Black Swans lurking around Australia’s banking system

March 28th, 2010

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We must confess, we are getting more and more nervous about the potential for a Black Swan hitting the Australian economy. Particularly, we are looking at a vulnerability in the banking system. Here are some facts about Australian banks:

  1. As at December 2009, around 75% of the Australian mortgage market is held by the Big 4 banks. 50% are held by Commonwealth and Westpac while 25% are held by ANZ and NAB. (source: CoreData’s Australian Mortgage Report Q1 2010)
  2. 60% of Commonwealth’s lending books are residential mortgages.
  3. 50% of Westpac’s lending books are residential mortgages.

Now, here’s an interesting news report from almost two years ago:

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

The question is: how true is this today? Since we are not banking analysts here, we are guessing that the situation in 2008 is not much different today. If Commonwealth Bank’s balance sheet is representative of the banking system, then judging from the fact that only around 1% of its total assets are government bonds, it seems that this is still true today. If we have any more information about this peculiar nature of the Australian banking system, we will inform you.

GoldMoney. The best way to buy gold & silverAssuming that this is true, then think of the implication: All it takes to paralyse Australia’s banking system is for some mortgage debts to go bad. Why? That’s because by nature, banks are highly leveraged. As we explained in Effect of write-down on bank balance sheet, bad debts will have more than proportionate effect on the equity of banks. For example, take a look at Commonwealth Bank (CBA) 2009 Annual Report– you can see that its leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Among the the $620.4 billion of assets, $473.7 billion are loan assets. That means, if around 6.6% of CBA’s loans go bad (any loans, not just mortgages), 100% of its shareholder equity will be wiped out. In reality, long before that happens, alarm bells will be ringing in APRA (the banking regulator).

At the current state of affairs, the health of Australian banks’ mortgage loan books is very dependent on Australia’s unemployment rate. Once the unemployment goes up to a certain level, a tipping point will be reached whereby mortgages will start to default. When enough mortgages default, any of the Big 4 can become insolvent. With that, the solvency of the banking system will be threatened.? As we wrote in RBA committing logical errors regarding Australian household finance,

As unemployment rises, it will eventually reach a critical mass of prime debts turning sub-prime. Once this critical mass is reached, the deterioration in the Australian economy will accelerate (see what?s happening in the US and UK today).

Of course, economists, politicians, media will harp about how ‘safe’ the banks’ mortgage debts are. A quick read on the Reserve Bank of Australia (RBA)’s latest Financial Stability Review will give you a feel that they are not worried about the solvency of mortgage debts.

But that is beside the point.

The issue is not how ‘safe’ or ‘risky’ mortgage debts are- on paper, they are ‘safe.’ The issue is this: Why on earth is Australia concentrating the risks to its banking system? Every financial adviser will counsel you on the importance of diversification. Yet, when it comes to the Australia’s banking system, the opposite is happening.

The greater the concentration of risks, the less the margin for error is. If you live life with less and less margin for error, that’s when accidents are waiting to happen. That is where Black Swans lurks (see Failure to understand Black Swan leads to fallacious thinking).

We are getting more and more nervous.

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  • MrV

    How would a deposit base chasing return fit into this picture?

  • Retail deposits goes into the liabilities side of the bank's balance sheet- it is not part of the bank's equity. Therefore, it will have no direct effect on the leverage ratio.

    But rising bank deposits interest rates means that the bank's profit margins will be squeezed. That means lower profits, which means lower growth in the equity.

  • iampivot

    So what's the general advice for young couples needing a place to live in Australia? Keep renting for a few more years?

  • Hi iampivot!

    Firstly, for the benefit of everyone here, whatever in this web site should not be taken as advice. But what this website offers is a forum of ideas for everyone to brainstorm. Some ideas will be good, some will be bad and some neither good nor bad. Some will be applicable to your situation, some inapplicable. So, each person will have to sift those ideas according to their own personal circumstances.

    Okay, coming to your question… you may want to read What to do for potential first home-owner?. One reader, Pete, suggested moving to another country.

  • David M

    Don't the banks get most of their money from overseas? If this is the case then they are extremely vulnerable to rate rises as a result of higher borrowing costs overseas. If higher than RBA rises are continually forced onto borrowers (as I believe they will be) then the defaults will start in those most vulnerable – the unemployed, some first home buyers and others just managing as it is. Does Australia have figures for those loans that are in trouble? I know they extract such figures in the US but I don't remember seeing anything like that here.
    I believe borrowing costs will rise sharply in the latter half of this year and defaults will follow with all the associated flow-on effects to real estate values, unemployment, etc. – but that is just a personal opinion.

  • Fordzephyr

    There is an inversion of the interest rate, especially after 6-12 months and the rate has also dropped in the past few weeks. Does this indicate the banks have sufficient funds from local depositors or that they can no longer afford to pay the rates on term deposits that are higher than the mortgage rates which is where a large portion of these funds are destined to be used?
    In regard to the potential 'Black Swan' event with Australian banks we have a government guarantee on deposits until October 2011 and after then….what? Where is the place of last resort as far as protecting one's capital? Will it be inflation or deflation? Whatever it is it is a long way off the good news stories such we have been getting bombarded with; that we are the “best economy in the OECD; the mining boom has a minimum of 20 years to run and we are truly the Lucky Country”. All good examples of potential media bias.

  • Hi Fordzephyr!

    In regard to the potential 'Black Swan' event with Australian banks we have a government guarantee on deposits until October 2011

    One thing we have to be clear of is this: government guarantee on retail deposits is just a guarantee on the liability side of the bank's balance sheet. That is, if you deposit your savings on the banks, you are one of the bank's creditor because your savings is the bank's liability. The guarantee protects your savings.

    But government guarantee will not guarantee the bank if their loan assets go bad.

    As for after 2011, those who believe in the deflation argument (e.g. Professor Steve Keen) will buy Commonwealth government bonds as a hedge. For those who believe in the inflation argument, they'll buy gold and foreign currencies as a hedge.

    Our expectation is that if any Black Swan event hit and paralyse Australia's banking system, the government will surely nationalise the entire banking system. The question is, what side-effect will there be? Will there be an AUD currency crisis as a side effect?

  • Matt

    Ok, you got me. i just donated.

    I have been thinking about the Aussie banks for the last couple of weeks after my retired parents asked if i thought they were safe for their retirement deposits. That in turn got me thinking about the equity positions in our banks and their exposure to the real estate market… and then you guys come out with this article and quantify it all, perfect timing.

    Was thinking more along the lines of David M then internal unempoyment myself. I understand a ready reckoner for bank funding at the moment is roughly 1/3rd RBA accessed, 1/3rd deposits and 1/3rd O/S funding. its this last one that i think could provide a catalyst for Aussie mortgage defaults as funding costs get pushed up O/S due to a sovereign crisis and that, inturn is passed along to our variable rate mortgage holders. How much influence the RBA still wields will be paramont at that point.

    Of course a “hiccup” in the relentless mining boom is always on the cards and is probably overdue.

    “Safe as houses” springs to mind.

  • Hi Matt!

    Thanks for the donation. We hope you enjoy the report and the email article.

  • Australia has some figures for these loans. In fact, the RBA's Financial Stability Review has some charts.

  • Matt

    Its consider a risk currency and seems to be extremely volatile as it stands. I guess im not to assured on the AUD right now, let alone if the big 4 need to be taken under wing. It wopuld appear that the AUD would suffer on a flight to safety scenario regardless of the underlying fundamentals. I guess if the banks are nationalised there'd at least be a good reason for it.

    If our total foreign debt is about 130% of GDP (from memory) and our net is 60%, i also wonder about the quality of the overseas assets comprising the difference. If there is a shock to foreign bond markets (assuming that is a main contributor to the difference), what will be the effect on our net position?

  • Matt

    Just realised Daily Reckoniong Aust has a mention of Euro investments by Aussie banks,, i must have my head jammed right up the zeitgeist this week.

  • Should the Euro bond implode, it will affect our banks' capital position. Depending on how much bonds they have, it may or may not be serious.