Australian Banks Must Increase Fees or Expand Loans to Remain Profitable

The news that's all the rage today is Westpac's (ASX: WBC) $19 billion bid for St. George (ASX: SGB). It would create the biggest bank, by assets, in Australia. So... should we care? Big five? Big four? Big deal!

Is it a big deal if you're an investor? That depends on whether you believe the banks are a buy. If one bank is buying another bank, then at least one bank thinks banks are a buy. But why? And is what's good for one bank good for the investor?

The question, as always, is where earnings growth is going to come from? In that light, the Westpac move is all about growing the loan book through acquisition. Growing the loan book means putting more Australian in debt. We'll get that in a minute. But let's take a quick look at the details first.

First, if you exclude non-recurring items, cash profits at Australia's big five banks grew by just 1.1% in the first half of 2008 compared to the year before. During the biggest credit crunch of the last thirty years, that's not awful. But it's not good either. By the way, all the data that follows, unless otherwise indicated, is taken from the KPMG survey "Major Banks: Half Year 2007/08." It's an excellent read. Seriously.

Aussie banks didn't face massive losses from bad housing loans (although at least one bank, ANZ (ASX: ANZ), took big losses on loans to stock brokers). So what ate into profitability? The "net interest margin" declined for all five banks in the first half of '08. The interest margin is the difference between what Aussie banks pay to borrow and what they pay out interest on deposits.

The credit crunch has raised the cost of "wholesale borrowing." ANZ's interest margin decline from 2.24% to 1.99%, Commonwealth Bank's (ASX: CBA) from 2.22% to 2.17%, NAB's (ASX: NAB) from 2.33% to 2.18%, Westpac's from 2.25% to 2.05%, and St. George's from 2.07% to 1.92%.

So here's the question, dear reader: if you're making less money lending money because the cost of money has gone up, how do you make more money? You make it up on volume.

Despite the decline in net interest margins, total net interest income actually increased by 9.8% in the first half to $17.6 billion. The banks managed that by growing assets by 19.9% in the first half compared to '07. Growing assets by that much is an accomplishment during a bear market in credit. How did the banks do it?

The banks grew their lending portfolios by 16.1% in the last twelve months ended March. Consumer lending (housing, credit cards, personal loans) grew by 11.2%. Business lending grew by 24.5%. Total bank assets in Australia now exceed $2 trillion.

Now THAT's how you grow your way out of a credit crisis. You lend more. It could, of course, be troublesome if you look at bank assets as other people's liabilities. Debt levels are already high at the household level. For banks to grow assets, household debt levels would have to grow even more and business borrowings would have to rise as well.

The trouble with growing your assets to drive your earnings is that you take increased credit risks to do it. This was the problem for the Government Sponsored Enterprises in the States and led to massive blow outs in their balance sheets (the regulators came in late to restrict the growth in balance sheet assets).

Eager to drive earnings and please shareholders (and make some money on stock options tied to earnings growth) bank managers in the States grew the balance sheet with little to no regard for asset quality. That is one simple explanation for how a mortgage lending bubble gets started.

Here in Australia, if banks are going to continue growing assets, the housing boom will have to keep booming. This is problematic too, with housing already so unaffordable. For example, the Australian Bureau of Statistics reported today that the number of home-loan approvals fell by 6.1% in March.

Higher interest rates are discouraging demand for housing loans. Yet the banks have to loan more to make up for declining margins. But the more they loan, the bigger the risk they take that the loans will be non-or under-performing.

Is there any way out for the banks? Well, they could hope for an increase in net interest margins. This would lead to a decline in the cost of borrowing money. The banks could leave the interest rates they pay on deposits fixed, and benefit from the lower cost of funding. An end to the global bear market in credit would help, then.

Of course, there's another way banks can grow earning without growing loan volumes. You know it well! Fees!

If profitability on loans is declining (and it is), the banks could make it up charging you more fees (not that they would ever do that). The growth rate in bank fees has actually declined, if you peruse the data from the Reserve Bank. But bank fees, as you can see from the chart below, contributed nearly ten billion to bank's income in 2008-basically half of a full year's profit.

Source: Reserve Bank Statistical Tables, Domestic Banking Fee Income, Table F6

There's consolation in that massive income from fees if you're a bank shareholder getting a dividend and some capital appreciation. But if the worldwide model of growing asset values through debt is under massive attack in the U.K. and the U.S., then why would it be terribly different in Australia?

Unless margins improve, banks will either have to raise fees to continue earnings growth, or expand the loan book. With rising interest rates, expanding the loan book is going to be hard to do, even if that's what you want to do. Westpac must know this and decided to take a short cut to balance sheet expansion: acquisition. Does this mean organic growth is dead? Hmmn.

Dan Denning
The Daily Reckoning Australia

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