1 Jul 2014
BIS holds line, supervision must remain intrusive
The Bank for International Settlements, the Basel-based “central bank for central banks” as it is known, has just released its annual report and the key themes are particularly worthy central bank favourites: markets out of synch with reality, the dangers of fudged data and an economically unsustainable misallocation of resources.
The BIS is particularly worried about ebullient financial markets at a time when real economies remain fragile. They’re right to be alert: for the first time in more than 20 years all the world’s major asset class have rallied together in the first half - shares, bonds and commodities.
The Dow Jones Industrial average, gold, the UBS commodity index, the 10 year US Treasury note, the MSCI index of developed world equities and MSCI Emerging Markets Index are all up.
Of course, by and large they’re up because the BIS’ clients, the world’s central banks, have given those markets a put option – central bank liquidity will be forthcoming until economies are robust, driving down yields and driving up risk appetite.
The issue for much of the developed southern hemisphere, and particularly Asia, is this part of the world may as well be on a different planet.
This is a point business leaders here have stressed and which provides the core argument for those who reckon a regulatory regime set up for the financial systems of the northern hemisphere is too draconian for the southern.
BIS general manager Jaime Caruana gave his view of the world as seen from Switzerland. “Since 2007, in the G20 economies, the ratio of total non-financial sector debt to GDP has risen by more than one fifth. This is the legacy of the massive fiscal stimulus during the Great Recession in the advanced economies and the significant new issuance of debt by corporates in EMEs (emerging market economies).
“Since then, the advanced economies have made some progress in reducing their fiscal deficits. But the upshot is that aggregate debt levels continue to grow. Overall, debt-to-GDP ratios are now 275 per cent in the advanced economies and 175 per cent in EMEs.”
Caruana recognises “this surge in debt has certainly helped to prop up current demand” but worries “what is less clear is whether it will generate higher income in the years to come and thus ensure sustainability”.
The BIS doesn’t break out Australian (or New Zealand or Singapore) data in much of its analysis but the picture in general terms in this region is much more robust. It does produce a nice table (IV.1) of early warning indicators for domestic banking crises.
Overall, the picture is one of plenty of risks ahead, notably in China, parts of ASEAN and Brazil, but for Australia the only warning light flashing is about the debt service ratio if interest rates rise 250 basis points.
Where there is another disjunction between the northern and southern hemispheres is in the BIS comparison of bank profitability (table VI.2). Once again Australia’s Big Four score well in terms of pre-tax profits to total assets at 1.28 per cent in 2013. That’s up from the 1.09 per cent between 2008 and 2013 but still down on the period 2000 to 2007 when pre-tax profits were 1.58 per cent of total assets. In 2013, of the countries reviewed, only Brazil, China, India and Russia posted higher profits on this measure.
Net interest margins though are about mid-table for the Australian banks at 1.79 (having declined from 1.96 in the pre-GFC period), well below the margins of the more profitable countries and the US.
Where Australia has excelled, and it’s a factor to which investors are attuned, is loan loss provisions as a percentage of total assets now, at 0.17 per cent, lower than in the pre-crisis period from 2000 to 2007, having hit 0.30 per cent from 2008 to 2012. Meanwhile operating costs have consistently declined over the three periods from 1.99 to 1.20 to 1.11 per cent of total assets.
Bank Profitability – Profits and Bad Debt Charges
Source: RBA
To the extent the BIS data provides a global comparison – and this is always something argued about given different business mixes and sovereign influences of resident economies – the strong Australian bank profitability has been driven by lower bad debt charges and improved efficiency.
It also reflects the pervasive impact of the financial crisis which not only devastated northern hemisphere banks in the aftermath of the crisis but continues to throttle their growth as they work through long, painful recapitalisations and restructurings – hardly the recipe for profitability.
Australia, in this regard, is a Stephen Bradbury rather than a Cathy Freeman.
Comparisons with Canada, the banking market most frequently cited with Australia, show lower pre-tax profits (1.06 per cent), lower net interest margins (1.65 per cent), identical loan loss provisions (0.17 per cent) but substantially higher operating costs (1.78 per cent) in Canada.
While many submissions to the Murray Inquiry – apart from those provided by the big banks – have argued there is excess profitability in the sector the BIS annual report hardly supports this contention.
What the data paints is a picture of banks operating in a robust economy which came through the financial crisis as well as banks anywhere and have continued to drive down costs while enjoying the fruits of an economy untraumatised by the GFC.
“Outside the euro area, banks’ pre-tax profits improved last year but remained generally below pre-crisis averages,” the BIS said.
“Instead, lower credit-related costs were the main factor at work. Loan loss provisions have been declining in most countries, reflecting the economic recovery and progress in loss recognition.”
In its submission to the Murray Inquiry, the Australian Bankers’ Association makes the further argument that on the key profitability measure of return on equity the Australian banks rank mid-table in comparison with major Australian companies.
“When Australian banks are compared with banks of other countries that survived the GFC relatively well, such as Canada and China, the profitability of the four majors does not stand out (see Figure 4.17 ABA Submission),” the ABA said.
“Australian major banks delivered RoEs of between 13-19 per cent in 2013, China’s banks 18-23 per cent, and Canada’s banks 14-23 per cent. Banks in countries that bore a higher impact from the GFC, such as the US, UK, France, Spain and Italy, currently show much lower RoEs, signalling that these systems are still in recovery. Prior to the GFC, average RoE for the major UK banks was 22-23 per cent. This compares with RoE close to 20 per cent for Australian major banks over that same period.”
The profitability debate will of course continue to rage in Australia but the underlying message from the latest BIS report is that with emerging global asset bubbles, high debt vulnerability and uncertain recoveries there remain plenty of anxieties in the global economy but Australian bank profitability shouldn’t be one of them.
Hence Caruana’s focus: “The first (element) is confidence in banks’ risk management. This goes all the way from the overall risk culture to the risk models themselves. The large reported dispersion in risk-weighted asset calculations suggests that there is still plenty of scope for inconsistency, and perhaps even for gaming the rulebook. Stringent regulation can alleviate this problem.”
He likes a leverage ratio which, “If calibrated rigorously… can create a credible backstop for the risk-weighted ratios”.
But the overall key is “proactive, rigorous and intrusive supervision”.
“This is the best way to ensure that solid liquidity and capital buffers are in place,” Caruana says. “And it is a good way to encourage a prudent risk culture, one that allows for diversity and risk sensitivity, but penalises and prevents attempts to game regulations.”
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.