Thursday, December 16, 2010

Ken Henry – on the money

Treasury head honcho Ken Henry raised a bunch of interesting points in his talk to the Australasian Finance and Banking Conference yesterday.  A transcript is available here and is well worth a look.

On the currently vexed issue of bank lending margins Henry does what relatively few commentators have done and simply ties the matter back to the overarching issue of what return on equity they need to be driving.  This seems pretty reasonable – given that the banks have good cost control (and they do) and are getting their funding on the cheapest terms they can find (and they do, within the confines of their debt maturity and duration requirements) the single biggest factor driving their loan rates is how much return they need to get.

Henry makes the point that banks have averaged around 15% ROE since 1992, and poses the following question:

Is a 15 per cent post-tax rate of return on equity too high or too low?

It’s a good question, and one I’ve mulled over many times (here and here and here).  However, I’m not so sure about Henry’s follow-up:

One way of answering that question is to say that it cannot be regarded as too high if the industry is sufficiently competitive; if the provision of banking services is sufficiently contestable. And that is one reason why there is so much focus on banking competition.

The reason I’m not sure about this relates to the 8 year period between 2000 and 2007 – surely a time of unprecedented competition in the finance and banking sector as credit markets eased sufficiently to allow the non-bank lenders to run amok and the banks to cut both margins and lending standards, in the process piling on huge lending volumes.  The big four banks managed averaged a whopping 18.7% ROE (after tax) over these years, while 10 year Govt. bonds averaged just 5.7% (pre-tax).

If returns of nearly 19% were reasonable back then, surely 15% is very reasonable now.  Trouble is, I don’t think either of those statements is correct.

So, while Henry hasn’t provided any answers to this difficult question, he’s doing more than most by asking the question in the first place.


Anonymous said...

There are two other factors at play in determining ROE - rate of balance sheet growth and fees. The former has been traveling in double digits for a considerable time and the recent reductions in ROE can be linked back to the that slow down and the competition on fees which has reduced them as well. Growth is key and a major watch point for banks (especially if you are a shareholder).

The Weatherman said...

On the subject of fees, it's been interesting to see the banks backing off over a number of its fees in recent times. Likely that this will continue with the new NCCP laws becoming effective for the banks as at 1/1/11.

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