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Our banks are not as solid as we think they are

Adam Creighton

by Adam Creighton

23 Nov 05:50am

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Filed under: Banks, Economy, Finance, Gfc

40 comments

If the value of your total assets fell by 6 per cent would you be insolvent? If you are sensible probably not. Big companies like Woolworths or BHP would have to endure at least a 40 per cent drop in their assets before their assets were worth less than their liabilities.

Vintage Bill Leak, circa 2010

Yet Australia’s four major banks would be. If National Australia Bank’s total assets for instance fell in value by 6 per cent to $717 billion, its capital or shareholders’ funds would be more than wiped out.

Such fall is far from impossible given the big four banks’ massive exposure to home lending. The International Monetary Fund prompted lots of dismissive harrumphing from Australia’s big four banks this week when it suggested they held too little capital – the difference between their assets and liabilities.

ANZ’s chairman said extra capital would make the big four banks, which have among the highest returns on equity among any group of large banks in the world, “globally uncompetitive”.

The IMF said the four majors were “highly profitable, enjoying a funding cost advantage derive partly from the implicit government support and earning larger net interest margins than smaller banks and international peers”.

A very large chunk of their $25 billion a year profits arises from their ability to borrow more cheaply thanks to investors’ knowing that hapless taxpayers’ stand ready to bail them out if they falter.

“Significant and protracted difficulties in any one of them would [have] severe repercussions for the entire financial system and the real economy” the Fund added.

It is a little unfair to compare banks with ordinary firms – taking in deposits and lending them out is their core business. But the truth is Australia’s banks, like the bulk of the West’s financial system, are woefully and recklessly undercapitalised.

A century ago and decade thereafter, before prudential regulation was even conceived and only market forces provided discipline, Australia’s banks maintained capital ratios of between 15 per cent and 20 per cent, more than three times what they maintain today.

With harrowing memories of the 1890s, when the Depression wiped out half of Australia’s banks, banks prudently built up their capital ratio to near 20 per cent. When the Great Depression stuck in 1929 not a single bank failed.

A far smaller economic lull in 2008 paralysed the world’s financial system.

Negligent prudential standards are far from unique to Australia: since the beginning of the 20th century capital ratios have fallen by a factor of around five in the United States and the United Kingdom, eliciting a massive increase in the value the contingent claim banks have on taxpayers.

Yet the United Kingdom, Sweden and Switzerland, for example, have realised the error and are jacking up mandatory capital holdings for their biggest banks. Australia’s though will have only to meet the new ‘Basel III’ requirements, a fig leaf of prudence that maintains the status quo.

The pain of boosting capital – the tax system provides a big financial incentive to use debt over equity – would not be meted out on borrowers as the banks claim, but would mainly sap their profits and bonuses. As mandatory capital rose the implicit guarantee taxpayers unwittingly provide would fall, enabling smaller players to compete and preventing the larger players from passing on their higher costs.

Whatever combined costs borrowers, shareholders and managers incurred would be more than offset by the fall in banks’ contingent and grossly unfair claim on taxpayers.

Of course bank shareholders and managers have an incentive to cut capital to bolster profits in the knowledge their gains are unlimited and their losses capped, while taxpayers’ are not.

And banks’ creditors have not exerted much countervailing discipline knowing taxpayers are the ones really carrying the can.

But the mystery is how, with teeming armies of credentialed and highly paid bureaucrats having pored over banks for decades, banks hold vastly less capital now than they did before such oversight even began?

One theory is bureaucrats become captured by the institutions they ‘supervise’, reluctant to upset friends or limit lucrative job opportunities later. For their part, formal regulation means the banks and their creditors absolve themselves from serious prudential introspection, and instead focus on jumping through (or avoiding) the arbitrary and naive hoops regulators set for them.

Remember regulators in their wisdom for decades advised banks against holding any capital against European sovereign debt, much of which is now worthless.

Ideally government wouldn’t regulate banks and wouldn’t save them if they collapsed. But that possibility is a libertarian fantasy given the big government reality. The second best option is to force banks to hold much more capital than they do.

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40 comments

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    • acotrel says:

      05:43am | 23/11/12

      ‘Ideally government wouldn’t regulate banks and wouldn’t save them if they collapsed. But that possibility is a libertarian fantasy given the big government reality. The second best option is to force banks to hold much more capital than they do.’

      Perhaps it is time to lose the fantasy and get real ? The ideology is flawed, The great big new religion of globalism is based on bullshit. The GFC proved that !

      Reply

    • Super D says:

      07:30am | 23/11/12

      I’m not sure if your making a point or an argument or what? Do you want no finance from overseas? That really wouldn’t pan out well for most people.

      Did you mean to say that the new religion of global warming is flawed? That would be off topic but accurate and would have made more sense.

    • marley says:

      07:51am | 23/11/12

      acotrel - “globalism” isn’t some “new” religion.  The world has been trading across borders, investing and banking internationally, since the days of the Romans.  No, make that the Phoenicians.

      Unless you want to retreat to an entirely self contained economy, with no outside input , you have to deal with the reality that the Australian economy relies on selling internationally, on buying internationally, and on attracting foreign investment.  Of course, if you want to reject all that, there are models for doing so:  Albania in the mid to late 20th century, or North Korea right now.  Personally, I’ll take my chances with globalism.

    • Tyr says:

      08:21am | 23/11/12

      He has no idea what he’s talking about at any time, on any topic.

    • expat says:

      08:27am | 23/11/12

      Globalisation is here to stay Acotrel, you cannot have all the benefits without the negatives.

    • B. says:

      06:29am | 23/11/12

      Should basket-case Europe’s economic stupidities flow onto Australia we would not fare as well as we did during the GFC when we enjoyed the wise monetary management from the previous government’s budget surplus.

      Just think how dreadful such an outcome would be since the Labor government’s three-year vote-buying spending spree - we would not only be broke but very seriously indebted.

      Reply

    • Achmed says:

      07:04am | 23/11/12

      Like Howard did to get his surplus banks sell off assetts to provide a larger surplus while undermining the assett base.
      After Howards raid on our assetts we are left with; Medicare mmm not much else….Australian taxpayers own little now thanks to Howard.

      Reply

    • dovif says:

      08:12am | 23/11/12

      Howard sold off Telstra, what else did he sell, why don’t we go back to the privatisation of the last ALP government, does CBA, Qantas etc ring a bell

      Banks selling off assets? can you point me to when the banks are selling assets?

    • marley says:

      08:15am | 23/11/12

      It wasn’t Howard that sold Qantas or the Commonwealth.

    • Stephen T says:

      09:27am | 23/11/12

      @Achmed: Agreed, but I think Politicians of all persuasions are equally guilty of disposing of public assets.  When I think of the damage inflicted by Bob Carr and Anna Bligh on their respective States, and on the Federal front Bob Hawke and Paul Keating’s actions were what actually started it all, remember our Bank and the Airline Hawke sold to his mate Sir Reg.  They are all tared with the same brush.

    • Achmed says:

      06:21pm | 23/11/12

      Telstra, $30b, Australian Airports$8.5b and in his memoirs Howard happily cliams credit for the finalisation of the Commonwealth bank sell off $5.1b
      Reserve bank assetts including our gold bullion reserve $2.4b
      National Railway and frieght corp$1.05b
      Dasfleet $407M
      Broadcast Australia $650M
      Radio licence spectrum $1B
      Property portfolio $1b
      Total $ 51,7 billion, and that is how he got a $23 billion surplus….Take those sales away and we have a $28 billion deficit…

    • Tubesteak says:

      07:06am | 23/11/12

      The RBA only guarantees deposits with banks as a safeguard for consumers. They won’t bail out the bank itself

      Basel III is more than a fig leaf

      Considering a bank’s balance sheet is a near mirror a fall in assets would also mean a fall in liabilities. The correlation is not direct but there is a correlation

      Reply

    • dovif says:

      07:09am | 23/11/12

      This is one of the most stupid article ever written on the punch

      The assets of the banks are the loans, most of which are mortgaged against houses and business assets, the mortgages are never more than 70% of the asset, and if it is not, it is covered by insurance. The liability are borrowings from investors etc

      To make a $300,000 loan to someone, the bank would borrow $280,000 and front up $20k in equity

      That is quite normal, the writer have no understanding of the banking industry, the fact that the loans are secured over asset, with a buffer and if you add the 6% buffer to the 25% buffer on the asset, the real buffer for the bank is much closer to 30% ie not much different then Woolies, as stated by the writter

      If the banks are required to carry much larger equity, it will make it more costly for Australian to get financing for their home and have adverse effect on the economy

      Reply

    • Ziggy says:

      07:32am | 23/11/12

      Yes, that’s how it should be analysed. In fact our banks are safe as houses.
      Apologies for that one- couldn’t resist.In reality Woolies is much more vulnerable given their incredibly high costs for an alleged low margin retailer. Drop their sales just 20% and panic will set in because, like the dinosaurs watching the meteor approaching,they will have too little time to react before oblivion in the shape of a liquidator arrives at the doors.
      We deal in commodities a fair bit and always make sure we hold our cash reserves in Aussie Banks because they are the safest banks in the world.

    • pete says:

      08:04am | 23/11/12

      “If the banks are required to carry much larger equity, it will make it more costly for Australian to get financing for their home and have adverse effect on the economy”

      Yeah just keep playing chicken until we really get hit.

      dovif has no understanding about the risks Australian banks and in turn the taxpayer currently face.

    • Tubesteak says:

      08:16am | 23/11/12

      The banks don’t keep loans on their books. They sell the loans to unrelated securitisation vehicles for the NPV of the loan. This frees up cash flow for the bank

      This is also one of the misconceptions surrounding the GFC. The loans were on over-inflated assets and some of them subject to balloon payments that were inevitably going to be defaulted on (thank the US government for this as it was their policies that encouraged these loans). Banks securitised the loans and in-sold them. The impression was that this was dodgy when it is normal practice. In a properly functioning market nothing bad happens. But the government had poisoned the well by forcing certain providers to make bad loans as well as inflating the property market with cheap access to finance

    • Markus says:

      08:18am | 23/11/12

      Your last sentence glosses over a real problem with the Australian economy at present.

      Requiring banks to carry larger equity would make it more costly for the initial deposit for a home, but substantially reduce the overall cost of the home, as there would be less credit readily available for banks to give out.

      That increasing the affordability of housing for Australians would actually have an adverse effect on the Australian economy just shows how severely overinvested Australian banks are in unproductive housing and property markets.

    • wakeuppls says:

      08:18am | 23/11/12

      dovif

      It’s even safer for the banks than that. They don’t need to borrow most of the time to make loans. They only need 10% of their loans or close to, in deposits to make those loans. They simply create the other 90% out of thin air. It’s fairly easy to see where inflation comes from with this fact and it’s also easy to see why it really takes a massive hit to bank deposits (bank runs) to collapse a large bank.

    • Mav says:

      08:42am | 23/11/12

      ” the mortgages are never more than 70% of the asset, and if it is not, it is covered by insurance.”
      Isn’t that 80% of the asset?
      Anyway, have you looked at the capital adequacy of the counter-parties - i.e. the insurance companies - to cover the claims? It is 100 times worse than that of banks!
      Your comment is the one that is most stupid and uninformed.

    • Big Jay says:

      09:00am | 23/11/12

      Good analysis. Especially in saying that any mortgage with over 80% would be insured, I’d forgotten about the role of LMI.

      I’m not expert in the field but didn’t AIG need to be bailed out because it was being crushed from all the insurance claims on mortages from lenders there?...If banks asset values fell here, because underlying assets (like houses) lost value, I’d be a bit worried about the insurer going under too.

    • Lucas says:

      10:33am | 23/11/12

      As a banker, I will second this post. The writer doesn’t understand the concept of the banks assets and liabilities and insurance arrangements and lending criteria. The big 4 banks are safer now than they ever have been.

      The section of this article that is glossed over is the Basel III requirements and the various “Tiers” of capital which offer different levels of security. Some securities are more secure than others and it is important to differentiate these rahter than lump them into the same category.

      It is interesting to see this post however, as what the author is suggesting is that the banks are not profitable enough - they need to raise interest rates for borrowers and drop rates for depositors to ensure a more safe operating margin perhaps?

    • Al B says:

      10:46am | 23/11/12

      Good post Tubesteak.

      Just on this topic of bank balance sheets and how safe they really are…Max Keiser’s programs on RT are an interesting perspective on the amount of ‘repackaging’ going on and its implications. It just takes some folks a few episodes to see past the veneer of crazy lol…

    • No Financier says:

      10:51am | 23/11/12

      @Big Jay said ...“AIG need to be bailed out because it was being crushed from all the insurance claims on mortages from lenders there.”

      Mortgagees need to say NO to the banks and lenders who try to sign them up for a mortgage that is beyond their means to readily repay.  I thought prudence was a virtue.

      Banks need to stop lending to anyone and everyone without taking heed of a person’s ability to repay.

      How can you build equity out of debt?  Simple, sell your debt to some idiot willing to buy it, without knowing anything about the borrower on the other side of the coin.

      If bad debt is going to be swept under the carpet, or on-sold, you end up with loads of equity flying around, but it is an Equity House of Cards. 

      Building an equity model based on shifting bad debt is like building a house on sand.

    • No Financier says:

      11:03am | 23/11/12

      @Lucas, re…“The writer doesn’t understand the concept of the banks assets and liabilities and insurance arrangements and lending criteria.”

      I would have thought the most prudent form of insurance for a bank to employ would be to lend responsibly, rather than simply offload bad debt risk to an Insurance Company to cover the risk of default.

      I went into my bank the other day to deposit a cheque and was promptly sat down by one of the managers to tell me: “Look, we see you are so far ahead with your mortgage, how about you think about an investment property.”

      I replied, “Didn’t I just mention my wife is giving birth in a few months?”

      Bank Manager:  “Isn’t that nice.  Let’s have a closer look at how much we can lend you.”

      Me:  “I’ll think about it!”

      I do not call that prudent lending. 

      As you are a Banker, please enlighten me if I have oversimplified the concept.

    • No Financier says:

      11:11am | 23/11/12

      As dovif points out: “assets of the banks are the loans most of which are mortgaged against houses and business assets”.

      Any sort of loan is a risky asset at best - the potential for right-off is high, surely?  Surely banks should have more Solid Assets and lend against those?

    • Idiot not Abroad says:

      11:27am | 23/11/12

      Tubesteak

      If what you say is correct “The banks don’t keep loans on their books. They sell the loans to unrelated securitisation vehicles for the NPV of the loan. This frees up cash flow for the bank”

      I (as a bank) get $1000 through mortgaging and insurance, etc., so the NPV may be $800 on-sold for securitisation.  That securitisation firm on-sells for further securitisation for $640, and so on…$512 to $410.

      So suddenly $1000 has become $3362.  Seems dumb to me!

      Is that how it works?  Even remotely?  Talk to me like I never did Economics in High School, coz I didn’t smile

    • Mav says:

      11:34am | 23/11/12

      Tubesteak, you are incorrect re shifting of loans via securitisation. Most of the mortgages are still in big 4 bank books. Securitisation is mostly used by non-bank lenders.
      Have a look at APRA stats if you are unconvinced - http://www.apra.gov.au/adi/Publications/Pages/monthly-banking-statistics.aspx
      Table 2 - Loans and advances on Australian books of individual banks, Columns E & F - $1.12 trillion in total mortgages.

    • Mav says:

      11:54am | 23/11/12

      @ Lucas says “The writer doesn’t understand the concept of the banks assets and liabilities and insurance arrangements and lending criteria.”
      LOL.. lot of bankers crawling out of woodwork in order to smear the writer. The LMI Insurance companies simply don’t have the capital to pay out the claims. They are another AIG in the making - QBE is battered by Hurricane Sandy and Genworth has twice postponed its Aussie IPO.

    • Tubesteak says:

      03:54pm | 23/11/12

      Mav
      It’s the income stream of the loan and its liability that is shifted. The contract may still exist so admit to sever the connection between borrower and lender. All risk is shifted and the income flow is moved forward to the present

    • Lucas says:

      05:05pm | 23/11/12

      @No Financier.

      That is a smart move on your part to decline the finance. The manager really shouldn’t be giving financial advice like that, it is not the job of a bank manager to suggest investments.

      I hope that you have massaged the language a little bit there from the real conversation, and would draw to your attention responsible lending legislation that has come in recently and mean that the bank is not allowed to put you in a position that you cannot afford. If the bank manager chooses to ignore your upcoming cost increase (congratulations) then that is not too smart. I would like to think that when the time actually came to application your loan would be declined (or maybe not depends on how far ahead you are). It also doesn’t mean that you wouldn’t have made money if you bought a nice positively geared investment property with stable tenants at a realistic price.

      @ Mav - they will be reinsured. The australian property market is so small that you wouldn’t get into an AIG situation. And I would put it to you that long term all that happened was the insurer screwed up and they had to sell stock at a below fair price, to their own detriment.
      further reading - http://money.cnn.com/2012/08/23/news/economy/federal-reserve-aig-bailout/index.html

    • pete says:

      07:16am | 23/11/12

      The safest and smartest option would be regulatory tools that limited LVR to 80%. Declining lending standards put banks in this position and in turn taxpayers, they also indebted the population to buggery.

      Reply

    • James Harper says:

      08:21am | 23/11/12

      Our banks aren’t solid because of Australia’s hidden subprime mortage problem. Every single definition of what was happening with US subprime is / has been happening here with brokers lying about the veracity of income, specifically falsifying documents to claim self employment when there was none. See link below for full details…

      http://australianpropertyforum.com/topic/9672375

      On top of this there is the Collateralized debt Obligations which have been onsold into the market place, combined with the surge in sovereign wealth funds and central banks diversification into Australian treasuries this is a perfect storm far, far worse than the US sub prime melt down.

      These are not issues with low doc, or no doc self employed loans - they are specifically looking at falsified documents - exactly the same in every respect to what happened in the US.

      And that’s why the banks are not solid.

      Reply

    • NESLIHAN KUROSAWA says:

      09:41am | 23/11/12

      Hi Adam,

      Do we all really get how banks make all that money? And after seeing what has been happening with the banking sector in some Euro Zone countries, can we honestly say that banks will end up losing their capitals as well as their reputations?  With all the foreseen deregulation moves in the banking sector , why hold them responsible for their decisions now? Ideally banks are in the business of making money under any circumstances, right?  And they will always protect their own interests first and foremost?

      As we have seen in places such as Greece banks exclusively were the first to benefit from the bail out packages offered from the other Euro Zone countries. So at the end of the day and on a very personal level should we all really worry about what happens to our personal savings or the profits of some major banks? As we have also witnessed recently in the USA,  a lot of Americans have lost their homes due to faulty financing and mortgaging practices? Is that also fair? 

      How do the banks get all that money and make all those critical moves relating to our everyday life savings as well as the very assets and personal investments like our home mortgages? Does it make any difference either way, if our banks may seem to be on the solid and reliable side now?  What about in the future?  Can we make truly make sure that our valuable savings, superannuation plans and lifelong dreams are completely secure? Looking at other nations’s track records can we afford to be a little optimistic, pessimistic or realistic at the same time?  Kind regards.

      Reply

    • wakeuppls says:

      10:17am | 23/11/12

      While governments regulate banks and encourage poor lending standards, whilst simultaneously providing them with a safety net if they do indeed collapse, we will forever see our savings and our wealth being squandered in high risk financial transactions.

      The market has a solution to these banks. It seems though that governments worldwide are determined to deny it.

    • Markus says:

      11:51am | 23/11/12

      Iceland had a solution to these banks, too.
      Sadly other governments around the world have not felt compelled to act in a similar way.

    • AdamC says:

      09:55am | 23/11/12

      I do not agree with this. Sure, much higher capital ratios would boost security, but it would also serve to further ration credit. In Australia, that would limit small business’ access to funding even more and increase the share of residential mortgage lending.

      Ultmately, no bank can survive a run, so there is necessarily a limit to how effective capital ratios can be in preventing insolvency.

      Reply

    • Shane From Melbourne says:

      11:02am | 23/11/12

      The major difference between the United States and Australia is that Australia has non recourse mortgage loans while the United States has recourse loans aka “jingle mail” so in theory even if the person sells the house for a loss they are liable for the difference. In practice if the person is unemployed and bankrupt, the negative equity is still going be on the banks books. It all depends upon whether the property market deflates slowly or the Australian economy experiences a sharp rise in unemployment and thus mortgage defaults and more importantly property values. The original poster’s premise is still valid, negative equity is still negative equity and the hit has to be taken by someone whether is is the banks, the mortgage insurer or the investor that lent the money or the investor that bought the CDO

      Reply

    • pete says:

      11:27am | 23/11/12

      Do you actually know what you’re talking about Shane, or do you just parrot what Kochie told you?

      Firstly, you’ve confused recourse and non recourse.

      Secondly, the US only has 11 non recourse states where you can walk away from the mortgage.

      Thirdly, the biggest busts happened in recourse states like Florida and Arizona where you can’t.

    • Esteban says:

      12:17pm | 23/11/12

      We have had the current arrangements for capital adequacy ratios for a couple of decades now.

      What has changed that make them inadequate now compared to previously?

      The only thing I can think of is Australian banks have embarked upon a program to sell all their freehold properties (bank branches) and lease them back.

      This has enabled them to lend out more by swapping one asset class (land and buildings) for another asset class (loans).

      Although this has been going on quietly virtually since the current capital adequacy ratios came into being I doubt that the value of these landed assets was high enough to significantly corrupt the capital adequacy.

      So why is it a problem now? What else has changed/ The article does not reveal.

      One of the lesser known reasons Australian banks did so well from 2008 and are in such a good position now is because we had our banking crisis in 1991.

      Does anyone realise how close Westpac came to going under in 1991 after recording a record loss on the back of writeoffs?

      The share offering to shore up Westpacs balance sheet and cover the loss was not taken up by investors and it was left to the underwriter to cough up.

      The share offering prospectus did not disclose a tax liability in the USA and the underwriter had grounds to pull out of the deal which would have left Westpac insolvent and in big trouble.

      The underwriter chose to proceed with the deal perhaps realising that the whole Australian banking system would have collapsed.

      This is despite the fact that they underwrote the offering at $3 a share but the price on the market had fallen to below $2.50.

      Finally good old Kerry Packer emerged from the shadows and bought millions and millions of options to buy which helped push the daily share price above the $3 of the issue price.

      Thanks to the underwriter, AMP and Kerry packer the crisis was averted. The underwritten share offering saved the balance sheet which was further strengthened by a push by Westpac to write home loans which had a more lower capital adequacy requirements than business loans.

      We had our current capital adequacy requirements while alll that unfolded.

      A few gentleman handshakes in board rooms achieved what capital adeqacy ratios could not

      However after that the Australian banks emerged much wiser and it was that wisdom that played a major role in becoming embroiled in the worst of the 2008 stupidity.

      One cannot underestimate the value of a corporate memory. How many young banking executives out there know the full history of those tense days?

      Reply

    • pete says:

      12:36pm | 23/11/12

      You’d love to see the domains of those questioning the author’s claims. CBA, Westpac, ANZ and NAB and the ABA would have to be in the mix.

      Reply
 
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