Over the past few decades there has been a relentless march by Australian banks to reduce costs. I used to work for three foreign banks in the 80s, 90s and naughties who used to laugh at Australian banks’ cost to income (CI) ratios – all below 50% (now in the low 40s). They’re not laughing now.
To err is human to arr is pirate – Seen on a t-shirt
To be fair to the banks, for more than three decades they have been responding to a global clamour of bank equity analysts who insist that all Australian banks cost to income ratios are too high – I have seen In the late 1980s and early 1990s this cost reduction took the form of branch closures and redundancies after mergers between the then big six and the sale of the CBA. The following decade saw a shift towards automation and then outsourcing of processing and call centres to Asia.
The past five years has seen a tremendous shift in retail frontline functions to brokers.
Now we have 54% of all home loans originated by brokers. In the US that number is 95%.
What all of these strategies have in common is that they’ve been spectacularly successful in reducing costs. So the equity analysts have been kept happy. But these strategies have also had unintended consequences and this article is about those consequences.
Certainly when you compare Australian banks’ CI ratios to those of our global competitors we’re always at around the lowest (with China, Hong Kong and Singapore currently ahead of us – China, because labour is cheap and Singapore and Hong Kong have tiny geographical areas for their branch networks to cover). The European banks typically have a CI ratio of around 60-70%. That’s because they dabble more in Investment banking – which means they pay their bankers more. Even within Australia, the major banks have a CI average of around 43% and Macquarie (our sole investment bank) has a CI that ranges between 60-70%.
While the aforementioned strategies have worked to reduce macro costs our banks have also had a few rules about the way they do business which differentiated them from their global peers:
- Stay away from high cost banking (such as investment banking). Sure Aussie banks dabbled in Investment banking for a few years but they weren’t willing to pay the salaries required to entice major players which meant that their learning curve was too steep. While they all failed, the benefit to the local banks was that they had some staff that benefited from that experience and served those institutions well for decades to come. This was in the era when banks knew how to manage risk.
- Reduce the number of institutional banking staff as margins in this segment are much lower than other banking segments. This is a recent strategy and the abandonment of this segment should be of tremendous concern. This is/was the incubator for good banking staff. This is where the largest and most complicated transactions were done.
- Keep pay increases to a minimum (so that revenue always outpaces the largest cost). This strategy only works well when there’s no competition (like the period since the GFC). In the past this strategy has ensured that foreign banks (who paid a minimum of 50% more) would always ensure they poached the good staff from local banks. By the time the local banks adjusted their salaries to compete, the good staff were gone and they found themselves paying over the market price for second rate staff.
- Increase their reliance on retail banking (mortgages). There is a view now amongst the major banks that this is the only option available to them given the changes to bank regulations. It’s not but if lazy senior management gets rewarded for not taking a risk and fired for taking one why would they.
- Transfer operational tasks to offshore (cheaper) processing centres. These changes to the cost structure have now run out of steam. They’re a one-off. Politically, they play into the hands of politicians with a xenophobic axe to grind. Watch this space.
All of this sounds rosy unless you work for a bank or are a customer of one. The problem that arises from the above is that our banks are now little more than large building societies. This wouldn’t be a problem if that was the end of it. This dumbing down of our banks means that very few staff are now being trained in more complex products and thus where once we led the region in the quality of banking intellectual horsepower, we’re now lagging. Further, the biggest complaint we have from customers migrating their relationships from banks to brokers is that they no longer have a contact point in a bank. The contact phone number, if they’re given one at all, is usually o a call centre. While this has been true for retail customers with home loans for many years, it is now a reality for more and more business customers.
As employees, banks employed 3.8% of the workforce in 2006 and in 2016 that number was slightly lower at 3.7.
So the next time a bank CEO reports record profits and speaks of significant headwinds to placate the horde of angry journos, remember those numbers.
As employers the banks’ importance in the economy is trending flat to slightly down. You would think that shareholders would be very happy. Well, they’re not. The reason for this is banks’ return on equity has climbed down from around 17% in 2006 to around 12% in 2016. While, the preceding numbers point to a massive increase in productivity there’s more to them. The employment numbers (compiled by the ABS) do not show the number of jobs that went offshore. More importantly, the ROE numbers include the massive increases in Tier 1 capital that APRA has forced our banks to raise in the past 5 years.
Why is this a problem? We have the best banking system in the world. The envy of all others. Right?
Sort of. That system was built post deregulation by bankers that understood risks and took them (not always successfully). These days there is an unfounded fear of any risk. Which tends to indicate that bankers have lost the ability to manage risk – which is what banks do (or at least used to do) and now they just avoid risk altogether.
Let me give you an example.
A client, who is a small business owner, walks into their bank and requests an overdraft. The small business banker at the branch pulls out a checklist. The client has turnover of $5M and sells to major retailers around the country. Last year they had a net profit of $800k. They are seeking an unsecured overdraft of $800k to tide them over between invoicing of clients and collection of the outstanding payments.
The banker asks for the client’s family home as security. The client refuses. The application is rejected. Credit rejection happens to 60% of small business owners that apply for bank credit.
Let’s dissect why the above scenario happens.
The client wants to protect the family home so is hesitant in providing it as security. Despite the fact that banks say they don’t want to rely on security (they call it the second way out), they do. A loan secured by property reduces the capital the bank has to put aside for the loan. An unsecured loan to an unrated counterparty would make the transaction uneconomic for the bank.
In my mind, this alteration of bank capital rules introduced under Basel III is the main reason that economic activity has not recovered post GFC.
Continuing with the above scenario, the client comes to see us and we arrange for private funding at a cost that is at least 50% more than what they would’ve received from the bank. Unfortunately, most small business owners don’t come and see us. They merely make do by either reducing the amount of business that they conduct or try negotiating slightly better terms. If you consider that small business is the largest employer in our economy, this has an overall impact of holding the economy back.
The role of banks in a modern economy is to ensure the provision of capital to the economy. Unless you’re a purchaser of either an owner-occupied or investment property banks have stopped fulfilling that role.
The role of governments should be to hold banks to task if they don’t fulfil that role.
The solution is not easy but at the very least the following should be starting points for things to consider.
In the last seven years we have delegated the running of the economy to regulators like APRA who get the rules of regulation handed to them by a committee in Switzerland. Yes, we have a seat at the table but these rules (known as Basel III) have been heavily influenced by European banks who have had enormous issues with a lack of capital, failure of stress tests etc. We have not had such issues. Worse, APRA’s interpretation and implementation of those capital rules is stricter than those for European banks (perversely because our banks are stronger).
- Ensure that Australian banks diversify their revenue base (even by a small fraction). Don’t just rely on reducing costs and mortgages. Yes, I understand that there will be capital consequences under Basel III – charge the clients more (it will be cheaper for clients than going to private funders). We can then measure the true size of debt. It’s not just China that has a shadow banking market.
- Ensure that banks return to managing risks on their balance sheet rather than avoiding them.
- To facilitate No. 2 ensure that bankers are being trained in the dark art of credit and not just working off a check-list. In-fact, I would ban check lists for commercial loans. Force the bank to assess each application on its merits.
- Introduce conditions on existing and new banking licenses. If a bank continually shirks its obligations to the economy introduce a tax that will increase its cost of funds until the issue has been addressed.
- APRA audits foreign banks to ensure compliance with the type of license that they have (wholesale, retail etc). The same should apply to Australian banks. If it’s found that the Aussie banks are no longer playing in a certain segment of the market. That portion of the license should be re- considered and perhaps granted to an institution that will make better use of it.
- Stop considering a transaction merely on reputation risk. That ship has sailed.
Let’s stop wasting time on senate estimates and talk of Royal Commissions. I don’t think the banking system is broken. It’s just been shut to many segments of the economy thanks to regulatory rules drawn up by European banks. It has stopped providing the lifeblood of our economy. Capital. This has been decades in the making and goes back around 33 years.
By allowing the six banks to be reduced to four was, with the benefit of hindsight, a major strategic error. The takeover of regional banks by large banks has compounded that error. Now, banks’ vertical integration strategies are in the spotlight. But the blame should not rest with the banks – they did what their shareholders (and equity analysts) wanted them to do.
The blame, as always, is with the regulator (ultimately, the government). So next time you hear a politician having a go at banks ask yourself, when they were/are in power, what they did. In fact, the only time in my memory that government did anything that benefited the electorate was when they issued 16 foreign bank licenses.
That was in 1985.