Posts Tagged ‘bank’

What if Australia?s banking system needs a Government bailout?

Tuesday, August 17th, 2010

As most of us are aware, Australia has the ?four pillars? ? four large banks that provide the majority of Australia?s local banking credit. Over the last few decades, these four banks have increased their exposure to residential mortgages, even in the face of what appears to be a large housing bubble.

Mark Joiner, NAB?s finance director is confirms in this article:

[CBA and Westpac] ?with mortgages accounting for more than 60 per cent of the Sydney banks’ balance sheets?

“Australia should have a balanced economy; not a big skew to mortgage or business lending”

Each of these four banks lends money to each other and has enough influence on the economy to be considered ?too big to fail? by most – the failure of one bank potentially triggering the collapse of another and so on.

Popular opinion suggests that if such a scenario were to occur, the Australian Government would step in to bail out the banks and prevent them from collapsing. This would require the Government to acquire money, either by borrowing it, selling bonds or ?printing? it.

If we make the assumption that the Government would be forced to act in this way, the repercussions of such action could be that borrowing or bond sales increase the Government?s financial liability. This increases the risk of lending to the Government, possibly even our AAA debt rating. Such increased risk will:

  • increase the cost of borrowing for the Government and local companies including banks
  • decrease the amount of credit easily available
  • increase the Government deficit and annual interest payable
  • increase local interest rates, making it more expensive for the public to service debt or take on new debt, possibly reducing the ability of the public to purchase property

If the Government resorted to money printing (or equivalent), it is likely that the value of the Australian dollar would depreciate, causing credit problems similar to the ones mentioned above. And if such problems persist, they would form part of a feedback loop that amplified them over time (see Serious vulnerability in the Australian banking system).

However, this does not mean that the problems would be inescapable. Strong fiscal policy, increased taxes, reduced spending ? all of these could contribute to bringing Australia back into healthy financial territory.

But what are we missing? Even now, people are crying out for spending on infrastructure in NSW, VIC and QLD by the state and federal governments. How will the Australian Government have the funding to pay for any of this if it is trying to pay down debt, or if the cost of debt is increasing? Every dollar of government spending sourced through taxes, services, bond sales or borrowing has been labelled to be spent on something. If the Government allocates money to bail out banks, it is taking it away from spending on other items. From this we get a mis-allocation of spending, which will create market distortion and potentially hamper the economy at a time when Australia can least afford it.

From this we can deduce that there must be a limit to how much money the Government would realistically allocate to a bank bailout. At some point the risk of bank failure to the economy will become less than the risk of removing Government spending from the economy. Whether from this point the banks will actually fail or not cannot be known at this point.

And a final point to consider is that after bank bailouts, will the banks be very cautious lenders who have learned valuable lessons about asset risk and reserve requirements, or will they have an increased risk appetite due to a feeling of assurance that the Government will always step in and save them from ruin?

Why are Australian banks not willing to lower mortgage rates?

Sunday, August 17th, 2008

Australian banks have been under pressure from many fronts to lower their mortgage rates in response to a possible interest rate cuts from the Reserve Bank of Australia (RBA). The government and opposition parties are demanding that the banks should do the ‘right’ thing by easing the strain of the working majority. The RBA added to the pressure by declaring that it sees no reason why mortgage rates should not lowered in response to monetary easing. The media poured fuel into the fire by accusing the banks of greed.

So far, none of the banks are committed to do so- none pledged to lower their lending rates to match the RBA’s cut in the cash rate. As we said before in Too eager for an interest rate cut?,

Fourth, an interest rate cut by the RBA need not necessary mean a cut in the mortgage rate. In fact, the opposite can occur.

Understandably, with Australian households under unprecedented debt stress, this has fuelled popular sentiments against the banks. They have become the new bogeyman to target. But as one of our readers said very well in Would the RBA?s rate cut do any good?,

It is not so much bank bashing (kind of pointless beyond the immediate feel good and but easy to slip into) but the realities do need to be looked at, and yes, I agree it may be far too late for the banks to do much else and are themselves to an extent pawns in the bigger global picture.

Here, we try not to pass moral judgements on banks. After all, banks are just impersonal profit-making institutions. Therefore, it is inappropriate to apply moral motives on non-person entities. What can expect from entities in which their clearly stated objectives is to make profits?

While it is true that the money market rates for the banks have fallen since the market’s expectation of an interest rate cuts has risen, does that automatically mean that this alone is a good reason to cut mortgage rates? Motives aside, what are the possible reasons why banks are not willing to lower mortgage rates? We can think of a few reasons here:

  1. Mortgages are long-term debt (typically up to 30 years). Cash raised from money markets are short-term credit (which ranges from 1 month to 1 year). How can we expect the banks to lower their long-term lending rates just because the cost of their short-term credit has fallen? Indeed, as the situation for the non-bank lenders like RAMS had shown, borrowing short-term money to fund long-term lending is a good way to become bankrupt, thanks to the credit crunch. This flows on to the next point…
  2. Because of the risk involved with funding long-term debt entirely with short-term credit, banks have to diversify their lending source. As this news article said,

    Our banks raise about half their cash from local deposits, a quarter from local bonds and the rest from the global market.

    While the RBA may have some influence on the domestic short-term money market rates, we can assure you that they have no influence on the global markets. Indeed, as we explained before in Can falling interest rates and rising mortgage rate come together?, there is insufficient savings domestically to fund all the loans. Therefore, the banks have to get the shortfall from overseas and submit themselves to the global credit conditions. The global credit conditions are far from settled and major eruptions can still occur any time. As we said before in The next financial time bomb- Credit Default Swaps, CDS is the next global time bomb to explode. Indeed as this news article reported,

    Most institutional investors expect another failure of a major financial services firm in the coming year and view credit default swaps as a serious threat to market stability, according to a survey by Greenwich Associates.

    Once the banks cut their mortgage rates, it will be very unpopular for them to raise them again in the event of further ructions in the global credit markets.

  3. What if the banks expect more bad debts in the future? Lending rates are proportional to the risk of default of the loans. The banks’ unwillingness to lower mortgage rates could be a sign that they are pricing in more risks on their loans.
  4. It is open knowledge that price inflation is still on the rise in Australia. In fact, the RBA expects price inflation to peak at around 5% before turning down again. For any given nominal rate, rising price inflation implies a lowering of real rate. As we explained before in Is property a good hedge against hyperinflation?, during times of hyperinflation,

    At the same time, you can expect bankers to raise borrowing rates very quickly to protect their profits.

    By not raising their lending rates when price inflation are trending upwards, banks are actually losing money in real terms.

Finally, we would like to point out that we are by no means defending the banks. Neither should this be construed as ‘predictions’ that banks will never lower their mortgage rates.

Effect of write-down on bank balance sheet

Sunday, July 27th, 2008

On Friday, National Australia Bank reported a $830 million write-down on their assets. As this news article, More NAB bad debt revealed reported,

National Australia Bank’s senior management has been castigated by banking analysts after the bank released a fresh $830 million writedown of its investments in US housing mortgages.

The stock market reacted by plunging 3.5% at the time of writing. Will there be more? We will leave it to the mainstream media chatter to talk about it. Meanwhile, we will show you how a write down will affect the bank’s balance sheet. For this, we continue a simplified bank balance sheet from Introduction to banking corporate accounting:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Let’s say 2% of a bank’s non-performing assets is being written down. That means $1.97 of the asset will be gone. In that case, the asset part will look like this:

Asset: $96.53 (Loans), $10.50 (Cash)

But what about the liabilities and equity side of the balance sheet? The liabilities side remains intact because they represent the saver’s deposit. Therefore, it will be the equity side that gets deducted:

Equity: $2.03

The balance sheet now looks like this:

Asset: $96.53 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $2.03

In one write-down the bank’s capital ratio gets reduced to 2.03/96.53 = 2.10%. It’s reserve ratio is still 10%. Will it get into trouble? As we explained before in Banking for dummies,

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Let’s say the bank pays 9.5% interest rates to its depositors (liabilities) and receives 10% interest rates from its loans (assets)- assuming interests-only payments. That means it will have to pay $105 * 9.5% = $9.975 to its depositors and receives $9.653 from its loans. In this case, the bank is in trouble.

Or let’s say banking regulations says that the capital ratio cannot go below 4%. Currently, it is at 2.10%, which means it is in trouble. It has to either sell its assets or raise cash (via equity raising) to bring the ratio up again.

No matter what, the bank’s profit will fall.

Introduction to banking corporate accounting

Thursday, July 24th, 2008

Today, we will go deeper in depth on corporate accounting for banks. Without a proper understanding of this, it will impair our ability to appreciateĀ a bank’s financial position. Back in Banking for dummies, we explained that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

Today, we will go deeper into that.

First, we will introduce the basics of accounting:

Assets = Liabilities + Equity

So, let’s say you deposit $100 into the bank. In this case, the highly simplified bank’s balance sheet will be:

Assets: $100 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

In this example, the bank is losing money because it is borrowing $100 from you which it has to pay interests on. But its $100 of cash is sitting there idle. Therefore, the bank has to lend out, say $90 at a higher interest rate than it borrows the cash from you. The balance sheet will now look like this:

Asset: $90 (Loans), $10 (Cash)
Liabilities: $100 (Deposits)
Equity: $0

Let’s say it pays 5% p.a. interest rates on deposits and receives 10% p.a. interest rates on its loans. At the end of the first year, the bank balance sheet will be (assuming interest-only payments on loans):

Asset: $90 (Loans), $19 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

Now, there are 2 ratios that you need to understand. First, government regulations require that banks keep a certain ratio between equity and risky loans (in the assets) that it makes out to others. We shall call this the capital ratio. In this example, the capital ratio is 4 (Equity)/90 (Loans), which gives 4.44%. That is, its leverage is 22.5 times. There is another ratio called the reserve ratio, which is the ratio of cash and deposits. In this example, the reserve ratio is 19 (Cash)/105 (Deposits), which gives 18%.

Now, let us assume that the reserve ratio has to be, by law, a minimum of 10%. In that case, this bank has an excess reserve of 8% (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy?). It can lend out an additional $8.50 to give a balance sheet of:

Asset: $98.50 (Loans), $10.50 (Cash)
Liabilities: $105 (Deposits)
Equity: $4

In this case, its reserve ratio is $10.50/$105, which gives 10%. Its capital ratio is 4/98.5, which gives 4.06% (leverage of 24.6 times).

Banking for dummies

Wednesday, April 23rd, 2008

One of the most lucrative business in the world is banking. This is especially true in a world of fiat money and fractional reserve banking system, where money that is backed by nothing can be created from thin air. As we have seen previously in Reserve Bank of Australia entering the landlord business, the central bank can always prevent or prempt a shorter term financial meltdown by pumping liquidity into the system (that is,’printing’ money and then followed by lending them or buying up bad debts or some other tricks- see Recipe for hyperinflation) and introducing moral hazard. But in the longer term, the people have to pay for these moral hazards via inflation.

Today, we will take an introductory look at the business of banking.

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank’s liability but your asset. In accounting technicalities, your money goes into the bank’s balance sheet as an asset with a corresponding liability.

Currently, today’s banking system is a fractional reserve banking system. That means banks do not have to keep all your deposit money in its ‘vault.’ Since it is unlikely that you will recall most of your deposit money at any one time, it can lend out the vast majority of your deposit money while simultaneously maintaining the full balance in your bank statements. Legally, banks have to keep a minimum ratio of deposit money in its ‘vault’ to deposit money. This ratio is the reserve ratio, which is 10% in the US. Countries like Australia do not have formal reserve ratio requirement. The implication is that if every bank customer decides to recall all their deposit money simultaneously, the bank is insolvent instantaneously. That is, there is a run on the bank.

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ‘vault,’ it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default. Side note: With the rise of securitisation (see Collateral Debt Obligation?turning rotten meat into delicious beef steak), banks (and non-banks as well) are able to lend and re-lend money many times over, spewing out massive amount of credit into the financial system.

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act. For example, there are government regulations that require banks to keep a certain ratio between risky assets (loans and bonds) and equity capital (excess of assets over its liabilities). The upcoming Basel II accord is another such example.

The global credit crisis has thrown many spanners in the works of many banks’ portfolio and by extension, the global financial system. As you can see, bad debts is causing the mayhem in banks’ portfolio (see Is this sub-prime or solvency crisis?). When the financial system realised that the price of money was too low for too long (see Prepare for asset repricing, warns Trichet, which is written back in January last year), banks (as well as non-bank) become very much risk averse and hoarded money as a result. In other words, money suddenly becomes scarce (which implies its price, the interest rates has risen).

So, as we asked before in Reserve Bank of Australia entering the landlord business, what might be the “possible repercussions if the RBA had not [got into the landord business]?” When money becomes scarce and banks (as well as non-banks) become more scared, lending seizes up and credit standards become tighter (see Rising price of money through the demise of ?shadow? banking system). For economies that are drugged up by credit (e.g. Australia, UK and the US), this can cause the economic activity to seize up. The fact that the RBA is temporarily swapping risky assets (mortgage bonds) for thin air money at a bargain price is a very telling sign. And it is not only the RBA that is doing this- it looks that other central bankers are coordinating their efforts in pumping liquidity into the financial system. At least this is the official reason. Since the RBA did not reveal who they get their mortgage bonds from, other conspiracy theorists believe that the RBA are bailing out some financial institutions (which include banks and the non-bank lenders).

For bankers, there is such a thing as free lunch.