Profits of the five largest banks increased 11% to $16.1 billion over the year to September 2006; the average return on equity of the five banks approached 21%; income increased at close to three times the rate of inflation; costs barely increased, and efficiency ratios fell rapidly over the year. While coloured by the transition to new accounting standards, the reported profits of the top five suggest the 2006 banking year might be the best ever for Australia’s banks.

The average return on equity – the most comparable measure of profit – increased to 20.8% in 2006 from 19.5% in 2005.

Westpac topped the return on equity rankings for 2006 with a return of 23.0%, followed by St George with a return of 22.9%, according to the six-monthly survey of bank profits by professional services firm KPMG. National Australia Bank trailed the pack with a return of 16.9%.

KPMG noted that estimates of return on equity for 2005 are higher under international financial reporting standards than they were under AGAAP accounting standards. Under IFRS, the average return on equity of the five largest banks was 19.5% last year, compared with an estimate of 18.3% under AGAAP.

Surging income – driven mostly by lending growth and also by fee income from wealth management rather than outright price increases – underpinned a sharp decline in the cost to income ratio across the sector. The efficiency ratio for the five banks, in aggregate, fell to 47.5% in 2006 from 50.2% in 2005.

St George, ANZ and Westpac all reported expense ratios below the sector average, while CBA’s ratio was at the average, while the average in turn was skewed by NAB’s (fast improving) cost ratio.

KPMG estimates that operating costs increased by a mere 0.3% during 2006, a level that seems too good to be true. The rate of cost growth appears odd, given inflation, in Australia at least, of around 4%.

Staff costs increased by 4.6%, reflecting both wage inflation and a rise of 2000 in aggregate staff numbers. Information technology costs fell by 0.7%. Other operating costs fell by 4.7%, though by only 0.7% excluding NAB.

KPMG said trends in interest margins were hard to interpret given different presentations by banks, particularly at NAB. KMPG estimated that, excluding NAB, net interest margins for major banks fell 12 basis points over 2006. About half this reflected reduced spreads (that is, the effect of price competition), and about a quarter was the continuing reliance on wholesale funding.

On credit quality, the five banks in aggregate reported a slight increase in the incidence of impaired loans to gross assets. This ratio increased to 0.22% in 2006 from 0.21% in 2005.

Banks, however, have reduced provisions. The ratio of specific provisions to gross impaired loans fell to 31.0% in 2006 from 38.3% in 2005. Banks also reduced collective provisions by a quarter, to 0.6% of loans from 0.8% under the old general provision.