Wednesday, July 18, 2012

Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.