It’s a sorry state of affairs when it takes a speech from a regulator to advance the case of Australia’s banks for lifting home-loan rates more than the Reserve Bank’s 0.25% increases.

It’s even worse when that regulator is the No.2 at the RBA.

But that’s what happened on Wednesday when deputy governor Ric Battellino, in a speech in Sydney, outlined the arguments for the rate rises above the RBA’s moves, and the benefits to the national good that could follow.

In effect, he bailed out the gang at Westpac, who couldn’t make a solid argument for eating a banana (“We’re hungry, give us more” is the best the bank could do), let alone sticking interest rates up by 0.20% more than the Reserve Bank’s December lift of 0.25%.

Battellino’s speech was entitled “Some Comments on Bank Funding”. It delivered in his usual low-key manner, and it came just under two hours after Westpac chairman Ted Evans tried his hardest at the bank’s AGM in Melbourne to mount a defence for his bank’s 0.45% rate rise (0.20% premium).

He failed and the RBA man succeeded.

In effect, it was the RBA bailing out the banks, led by Westpac, intellectually, not financially.

That was a year ago when the central bank “repoed” $45 billion of self-securitised mortgages to give the banks the liquidity they needed to get through the worst of the credit crunch.

Battellino and the RBA had the major role in that move, yesterday it was his comments on bank funding that not only provided a strong defence for the banks, but also the “silver lining” for us in copping the higher than RBA increases from the banks now, in exchange for fewer rate rises next year.

“These changes in banks’ cost of funds relative to the cash rate have meant that the relationship between bank lending rates and the cash rate has also become looser. It is difficult for banks to adjust their lending rates in line with changes in the cash rate when the cost of their funds is rising substantially relative to the cash rate,” Battellino said.

“We estimate that if banks had not adjusted their lending interest rates to reflect their higher cost of funds over the past couple of years, they would now be incurring losses.

“That would have threatened their ability to keep raising funds and, in turn, their capacity to lend. In the event, early in the financial crisis, banks did not pass on all of the increase in their cost of funds, but recently increases in lending rates have run ahead of the cost of funds. Banks’ margins are now a little wider than at the start of the crisis, and therefore are adding to profits.

“This recent widening in the net interest margin has been largely due to wider margins on banks’ business lending. The margin on variable housing loans is much the same today as it was at the start of the crisis; it had fallen until recently and the increase in home-loan interest rates in December restored it to around its pre-crisis level.

“Margins on business loans, however, are now substantially higher than they were immediately before the crisis. This comes after a prolonged period when margins on business loans had narrowed.

“Margins on business loans tend to vary over the economic cycle, reflecting changes in perceptions of risk by banks.

“With the economy and business climate now improving, the economic justification for wider margins on loans is becoming less compelling, so it would be reasonable to assume that, in a competitive banking sector, we should see margins level out soon. Over the past couple of months, there have been some signs that this is starting to occur.”

And there’s a benefit

“As you know, the cash rate is currently 3.75 per cent. This is still 50 basis points below the previous cyclical low of 4.25% in 2001. On the surface this might suggest that the cash rate is still unusually low. However, with other interest rates in the economy having risen by at least 100 basis points relative to the cash rate over the past couple of years, they are now above their previous cyclical lows.

“Taking these considerations into account, it would be reasonable to conclude that the overall stance of monetary policy is now back in the normal range, though in the expansionary segment of that range.”

In the end a fairly easy argument to make: Going broke versus staying in business and not copping as many rate rises in 2010, when they would start hurting more borrowers. In fact, if we are lucky we could only see a couple rate rises in 2010 — it all depends on which way the economy goes (surge or steady).

Banking’s profit ignorance sprung by former banker: But while Westpac was fluffing its lines and Battellino was coming to the its defence, banks and bankers generally copped a pounding in a comment piece by Martin Taylor, a former CEO of Barclays, the big UK bank.

The commentary was published in the Financial Times by Taylor, who ran the bank from 1994 to 1998. He is currently chairman of a agri-company called Syngenta, which has more than $US11 billion in annual sales. He is also an adviser to Goldman Sachs, who will no doubt feel wounded from his comments. He therefore (for a former Financial Times journalist), has a better-than-average understanding of business.

Taylor’s commentary demolished the defences the banks have on their profitability, pay and high dividends to shareholders, and more importantly, their abilities as businessmen and understanding of how they make profits.

As a former CEO in the more sedate 1990s, Taylor knows what he is writing about. The comments go straight to the heart of basic management, the ability to recognise where you get the money to pay salaries and dividends (from actual cash not book or paper “profits”). Bank boards and their members were not spared in the attack.

He says the banks were booking non-existent cash earnings as though the cash was coming in through the front door and every other corporate orifice.

“Observers of financial services saw unbelievable prosperity and apparently immense value added.

“Yet two years later the whole industry was bankrupt.

“A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly.

“Not only has the industry — and by extension societies that depend on it — been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again.

“What were the sources of this imaginary wealth?

“First, spreads on credit that took no account of default probabilities (bankers have been doing this for centuries, but not on this scale).

“Second, unrealised mark-to-market profits on the trading book, especially in illiquid instruments.

“Third, profits conjured up by taking the net present value of streams of income stretching into the future, on derivative issuance, for example.

“In the last two of these the bank was not receiving any income, merely ‘booking revenues’.

“How could they pay this non-existent wealth out in cash to their employees? Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it. Paying out 50% of revenues to staff had become the rule, even when the ‘revenues’ did not actually consist of money.

“How did the shareholders let them get away with this?

“How did the directors let it happen?

“Innumeracy, and inability to understand accounts that have become misleading to the point of treachery.

“How depressing the shame and folly of it all is, when one considers that the system was brought down not because risk management was deficient (though it was), nor because greed was rampant (though it was), but because bankers could not count.

“Merry Christmas.”

So what was the difference between Bernie Madoff’s Ponzi scheme and mainstream banking?

Peter Fray

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