Reserve Bank governor Glenn Stevens has warned that shareholders and customers will have to share the pain of making banks safer by holding more liquidity in the form of low-yielding government bonds and similar assets.

In his final speech for 2009, Stevens told the annual dinner of the Australian Business Economists forecasting conference that increased safety and better regulation will come at a cost.

Higher rates for customers, as the holders of home loan mortgages with Westpac, the ANZ and CBA found out last week, but not the NAB, which has gone for a pricing point of difference.

Some reports this morning  warned of higher interest rates, not many mentioned shareholders, who are the other part of the equation.

The banks are engaged in a fierce war for customer deposits and are offering significant premiums over what they were offering a year and two years ago for one-, two- and three-year funds.

Stevens makes the point that customers on the lending and deposit sides (many are one and the same) will have to wear a higher cost.

“Customers of financial institutions — depositors and borrowers — will also pay via higher spreads between what lenders pay for funds and what they charge for loans,” he warned.

“That is, they will pay more ex ante (before) to use a safer financial system, as opposed to taxpayers having to pay large costs ex post (after) to re-capitalise a riskier system that runs into trouble.

“Capital is not free; shareholders have to be induced to supply it, and it will have to be paid for. High-quality liquid assets typically carry lower yields, too, so mandating higher liquidity will have some (modest) cost as well,  Stevens said.

And he reminded the banks and analysts and investors that shareholders in these banks should also have to meet their share of the higher cost.

“Admittedly it can be argued that shareholders of financial institutions will have a less risky investment and so should be prepared to accept lower returns.”

Now all the banks have cut dividends (the Big Four by about 24% in the latest half years), but those reductions have been linked to the losses from imprudent lending to the likes of Allco Financial, ABC Learning, Centro and other early casualties, plus to accommodate a rise in bad and doubtful debts triggered by the slowdown and credit crunch this year.

What the banks haven’t said so far is that shareholders will have to wear more dividend cuts, or no increases for some more time to meet their share of the cost of owning a safer institution.

Nor have bank CEOs focused on the fact that increased costs of making the banking system safer means lower pay and bonuses for bankers (And therefore, over time, lower cost structures).

Those sorts of comments were absent in the remarks in the past five days from Westpac’s Gail Kelly and the CBA’s Ralph Norris who warned customers that mortgage rates will have to rise by more than the RBA increase because of the higher cost of funds, and ignored making the same message to shareholders.

Many investment analysts are still parading the erroneous idea that Australian banks have surplus capital and will be able to return that to shareholders in coming years. It’s a line that is stuck in a 2005-07 grove and can’t be updated. They should heed what  Stevens said last night.

“Now, of course, protecting the interests of taxpayers is very important, and there is no doubt that certain types of behaviour need to be backed with much more capital, if not severely curtailed or even stopped altogether. It is appropriate that pricing play a role in achieving that,” Stevens said.

And that includes sending pricing signals to shareholders and all investors that greater financial strength in the banking system means lower returns.

It is a message that will percolate down through investors of all sizes, individuals, self-funded retirees, super funds of all sizes.

But Stevens is experienced enough to know that, as he said last night: “Ultimately, the cycle of greed and fear itself cannot be regulated away.

“To assume that unrealistic optimism will not again, at some point, overwhelm the sober instincts of investors, bankers and commentators and others would be a triumph of hope over experience.”

Peter Fray

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