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How safe are our banks?

David Bassanese
Monday, November 23, 2015

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By David Bassanese

Not content with requiring our local banks to load up on more capital than they probably really need - given their relatively low risk (by global standards) business models - the Australian Financial Review saw fit to publish an entertaining article on the weekend by my old economics sparring partner Chris Joye warning of a potential “sovereign debt crisis” that we need to insure against.   

Could Australia become the next Greece, as some often like to imagine?

Australia, it seems, is at risk of a surge in offshore financing costs come the next recession because foreigners will dump our government bonds and slash funding to our banks.  

The solution?  We need to reduce our exposure to offshore funding by encouraging more domestic saving – and by encouraging super funds to own more government bonds rather than forcing banks to take most of the local risk in owning them.

As an aside, the article noted that bond returns over the past century have not really been that bad compared to equities – and super funds seems to be taking excessive risk with their clients portfolios by overly focusing on equities. 

I’m not sure where to begin in unpacking this multi-faceted argument.

But let me begin by noting one apparent contradiction.  

Australian government bonds are so risky it’s argued, that we should not leave it the sole domestic institutional responsibility of banks to own them – yet at the same time it’s argued that super funds should own more given their historical and likely future decent risk-adjusted returns. 

If we’re really facing a potential sovereign debt crisis, I’d be really happy if my super fund continued to give government bonds a wide birth!

As for the relative return potential of bonds versus equities, basic finance theory tells us that higher risk assets should over time offer higher returns – and equities prices are far more volatile than bond prices.  Own a company share outright, moreover, and there’s also the risk of permanent capital loss should that company go bust. 

While in theory there is always the risk of a sovereign debt default, at least in the case of Australia it is arguably very much smaller.   

Given Australia’s still quite low level of net public debt (less than 20% of GDP) – and the fact we mainly borrow in our own currency – it’s hard to believe we might ever be at risk of not paying back our debt. And it’s hard to believe many foreign investors would view such a risk serious enough to dump our bonds.    

Due to their long-time horizon, I’d argue the average super fund investor should be encouraged to retain exposure to “riskier” equity-like assets (at least as defined by annual price volatility) for the sake of generating decent long-run returns.

Of course, it’s a different matter for  those close to or already in retirement – as portfolios should naturally have less risk (such as by owning more bonds) as short-run capital loss starts to matter more relative to potential portfolio returns.

But even here there are some innovative “managed risk” equity products emerging which could offer better risk-adjusted returns than the traditional allocation to bonds.   

And let’s not forget that the past three decades have flattered bond returns because interest rates have consistently trended down from what had been quite high levels – thanks to falling inflation after the prices shocks of the 1970s.  

Given the current low level of bonds yields – and the likelihood that they will eventually rise to more reasonable levels as the global economy shakes of the financial crisis – I suspect bonds returns over the next 5 to 10 year (at least) will be quite abysmal.  Again, I’m happy my super fund is not being forced to own more of them! 

What about our banks?  To my mind, Australia already has among the most stringent prudential regulations in the world and strong banks that run relatively simply business models that focus on the domestic housing sector (which I have also long maintained is on relatively sound foundations).  

Indeed, we often forget that by global standards our banks enjoy relatively low costs (and high profitability) by concentrating on the relatively simple model of borrowing cheap and lending at higher rates to business and households – rather than engaging in a lot more higher risk (and higher cost) investment banking operations seen in other bank models around the world.  

What’s more, let’s also not forget that banks have significantly reduced their exposure to offshore and short-term funding since the global financial crisis.  


And if we seriously don’t want to borrow from abroad, it also implies we must reduce our current account deficit - an outcome only possible through a reduction in economic growth brought about by higher forced saving and/or less investment.  It’s a high price to pay for denying ourselves ready access to cheaper offshore funding to fulfil our investment needs. 

So what will happen come the next recession?  Bank share prices – like that of most listed companies – will take a serious hit. Their bad debts will also rise. But that is a normal cyclical response, and does not necessarily suggest deep-seated structural problems that our banks can’t handle or our prudential authorities have not already made provision for. 

Indeed, it’s also likely the Reserve Bank will slash local interest rates (to the extent they start at a higher more normal level than where they are now) which will boost net cash flows for those with a mortgage.  

Due to the recourse nature of local home loan lending, the fact many households are ahead on their home loans, and it is mainly cashed up older property investors that own most of the housing debt, I also suspect the inevitable rise in mortgage defaults will be quite manageable for the banking sector. The higher capital buffers recently forced on banks will also help.  

Unlike in most housing busts, moreover, Australia also won’t likely face the problem of excessive overbuilding during the preceding boom. 

As during the GFC, RBA rate cuts will also reduce domestic funding costs for both banks and governments – helping offset any overall upward pressure that might come from higher offshore funding. And banks also now have new emergency source of funding from the RBA should even that be required. 

In fact, far from surging due to capital flight, I suspect yields on Australian government bonds and overall bank funding costs will fall significantly during the next recession.  Provided they can manage the potential downside $A currency risks, many foreign investors would likely regard Australian government bonds and bank debt as great investments in the event of any serious recession induced temporary price weakness.

All up, as with any insurance, it’s good to feel protected - but it does come at a cost. In this case it would be forcing super funds to own more low yielding bonds that will hurt our retirement nest-eggs.  Our retirement would also be hurt by further impositions on bank returns on equity, while the economy would be at risk should be see the close the local funding gap between saving and investment. 

Our retirement would also be hurt by further impositions on bank returns on equity, while the economy would be at risk should we force ourselves to close the local funding gap between saving and investment.  



Published: Monday, November 23, 2015

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