Predicament Too Fragile For Turnbull's Tactics

Sydney Morning Herald

Friday October 3, 2008

Malcolm Maiden mmaiden@theage.com.au

You have to wonder what Malcolm Turnbull has been smoking after his calls for the banks to pass on 100 per cent of the interest rate cut the Reserve Bank will announce next Tuesday, and his suggestion that the Prime Minister and the Treasurer have wimped it by not demanding the same thing.

Kevin Rudd and Wayne Swan have both said that the banks should pass on as much of the cut as possible but that, while the credit crisis rages, the stability of the banks and Australia's financial system is paramount - and they are right.

The Reserve is probably going to respond to the sudden intensification of the crisis in the past month by cutting rates by a half a percentage point. If the banks pass on the lot, their profitability will be eroded in the middle of what is, in effect, a global crisis of confidence in the quality and sustainability of bank earnings. That coincidence is best avoided.

The banks source about half the money they lend to their customers from their own bank deposits, another 20 per cent from medium-term wholesale borrowings and the balance from short-term money markets. Last month, the cost of both debt portions soared.

Before this crisis hit in August last year, they were sourcing 90-day funds from bank bills priced about 10 basis points (one-tenth of 1 per cent) above the effective cash rate, which is the official cash rate adjusted for likely moves over the 90-day term of the bill.

In the first full flood of the crisis in March this year, when the US Federal Reserve stepped in to save Bear Stearns, the premium blew out to 77 basis points, or just over three-quarters of a percentage point.

It fell back to about 50 basis points by the end of August, and to a low of just under 30 basis points early last month as the debt markets priced in the Reserve Bank's decision to cut the official cash rate from 7.25 per cent to 7 per cent.

But then all hell broke loose. Fannie Mae and Freddie Mac were nationalised, Lehman Brothers was allowed to collapse and banks started toppling like dominoes, forcing nationalisations, massive liquidity washes from the Western world's central banks, and unprecedented direct government bail-out moves: the $US700 million package that has struggled to win congressional approval and may or may not get banks lending again; the Irish Government's virtual blanket guarantee of Ireland's bank loans and deposits; and moves in Europe now, led by the French President, Nicolas Sarkozy, for a $US500 billion bad-debt support package to move troubled debts out of Europe's banks and replace them with cash.

The bank bill margin blew out to just under 100 points on Monday, a record high that has been alleviated only partially by a subsequent retracement to about 70 basis points yesterday. Three-year debt that fills an extra 20 per cent of the funding base for the banks, on top of the 30 per cent sourced from bank bills, is meanwhile being priced at about 130 basis points above cash, compared with about 10 basis points before the crisis began.

Australia's banks are therefore in a position to argue that their profits will be pressured if they pass on next week's expected rate cut in its entirety, despite already unilaterally raised their lending rates by about half a percentage point during the crisis.

It is true that over the years Australian banks have been more profitable than their overseas peers. Their absolute profits are always targeted for criticism, but are irrelevant: they are huge, highly geared enterprises, and their profits are correspondingly large. The better measure is the return on equity they generate - at 15 to 22 per cent currently, solid but not spectacular.

But there is a circular, corrosive relationship between the collapses that have been occurring and the fear rampant in the markets, so intensely inside the banks themselves that they have to all intents and purposes stopped lending beyond 24 hours to each other, let alone their customers.

Our banks remain well capitalised and are relatively well insulated. But their loan losses are rising as the financial shock works its way into the real economy: they don't need, and the markets and economy don't need, an additional self-inflicted shock.

A half-a-percentage-point cut in official rates will give the banks room to repair their margins and pass on a meaningful cut - perhaps a touch more that half of the total.

And when the crisis is resolved, Turnbull will have an issue to explore. The power of the big banks is rising in this crisis as non-bank competitors are squeezed out, and when the markets are settled they will be in a position to increase their power further, by building lending market share. The risk is that they will use that power to lock in margins that would have been competed away before the credit crisis changed the competitive landscape.

But in the context of the biggest banking crisis in living memory, it's a lower-order issue - and a slightly bizarre one for Turnbull to push, given the Coalition's traditional pro-business roots.

Passage of the US package is crucial, but unlikely to immediately unwind the tension. The markets will want evidence that it is working to free up liquidity locked in the banking system.

Concerns in credit markets about Morgan Stanley have eased after Japan's Mitsubishi bank confirmed this week that it will buy in as a new cornerstone investor. But other rescue deals including Bank of America's acquisition of Merrill Lynch still await confirmation.