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Bank dominance causing a misallocation of capital

Published on Cuffelinks - 28 Mar 2014

The macro and micro economic reforms of successive Australian governments over the past 30 years are widely acknowledged as having provided the foundations of our continuous economic growth. The structural changes occurring across the Australian economy and throughout the developed world driven by outsourcing and offshoring, technological improvements, the internet and emergence of China, India, etc. give a great imperative to the Financial Services Industry Inquiry (Inquiry) to make recommendations that will support Australia’s future economic growth. The Inquiry’s terms include: “Recommendations will be made that foster an efficient, competitive and flexible financial system, consistent with financial stability, prudence, public confidence and capacity to meet the needs of users.”

What is the role of an ADI?

It is imperative that everyone has confidence in our financial institutions, particularly Approved Deposit-taking Institutions (ADIs/banks). ADIs are mobilisers and allocators of capital, and therefore enablers to sustainable economic growth. They provide a critical enabling function, just as other infrastructure companies do.

However, banks should not be producers of real economic growth in their own right. Nevertheless of the top 30 companies listed on the ASX, ten are financial institutions. Combined they contribute approximately 27% to Earnings Before Income Tax (EBIT) of the index and CBA, Westpac, NAB and ANZ are ranked in the top 5 by market capitalisation. Arguably, in the long run the size of these metrics is not sustainable.

Comparatively, only 3 of the top 30 companies in a combined Dow/NASDAQ index in the United States are financial institutions (Bank of America, Jp Morgan and American Express), ranking 14th, 19th and 30th respectively. They contribute 12% of EBIT.

In Australia, over the past 30 years, the Materials sector, including BHP and a wide range of commodity-related industries has declined, the Industrials sector has all but disappeared whilst the financial services sector has doubled its share of the economy.

The US economy shows a very different picture. In the 1980s, the largest American companies were in the Materials and Industrials sectors, and like Australia, these sectors are now significantly smaller. However, unlike Australia these sectors have not been replaced by financial services. The USA has produced global IT corporations, such as Microsoft, Apple, Oracle, Google, Yahoo, Amazon, Facebook, LinkedIn, Twitter and Cisco Systems and pharmaceutical and biotech companies like Merck, Gilead Sciences and Pfizer, that through innovation are helping to transform the US economy. Unfortunately, Australia has not followed suit as there is only one health technology company (CSL) and no information technology companies in our top 30.

Optimum size of financial services sector

In July 2012, the Bank for International Settlements (BIS) published a study on the banking systems of 22 countries over a 30 year period. Its findings were that if a financial services sector was either too small or too large in terms of share of Gross Domestic Product (GDP), then it was an inhibitor to economic growth.

More recently the US Bureau of Economic Analysis revised down the real output of the US financial services sector from 7% to 6.4%. A percentage of this figure reflects the fact that the USA is a global financial centre, so for Australia, which is at best a regional centre, the figure should be smaller.

These indicators point to Australia’s financial services sector being too large, and it must shrink or the economic pie must grow substantially to return it to equilibrium.

Prior to the GFC there was an implicit Federal government guarantee of the ADIs. With the GFC, the implicit guarantee became explicit. Even though the retail depositors’ guarantee has been reduced from $1,000,000 to $250,000 per depositor, in the mind of the public the Federal government will always step in to save an ADI. Moral hazard needs to be addressed by the Inquiry.

Misallocation of capital

Investment decisions are made for a variety of reasons using a range of quantitative tools and techniques. A frequently used starting point when considering investments is to compare expected returns to the risk free rate of a Commonwealth Government Security (CGS).

However, if you had the choice between investing in bank shares compared to a CGS since the GFC on a risk/return basis, there has been a compelling case to choose shares:

  • both are effectively guaranteed which neutralises the equity risk premium
  • bank shares pay fully franked dividends that are tax-effective, but there is no equivalent tax relief on CGS income
  • there is a capital gains tax discount on equity investment price gains
  • the public has become accustomed to bank profits and return on risk adjusted capital increasing regardless of the economic environment while companies in other sectors produce mixed results.
  • So from a simple investment perspective, bank shares provide a substantially and arguably better ‘risk free’ return than government bonds. However, there are other factors that are significantly adding to the misallocation of capital:

  • a triangulation occurring as the largest fund management companies are owned by the major banks, and they are investing either directly in their own shares or other bank shares, or indirectly through ASX indices
  • compulsory superannuation is turbo charging the direct and indirect investment in bank shares as the major fund managers must invest the money
  • retail investors, including SMSFs, understand the returns they can achieve from owning bank stocks and are buying bank shares instead of bank term deposits.
  • This cycle is unhealthy and risky and the obsession with financial services is resulting in a misallocation of capital. The market can’t self-correct for this, hence a circuit breaker is required.

    Current framework needs changing

    The current financial framework needs changing. In formulating its recommendations, the Financial System Inquiry should consider outcomes that would further reduce systemic risk without creating unnecessary impediments to Australia’s economic growth.

     

     

    2014 Interest Rates

    Interest rates will likely remain on hold over the coming 12 months as the Reserve Bank of Australia (RBA)will not want to limit its ability to respond to global economic events. Even with tapering the level of Quantitative Easing (QE) by the Federal Reserve and by other central banks, e.g. Bank of Japan, combined with high levels of unemployment in Europe and under-employment in the USA and Australia will mean that the pressure on rates is down.  


     

    Interest Rates and Australian Dollar

    The current discussion on the Australian dollar has focussed on the relationship between Australian interest rates and their relativity to those of our major trading partners. As any one who works in the financial markets knows forward exchange rates are calculated based on interest rate differentials. Whereas, the spot Australian dollar rate reflects any number of factors, both economic, e.g. trade and behavioural. These are cornerstone principles in the operation of foreign exchange markets.

    Some commentators are suggesting that the RBA should "print money", as a means of releasing the upward pressure on the Australian dollar. This proposed solution is extraordinary and ignores the fundamental premise that Quantitative Easing (printing money) represents an economic default.  The Australian economy's strong performance of the last 25 years is a result of sound macro and micro economic management, not because the RBA, Federal Treasury and the Government of the day have implemented desperate policies that undermine the cornerstone concepts of financial markets. The world is awash with money the impacts of which will be felt for many years. We should not be adding to the problem with ill conceived ideas.