My God our media is backward. I mean it. It has no idea what is going on beyond a press release shoved in its face. It’s baffling.
The weekend reaction to the banks’ Friday rate hikes was dominated by a schoolyard binary construction of the problem: the banks versus the government. Some took the side of the government, that the banks are a greedy bunch of so and sos. Most took the side of the banks, that the government has no right to interfere in private business decisions. Laudable sentiments if the banks are private. Which they are not. But let that pass. I’ve already written that what’s really at stake here is the political economy of banking and the government’s failure to openly address that is now coming back to haunt it.
No, that’s not my point today. I want to make a much simpler point: Australia is caught in a credit crunch and the banks just made it worse, not better.
How so? To understand you have to have a handle on the basic tenets of banking. Like all businesses, banks have a balance sheet. There are two halves to the balance sheet: assets and liabilities. For banks it’s a little confusing because outgoing loans – for houses, cars etc. – are in fact assets. They are the stuff from which banks draw an income. The bank’s liabilities are also loans, but those taken from others, like deposits or bonds. The difference between these two is the bank’s equity or capital base. The ratio between the amount of capital and total assets is called the leverage. It’s the number of times against which the bank’s capital has been multiplied in its outgoing lending book.
That’s it, not so hard.
There are two ways in which a bank can find itself in trouble. The first and most common is when its assets – the loans it has given to its clients – deteriorate in quality. This happens when the folks who borrowed the money struggle to repay it. They might have lost their job, or the asset they offered as collateral against the loan – say, a house – may have lost value and their own balance sheet is under pressure. If they sell, they can’t repay the whole loan amount. You can see how this process can feed upon itself as distressed sales leads to more falling prices. At a certain stage the banks themselves get into trouble as enough assets are impaired and their capital begins to decline. They must then restrict lending and the problem gets worse again. This is called a credit crunch.
This is what happened in the US. Australia is also in the early stages of such a process with falling house prices, rising unemployment and rising impaired loans at the banks. It’s difficult to judge how far into this we are and whether it can be reversed. The jobs generated by the mining boom offer the hope that it is possible to arrest the decline and instead of a credit crunch we get a stall in housing and a redistribution of capital elsewhere. The primary protection against the process getting out of control is monetary policy, or interest rates, which can be lowered to alleviate the borrower stress at the heart of the problem.
The second way in which a bank can find itself in trouble is on the other side of the balance sheet: the liabilities. This happens when the people lending money to the bank – depositors or investors – get nervous and want a higher interest rate to give the bank their money. In the past this was not much of a problem for Australian banks as they relied upon steady deposits. However, after the millennium, the banks went a bit nuts borrowing less stable money from investors here and abroad and loaned that money largely to punters betting on houses. Now, through a combination of the troubles in Europe, the fact that the process of deteriorating assets is under way, and through their own incompetence in the mishandling of covered bonds, investors want much higher interest rates to lend our banks money. So yes, they need to raise interest rates to extract more money from the other side of the balance sheet to compensate. If they don’t then they’ll not be able to lend money on unprofitable loans and the credit crunch still transpires as the banks limit the supply of credit.
In short, whichever way the banks turn right now, whether they pass on their borrowing costs to mortgagors and put downward pressure on their assets, or they absorb the higher funding costs and stop making unprofitable loans, we edge further into a credit crunch. And indeed, as you can see, the two halves of the balance sheet aren’t at all separate. As risk builds in one then it has a deleterious effect on the other and so another feedback loop threatens. This is systemic stress and is exactly where we are now, whether you want to blame the government or the banks (or, in my case, the politico-housing complex).
As long as the banks cost of funds remains elevated, the question that matters most is can the RBA arrest this developing feedback loop by cutting interest rates? To my mind it is now clear that the central bank, which handled its actions flawlessly last year, erred dramatically last week in staying on hold. By pushing the banks to hike unilaterally, the first time in history, the banks have shaken the foundation of the one commonly (and sensibly enough) held truth in Australian asset markets, that when asset prices decline, unemployment or other economic adversity threatens, the RBA will save us by cutting interest rates. The insurance is still there but a nasty crack now runs through its base and I can only see this making asset markets worse.
We’re into a credit crunch all right.