Europe’s political system of bread and circuses is making up for the lack of bread with more circuses. Guess who is in charge of the EU’s meeting of finance ministers? The Polish Finance Minister, who recently predicted war in Europe within 10 years! And in Germany the media is up in arms because Germany’s gold reserves may be used as collateral for the bonds that will finance the bailout fund.
Best of all, the politicians are trying to force the banks to write down sovereign debt and increase capital – at the same time. This is like entering a one-legged man in a butt kicking contest so he doesn’t feel left out.
But there is plenty happening closer to home too. While the Europeans are trying to save their banks, Australians are having a whinge.
It’s bank earnings season in the land down under. Which means it’s bank bashing season too. For the next few weeks you will get to hear journalist after journalist rattle off their thoughts about the gadzillion dollar profits three of the big four pillars of the Aussie banking system will report.
Our favourite piece out so far on the gouging bankers is the ironically titled ‘Last Word’ column on the back of last weekend’s Australian Financial Review. ‘Last Laugh’ would be a better title. The article is a wonderful mish mash of contradictions, ignorance and completely missing the point.
For example, the writer could have written about the inherent fraud of fractional reserve banking, which allows banks to loan more money than they hold in deposits. Or about the ridiculous advantage banks have in being backstopped by the central bank, the government with bailouts and the government again with deposit guarantees and a third time with mortgage-backed security purchases. (Yes, your government is buying the same stuff that blew up in the US.) Perhaps the writer might have mentioned that NAB is seeking the right to evict renters from foreclosed properties without notice.
But no. The writer takes the bank to task on a bunch of things that are completely nonsensical. Take this amusing statement:
‘The shock jocks have never understood that banks protected from takeover, and licensed to operate in an economic environment in which the tax system heavily favours mortgages over other forms of investment, will consistently spit out return on equity of 10 to 20 per cent unless there is government intervention.’
Protected from takeover, licensed to operate, tax system heavily favours mortgages – these are examples of government intervention, not the absence of it!
And, apart from the licensing, these are not reasons why the banks manage a certain return on equity. Competition always reduces returns to the point where they reflect risk. If banking is so safe and favoured, it should get lower returns, as there are fewer risks.
Another reason bank bashing is popular, according to the writer, is that the banks have not assured the public they will be passing on any interest rate cuts from the Reserve Bank. But why haven’t they? The writer provides the answer: ‘It is now illegal to give guidance on rates as it is regarded as price signalling.’
Huh? Banks can’t announce interest rate changes in advance? And then people get grumpy at them when they don’t.
Strangest of all in all this bank bashing is that banks pay out so much of their earnings in dividends. That means they return it to the shareholders. They don’t keep it for themselves. The idea of a company wanting money for the sake of keeping it for the company is inherently ludicrous, but don’t tell the Occupy Wall Street protesters in Sydney and Melbourne or they might stop protesting.
The real issue with the banks is that they represent time bombs, which bankers are paid to sit on top of. Philosopher and options trader Nassim Taleb does a great job of explaining this point. If banks need bailouts every couple of years, then we should consider the banks utilities. And pay bankers as such. Allowing them to rake in commissions when times are good and rely on bailouts when things go wrong is not a feasible business model. Unless you own politicians, that is.
What we have here is the typical example of government intervention worsening the problems it is trying to address. The more intervention, regulation and safety measures the government creates, the bigger the crisis when it comes.
ROE v WACC
But why do banks need bailouts every couple of years? Why are bankers sitting on time bombs?
The answer lies deep in the murky world of corporate finance and bank financial management.
Return on Equity (ROE) is how much a company makes relative to how much was invested in it. According to the banks, their ROE sits somewhere in the middle of the pack for the top 50 Aussie companies.
It’s the Weighted Average Cost of Capital (WACC) that makes you realise how fragile banking is. It is the figure that tells you how much it ‘costs’ a bank to obtain funds. There are two ways to obtain those funds – debt and equity. The WACC averages out the costs of the two based on how much debt and how much equity a bank, or company, uses to fund itself.
The cost of debt is obvious – it’s the interest rate. The cost of equity is a theoretical concept, making the WACC difficult to calculate.
But here is the point. If the ROE is more than the WACC, the bank is doing fine. Its investments are returning more than it cost to finance them. If the WACC is greater than the ROE, the cost of funding is greater than the bank’s return, which indicates the bank is in trouble.
What makes banking so dangerous is that it treads a fine line when it comes to ROE v WACC in all sorts of ways.
Banks’ returns aren’t much greater than their cost of funds. It’s just that a lot of funds are involved, so the profits seem large. But a small move in ROE or WACC can mean a big change in profits.
Because the banks’ business is debt – and they rely on debt to fund the debt they lend – debt flows are crucial to them. It affects both their costs and their revenues. If the debt flow is interrupted – a liquidity crisis – banks cannot finance their activity. And their profits vanish at the same time, because there is less lending taking place. Worst of all, the value of their debt must often be revised down, so the balance sheet is in trouble too.
The demand for debt in the absence of willing suppliers sends the cost of debt soaring in these circumstances. That in turn sends the WACC soaring for banks. You could say they get WACCed.
Worse still is the ‘maturity mismatch’. The banks’ business model is to borrow short and lend long. That’s another way of saying they borrow money regularly for short amounts of time and lend money to people for longer periods. Because long-term interest rates tend to be higher, the banks make a profit on the difference.
But when there is a liquidity crisis, it’s the reliance on short-term financing that trips banks up. They cannot pay their regularly maturing debts with more short-term debt, as there isn’t any available. It only takes a few days of liquidity crisis before the banks are in deep trouble, whereas companies that borrowed for long periods can delay their borrowing much more easily.
So, basically, when things go wrong for banks, everything goes wrong at the same time. No wonder bankers want bonuses. When their bank gets WACCed, they could be out of a job at almost no notice.
But while things are still plain sailing in the Aussie economy, why worry?
Rip and reap, baby!
Before it’s too late…
The Daily Reckoning Weekend Edition