ROE – From the outside

Small banks …

This post by Cetier on the RBNZ Financial Stability Report poses an interesting question about the future of small banks. He notes that the big banks seem to be doing fine but that small NZ banks are struggling to cover their cost of capital. This disparity between big and small banks also seems to be feature of the Australian banking system. It also looks like big banks in the USA are getting bigger at the expense of the small banks.

There is a perennial question of whether small banks need some support (possibly in the form of less onerous regulation) so that they can offer a source of competition to the larger banks. This is a policy choice that the USA has very deliberately made but it has been argued that this is one of the factors that contributed to the recent spate of bank failures.

This is part of a larger conversation about the tension between competition and financial stability. Marc Rubinstein did a good post on this question which I covered here.

I don’t have any answers but the question is one that I think will get more focus as the US considers its response to the most recent case studies in why banks fail. I don’t have enough expertise on the US Banking system to offer an informed opinion but the Bankers Policy Institute does offer an alternative perspective that argues that the failures were more a question of bad management and lax supervision than of regulation per se. I can say that the risks these US banks were running did seem to clearly violate the principles of Banking 101.

Let me know what I am missing …

Tony – From the Outside

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

Thinking aloud about Australian bank ROE

I have been wanting to put something down on the question of Australian major bank ROE for a while. The issue generates a lot of heat but the public discussion I have observed has been truncated, in my opinion, by misconceptions.

I think we can agree that banks need to be profitable to be healthy and a healthy banking system underpins the health of the economy as a whole. Excessive profitability however is clearly bad for consumers, business and for the economy as a whole. The problem is determining what level of profitability is excessive. This post is unlikely to be the final word on this topic but hopefully it introduces a couple of considerations that seem to me to be largely missing from the public debate.

Most of what I read on this topic seems to treat the ROE of the Australian majors as self evidently excessive and focuses on what to do about it. Exhibit A is the reported ROE which in the 2019 half year updates varied from 10.05% to 14.10%. This is much less than it was but still substantially better than what is being achieved by most banks outside Australia and by the smaller local banks. Exhibit B is the fact that the Australian banking system is an oligopoly which almost by definition earn excess profits.

Reported ROE exceeds COE – case closed

Any discussion of ROE must be anchored by the estimated Cost of Equity (COE), the minimum return that investors require to hold equity risk. There are a variety of ways of calculating this but all of them generate a number that is much less than the ROE the majors currently earn. So case closed.

There is no question that the Australian majors cover their cost of equity, but it is less clear to me that the margin of excess profitability is as excessive as claimed.

Corporate finance 101 teaches us that we can derive a company’s cost of equity using the Capital Asset Pricing Model (CAPM) which holds that the required return is equal to the Risk Free Return plus the Equity Risk Premium (ERP) multiplied by the extent to which the return the individual stock is correlated with the market as a whole. The general idea of being paid a premium for taking on equity risk makes sense but there are a bunch of issues with the CAPM once you get into the detail. One of the more topical being what do you do when the risk free rate approaches zero.

I don’t want to get into the detail of those issues here but will assume for the purposes of this post that a rate of return in the order of 8-10% can be defended as a minimum acceptable return. I recognise that some of the more mechanical applications of the CAPM might generate a figure lower than this if they simply apply a fixed ERP to the current risk free rate.

Two reasons why a simple comparison of ROE and COE may be misleading

Banking is an inherently cyclical business and long term investors require a return that compensates them for accepting this volatility in returns.
Book value does not define market value

Banking is a highly cyclical business – who knew?

It is often asserted that banking is a low risk, “utility” style business and hence that shareholders should expect commensurately low returns. The commentators making these assertions tend to focus on the fact that the GFC demonstrated that it is difficult (arguably impossible) to allow large banks to fail without imposing significant collateral damage on the rest of the economy. Banks receive public sector support to varying degrees that reduces their risk of failure and hence the risk to shareholders. A variation of this argument is that higher bank capital requirements post the GFC have reduced the risk of investing in a bank by reducing the risk of insolvency.

There is no question that banks do occupy a privileged space in the economy due to the central bank liquidity support that is not available to other companies. This privilege (sometimes referred to as a “social licence”) is I think an argument for tempering the kinds of ROE targeted by the banks but it does not necessarily make them a true utility style investment whose earnings are largely unaffected by cyclical downturns.

The reality is that bank ROE will vary materially depending on the state of the credit cycle and this inherent cyclicality is probably accentuated by accounting for loan losses and prudential capital requirements. Loan losses for Australian banks are currently (October 2019) close to their cyclical low points and can be expected to increase markedly when the economy eventually moves into a downturn or outright recession. Exactly how much downside in ROE we can expect is open to debate but history suggests that loan losses could easily be 5 times higher than what we observe under normal economic conditions.

There is also the issue of how often this can be expected to happen. Again using history as a guide for the base rate, it seems that downturns might be expected every 7-10 years on average and long periods without a downturn seem to be associated with increased risk of more severe and prolonged periods of reduced economic activity.

What kind of risk premium does an investor require for this cyclicality? The question may be academic for shareholders who seek to trade in and out of bank stocks based on their view of the state of the cycle but I will assume that banks seek to cater to the concerns and interests of long term shareholders. The answer for these shareholders obviously depends on how frequent and how severe you expect the downturns to be, but back of the envelope calculations suggest to me that you would want ROE during the benign part of the credit cycle to be at least 200bp over the COE and maybe 300bp to compensate for the cyclical risk.

Good risk management capabilities can mitigate this inherent volatility but not eliminate it; banks are inherently cyclical investments on the front line of the business cycle. Conversely, poor risk management or an aggressive growth strategy can have a disproportionately negative impact. It follows that investors will be inclined to pay a premium to book value for banks they believe have good risk management credentials. I will explore this point further in the discussion of book value versus market value.

Book Value versus Market Value

Apart from the cyclical factors discussed above, the simple fact that ROE is higher than COE is frequently cited as “proof” that ROE is excessive. It is important however to examine the unstated assumption that the market value of a bank should be determined by the book value of its equity. To the best of my knowledge, there is no empirical or conceptual basis for this assumption. There are a number of reasons why a company’s share price might trade at a premium or a discount to its book value as prescribed by the relevant accounting standards.

The market may be ascribing value to assets that are not recognised by the accounting standards.The money spent on financial control and risk management, for example, is largely expensed and hence not reflected in the book value of equity. That value however becomes apparent when the bank is under stress. These “investments” cannot eliminate the inherent cyclicality discussed above but they do mitigate those risk.

A culture built on sound risk management and financial control capabilities is difficult to value and won’t be reflected in book value except to the extent it results in conservative valuation and provisioning outcomes. It is however worth something. Investors will pay a premium for the banks they believe have these intangible strengths while discounting or avoiding altogether the shares of banks they believe do not.

Summing up …

This post is in no way an exhaustive treatment of the topic. Its more modest objective was simply to offer a couple of issues to consider before jumping to the conclusion that the ROE earned by the large Australian banks is excessive based on simplistic comparisons of point in time ROE versus mechanical derivations of the theoretical COE.

As always, it is entirely possible that I am missing something – if so let me know what it is ….

Tony

Are banks a special kind of company (or at least different)?

This is a big topic, and somewhat irredeemably technical, but I have come to believe that there are some unique features of banks that make them quite different from other companies. Notwithstanding the technical challenges, I think it is important to understand these distinguishing features if we are to have a sensible debate about the optimum financing structure for a bank and the kinds of returns that shareholders should expect on the capital they contribute to that structure.

You could be forgiven for thinking that the Australian debate about optimum capital has been resolved by the “unquestionably strong” benchmark that APRA has set and which all of the major banks have committed to meet. However, agreeing what kind of return is acceptable on unquestionably strong capital remains contentious and we have only just begun to consider how the introduction of a Total Loss Absorbing Capital (TLAC) requirement will impact these considerations.

The three distinctive features of banks I want to explore are:

The way in which net new lending by banks can create new bank deposits which in turn are treated as a form of money in the financial system (i.e. one of the unique things banks do is create a form of money);
The reality that a large bank cannot be allowed to fail in the conventional way (i.e. bankruptcy followed by reorganisation or liquidation) that other companies and even countries can (and frequently do); and
The extent to which bank losses seem to follow a power law distribution and what this means for measuring the expected loss of a bank across the credit cycle.

It should be noted at the outset that Anat Admati and Martin Hellwig (who are frequently cited as authorities on the issues of bank capital discussed in this post) disagree with most if not all of the arguments I intend to lay out. So, if they are right, then I am wrong. Consequently, I intend to first lay out my understanding of why they disagree and hopefully address the objections they raise. They have published a number of papers and a book on the topic but I will refer to one titled “The Parade of the Bankers’ New Clothes Continues: 31 Flawed Claims Debunked” as the primary source of the counter arguments that I will be attempting to rebut. They are of course Professors whereas I bring a lowly masters degree and some practical experience to the debate. Each reader will need to decide for themselves which analysis and arguments they find more compelling.

Given the size of the topic and the technical nature of the issues, I also propose to approach this over a series of posts starting with the relationship between bank lending and deposit creation. Subsequent posts will build on this foundation and consider the other distinctive features I have identified before drawing all of the pieces together by exploring some practical implications.

Do banks create “money”? If so, how does that impact the economics of bank funding?

The Bank of England (BoE) released a good paper on the first part of this question titled “Money creation in the modern economy” . The BoE paper does require some banking knowledge but I think demonstrates reasonably clearly that the majority of bank deposits are created by the act of a bank making a new loan, while the repayment of bank loans conversely reduces the pool of deposits. The related but more important question for the purposes of this discussion is whether you believe that bank deposits are a form of money.

Admati and Hellwig identify the argument that “banks are special because they create money” as Flawed Claim #5 on the grounds that treating deposits as money is an abuse of the word “money”. They are not disputing the fact that monetary economists combine cash with demand deposits in one of the definitions of money. As I understand it, the essence of their argument is that deposits are still a debt of the issuing bank while “real” money does not need to be repaid to anyone.

It is true that deposits are a bank debt and that some deposits are repayable on demand. However, I believe the bigger issues bearing on the economics of bank financing stem from the arguments Admati and Hellwig advance to debunk what they label as Flawed Claim #4 that “The key insights from corporate finance about the economics of funding, including those of Modigliani and Miller, are not relevant for banks because banks are different from other companies“.

Their argument appears to focus on using Modigliani and Miller (“M&M”) as an “analytical approach” in which the cost (contractual or expected) of the various forms of financing are connected by a universal law of risk and reward. Their argument is that this universal law (analogous to the fundamental laws of physics) demands that using more or less equity (relative to debt) must translate to a lower or higher risk of insolvency and that rational debt investors will respond by adjusting the risk premium they demand.

I have no issue with the analytical approach or the premise that funding costs should be related to risk. What happens however when one of the primary forms of debt funding is largely protected from the risk of insolvency? In the case of the major Australian banks, deposits account for over half of a bank’s total funding but are largely isolated from the risk of insolvency by a number of features. One is the Banking Act that confers a preferred claim in favour of Australian depositors over the Australian assets of the bank. The other is government guaranteed deposit insurance coverage capped at $250,000 per person per bank. The rationale for these acts of apparent government generosity is a contentious subject in itself but, for the purposes of this post, my working hypothesis is that the preferred claim and deposit insurance are a consequence of the fact that the community treats bank demand deposits as a form of money.

Consequently, the risk that an Australian depositor will face a loss of principal in the already remote event of insolvency is arguably de minimis and the way that demand deposits are priced and the way they are used as a substitute for cash reflects this risk analysis. There remains a related, though separate, risk that a bank may face a liquidity problem but depositors (to the extent they even think about this) will assume that central bank Lender of Last Resort liquidity support covers this.

Admati and Hellwig do not, to the best of my knowledge, consider the implications of these features of bank funding. In their defence, I don’t imagine that the Australian banking system was front of mind when they wrote their papers but depositor preference and deposit insurance are not unique Australian innovations. However, once you consider these factors, the conclusion I draw is that the cost of a substantial share of a bank’s debt financing is relatively (if not completely) insensitive to changes in the amount of equity the bank employs in its financing structure.

One consequence is that the higher levels of common equity that Australian banks employ now, compared to the position prior to the GFC, has not resulted in any decline in the cost of deposit funding in the way that M&M say that it should. In fact, the more conservative funding and liquidity requirements introduced under Basel III have required all banks to compete more aggressively for the forms of deposit funding that are deemed by the prudential requirements to be most stable thereby driving up the cost.

The point here is not whether these changes were desirable or not (for the record I have no fundamental issue with the Unquestionably Strong capital benchmark nor with more conservative funding and liquidity requirements). The point is that the cost of deposit funding, in Australian banking at least, has not declined in the way that Admati and Hellwig’s analytical approach and universal law demands that it should.

Summing up, it is possible that other forms of funding have declined in cost as Admati and Hellwig claim should happen, but there is both an analytical rationale and hard evidence that this does not appear to be the case, for Australian bank deposits at least.

The next post will consider the other main (non equity) components of a bank funding structure and explore how their risk/cost has evolved in response both to the lessons that investors and rating agencies took away from the GFC and to the changes in bank regulation introduced by Basel III. A subsequent post will review issues associated with measuring the Expected Loss and hence the true “Through the Cycle” profitability of a bank before I attempt to bring all of the pieces together.

There is a lot of ground to cover yet. At this stage, I have simply attempted to lay out a case for why the cost of bank deposits in Australia has not obeyed the universal analytical law posited by Admati and Hellwig as the logical consequence of a bank holding more equity in its financing structure but if you disagree tell me what I am missing …

Tony

Post script: The arguments I have laid out above could be paraphrased as “banks deposits differ from other kinds of debt because banks themselves create deposits by lending” which Admati and Hellwig specifically enumerate as Flawed Claim #6. I don’t think their rebuttal of this argument adds much to what is discussed above but for the sake of completeness I have copied below the relevant extract from their paper where they set out why they believe this specific claim is flawed. Read on if you want more detail or have a particular interest in this topic but I think the main elements of the debate are already covered above. If you think there is something here that is not covered above then let me know.

Flawed Claim 6: Bank deposits differ from other kinds of debt because banks create deposits by lending.

What is wrong with this claim? This claim is often made in opposition to a “loanable funds” view of banks as intermediaries that collect deposits in order to fund their loans. Moreover, this “money creation through lending” is said to be the way money from the central bank gets into the economy.19 The claim rests on a confusion between stocks and flows. Indeed, if a commercial bank makes a loan to a nonfinancial firm or to a private household it provides its borrowers with a claim on a deposit account. Whereas this fact provides a link between the flow of new lending and the flow of new deposits, it is hardly relevant for the bank’s funding policy, which concerns the stocks of different kinds of debt and equity that it has outstanding, which must cover the stocks of claims on borrowers and other assets that the bank holds.

A nonfinancial firm or household that receives a loan from a bank will typically use the associated claim on a deposit account for payments to third parties. The recipients of these payments may want to put some of the money they get into deposits, but they may instead prefer to move the money out of the banking system altogether, e.g., to a money market fund or a stock investment fund. 20

From the perspective of the individual bank, the fact that lending goes along with deposit creation does not change the fact that the bank owes its depositors the full amount they deposited. The key difference between deposits and other kinds of debt is not that deposits are “like money” or that deposits may be created by lending, but rather that the bank provides depositors with services such as payments through checks and credit cards or ATM machines that make funds available continuously. The demand for deposits depends on these services, as well as the interest that the bank may offer, and it may also depend on the risk of the bank becoming insolvent or defaulting.21

The suggestion that bank lending is the only source of deposit creation is plainly false.22 Deposits are created when people bring cash to the bank, and they are destroyed when people withdraw cash. In this case, the reduction in deposits – like any reduction in funding – goes along with a reduction in the bank’s assets, i.e., a shortening of its balance sheet, but this reduction affects the bank’s cash reserves rather than its lending. The impact of such withdrawals on banks and entire banking systems are well known from the Great Depression or from the recent experience of Greece. In Greece in the spring and summer of 2015, depositors also were worried about the prospect that in the event of the country’s exit from the euro, their denomination of their deposits would be changed, whereas a stack of bills under a matrass would not be affected.

Why this blog?

making sense of what I have learned about banks with a focus on bank capital management.

Late in 2017 I decided to take some time out from work (the paid kind to be precise). My banking career has spanned a variety of roles working in a large Australian bank but the unifying theme for much of that time was a focus on bank capital management. This is a surprisingly rich topic (yes honestly) and one that I am not done with yet. Accordingly, I want to devote some of my time out to an attempt to make sense of what I have learned and apply that knowledge to topical banking issues. It was suggested that I write a book but I have opted for a blog format in part because it will hopefully allow for a two way dialogue with like minded bank capital tragics.

An alternative title for this blog was “The education of a banker; a work in progress” which sought to convey the idea that I believe I have learned quite a lot about banking over the past four decades but the plan is to keep learning. Some of the perspectives I offer are to, the best of my knowledge, based on very firm foundations while others are ones which reasonable people can disagree upon or outright speculative. To the best of my ability, all of the views expressed will be “lightly held” in the sense that I am just as interested in identifying reasons why they might be wrong as I am in affirmation.

I settled on “From the Outside” based on an informal survey of a group of like minded people with who I have already devoted many emails and coffee catchups debating the issues I intend to explore. The title highlights that I bring a perspective forged working inside a bank over many years but now looking at the questions from the outside. Each reader will need decide for themselves whether I achieve a balanced view or have become irredeemably institutionalised. I will seek to correct what I believe to be unfounded criticisms of banks (for the record, I don’t think the current ROE major Australian banks are targeting is excessive) while at the same time there are other areas where I believe Australian banks need to do better (engaging with long time customers in a way that recognises their loyalty would be a great place to start).

The focus of the blog will no doubt evolve over time (and hopefully in response to feedback) but the initial plan is to explore a sequence of big picture themes in parallel with topical issues that arise from time to time. I also plan to share my thoughts on books and papers I have read that I think readers might find worth following up.

The big picture themes will likely encompass questions like the ways in which banks are different from other companies and the implications this has for thinking about questions like their cost of equity, optimal capital structure, risk appetite, risk culture, prudential regulation etc. Topical issues would encompass discussion papers, academic research, opinion pieces, prudential regulation and anything else that intersected with banking, finance and economics.

I am currently working my way through APRA’s Feb 2018 discussion paper on Revisions to the capital framework for ADI’s. I think there is a lot to like in the proposals APRA has set out but also some gaps and possible unintended consequences that are worth exploring.

… and so it begins

Tony

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