Friday, February 13, 2009

Keynes Mark II and Banks’ ROE

Another good piece in today’s AFR, this time by Robert Skidelski, about the nature of the failure the financial markets are now experiencing, and what this means for the future. This snippet gives you an idea where he’s coming from:

But the crisis also represents a moral failure: that of a system built on debt.  At the heart of the moral failure is the worship of growth for its own sake, rather than as a way to achieve the ”good life”.  As a result, economic efficiency – the means to growth – has been given absolute priority in our thinking and policy.  The only moral compass we now have is the thin and degraded notion of economic welfare.  This moral lacuna explains uncritical acceptance of globalisation and financial innovation.

This bit alone raises some interesting issues, not the least being that lacuna is a great word and one we should use more often.  But seriously, who is to blame for all this?  One thing I’ve tried and failed to comprehend over many years is what it is that’s driving the banks, because surely that’s the direct cause of the financial crisis, regardless of whatever shortcomings the regulators, ratings agencies and central banks may have had.

This table shows the returns on equity achieved by the big four banks in Australia since 1998, compared with the average 10 year bond rate for each of those years.

  2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998


ANZ 14.5 20.9 20.7 18.3 19.1 20.6 21.6 20.2 19.3 17.6 14.6 18.9
CBA 19.8 20.7 20.4 18.2 12.5 10.7 14.7 13.5 22.1 20.5 18.5 17.4
NAB 14.3 17.1 17.7 15.0 15.8 18.3 17.0 18.4 18.1 17.3 17.8 17.0
WBC 23.1 23.5 23.0 21.7 19.9 19.2 21.7 21.1 18.4 16.8 14.7 20.3
10Y GOVT 6.1 5.9 5.5 5.3 5.7 5.3 5.9 5.7 6.5 5.6 5.8 5.8

I realise that the basis of preparation of these numbers varies by bank, but the fundamental question remains: why do banks seek (and achieve) a return on equity of 15-20% (and that’s after-tax) when the risk-free bond is yielding 5-6% (and that’s pre-tax)?  I’d hazard two points on this:

  • If the risk premium is really that big, should such risky institutions be allowed to form the cornerstone of our economy?
  • If the risk premium isn’t really that big, why do the banks feel it’s their responsibility to deliver these returns?

Given the way our banks are capitalised, managed and regulated I don’t think for a moment that the risk premiums embedded in these returns are warranted.  But what would happen if one of the banks actively targeted an ROE of 10 or 12%?  Presumably their shares would be dumped.  So is this what it all boils down to – institutional investors demanding such high returns from banks that they’ve turned themselves into casinos to generate those profits?

I’ll keep pondering!

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