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Australia is caught in a credit crunch and the banks just made it worse, not better.
Banks' rate moves reveal system cracks
February 13, 2012
The media reaction to the banks' Friday rate hikes has been dominated by a schoolyard binary construction of the problem: the banks versus the government.
Some have taken the side of the government, that the banks are a greedy bunch of so and sos. Most have taken 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.
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This columnist has already written that what's really at stake here is the political economy of banking and the government's failure to openly address that fact is now coming back to haunt it.
Instead this column will argue 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 problem 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 new millennium began, 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 this writer's case, the politico-housing complex).
So, the only question that matters right now is this: 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 this commentator can only see this making asset markets worse.
We're into a credit crunch all right.
David Llewellyn-Smith is the editor of MacroBusiness and co-author of the Great Crash of 2008 with Ross Garnaut. This is an edited version of a longer article available free at MacroBusiness.
Earlier, the Commonwealth Bank, Australia's biggest mortgage bank, announced that its standard variable mortgage rate will rise 10 basis points to 7.41 per cent from February 20.
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Commonwealth Bank and regional lender Bendigo and Adelaide Bank become the latest banks to break ranks with the RBA. Photo: Jessica Shapiro
The moves round out the out-of-cycle rate rises among the big four banks.
Also today, Bendigo and Adelaide Bank increased its standard variable mortgage rate 15 basis points to 7.45 per cent.
Westpac and the ANZ defied Treasurer Wayne Swan and lifted variable rates 0.10 and 0.06 percentage points respectively, on Friday, despite a decision by the Reserve Bank to hold its cash rate steady. The ANZ bank today announced it would cut 1000 jobs by September 30 to cope with weaker demand for banking services.
As with other banks, CBA blamed today's rate increase on rising funding costs, adding that greater uncertainty emanating from Europe was exacerbating the situation.
“In making this decision, we have been cognisant of our total funding costs, of which the official cash rate is only one factor,’’ said CBA group executive of retail banking Ross McEwan.
‘‘The Commonwealth Bank believes Australian banks should continue to price sensibly, taking into account factors both on and offshore, rather than experience similar problems to those that many banks overseas have experienced,’’ Mr McEwan said.
"Whilst we understand that any increase in interest rates is not favourable to borrowers, our millions of deposit customers are favoured and since the commencement of the GFC we have seen significant competition in retail deposits pricing," he said.
CBA said it would raise the interest rate on its six-month term deposit account by 20 basis points, also effective February 20.
National Australia Bank, the last of the four big banks to announce its interest rate stance, said it is reviewing its rates.
Commonwealth Bank shares rose 41 cents, or 0.8 per cent, to $50.29, slightly less than the overall market's gain. Bendigo and Adelaide Bank shares rose 6 cents, or 0.7 per cent, to $8.19.
Bendigo, like ANZ, has also said it would review interest rates independently of the Reserve Bank. Westpac's new variable mortgage rate is 7.46 per cent and ANZ's is 7.36 per cent.
Bendigo managing director Mike Hirst said current banking margins are not sustainable and adjustments to interest rates must be made.
“This is not a popular move, we know that, but it is the right thing to do to restore a proper balance between depositors, borrowers, the Bank’s shareholders and our community partners. At current funding cost levels that balance is out,” he said.
At current pricing levels banks were “subsidising mortgages,” Mr Hirst said.
“If you look at the traditional role of a bank this makes no sense and is unsustainable,” he added.
Mr Hirst said banks had a fundamental choice to make: adjust the pricing on loans or restrict lending. He added the latter option would have significant implications for the economy and would not be the right thing to do at this point in time.
He also said many staff at Bendigo have taken unpaid leave to help reduce costs, while no new back office staff are being hired.
Bendigo’s new mortgage rate will apply from February 21.