Could one of Australia's main lenders fail? (and what would happen if they did?)

The Big Four

Australia's four major banks were named this week as being the most profitable in the whole world...for the third year in a row! Big bank profits appear likely to come it at well in excess of a combined $25 billion, and probably some way higher than that.

Why? It's partly because the Australian banks have wider interest margins than most, and lower equivalent costs. 

It's also because of a lack of competition worthy of the name. After a number of smaller lenders went to the wall during the global financial crisis, the 'big four' banks (Commonwealth, Westpac, ANZ, National Australia Bank) control a massive 83% of the mortgage market in Australia. 

Last year, as cuts in the cash rate were relentlessly delivered by the Reserve Bank of Australia (RBA), the major lenders consistently failed to pass on the full cuts to borrowers citing 'higher funding costs". It's laughable really, given the profits which will now again be reported, but the truth is that the banks get away with it because of the "feeble competition". It's an oligopoly.

Sure, there's talk of introducing more competition, and perhaps Macquarie will step in to become a fifth major player, but it all feels rather half-hearted given the monstrous profits which have once again been generated.

Some are more equal than others

Under Corporations Law, you might be forgiving for thinking that all companies are created equal. In theory, maybe businesses are in many ways equal, but in reality some are far more equal than others. If a retail company becomes insolvent and goes under it would be sad news for the owners and the employees, but the sun would likely come up tomorrow and the world would continue as before. 

There are some industries which the government might elect to support, such as car manufacturing. And then there are some businesses without who out entire financial system would implode: namely, the banks.

Without the banks to transfer money between borrowers and lenders, for want of a better word, we'd be well and truly stuffed. How would we even survive on a day-to-day basis with no cash cards, credit cards,  internet banking, ATMs? Undeveloped countries manage to run cash economies reasonably enough, but for the Australia of today, we'd be faced with almost unthinkable turmoil.

What do the banks DO?

At the simplest level, banks make their colossal profits through charging a higher rate of interest on their loans than they pay out on the money we bank as deposits.

If you've ever tried to buy a property with a deposit of less than 20% of the purchase price (an 'LVR' of more than 80%) you'll be aware that the bank can charge you a higher rate of interest as well as hit you up for Lenders Mortgage Insurance (LMI) as compensation for the higher perceived risk.

Investment banks also generate profits from issuing financial advice or from engaging in transactional activities such as capital raisings or takeovers.

Of course, under the modern system of banking, banks are not required to hold enough money to pay all of its depositors. It's known as fractional reserve banking. If we simultaneously all demanded our cash, the banks would not have the funds available to pay us, so much rests on our collective confidence in the institutions. Sometimes governments therefore choose to guarantee deposits up to a certain level in order to shore up confidence.

In fact, where I am today - in England - we saw a modern version of an old-fashioned 'run on the bank' in 2007 after rumours spread of the Northern Rock bank being in financial strife. The result was that the Bank of England had to step in as the 'lender of last resort' to provide emergency funding. The UK Treasury ultimately intervened and nationalised the bank.

Last resort

And that is the key point. 

There is simply no way Australia could allow one of its major lenders to fail because the fallout would be catastrophic beyond belief. For this reason the banks receive what is known as an implicit guarantee from the government.

The paradox of an implicit guarantee is that it can cause the largest banks to become larger still. They are seen as more creditworthy which can attract more business, and the very act of becoming larger reassures banks that they will become 'too big to fail'. An implicit guarantee could therefore the theory be seen to encourage reckless management.

However, banks will quite rightly be subject to increased regulation in the form of BASEL III and stress testing. 

What would happen if a major bank failed?

Overall, it is unlikely but certainly possible that with massive exposure to residential property one of our major banks could fall into difficulties. Take a look at the typical capital structure of a bank's balance sheet - you will notice that the net asset positions are surprisingly low given the vast loan balances on the books. 

However, a bank collapse would have the most diabolical and far-reaching consequences for the Australian economy. 

What would happen? Well, consumer confidence would instantly evaporate, the money supply would be annihilated as the insolvent or failed bank ceased lending funds to instead shore up their reserves...and we would likely end up in a deflationary economy with disastrous outcomes for the entire country.

So, it is for all these reasons that hell would probably freeze over before one of our major lenders would be allowed to fail. In business and economics, some are indeed created more equal than others.

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A bit of talk of 'Ruddmentum' in the press - on a two party preferred basis Labor might have gained as much as five points in the polls! I'm not sure how thorough the polls were, though. Business leaders, who hate uncertainty, will push for an early election to be called.