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Establishing a People’s Bank

By Christopher Joye - posted Monday, 11 January 2010

Today I am going to consider the political sensitivities surrounding the profitability of the major banks. I will also put the counter-intuitive argument that simpler banks like Bendigo & Adelaide are in many respects safer than the majors despite what investors and the credit rating agencies say. And I will conclude with some recommendations on what Ahmed Fahour can do with Australia Post in the context of the controversial debate regarding a so-called “People’s Bank”, which I have recently considered. In short, I will propose that there is a case for a new public banking capability in regional and rural Australia. But in the metro markets I would encourage Fahour to stick to much simpler third-party distribution, and open up his 4,000 outlets as commercial conduits for smaller lenders.

The commentariat has started serving up some high quality fodder on these subjects. Indeed, Business Spectator’s own Stephen Barthomoluez has produced an excellent column in which he warns the big four banking “oligarchs” (perhaps this will become a new descriptor in the local lexicon) from acting as pure profit maximisers:

A sharp rebound in profitability would be contentious and politically sensitive. There are already calls for federal government intervention to create more competition for the majors. The appointment of former senior National Australia Bank executive Ahmed Fahour to head up Australia Post has sparked urgings for the creation of a post office bank.

While it is vital that the majors remain solidly profitable - the wreckage in financial sectors and fiscal settings elsewhere illustrates how destabilising and destructive an unprofitable system can be - it would be a sign of an unhealthily concentrated and uncompetitive system if the majors were too profitable. It would also almost inevitably lead to government intervention.


Now although I have not always seen eye-to-eye with Bartho, he must rank among Australia’s best banking analysts (I think my previous divergences with him at least partly validate my capacity to make such an assessment). And I mean “analyst” in the genuine sense of the word. The more conventional market analysts are not paid to critique public policy, or to reflect on abstract changes to the banking business model--they earn their crust by accurately valuing these companies and thus predicting how they will behave (or, put differently, forecasting their future cash-flows).

This makes analysts rather useless when it comes to evaluating the actions of banks from a public policy perspective. I have noticed a similar phenomenon with economists. When I first started out I thought that the market economists would make great sparring partners in debates about monetary policy. Yet they actually proved to be surprisingly unwilling and ill-prepared accomplices. I appreciate this might sound odd, but it is true. I am friends with many of these guys. And a very senior sage explained the problem to me one day. In response to a criticism I had levied against him about his disinclination to question the RBA, he averred, “Mate, it is not my job to think about what the RBA should or should not be doing - it is my brief to predict their behaviour; if anything, I need to spend more time thinking like them”.

Anecdotally, I have found an inverse relationship between the forecasting prowess of economists vis-à-vis monetary policy and their preparedness to critically appraise the RBA. This is no surprise, since the aforementioned analyst also opined that if he relentlessly questioned the RBA the central bankers would be less disposed to sharing their views. The concern is that if you take on the bank you will be removed from the informational flows. Dr Stephen Kirchner of the CIS and I have independently argued that exactly the same dynamic can be applied to journalists. And, of course, the principle is germane to banking analysts - can you imagine a leading analyst making the sort of statements one reads here and then expecting seamless access to the big four CEOs? I don’t think so. (As an aside, notwithstanding my regular questioning of the RBA I actually find them to be very open-minded - it has not appeared, for example, to impact on our professional relationship with them.)

Returning to Bartho’s recent column, he canvasses an important point, which is something I raised with him some time ago in a debate about the oligarchs. In previous posts I have presented RBA data that shows that the major banks’ return on equity declined only modestly during the GFC. That is, their RoEs have remained in solid double-digit territory and are no less than those experienced in the early 2000s. Leveraging off CBA analysis of its own cross-divisional returns, I (and others) have also belaboured the fact that their underlying businesses have been hugely profitable on a cash basis - it was the large expected losses in their business lending areas (aka “impairments”) which dragged down their reported profits. Naturally if the anticipated economic Armageddon does not come to pass, these impairments will evaporate and future profits will soar. This is the origin of Bartho’s concerns given that the sustenance of such profits during the recent calamity has relied directly or indirectly on the public purse.

Yet whenever I have suggested that the majors should be able to absorb more of their funding cost pressures, I have met with the refrain, No we need to protect the banks’ profits or their ability to raise equity capital will suffer. This logic is, however, flawed.

One of the principal behavioural complexities we face today is the relentless focus on returns to the detriment of risk. If you are assuming a much higher probability of loss (viz., risk) in order to generate better returns, your risk-adjusted returns have not increased. This is why equities are not the wonderful investment class that many in the commentariat claim. I recently came across the statement that your best asset-allocation bet since the 1970s was Australian shares. This is certainly true on a raw return basis. But when you risk-adjust the historical returns using any standard methodology, such as a Sharpe Ratio, Australian shares stack up poorly against many fixed income alternatives. The commentariat’s pathological tendency to ignore risk and focus mums and dads on raw returns is a real problem: we seem to have this mental blind-spot where we erase from our minds the 40-50 per cent price falls seen in global equity markets in 1987, 2001 and 2007-08. Punters get lured into the market by commentators acting like casino promoters. The challenge is not just for retail investors: as I have regularly highlighted here, the same behavioural biases afflict many retail super funds’ asset-allocations, which have amazingly highly 60-70 per cent weights to global equities. And slowly but surely this is starting to attract the appropriate criticisms from regulators and asset consultants.


Coming back to our oligarchs, there is nothing wrong with a decline in the major banks’ return on equity (which is, in fact, likely to increase significantly in the next few years) if that is accompanied by a commensurate reduction in their expected risk. And that is precisely what we have observed since the start of the GFC. As is now well understood, taxpayers have effectively said that they will insure away the risk of bank failure. This is an incredibly important policy innovation since it fundamentally changes the perceived risk of these enterprises. Banks are clearly not just “private concerns” as many would have us believe. At the first sight of mortal adversity, taxpayers were compelled to guarantee all of their funding sources at no price in the case of most deposits, and at an arguably sub-market price in respect of their wholesale liabilities. Furthermore, a taxpayer funded lender to the banks, the RBA, supplied them with cheap loans that were a vital lifeblood of liquidity during the darkest days of the crisis when extreme counterparty risk eviscerated liquidity for even the most creditworthy institutions. This is, in fact, one of the RBA’s key responsibilities - as a lender of last resort to private banks that are otherwise prone to fail.

Setting aside the significant new moral hazard concerns that have emerged from this crisis, what do these actions tell us? They clearly illustrate that bank shareholders get the benefit of a raft of (call-option like) protections that are not supplied to other private companies. Given taxpayers have revealed that they are willing to insure away much of the downside risk associated with catastrophic bank failure, these institutions have, by definition, significantly lower equity risk.

If the probability of loss associated with investing with the majors has declined care of these profound changes to our prudential system (APRA was founded in 1997 on the explicit basis that it would never, ever guarantee any institution), the expected returns should also fall. That is, investors should be more than happy to accept lower returns since the risks associated with putting your dough with the banks has also fallen.

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First published in the Business Spectator on January 6, 2010

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About the Author

Christopher Joye is the CEO of Rismark International and was the principal author of the 2003 Prime Minister’s Home Ownership Task Force report. You can find Christopher's blog at Christopher Joye's Concrete Detail Blog.

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