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:
- 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)
- 60% of Commonwealth’s lending books are residential mortgages.
- 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.
Assuming 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.