At a recent event I met and had a long chat with a retired economist who, in his professional career, specialised in providing advice on how to formulate taxation policy in Australia. He’d worked in Canberra’s public service and then set up a consultancy to do similar work but at a vastly higher hourly rate.

We found a common interest; he was looking to buy a holiday house in Manly and I’d recently moved there and he wanted to know whether there were good jogging routes. Evidently, he was obsessed with running and fitness despite his age.

The other common topic of interest was that of bank regulation.

Since retiring, he’d become increasingly frustrated with the big banks and the financial sector. He belonged to an economics discussion group and had regularly ‘locked horns’ with what he described as a ‘bank apologist’ in the group.

His beef with banks was more subtle and different to most people. He did not complain about bank service levels or fees and charges, and made no mention of historic scandals such as the practice of charging fees to people who were no longer alive.

His concerns were two-fold.

One was that in his lifetime, he’d never known a period in which banks did not make stellar profits, except for a very brief moment in the early 1990s recession. He saw this, the sheer longevity of high profits, as a sign of an entrenched oligopoly-based pricing power. As an economist, he’d learned at university that over the long-term, competition will erode profitability as entrepreneurs will greedily eye excess profits and move into that market to feast on the spoils. They’ll keep coming until the profits are negligible.

Why was it that strong bank profits had held up for decade after decade?

His second concern was with the amount of equity that banks had in their balance sheets. Hundreds of billions… He saw this as a huge resource drain, starving other businesses of valuable capital.

At the root of his frustration was dismay with the group of public servants who were paid to supervise the banks, paid to make sure they operated prudently and did not put depositors at risk. He detected that these public servants faced a corrosive conflict of interest.

If a bank failed, soon after the bank’s board and management were dismissed, public fury would refocus to the careers of those public servants whose job it was to ensure those banks did not fail.

So, in his view, they are incentivised to do everything they can to protect bank profitability and ensure high levels of equity as a means of absorbing losses and preventing failures. However, what’s really riling him, is that while the public servants benefit professionally from banks that don’t fail, they face no criticism for the costs of that conservatism.

These consumer costs come in two main forms. First, high profitability is essentially the result of a wide lending margin, the difference between what a bank pays on deposits and what it receives on loans. Of these two groups, it is probably the Australian depositors who are most gouged because they get lower interest rates than what would be available in a more competitive system.

A second cost, albeit more indirect, is that of insufficient innovation – both in terms of innovation in banks themselves and the wider lost innovation in the economy from banks failing to invest in higher-risk ventures.

Austrian economist Joseph Schumpeter famously invoked the idea of ‘creative destruction’ as the essence of competitive and free markets, and showed how it was essential for long-term prosperity.

Under this process, banks that have bad boards, poor or lazy management, or the wrong business strategy should fail. The capitalist system should devour them and, once destroyed, new growth can happen. Better people with better ideas can come in and start to generate more innovation, both in their own operations and help drive it more widely.

This Darwinian cleansing process can’t happen if banks are supervised in a way that lowers the risk of failure to near zero.

It is worth looking at some numbers to get a glimpse as to what’s happening.

Recently, the Commonwealth Bank of Australia (CBA) released its annual financial results, reporting the earnings and balance sheet position for the calendar year, end-2023.

Note that banks have two main buffers to absorb losses on their loans. One is the amount of profits generated in a year. The second is the amount of equity they maintain on their balance sheet.

Throughout 2023, the CBA generated $10.18 billion in after tax profits.

As of the end of 2023, the amount of equity recorded on the CBA’s balance sheet was $96 billion.

Combining profit and equity, CBA has roughly $105 billion available to absorb losses on its lending.

After an increase in the Reserve Bank of Australia’s (RBA) cash interest rates of 4.25 percentage points (425 basis points), you would expect that banks would be losing a lot of money through defaulting customers.

So how much in loan assets did CBA write off in 2023?

On its housing loan book, just $17m. That’s about the price of just one Sydney waterfront property.

And how much did CBA lose across all its business and other portfolios in 2023?

Just above $500m.

In total, for the whole year, CBA lost less than 0.5 per cent of its combined buffer of profits and equity.

This is an absurd situation. CBA has a total pool of loan exposures of more than $1 trillion.

We have these massive domestic banks that are holding vast amounts of capital, and – rather than use that capital to back risky ventures, start-ups, entrepreneurs, dreamers, and go-getters – they are making loans that are so conservative and so secured, the losses are minuscule. A key economic value of having large banks is so they can support high-potential (yet risky) business ventures.

Of course, it can be argued that one day the economy will tank and we’ll need these conservative loans, high profits, and large equity buffers to manage all the risks.

Maybe.

But even during the Global Financial Crisis, a time of an unprecedented loss of confidence in financial systems, the four major banks maintained strong profitability. They were miles away from eating into any of their equity buffers. Luck played a part as well.

Furthermore, we have seen a repeated pattern over the years where the government will quickly step in and provide extensive financial sector support when the economy faces a real threat. This happened in the GFC and more recently during the pandemic lockdowns. It can be taken as a given.

With so much capital on their balance sheets and the government willing to jump in at any moment, the banks should be making much riskier loans, and they should be willing to bear much higher losses.

I hope it is not the case that the careers of bank supervisors are thwarting this process, but I fear the retired economist I conversed with has a point.

---

Nick Hossack is a public policy consultant. He is former policy director at the Australian Bankers’ Association and former adviser to Prime Minister John Howard.

Get 10 issues for just $10

Subscribe to The Spectator Australia today for the next 10 magazine issues, plus full online access, for just $10.

SUBSCRIBE 10 issues for $10 REGISTER 3 articles a month

Already a subscriber? Log in