Bank Profit Pressure

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Big Banks Profits Under PressureBank-Profit-Pressure1

I was reading the interesting Chanticleer article in the Easter edition of the Australian Financial Review on Friday entitled “Big Banks’ days in the sun could be numbered”.

The basic premise of this article is that the current run of high bank profits which are benefiting from reducing level of bad and doubtful debt charges is likely to be short lived because the requirements of the regulatory regimes of Basel 111 and G20 to introduce increased capital adequacy ratios and to match loans with deposits by 2018 is going to severely squeeze margins and, therefore, profits.

However, the effect will not be that simple as bank profits need to be high enough to meet investor requirements or their share prices will simply fall until their rates of return move back to acceptable levels.

An examination of what effect these changes will have on the price of deposits and loans is discussed below.

In this instance, the “price” of deposits and loans is defined as the margin above or below the interest rate in the relevant international wholesale money market. ??If we examine each of these changes separately:

Increased Capital Adequacy Ratio (reduced debt/equity ratio)

If capital adequacy ratios are increased (effectively the debt/equity ratio is reduced), this will reduce the financial riskiness of the banks and thus reduce the required rate of return on their equity. As such it would be expected that bank profit ratios would fall simply because in a normal competitive market where there are no monopoly prices,  over a period, system profit levels match the riskiness of the industry.

However, as equity requires a higher rate of return than debt and more equity will be required per dollar of each loan, it is likely that this change will lead to an increase in the required bank margins and with the competition for deposits already being strong with prices already increasing, it is likely that the increase in the required capital adequacy ratios will over time lead to an increase in the price of loans.

Matching the Quantum of Loans and Deposits

The second reason cited for lower profits is the requirement to match the quantum of loans with deposits by 2018. This is definitely going to be a major issue for Australian banks which, under normal circumstances, need to raise significant funds on overseas markets to meet funding requirements and with deposits currently only amounting to around  80% of loans there is going to need to be a major catch up period where significantly more deposits have to be raised to catch up on the shortfall. This will be in a period where all of the banking community is going to be in the same position trying to raise additional deposits.

In simple terms, if the demand for something is increased i.e. deposits, with no increase in supply, it’s price will simply increase until supply and demand are back in balance. This suggests that the price of deposits will increase significantly especially in the catch up period.

Even with a lower risk profile, banks will still need to earn an acceptable rate of return and, if the price of deposits is increased significantly, with everything else being equal, this will reduce margins and, therefore, bank profitability and share prices. Everything, therefore, will not be equal. It is likely that there will be some changes in the demand for deposits and the supply of loans through covered bonds, an improved local bond market, better securitisation products but they are unlikely to completely offset the profitability effects of the regulatory changes and it is likely that over time the price of both loans and deposits will increase above their current levels.

There is, therefore, likely to be a significant short term  increase in the price of deposits which will cause a further increase in the price of loans in order to enable banks to earn the required rates of return on equity.

In Summary

  • as far as risks are concerned, the effect of these changes will be to lower the risk of the banking system in that it will have more equity capital??;
  • it will encourage deposit and loan market innovations??; and
  • as far as prices are concerned, both deposits and loans will increase in price??.

We are taking careful note of all of these changes as we are in the process of establishing a bank in an offshore, highly regulated location.

Do you think bank profits will take a hit? We have our opinion but we’d love to hear your thoughts.  Would you like our help with any of the above? Please call on +61 2 9258 1972 or go to our Contact page.

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