In my previous Macro 101 post a number of people asked me some genuinely good questions about the functional process of the banking system under in certain scenarios.
These questions made me realise just how much more there is to say about banking operations. But more importantly it also made me realise how important it is to understand the functional aspects of banking so you can make an educated assessment of policy statements by both the government and banking leaders.
I do not want to overly politise this stream of posting because I want to discuss the “how” not the “why”. However as Gittins!(Yep I actually agreed with him once) says, we are all burdened with our political baggage and I do not want to blur this stream of conversation with what I perceive to be my somewhat socialist tendencies.
In fact in a personality tests I am in the same quadrant as the Dalia lama and mother teresa. Hard to believe if you had every met me let me tell you.
So in this macro 101 stream I will simply pose questions and let you decide, given your own political baggage, what they actually mean. I will leave it to my other streams of conversation for you to make an assessment of my social and political stance on topics.
So in the context of functional banking I want to discuss something that I think is fundamental to the economy of Australia at the moment. Banking profits.
Yes, this is a highly politised topic, but anything to do with the economy always is. I will simply be providing a functional assessment of these topics in terms of how the economy “actually” functions and I will leave it to my dear readers to make up their own minds about the socio-political implications of this topic.
Over the last few months or so I have found it very interesting that the MSM (main-stream media) has been unable to provide a valid assessment of the overall economic model Australian banks work in, and why banks have been able to make claims that their funding costs are rising yet their profits are growing.
This phenomen is quite difficult to explain given the number of supposed economic journalists in this country. How is it that none of them can provide the public with a reasonable explaination of this conundrum or a valid assessment of the state of credit in this country? Or even how it works for that matter.
The facts are very simple because it is possible to have both rising funding costs and rising profits in the Australian banking system because the government provides them with a framework that allows it. The fact that bankers turned up to a senate enquiry and stated that funding costs were rising and therefore everyone assumed that banks would therefore be less profitable is not a problem with bankers. They may well have been telling the complete truth in regards to this particular topic. The problem lies with the fact that the people tasked with making the assessment on behalf of the citizens of Australia obviously didn’t understand how the banking system actually works and the massive risk the economy carries by the government facilitating it.
The banks “price” of wholesale debt funding may still be rising, but if you understood the system of banking in Australia you would understand that this in no way can lead to the conclusion that banks will be less profititable enterprises.
In my mind the most disturbing thing about this situation is that politicians , who supposedly have access to the economic elite at the treasury, are supposedly horrified by this outcome. The treasury and the RBA have access to every statistic required to make an approximation of the profits that the banks will achieve during any reporting period. APRA provides them with metrics on deposits and lending, the RBA governs their reserve position, the capital requirements are well known and reported, their share price, bond issuance and debt maturity are no secret and foreign capital inflows to financial institutions go through reserve (RBA) accounts.
The fact that this issue wasn’t adequately addressed at the latest senate enquiry into banking, and has not been addressed in the mainstream media since, leads me to believe that there are simply too few people in this country who actually understand how the banking system is working. I can therefore only presume that this applies more generally to the rest of the economy as well.
As I said in my previous postloans create deposits. But the deposits are not backed by a tradable financial asset. In most cases in Australia they are backed by some form of illiquid asset such as a house, in some cases it isn’t even that tangible. So if you go into a bank to get a home loan for a house, the banks creates an asset and a liability. The liability is a deposit which is the “monetised” version the house.
The problem is that the “money” doesn’t actually exist in a form that is tradeable to entities outside the bank. Do you think CBA would actually be able to hand over $343 billion in cash if all of their customers demanded their deposited money tomorrow ? If the deposit holder comes to the bank to take out $100, then bank can’t go to the house and sell the toilet window to get the money.
So by issuing the loan the bank has created itself a liquidity problem. It doesn’ t “actually” have the money it claims to have because most of the assets that back up deposits are non-financial in nature. Banks deal with this by holding or obtaining financial assets(reserves) to provide liquidity. But they don’t need these assets on a 1:1 basis because the amount of money actually requested by customers at any one time is a small proportion of the actual recorded deposits.
In an economy without reserve requirements liquidity management is governed only by the need to meet reserve requirements through interbank transfers and currency demands. In otherwords the likelihood of “money of exchange” demand from deposit accounts. Savings accounts obviously have a higher probability of demand than term deposits, but the bank also pays more for the slower velocity accounts. So there is a trade-off between cost and probability of demand, and the amount of reserves required by each bank at any one time is dependent on the value and type of products they have on offer. This is different from many other countries that simply have a regulated %.
Let me give a simple example.
Let’s suppose the bank gives a loan for $100 at 7%. That means they will receive $7 in “money of exchange” per year from the customer ( I’ll ignore principal). For simplicity let’s assume that deposit sits in a term deposit account then the bank will pay 5.5% on it. As this is a low velocity account then the probability of demand may only be 5%. Therefore the bank will want to have a “money of exchange” deposit of 5% of the value of the loan. However that deposit will also have a probability of demand of 5% so they may need to make it $5.25 to offset this. Lets say they are also paying 5.5% on that deposit. So the banks will be paying $5.50/year on the original loan deposit and $0.31/year for the additional “money of exchange” deposit that offsets it. The bank is therefore making $1.19/year by simply issuing credit and offsetting its liquidity risk with a secondary source of funding. As long as the mortgager keeps paying the loan and the secondary sources of offsetting deposits are available at a lower rate then the income is guaranteed. Yes, this is an oversimplified example but it demonstrates the basics.
So under this framework the bank can improve its profit position in a number of ways. The easiest is to simply increase the volume of lending. It is fair to say that Australian banks have offset their increasing “costs” by increasing volume. If you look at CBA’s latest financial statement it show very clearly that they have done exactly that.
However as I said above. Banks can only increase credit issuance if they have available sources increasing reserves to match their credit issuance. Australian banks have been meeting this requirement with ever increasing amount of foreign sourced capital. Australian banks are constantly rolling over this foreign debt. Just like a person trying to get a new credit card to pay off a credit card, during the GFC the banks had to run to the government for backup otherwise it would have become very obvious that the banks simply did not actually have all the “money” their computers said they had.
But the point is that this environment is almost in completely controlled by the government. The government sets nearly every single economic metric that determines firstly whether foreign capital flows into this country, whether it becomes reverses available for credit expansion when it gets here, and what is done with it if it is.
But the government continues to provide explicit and implicit support for the banking system as it stands today. The government is running economic policy that attracts foreign capital into banking, it allows the expansion of reserves relative to those inflows, and provides the domestic environment to incentivise banks to continue to expand lending for domestic housing. At the same time it allows banks to charge fees on those same loan created deposits and perform compliance trickery to increase their profits.
So given all of these points, do you not think that the government may need to have a senate enquiry into itself at the same time as the banks?