up in household debt. LF Economics estimates that in the second quarter of 2015 Australia’s unconsolidated household debt was 123 per cent of GDP, the highest in the world. The euro area was half that, the UK 86 per cent and the US 79 per cent. That’s what a quarter century of uninterrupted growth does. Recessions purge bad debt from the system and economic growth hides it. When the tide goes out in the next recession, we’ll see who’s been bathing naked.
Second, the level of debt makes Australians especially sensitive to interest rate rises. Bond rates are telling us that there’s no prospect of that but if the markets are wrong it might not be pretty. Third, because of the increase in overseas bank funding, our banking sector is now more exposed to overseas developments, including currency movements. Our banking sector is anything but an island.
