There has been plenty of speculation about the impact of Westpac’s decision to lift its mortgage rates on the outlook for RBA interest rate policy and the impact of the decision on consumer sentiment and the economy.
The bank blamed the rise on the increased regulatory costs associated with recent moves by Australia’s prudential regulator, APRA, to make the big four banks, and Macquarie, hold more capital against their home loan mortgage books.
Capital is part of the funding structure of a bank. But its primary role is for loss absorption should Westpac’s customers fall on hard times and the bank has to materially increase its write-offs against debts customers can’t repay.
It’s this fact that the money raised in the form of capital could be written off (lost) by shareholders of the bank that make it relatively expensive to raise for the bank and its current shareholders. Likewise, it’s also a cost to the bank because APRA is expressly saying that more capital has to sit on the sidelines of the balance sheet (less leverage) as security against potential home loan mortgage losses and can’t be deployed for more loans. That means Westpac’s returns suffer.
So you can see how the board and management of Westpac, focused on maintaining its cash earnings of $7.82 billion, and return on equity (RoE) of 15.8%, wanted to increase income from home loan mortgages.
Most Australians are in some way a shareholder of Westpac and the banking system, so we all benefit from it being strong and robust. But, I’m old enough to remember the “recession we had to have.”
I remember Westpac almost being taken down by its subsidiary AGC.
I remember mates working for the bank worrying about their futures and an old colleague has since recounted the real fear in one of the bank’s dealing rooms that they might get a “don’t come Monday” call.
And, I also remember exactly where I was sitting in the JB Were dealing room in Bligh St Sydney when a quiet whisper swept across the floor that “Packer was in” buying options, and as a result Westpac was about to be saved.
What Seth Godin said
I was reminded by all this in a blog written by Seth Godin on the weekend.
If you’re not familiar with Godin, you should be – he’s a US-based best selling author and great thinker on topics such as the post industrial revolution, marketing, leadership and the spread of ideas.
Godin questioned what corporations were for and said the purpose of a company was “to serve its customer”. He said it had an obligation not to harm anyone else and an opportunity to enrich the lives of its employees.
“Somewhere along the way, people got the idea that maximizing investor return was the point,” Godin wrote. “It shouldn’t be.
“That’s not what democracies ought to seek in chartering corporations to participate in our society.”
But it’s what Godin said about management culture that really made me think about Australian banking:
The great corporations of a generation ago, the ones that built key elements of our culture, were run by individuals who had more on their mind than driving the value of their options up.
The problem with short-term stock price maximization is that it’s not particularly difficult. If you have market power, if the cost of switching is high or consumer knowledge is low, there are all sorts of ways that a well-motivated management team can hurt its customers, its community and its employees on the way to boosting what the investors say they want.
No doubt Godin would argue that the managers of Westpac past might have appreciated they were saved by an outside force in Kerry Packer. They may have also recognised the bank, among others, dodged a bullet in the GFC when the federal government guaranteed the debt, (local, foreign and depositors).
They might also have recognised that global capital markets took that guarantee seriously because the taxpayer balance sheet was so healthy and carried little debt. The same taxpayer whose balance sheet effectively backstops Westpac and its major bank colleagues because of their too-big-to-fail status.
Which brings me back to the tension between Australia’s prudential regulator (APRA) forcing the majors and Macquarie to hold more capital against home loan mortgages and Westpac’s decision to rebuild RoE by recouping this cost with last week’s 0.2% increase in mortgage rates.
APRA is focused on financial stability and ensuring depositors get their money back. Equally, in making the financial system more stable, APRA is protecting taxpayers by trying to ensure that neither the government’s deposit guarantee scheme or the RBA’s giant bank liquidity line is never called on to bail out an Australian bank, building society or credit union.
There is a low, but still real, probability that this will ever happen. But APRA has to act in the community and the economy’s best interest nonetheless.
But to a major bank like Westpac, used to holding less capital against its home loan mortgage book than its smaller rivals (because of its ability to run its own internal models under global banking regulations), APRA’s new rules simply scream more costs and less profits.
So, while the bank could have taken the decision to make less money, it’s clear that management and the board see this week’s rate hike as an inevitable consequence and cost of APRA’s efforts to make Australian banking safer.
Australia’s big banks are amongst the world’s most profitable
In its Financial Stability Review released last week, the RBA highlighted that Australia’s “Large Banks” are, with their Canadian counterparts, amongst the most profitable in the world when measured on a RoE basis.
Certainly things aren’t as rosy as they were pre-GFC for the banks’ owners but it’s clear that the banks have done a good job of rebuilding their margin. That RoE, and the current low levels of non-performing loans which is a factor in it, then helps drive the big banks’ “share price to book value ratio” to the highest in the RBA’s sub-set. This includes Canada, the United States, United Kingdon, Japan and Euro Area.
This suggests that Westpac’s actions last week in raising mortgage rates has little to do with restoring a threatened profitability profile and has little to do with the economy having to carry the cost of making the financial system more stable.
Rather it implies that Westpac’s borrowers, and potential the economy if the other banks follow suit, are simply restoring what the Westpac board and management see as their rightful reward for intermediating Australian savings back to Australian borrowers. They are doing this against a back drop where the banks’ liquidity is essentially guaranteed by the Reserve Bank’s massive committed liquidity facility, deposits under $250,000 are explicitly guaranteed by the Federal Government, and their too-big-to-fail status means they can take risks and charge prices to earn what looks like an excess return in an environment where they enjoy an effective government guarantee.
They may never have to endure a near death experience again.
Which brings me back to Godin again. He concluded his piece saying, “profits and stock price aren’t the point (with customers as a side project). It’s the other way around.”