KEY POINTS:
The domestic banks have played a major role in the boom and bust of recent years and their attitude towards funding and lending will have a significant impact on economic activity in 2009 and beyond.
In light of this it is important to understand how our banks operated over the past decade and the problems they now face, particularly in terms of maintaining their funding base.
The first point to note is the huge increase in bank lending to domestic retail borrowers over the past decade. This figure, which excludes lending to other large financial institutions and non-residents, exploded from $108 billion to $290 billion since 1998 with lending to individuals surging from $57 billion to $162 billion (see Table 1).
Bank lending expanded much faster than the domestic economy, with lending now representing 161 per cent of gross domestic product compared with just 105 per cent 10 years ago.
The housing-market boom, which saw the average sale price double between January 2002 and the end of 2007, was primarily driven by this dramatic increase in bank lending as over 95 per cent of money lent to individuals was in the form of residential mortgages.
The other side of banking is the funding or borrowings activities, which swelled from $129 billion in December 1998 to $338 billion in November 2008 (see Table 2).
Banks get their funding from three main sources: the domestic retail market (including individuals and companies), the domestic wholesale market (insurance companies and other big financial institutions) and from offshore. The retail market is a better source of funding for several reasons, including;
Retail depositors are more loyal, they don't usually change banks.
They leave between 10 per cent and 15 per cent of their deposits in cheque accounts where interest is not generally payable.
Their deposits are for longer periods than other funders.
Wholesale funders are less reliable because they shop around for the highest interest rates.
The biggest development over the past decade is that the banks have become increasingly dependent on offshore funding, which now represents 40 per cent of total bank borrowings compared with just 27 per cent in 1998.
In other words our banks delved into the great big new honeypot of money created by Wall St. This funding source accounted for 48 per cent of the growth in bank borrowings since 1998, with the NZ retail market contribution 36 per cent and NZ wholesale market 16 per cent.
The high dependency on foreign funding reflects our poor savings record and is a major contributor to the country's chronic current account deficit, this week's sovereign credit rating warning from Standard & Poor's and the slump in the value of the New Zealand dollar.
The problem New Zealand faces, with a number of other countries, is that too much bank funding has come from either wholesale or offshore sources and this funding supply has either slowed or is - in some cases - contracting.
Governments, particularly in Europe, have started making comments about the loan-to-deposit ratios of banks, a term that went out of fashion during the credit boom.
The loan-to-deposit ratio, also known as the customer funding gap, is the ratio of bank lending to domestic individuals, companies and other institutions compared with what the banks borrowed from the same domestic individuals, companies and institutions. Wholesale and offshore funding are excluded from the loan-to-deposit ratio because they are considered to be less reliable and more difficult to roll over.
The loan-to-deposit ratio for New Zealand banks is the relationship between the total domestic lending figure and the NZ retail funding figure. Based on these figures the loan-to-deposit ratio of the NZ-based banks blew out from 1.7 in December 1998 to 2.1 at the end of November 2008.
This compares with European bank averages of between 1.25 and 1.3. The Irish Government wants its two dominant banks to reduce their loan-to-deposit ratio from 1.65 to the European average as part of its guarantee over bank deposits and the Bank of England would also like to see its banking sector reduce its loan-to-deposit ratio from 1.7.
New Zealand banks are on a sound footing, particularly as finance companies supplied most of the loans to high-risk property developers, but the high loan-to-deposit ratio means that our banks have little new borrowing and lending capacity.
In other words the surge in bank funding and lending over the past decade is unsustainable because it was mainly fuelled by offshore and wholesale sources which are drying up.
New Zealand banks will have difficulty rolling over their overseas funding and this could result in a contraction in bank lending over the next year or so.
Therefore it is not surprising to hear that several businesses, particularly smaller ones, are finding it difficult to obtain bank funding.
Banks are rationing their lending - in complete contrast to the past decade - and they are lending only to low-risk customers.
The good news is that the banks are continuing to lend, with companies and institutions getting a bigger slice than individuals. Bank domestic lending increased by $6.3 billion in the three months to November 30, with individuals capturing just 41 per cent of the additional lending compared with their 56 per cent share of the total outstanding domestic lending.
Unfortunately, there are a large number of similarities between now and the 1920s and 1930s and this is why Governments and central banks are pumping huge sums of money into their banks and economies.
There was a proliferation of new lending institutions in the 1920s, exceptionally low interest rates and a massive increase in credit. These borrowings were used to invest in the sharemarket and property and to buy cars, fridges, radios and other consumer durables.
United States household mortgages swelled by 145 per cent, from US$15.3 billion ($28.1 billion) to US$37.7 billion in the 10 years to 1930, while NZ residential mortgages have surged by 184 per cent over the past decade.
Investment trusts in the 1920s were also similar to our hedge and private equity funds. These investment trusts had layer upon layer of debt, which was a huge positive during the boom years but a disaster when Wall St crashed in October 1929.
Governments and central banks will do everything they can to avoid the 1930s but the best they can do is stabilise the situation. The credit boom of the early 2000s will not be repeated for some considerable time.
Economists will be keeping a close eye on the banking sector, particularly in New Zealand as the non-banking finance company sector has been decimated in recent years.
The first task for the banks is to hold on to their offshore and wholesale funding. The second challenge is to attract more retail depositors as this will give them a more stable funding base and better loan-to-deposit ratios.
The second objective will be just as difficult as the first because New Zealanders, particularly retirees who are dependent on interest income, will start looking for higher interest rates outside the banking sector.
That is why lower interest rates have negative as well as positive features. They benefit borrowers, particularly those with mortgages, but they are a major negative development for retirees who are dependent on interest income to sustain their lifestyle.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com
