Brian Gaynor: Profits for banks, loss for New Zealand

One of the unique features of the New Zealand economy is the size, influence and profitability of the banking sector.

KPMG's Financial Institutions Performance Survey 2006 says the country's 16 registered banks had net earnings of $2.66 billion in 2005, compared with $980 million 10 years earlier.

Banking is the most profitable commercial activity in New Zealand by a country mile.

The four major banks, which accounted for 85 per cent of the sector's 2005 net earnings, would completely dominate the NZX if they were listed.

On the assumption that the four companies would trade on the same 2005 price/earnings ratio as their Australian parent, ANZ National Bank would be the NZX's largest listed company, Westpac second, Bank of New Zealand third and ASB Bank fifth.

New Zealanders have always underestimated the profitability of banking, as demonstrated when the Bank of New Zealand was sold for $1.5 billion in 1992. This was after the Independent Evaluation Report determined that the company's long-term sustainable earnings were in the $135 million to $180 million range.

The BNZ is now worth around $9 billion because its earnings are much higher than predicted and bank price/earnings ratios have expanded from the 8-10 to 14-17 range.

The accompanying table gives a clear indication how the four major trading banks are much bigger than the largest listed companies in terms of profitability and value. ANZ National, Westpac, Bank of New Zealand and ASB Bank had aggregate net earnings of $2.27 billion in 2005, whereas the 12 largest listed companies had total net earnings of $2.12 billion.

The four trading banks have an estimated market value of around $36.4 billion while the 12 largest listed companies had a market capitalisation of $34.8 billion, as at June 30.

Bank profitability has increased dramatically over the past decade, even though the interest rate spread the difference between the average interest rate received on loans compared with the average interest rate paid to depositors has fallen from 2.58 per cent to 1.77 per cent.

The banks have achieved a dramatic increase in earnings because of greater efficiencies and the introduction of new technologies, including internet banking.

Since 1995 the total number of bank employees has fallen from 24,900 to 23,070, even though total assets have grown from $101 billion to $240 billion.

There are now 2218 bank-owned ATMs compared with 1429 10 years ago and only 1165 branches compared with 1427 in 1995.

These innovations have led to huge improvement in efficiency, with the sector's operating expense-to-operating income ratio falling from 66.3 per cent in 1995 to 45.4 per cent last year.

TSB Bank and the Crown-owned Kiwibank, which are ranked 11th and 12th respectively in terms of size, are the only domestic-owned banks.

No private New Zealand-owned bank has been established in the past decade even though the sector is extremely profitable and there are no regulatory barriers to entry.

New privately NZ-owned banks have not been established because investors believe that the existing banks have a stranglehold on the market, yet at the same time New Zealand investors have been quick to sell the remaining domestic-owned banks to overseas interests.

There is obviously a major contradiction between these two different courses of action.

In the past two decades we have sold the ANZ Banking Group (New Zealand), which was listed on the NZX until 1986, Bank of New Zealand, ASB Bank and two other listed banks, Countrywide Banking Corporation and Trust Bank.

The 14 overseas-owned banks account for 98.2 per cent of total banking assets and 98.7 per cent of sector profitability.

These net earnings, both distributed and reinvested, make a negative contribution to the country's current account balance.

Thus, in 2005 the net earnings of the 14 overseas-owned banks had a negative $2.63 billion impact on the current account deficit. In addition, the banks were net overseas borrowers to the tune of $68.2 billion as at May 31, 2006.

Information on overseas borrowing and lending is difficult to obtain, but as at March 31, ANZ National Bank had net offshore borrowings of $19.6 billion and Westpac, $11.5 billion.

Both banks have become increasingly reliant on overseas funding in the past year or so. ANZ National now sources 36.9 per cent of its funding offshore compared with 32.6 per cent six months ago, while Westpac has 32.8 per cent of its funding from overseas compared with 28.9 per cent two years ago.

As the New Zealand economy expands and borrowing demand increases, the banks have to borrow offshore because there are insufficient domestic deposits to meet the demand.

Net bank overseas borrowings of $68.2 billion are a huge cost to the country and these borrowings contribute an estimated $1.7 billion to the current account deficit.

Thus, the 14 overseas trading banks contributed in excess of $4 billion to the March 2006 year $14.5 billion current account deficit through a combination of their net earnings and offshore borrowings. Bank economists don't quote these figures in their analysis of the New Zealand economy.

This makes the banking sector the fourth-largest contributor to the current account deficit after oil, mechanical machinery and automotive imports, which all exceed $5 billion a year.

Finally, the banks have a huge influence over the allocation of the country's economic resources because we have a shortage of equity and a strong reliance on borrowings to fund commercial activity.

The banks, particularly the four major Australian-owned banks, have a strong bias towards the housing market as residential mortgages now represent 50.5 per cent of total bank lending compared with 47.7 per cent at the end of 2004. By comparison, residential mortgages have fallen from 36.3 per cent to 35.2 per cent of total Australian bank lending over the same period.

The banks have a preference for residential mortgages in New Zealand because small and medium-sized companies, which are riskier and require greater credit analysis, dominate the commercial sector.

In addition, international banking regulations require banks to have only half as much capital when they lend on housing compared with the commercial sector.

Take ANZ National Bank as an example. The Reserve Bank of New Zealand requires banks to have a minimum total capital ratio of 8 per cent and ANZ National Bank easily met this with 10.7 per cent as at March 31.

But $41.1 billion of the bank's total on-balance exposures of $87 billion are to residential mortgages. Residential mortgages are 50 per cent weight- adjusted, meaning that only half of the $41.1 billion of residential mortgages are taken into account when the minimum total capital requirements are determined.

If 100 per cent of the residential mortgages were included in the minimum capital requirements, then the ANZ National group would just achieve the 8 per cent minimum total capital requirement, but its NZ parent company would fall well short.

The combination of offshore borrowing and residential property lending is a prudent strategy as far as the overseas banks are concerned, from both an earnings and capital requirement point of view.

But it is not a win-win situation as far as the New Zealand economy is concerned, particularly considering the impact on the country's current account deficit. Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.