“Basel I, II and III are typical examples of regulators trying to chase a moving target too slowly and often using the wrong tools to do so,” says Edwards. “In Basel II, there was a lot of emphasis on interest-rate risk, hence banks found ways to achieve higher shareholder returns by taking higher risks with credit risk instruments and off-balance sheet items. Basel III tries to correct credit risk, but it should now be looking at how to contain contagion, identifying problem banks and macro-prudential policies.”
Let’s not forget Basel I, which determined mortgages should carry a lesser capital charge than they did in the past. Many look to this as a reason for the recent global financial crisis.
Holding more capital for volatile times is hard enough, but the real killer for the banks is being forced to hang onto more cash and government bonds, says Kevin Davis, research director at the Australian Centre for Financial Studies.
Under the new reforms, banks will be forced to match their assets and liabilities, which means they can no longer make a profit by using short-term deposits to fund long-term loans. “Banks will not be able to produce liquidity as they used to … regulations designed to reduce risk to the system will inhibit their ability to affect the sort of economic transformation that we see as being socially valuable,” Davis says.
Due to Australia’s low level of public debt, the Reserve Bank of Australia, the central bank, now has agreed to provide banks with some access to a secured liquidity facility for a small fee. The decision aims to cover a shortage of government bonds, but this concession does not change much.
Scoular estimates Aussie banks are short about A$150 billion to A$250 billion of liquid assets to get through a 30-day crisis. He says the shortfall of stable funding – the amount of new liquidity that needs to be built up to ensure that longer-term loans can withstand volatile markets – is about A$300 billion to A$400 billion. Less lending for less money is inevitable.
With the ongoing structural changes and a soft outlook for credit growth for some time ahead, the outstanding question is: where are banks’ returns on equity (ROEs) heading in the new, uncertain world? In the future, lower “utility-like” returns on risk look likely.
While the banks’ profit numbers look impressive, the story behind the headlines is not so compelling, says Scoular. Revenue growth is weak. Earnings were mainly driven by cost containment – particularly the reduction in bad debt expenses. However, Scoular points out that while return on equity has been down for more than three years, the banks continue to have a healthy ROE at 15.9%. “There is no doubt that earnings growth remains under pressure. The requirement to hold higher levels of liquid assets dilutes profits. Also, the cost of debt is rising and the impact of terming out funding to meet regulatory requirements will have a negative impact on ROE. But offsetting this is the banks’ ability to pass the higher costs onto customers.”
Competition within the sector has intensified as the banks fight aggressively against each other to attract retail depositors and homeowners. “When margins get too tight the banks are likely to pull the price lever to maintain margins,” tips Scoular, while Davis points out that the new regulations are designed to reduce riskiness and one of the implications is that investors should require lower rates of return.
The burning question is whether the banks can avoid pain because of their tremendous market power. Can they make money through innovation, creating and marketing new products?
International banking consultant Satyajit Das says the new maths simply does not add up. Profits will be lower, and he predicts the banks’ ROE will halve to single figures. “Banks are already writing mortgages at a loss,” Das notes. The new liquidity controls mean banks cannot grow unless they grow their deposits and they can only grow as quickly as domestic savings build.
The ANZ’s Mike Smith recently said that the growth opportunities available to the bank in the wider Asia-Pacific region are simply not available in Australia. Major structural changes in the Australian banking system are forcing ANZ to become increasingly reliant on its overseas operations to cover a local earnings shortfall created by the lending slowdown and high-funding costs, he claimed.
Smart people know the game is over and are looking for opportunities for players outside of the regulated space, says Das. “Peer-to-peer lending, for example, which is like eBay for money.”
Parwada observes banks also are closely watching offshore social networking innovations, such as crowd funding. “Given that US authorities are moving to regulate this source of financing, this might be seen as the genesis of folding the otherwise spontaneous social phenomenon into the mainstream (that’s) dominated by licensed entities – along the same lines as non-bank lenders were spawned in the mid 1990s,” Parwada says.
