Overnight one of the world’s largest banks, HSBC Holdings, announced a massive rebound in its profitability. It also announced, however, that it was significantly reducing its target rate for future returns, sending an ominous message to bank shareholders everywhere.

HSBC lifted profits from $US5.8 billion to $US13.2 billion in 2010. That represented, however, a return on equity of only 9.5 per cent, below its own estimate of its cost of capital of about 11 per cent and well below its targeted rates of return, which had ranged from 15 per cent to 18 per cent.

The giant bank has now lowered that targeted range to between 12 per cent and 15 per cent, almost entirely because of its assessment of the impact of the new global capital and liquidity requirements that will flow from the regulatory response to the financial crisis.

HSBC chairman Douglas Flint referred to the higher tier one capital requirement, the counter cyclical capital buffer, the potential additional capital that may have to be held by banks of systemic significance and the proposed new minimum liquidity standards as the reasons for the decision to reduce the targeted rates of return.

With banks being required to progressively hold more and higher quality capital and more and higher quality liquidity, mainly in the form of low-returning government securities, it is going to be difficult for them to generate the returns on equity in future that they have in the past.

There is a double whammy aspect to the new prudential regime. With more capital and liquidity and therefore less leverage the banks won’t be able to grow their loan books — and their more capital intensive business loan books in particular — at the same rate as they would have in the past, if indeed they are able to grow those portfolios at all.

The Australian banks don’t face some of the additional short term retribution being experienced by the UK and European banks, where special bank levies and taxes on bonuses have been applied to compensate for the taxpayers’ bailouts of banks during the crisis. That broader picture of more capital and liquidity will, however, apply to them as well.

The relative concentration of the Australian system, the majors’ dominance of lending in an economy that has grown strongly for more than a decade and a half, and the skew towards lending for housing (as a result of regulatory requirements and its perceived low risk) which produced a boom in home loans, enabled the banks to generate exceptional returns pre-crisis despite the continuing erosion of their net interest margins.

In 2007, Westpac generated a cash return on equity of 23.5 per cent, CBA 21.7 per cent, ANZ 20.9 per cent and NAB 17.1 per cent.  By 2009 the ROEs had fallen, with CBA the best-performing with a return of 15.8 per cent, followed by NAB (11.8 per cent) Westpac (10.8 per cent) and then ANZ (10.3 per cent). ANZ had built up a capital surplus for its Asian expansion plans.

Last year the returns started to bounce back. CBA had a return of 18.7 per cent, Westpac 17.4 per cent, ANZ 13.9 per cent and NAB 13.2 per cent.

While they all have conservative capital positions, the local banks have yet to shift to the new liquidity requirements that will be phased in over the next half decade or so (assuming there are sufficient eligible securities in this market for them to be able to meet the requirements). The requirements will mean less leverage and a higher proportion of assets held in low-returning securities.

The mid-teens growth in demand for credit seen pre-crisis are also, it appears a phenomenon unlikely to repeated in the near to medium term, with households busily deleveraging and corporates and small and medium-sized businesses risk-averse. The banks are also reluctant to increase their lending to SMEs, given the risk and the risk-weightings that apply to business lending.

In housing, demand has fallen back to the mid single-digit levels and, thanks to NAB, a price war is breaking out that will thin margins and reduce the historically very high returns on equity associated with mortgage lending that explains their appeal to the banks and the returns that they have been able to achieve in the past.

With competitive pressures on rates and fees growing, the new regulatory measures looming and the outlook for the non-resource sectors of the economy subdued, it is unlikely that we’ll see a return to the 20 per cent-plus returns generated pre-crisis anytime soon, if ever.

The Australian majors may not have to downgrade expectations of future returns to quite the level that HSBC and some of the European banks have signalled they are targeting, but returns in the mid-teens would be a considerable achievement once the new regulatory environment is fully in place and would be appropriate, given that already quite conservative banks will be even less risky in future.

Anything remotely resembling their pre-crisis profitability with returns above 20 per cent would, in the less bubbly economic environment, either signal excessive risk-taking or oligopolistic behaviour and risk a regulatory and/or political backlash.

*This originally appeared on Business Spectator.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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