Alan Kohler has an interesting take on Australia’s banks today, both from an investment and national viewpoint. He begins:
The banks will be big winners from the Reserve Bank’s decision to buffer the Australian economy from the end of the mining boom and to try to bring down the dollar, by bringing interest rates down to GFC lows, and probably lower – because for that plan to work, credit growth needs to resume.
…In fact it’s probably not going too far to say that the industry in which Australia is truly the world leader is not resources, it’s banking – not the sort that caused the GFC, but old-fashioned deposit-taking and lending, the business that Wall Street banks are trying to get back to.
…In a way Australian banking does operate in a parallel universe: there’s just enough competition to keep the regulators off their backs, but not too much that margins can’t be expanded, as they are now. Tight regulation and a better culture kept them out of derivatives and the excessive leverage that goes with them, so their books are clean.
All true! Sort of. The Australian banks do use leverage. A lot of it. Their mortgage books have a capital reserve of something like 2%. Fundamentally, that’s how we got such expensive houses. Still, that’s not a problem until it is.
What is more of an issue is the banks also use derivatives. Lot’s of them. What for? In part, to manage the risks in their offshore borrowing portfolios. And that’s where Kohler’s happy tale has a hiccup. He goes on:
It’s a crucial question for Australia because as the mining boom deflates the banks need to step up and fund domestic investment and growth by recycling domestic deposits, and not relying on foreign debt.
So far so good. In the 12 months to August, deposits rose 12 per cent and thanks to the demand for term deposits among self managed super funds, the banks are rapidly reducing their reliance on wholesale funding.
That is kind of true, even if it’s a little more of a positive take than that of the IMF or ratings agencies. But the problem is this: credit cannot suddenly start to bounce without reversing the banks need for wholesale funds. Deposit growth will ease once credit issuance accelerates and folks look to spend rather than save their dough. It will ease further still as the falling terms of trade hit income growth. It will ease further again as interest rates fall and the carry trade reverses. Some of this will be helped by credit issuance itself, which will increase deposits.
Last year, Moody’s warned of just this outcome:
Australia’s major banks have worked to reduce their sensitivity to disruptions in wholesale funding markets by diversifying their investor bases, increasing the weighted-average tenors of their borrowings, and by increasing liquid assets. These improvements are likely to be reinforced by tighter regulatory requirements, although Basel III timelines are long.
Near-term growth in wholesale funding is also likely to remain restrained on subdued credit demand, ample deposit growth, and ongoing caution from the banks with regards to the potential for further volatility in wholesale funding markets.
Consequently, Moody’s expects the banks to continue reducing their wholesale funding requirements — in particular short-term wholesale funding — for the next 12-18 months.
However, the fundamental funding structure of the major Australian banks remains in place. Australia’s mandatory superannuation scheme will continue to capture retail savings, of which only a low proportion are available to fund the banks. This situation is due in turn to the low allocation– by international comparison — of superannuation savings to fixed-income investments and deposits.
Additionally, Moody’s notes that much of the recent increase in domestic deposits has come from the corporate sector. When the cycle turns and credit demand eventually picks up, the ratio of corporate deposits to loans may be expected to deteriorate. Retail deposit growth will then likely be insufficient to fund the banks’ needs, driving them to increase wholesale funding once more.
And the wash-up was clearly described by NAB just last week:
Banks in Australia will not be able to increase the proportion of their funding from foreign wholesale sources if they are to satisfy the demands of credit ratings agencies and regulators, NAB’s finance director Mark Joiner indicated yesterday.
“I regard us as at a peak in wholesale borrowing, not even in percentage terms but in dollar terms,” Joiner said at a Committee for Economic Development of Australia lunch in Melbourne.
“Australian banks will only be able to grow in line with what they are able to bring in on the customer side (with deposits).
“So they will not be able to go with an upswing in credit.”
”In my view, the Australian banks, for a long time, will only be able to buy the asset side of their balance sheet dollar for dollar with what they bring in on the customer side,” he said.
To me, assuming credit demand does pick up, bank balance sheets will remain constrained. Putting aside the question of whether an increase in household leverage would be wise, the moot question is whether whatever credit issuance there is can generate sufficient activity to fill the growth deficit left behind by falling mining investment. If not, bad loans are going to rise.
