Bank profits grow, and so does the criticism. Who’s right?

Commonwealth Bank chief Ian Narev announces a record full-year profit of A$7.8 billion, ahead of this week’s $2.1 billion quarterly result. Paul Miller/AAP

Like most companies, banks report their profits twice a year. Each time the majors report we see headlines about the size of the profits and implicit or explicit criticism of the amount – this time about A$27 billion.

The banks usually respond by pointing out absolute profit is not really the issue: as big companies, the dollar value of profit, revenue, assets, employment and investment will always be large. They suggest it makes more sense to ask whether their return on equity and their return on assets are reasonable. And using these criteria, ones we normally use to assess corporate profitability, the bank profits do not look excessive. There are many other listed Australian companies that are more profitable per unit of equity, and while the Australian banks do better than many banks in Europe or the USA, that is hardly accepted as a relevant benchmark these days.

The second argument put by the banks is that they pay about 70% of their profits out as dividends, much of which goes to augment the superannuation returns of most Australians. The fundamental point is that Australian banks are (mainly) owned by ordinary Australians, either directly or indirectly, so a wide range of Australians benefit from the profits earned either through dividends or higher share prices.

Dividend warning

This high rate of dividend pay-out has attracted some criticism recently. The regulator (APRA) has questioned whether the banks are paying out too much of their profit and should instead be keeping more in reserve to deal with future risks. Interestingly this is not an argument about excessive profits, but about the distribution of the profits.

There has also been some recent comment that the level of profit is not sustainable. Analysts have pointed out that banks are holding fewer reserves against lending risks than they have in the past, and warn banks may have to increase their reserves if business or household lending risks were to rise. This is pointing out that bank profits go up and down with the business cycle, again not directly challenging the level of profits, although it may be suggesting that we are at a peak.

Part of the reason banks attract so much attention, for example compared to the very profitable mining sector, is that their business is mainly domestic. If they are making too much profit, it must be because they are charging us too much. There is very little evidence of this: Australian banks have interest margins which are about average by international standards.

Comfortable oligopoly?

The other standard line of criticism of the major banks is that they constitute an oligopoly which controls the market as a collective. This is much more difficult to assess and any co-ordinated, anti-competitive behaviour by such a collective would be illegal and subject to action from the Australian Competition and Consumer Commission. One of the reasons the banks can appear to act in concert is that they all have very similar business models so their borrowing costs and lending risks rise at the same time and by similar amounts, so their price changes tend to be similar.

Any analysis would need to be careful since there are many financial markets – credit cards, investment banking, broking, wealth management, insurance etc – where even collectively the banks are not dominant.

Most critics point to the mortgage market as being the main area of concern. The four major banks manufacture over 80% of all mortgages. They actually retail a much smaller percentage as the mortgage brokers sell a significant number, around 40%, and actively market the fact in direct opposition to the bank’s own sales channels. But even there we have seen the banks (notably NAB) competing aggressively on price, and entrants like Macquarie pushing aggressively into the market.

So yes, the profits of the banks are large. This mainly reflects the size of the businesses rather than obviously excessive profitability, and regulators, rising risks and increased competition may cut into the profits in future.