Use your brain before joining the bank lynch mob

When the punters, the pollies and the media all get their knickers in a twist over rising mortgage interest rates, any argument - no matter how misconceived - is fair game.

We're being assured that the banks' huge and growing profits are obvious evidence of "gouging". And any increase in mortgage rates in excess of the rise in the official interest rate is obviously immoral and probably should be made illegal.

Sorry, but no matter how unlovely the banks are - and I'm no admirer or defender of them - those propositions don't make sense.

With Westpac this week being the last of the big four banks to announce its annual profit, much has been made of the 26 per cent increase in its underlying (or "cash") profit to $5.9 billion. Surely this is proof of profiteering?

Well, no, not when you look at it.

Turns out the main cause of the increase was not a rise in the bank's net interest income but a big fall in the amount of its annual provision for bad and doubtful debts.

The next supposed evidence that the big four banks are gouging is just the huge amount of their combined profits: $21.4 billion, as we were told many times this week.

But anyone who knows the first thing about business knows you can't tell much about how well a business is doing just by the size of its profit. You have to compare the size of the profit with the size of the business. A profit of $1 billion would be fantastic for a corner store, but pathetically poor for Telstra, for instance.

In other words, what matters is not the absolute size of the profit but the degree of profit-ability - profit as a proportion of the size the business, measured by the amount of its assets or the amount of its "equity" (the money invested by the owners of the business).

Our banks are very big - among the biggest companies in the country - so it's not surprising their profits seem huge. The big four earn a return on assets of a bit under 1 per cent a year, and that hasn't changed much. Their return on equity, however, is usually up at 16 or 17 per cent a year. (It's a lot higher than the return on assets because the banks are highly "geared" or "leveraged" - they have a high ratio of borrowed funds to shareholders' equity.

How does this return on equity compare? Right now it's high by the standards of banks in the United States and Europe - but that's because those banks have screwed up so badly. Compared with the banks in Canada - a country that, like us, escaped most of the conflagration - ours are in the same ballpark.

Compared with other industries, however, these rates of return are high. Most businesses would be delighted to earn as much. Of course, rates of return need to take account of the riskiness of the business you're in - the chances of making losses if difficulties arise.

In theory, banking is a fairly risky business, thus justifying higher rates of return than for less risky businesses. The idea is you need to do better in the good years to cover the one or two years every decade when you do really badly.

In practice, however, banking isn't all that risky because - as we were reminded during the global crisis - it's effectively guaranteed by the government. What's more, our banks haven't had a bad year since the early 1990s.

So our banks are doing very nicely. I regard their rates of return as higher than they need to be (as is probably also the case in Canada) and thus a sign that price competition among the banks, and between the banks and other lenders, is less vigorous than it should be.

Turning to the notion that there's something immoral or illegitimate about rises in mortgage interest rates in excess of rises in the official interest rate, it has no basis in law or economics.

Banks borrow on one hand and lend on the other. They are justified in raising the interest rates they charge if they suffer an increase in the cost of the funds they borrow. By far the biggest single influence over the banks' cost of funds is the official interest rate - the cost to the banks of borrowing "cash" from each other overnight.

But it's not the only influence over the banks' cost of funds. These days they get about half their funds from retail depositors, less than a fifth from the short-term wholesale market (bank bills) and about a quarter from the long-term wholesale market (three- to five-year corporate bonds issued by the banks), with most of the rest provided by the banks' shareholders ("equity"). More than half the wholesale funding comes from overseas.

The point is that each of these sources yields funds priced at some margin above the official cash rate. Provided those margins stay fairly steady in absolute size, movements in the cash rate will accurately reflect movements in the banks' cost of funds.

This was the position for some years before the global financial crisis and it explains why the public gained the impression that mortgage interest rates always do and should move in lock step with the official cash rate.

But that happy state was disrupted by the crisis, which caused many of those margins above the cash rate to blow out, thus justifying changes in mortgage rates different from changes in the cash rate. Most of those margins have fallen back a long way as the crisis has abated. But now the banks are under pressure to change the mix of their funding, getting more from retail and less from wholesale, as well as more long-term and less short-term.

Trouble is, the newly preferred sources have higher margins above the cash rate. It thus becomes an empirical question whether the banks are justified in raising their mortgage rates by more than the rise in the cash rate. And the judgment of the econocrats is that, as a group, the banks aren't justified, though the Commonwealth may have a better case than the others.

So if too many of the other banks use the cover of the Commonwealth's increase of 0.20 percentage points in excess of the rise in the cash rate to raise their own mortgage rates by more we can take this as a sign they're happily exploiting the inadequate competition in lending.

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Our media roasts old chestnuts

If a genie appeared from a bottle and offered me one wish, I'd choose to be a columnist on a major newspaper. So I guess you could say I love my job. But there are times when I feel compelled to warn people to be careful about what they read, hear and see in the media.

Many people assume the media give them a representative picture of what's going on in the world beyond their own experience. But this is a misunderstanding of the role of the news media and the nature of "news".

The media select from all the things happening in the world only those things they consider "newsworthy" and thus worth drawing to our attention. What is newsworthy? Anything the media believe their audience will find interesting and nothing they fear the audience will find boring.

What's interesting? Anything unusual. But also anything threatening. It's perfectly clear that people find bad news more interesting than good news, which is why the media give prominence to things that are going wrong and say little about things that are going well.

Most of what's happening in the world is highly predictable and terribly ordinary. This means much news is selected because it's unrepresentative. So there's a high risk it will leave people with a mistaken impression of what's happening in the world.

Journalists like to believe everything they report is new. In truth, it's often just a new example of a familiar story, one the journos know the audience loves to hear again. Sometimes a new, offbeat angle is ignored so the story can be forced to fit a tried-and-true formula.

A lot of news is selected because it will appeal to the audience's prejudices or stir people's emotions in the way they like to be stirred. Consider some recent examples from my field of economic news.

There has been much indignation over the Keneally government's decision to change the tax on poker machines in hotels, with suggestions of undue influence by the Australian Hotels Association. About 60 per cent of hotels with pokies - those that don't make much out of them - will now pay less tax or even no tax.

You have to read the reports carefully to discover the changes are actually "revenue neutral", meaning the savings to the 60 per cent of hotels will be exactly offset by the higher tax paid by the remaining 40 per cent, leaving the government's total revenue unaffected.

Rather deflating of the righteous indignation, don't you think?

The media make no pretence of being bound by the scientific method. Economists are always being reminded not to draw general conclusions from anecdotal evidence rather than economy-wide statistics.

But the media are tellers of stories. They're the industrialised equivalent of cavemen sitting around the fire at night swapping yarns. The telling of stories about other people meets one of our most primitive human needs.

What it doesn't do, however, is give us an accurate picture of what's happening in the world. Take all the stories we're hearing about waste in the Rudd government's program to stimulate the economy by constructing a new building at every primary school.

News gathering is selective. People with complaints of waste - justified or otherwise - have had no trouble getting publicity. People without complaints don't bother approaching the media. And where reporters have encountered people saying everything was fine, these facts would have been ignored as "not news".

There have been enough anecdotes to convince me waste has been a significant problem. The real question is: how significant? What proportion of schools has experienced wastefulness? What proportion of the government's spending has been wasted?

No number of examples of alleged waste can answer these questions. What they can do is cause people who don't understand the biases involved in news gathering to gain the impression "the waste has been huge" or even "all that money has been wasted".

The one thorough report we've seen so far came from the federal Auditor-General. It was critical, but far from damning. One of his findings was that 95 per cent of school principals agreed they were confident the funds "will provide an improvement to my school, which will be of ongoing value to my school and school community".

Every year since 1997 the Reserve Bank has published an annual survey of the fees banks charge to their business and household customers. And every year the media turn the survey results into the same much-loved story: huge increase in the fees banks rip from you and me.

This year, however, the story tended to be relegated to the business section, though the same formula was used: huge increase in the fees banks charge businesses.

You had to read the reports carefully to get the real story: last financial year the fees the banks charged households grew by 3 per cent (the lowest increase since the survey began and far less than the 8 per cent increases in the two previous years), whereas fees charged to business leapt by 13 per cent (far more than in the two previous years).

Most of the growth in fees collected from households came from charges paid by the greater number of people choosing to break their fixed-rate mortgage contracts, but this was largely offset by a fall in banks' income from transaction and account-keeping fees. Much of this was explained by the banks' offers to waive fees to people who made regular deposits, part of their greatly increased competition to attract deposits.

By contrast, most of the huge growth in fees collected from business came from higher fees to existing customers now considered to be more risky and higher fees on undrawn overdrafts.

The story no one thinks worth writing is that since the global financial crisis, the banks have gone easier on their household customers but harder on their business customers.

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