A licence to print money: bank profits in Australia

A decade ago the former Governor of the Reserve Bank of Australia, Ian Macfarlane, mused in front of a Parliamentary Committee:

I have often wondered why banks are so profitable - and they certainly have been extremely profitable in Australia … They always were very profitable, let's face it. They were very profitable in the regulated phase, and some of us thought that those profit rates would go down in the deregulated phase, as competition heated up. So you can understand why people are very interested in profits and very surprised that profits or rates of return on equity have remained so high.

Going back earlier, in 1964 Nugget Coombs, who had been the Governor of the Reserve Bank (and its predecessor) since 1949, said:

Banks are exceedingly privileged people. They are - of all industries - the most privileged people. They are guaranteed against loss - and even guaranteed against competition.

Banking is an essential part of the Australian economy - almost an essential service. So why should it be “extremely profitable” to use the Governor’s words? Why do bankers have to be exceedingly privileged? What does that mean to those of us who need to use the banking system? And what can we do about it?

The Australia Institute has just published a paper, A licence to print money: bank profits in Australia, that tries to answer some of those questions. It confirms the Governor’s words that the banks are indeed extremely profitable, especially the big four; the ANZ, Commonwealth, National and Westpac. Despite the setback due to the global financial crisis the profits of the big four have been gradually increasing from 1 per cent of GDP 20 years ago to around 2 per cent today - and they would have been higher still if not for the global financial crisis.

In the 2009 financial year the big four banks earned underlying profits before tax of $35 billion or just under 3 per cent of GDP. That figure adds loan losses back to adjust for the effects of the global financial crisis. It means that of every dollar spent in Australia, three cents ends up as banks’ underlying profit for just the big four. And when the global economic and financial crisis passes banks’ actual profit will again reflect their underlying profit.

Mr Macfarlane claimed that bank profits were excessive when they aimed for a return on equity of 18 or 20 per cent in a low inflation environment. That’s equivalent to 26 to 29 per cent before tax. Underlying profits in 2009 gave the big four a massive 29 per cent return on equity before tax.

If banks were earning more normal returns on their equity their profits would be much lower. In more competitive industries returns of around 10 per cent are more likely. It is estimated that around $20 billion is the additional profit banks earn as a result of their market power.

Part of the reason for the huge profits of the banks is the high degree of concentration in the financial market generally. In the early 1980s banks accounted for 50 per cent of all lending in Australia. Today it is over 90 per cent. In the meantime banks have seen off the credit unions, building societies, finance companies, mortgage originators and even the foreign banks. The banks became stronger during the period of deregulation.

Among the banks themselves the big four used to face some competition from the smaller and regional banks. However, St George and BankWest have recently been taken over by Westpac and the Commonwealth respectively. That follows the end of the Advance Bank, various state banks, the National Mutual Royal Bank, the Town & Country Bank, the Bank of New Zealand and the Bank of Melbourne. The St George and BankWest takeovers should never have gone ahead.

While those takeovers are now water under the bridge, there should be no more takeovers allowed in Australia. Competition from the other banks may not mean much to the big banks’ profits but at least it provides some variety in the market. It gives consumers some scope to avoid the plain vanilla services now offered by the big four.