What is wrong with Australian banking?

Spoiler alert, I am not going to provide a definitive answer to that question. I do however want to address a couple of the arguments advanced in an interview with Joseph Healy reported in the Chanticleer section of the AFR this week that I think bear closer scrutiny.

Healy has written a book titled “Breaking the Banks – what went wrong with Australian banking”. At this stage I can only rely on what was reported in the AFR so I may be missing some of the nuance of his argument. It is of course always good fun to see an “insider” spilling the beans on an industry but it is also important that we debate the questions raised on the basis of the facts as opposed to a good story. I have no intention of seeking to argue that there is nothing to see here; there are certainly major issues that need to be addressed. That said, some of the claims he asserts seem wrong to me. I offer an alternative perspective below – it is up to the reader to judge which perspective (dare I say set of facts) they find more convincing.

Let’s start with some elements of his thesis that seem to me to have a foundation of truth:

• Banks operate under a “social licence” that imposes a higher set of responsibilities than what is dictated by a pure free market philosophy
• The Cost of Equity for Australian banks is around 6-7% per annum and that banks should only earn a modest premium over their cost of equity in a competitive market

Healy cites the “fact” that major bank ROE around 12-13% is substantially higher than their cost of equity and the recent “failure to pass on the full 25 basis point rate cut” as evidence that the major banks are abusing their market power to extract unreasonable rents from the economy.

I don’t have any issue with the premise that banks (not just Australian banks) have a privileged position in the societies in which they operate and that this privilege carries responsibilities. It follows that earning a return that is materially higher than their COE begs the question how this can be justified. However, simplistic comparisons of a bank’s ROE at a relatively benign point in time with the COE that its shareholders require to be compensated for the risk they underwrite across the full business cycle is a fundamental error of analysis and logic. My reasons for this are set out in more detail in this post, but the key point is that this comparison conflates two things which are related but not the same thing.

The other problem I have is the argument that not reducing lending rates by the same amount as the change in the RBA cash rate amounts to a “failure to pass on” the rate cut. Fortunately I don’t need to lay out the detail of why this is wrong because Michael Pascoe and Stephen Bartholomeusz have both done a more than adequate job here and here.

All always, it is entirely possible that I am missing something but I have to call it as I see it. If you have not read the articles by Pascoe and Bartholomeusz then I can recommend them as well worth your time. Bank bashing is a long standing Australian past time and there is much legitimate cause for bashing them. Banking however is too important to allow yourself to join the mob (which sadly seems to include senior politicians) without understanding what criticism is legitimate and what is not.

Tony