Australian Banks: Sinners or Saints? – Joseph Healy

Issue 3 | 1 July 2009

Joseph Healy was appointed Group Executive Business Banking, National Australia Bank, in March 2009. He has also worked for ANZ, Lloyds Bank in London, CIB World Markets and Citicorp. Joseph Healy has particular expertise in debt and equity capital markets, corporate and structured finance, private equity and risk management. In the aftermath of the global financial crisis, Joseph Healy addressed The Sydney Institute on Wednesday 1 July 2009, to explain that banks need to do more to connect and engage with the broader community.

AUSTRALIAN BANKS – SINNERS OR SAINTS?

JOSEPH HEALY

I would like to thank The Sydney Institute, and Gerard Henderson in particular, for the opportunity to talk with you this evening.  The Institute has made a unique and valuable contribution to the public and intellectual life of Australia and I hope it continues to play this role into the future. So thank you Gerard, and thanks also to all of you who are here tonight for giving up your time to allow me to share some thoughts and musings on a topic that is very dear to my heart – banking and the standing of Australia’s banks within the community.

Hardly a week has gone by in recent months where the actions or inactions of an Australian bank have not been a hot topic of media, community and political discourse. Interest rates, lending practices, executive pay, jobs – even proposed arrangements for bank staff social functions have been discussed, dissected and in most cases condemned. I think it is pretty fair to say that the apparent disconnect between Australia’s banks and the expectations of many in politics, the media, and, most importantly, the broader community is as wide as it has ever been.

This disconnect is not a new phenomenon. Sadly, it has been with us for decades – and, as our CEO Cameron Clyne said in a recent speech, the banks must share part of the blame. We all know the reasons for it. At the NAB we are acutely aware that actions such as branch closures and the level of fees are seen by many as undermining customer and societal trust. We also know that decisions on mortgage and small business interest rates attract a lot of media and political interest, leaving customers with the impression that banks are making these decisions with no regard for their interests. When set against profits measured in the billions, one can understand why bank bashing has almost become a national pastime.

As an industry, I believe we have to acknowledge that some of this criticism is justified. Have we engaged sufficiently with our customers and the broader community on these issues? I think the honest answer is – “not enough”. For too long banks have hidden behind the excuse that “bank bashing” is largely ill-informed comment – and sometimes it is. But sometimes the criticism is valid and we need to be part of the debate. That’s not always easy.

The sceptical Scot in me says it’s much easier for a politician or talk-back radio host to criticize banks, rather than acknowledge that Australia’s banks have proven to be remarkably resilient, especially in the face of the Global Financial Crisis (GFC). But that scepticism is misplaced.  The sad reality is that, despite the fact banks are an integral part of our economy and almost every Australian has a relationship with a bank as customer, employee or shareholder, most people still don’t understand the fundamental role banks play. Banks simply need to better engage in the debate.  We must be on the front foot, listen to and seek to understand the criticism, present the facts and argue the case.

At the NAB, we owe it to our 40,000 hard working employees to better explain what we do and why we are doing it. To face into the issues that are causing the community angst.  Our employees are a critical part of the business and community fabric of this country and they are entitled to feel proud about their work.  Better articulating their case is a challenge for every leader in our industry. So what is the role of banking?

Banking can be credited with the “miracle” of liquidity creation. Banks lend and acquire assets that are basically illiquid in the sense that, even in the best of conditions, converting those assets back to cash involves cost and time. Yet the bank depositor, whose money largely funds those illiquid assets, can convert their deposits to cash-in-hand almost immediately and at little cost. The skill of a good banker is to invest deposited funds with the goal of delivering a return to deposit holders, other debt investors and shareholders.  This is the fundamental role banks play in our economy and society and the core skill of a good banker is risk management.

At the most basic level, banks help people, businesses, governments and communities to function and grow by providing financing. Banks provide the mechanism for funds to be transmitted domestically and internationally and, through ATMs and electronic banking, banks provide customers with 24-hour access to their funds. About 75 per cent of the loans that help Australians acquire their “quarter-acre dream” are provided by banks.

To my mind, the economics of banking has three core survival characteristics. First, the confidence and trust of customers; second, the ability to fund the business at a rate lower than the margin earned from lending and other activities; and finally, the ability to manage the risk of lending and other bank activities. Today’s environment highlights just how all three are intrinsically linked.

Bank funding costs have been rising for over a year and, because Australia, as a nation relies on overseas capital markets to fund part of our domestic demand for credit, our costs have been increasing. Interest rates set by the Reserve Bank aren’t the only factor determining the price of credit to our customers. We are also seeing an increase in risk as consumers and businesses adjust to a slowing economy.  If forecasts of slower activity and higher unemployment prove correct, then the level of bad debts will continue to rise. We are forecasting that to be the case at least through 2010.

It is in these tough times that bankers get a stark reminder of just how difficult it is to manage risk, and how integral that process is to the long-term health of our businesses, and, as we have seen overseas, the strength of the economies we operate in. If banks don’t maintain strong capital levels heading into a slowdown, they will not remain stable and secure and continue to play their role in the economy. One of the things that is often missed in current discourse about the GFC and bank profits is that the best way for banks to remain secure is to produce adequate profits to maintain strong capital levels. Profit results are rarely seen through this prism – but it is, in reality, far more important than the often hyped headline profit. While a bank can announce a four billion dollar profit, which is a very large number, what is often lost is that the bank may have risk assets of 400 billion dollars.  So the profit is barely a one per cent return on assets.

Let me illustrate why profits are so easily misconstrued and with sometimes disastrous results. In 1994, a British Bank, National Westminster, announced a half-year profit of £1.3 billion – an 82 per cent increase on the previous year. Bad debts fell and a higher dividend was paid. The tabloid media cried “Piggy banks” … “excessive profits”. The financial media, however, painted a completely different picture: the NatWest result disappointed and its future viability is in doubt. The bank’s employees and customers, in the main, were influenced by the tabloid media, while management read the financial media.

The political reaction reflected the populist sentiment and morale in the bank collapsed. Not long after, NatWest was acquired by another British bank; hundreds of branches were closed and thousands of staff lost their jobs. Today, we are seeing the re-run of this story in Europe and US. We are well versed at counting bank profits, but far less knowledgeable at understanding the real costs to employees and society of a poorly run bank.

All Australia’s four AA rated  major banks currently carry tier 1 capital of around 8 per cent – so about $400 billion of risk is covered by $32 billion of equity.   Compared with almost any other business, it means a much higher debt-equity ratio that has to be prudently managed. When I talk about equity in a bank’s capital structure I like to compare it with an air bag in a car. It is rarely used and in the hands of a safe driver, it may never be used, but if there is a crash, then the bigger the air bag the better, and the bigger the car and the faster it is being driven, then the bigger the air bag that is needed to survive.

Recent events have shown that many banks, especially overseas banks, have been driving fast cars with little in the way of air bags.  Not surprisingly there has been much criticism of the management of banks in Europe and the US, given the terrible economic and social consequences of the financial crises in those regions. Much of this criticism is warranted. Inevitably, tougher regulation governing banking practices will result.

But what’s the situation in Australia? Our banks are among the strongest in the world. Today, the Big Four are in very select company – they comprise half of the eight AA rated banks in the world. Even the critics of Australian banks agree that one of the key reasons Australia’s economic downturn has not been as severe as most of its trading partners because our banking system has held up much better in this crisis than most of its overseas counterparts.

Credit is tighter – but still available. I’m not claiming for one moment that the NAB saw the global financial crisis coming. We don’t boast a Nostradamus on our staff. That said, I can say that in the Business Bank we have been thinking about the prospect of a deteriorating economic environment for some time. There were three things that happened that got me thinking about how the economy could turn. The first was the publication of the book, The Black Swan. This book by Nassim Nicholas Taleb describes a black swan event (a northern hemisphere concept) as having three traits: 1. it’s an unusual occurrence – an outlier event; 2. when it does happen, the impact is huge; and 3. it’s only after the event that people rationalise what has happened (the U.S. sub-prime problem being a classic Black Swan event)

This book got me thinking about what could happen in our economy that we might not be able to predict using traditional risk-management tools. The second was the release of research by a leading consultancy firm that showed the growth in the level of the financial system relative to global GDP. The financial system went from 106 per cent of global GDP in 1996 to 600 per cent in 2006- a phenomenal level of growth by any yardstick.

This greatly concerned me because it indicated that there was a disconnect between what was happening in the financial system and the underlying economy – history tells us that these conditions are often symptomatic of a bubble. Thirdly, the significant earnings multiples being paid for businesses, particularly by the private equity community, made me question whether there was the capacity to handle the high levels of debt in the event of an economic slowdown.  A lesson l learnt years ago, is that if you overpay, you over-finance and there is no air bag in the event of a crash!

These three factors lead us start thinking seriously about how we should position the Business Bank for a slowdown. In response to this change in thinking, we started to beef up our risk management resources in the Business Bank.  We hired a number of experienced bankers, and moved experienced risk management executives into frontline roles to position the business for a different environment from the one that we had enjoyed since the last recession in the early 1990s.

More importantly, we started a campaign of educating our customers about the need to give more consideration to the risks their businesses could face in a downturn. Our customers were no different to us.  The last recession was 17 years ago. Some were not even in business then. So we got our bankers out in front of them, developed educational material and ran seminars to make them aware of the genuine prospect of a far more hostile economic environment going forward.

We talked a lot about the tale of the frog and boiling water, that well-known metaphor that is told to explain how people fail to react to important changes that occur gradually.  I feared that some of our customers would not sense the change that was taking place until it was too late. So, being on the front foot and helping our customers think about the adjustments they needed to make was an important part of our risk management. What’s the end result of that strategy? Well it’s hard to measure, but I think it’s fair to say that if we had not been proactively managing risk, internally and with customers, then the level of bad and doubtful debts that we see today could have been higher.

It is no secret to those who know me that I am passionate about business banking – especially banking for small to medium-sized businesses or SMEs as they are known. In SME banking, relationship banking is the key to success – understanding the needs and aspirations of SMEs and a commitment to the relationship. This involves having bankers willing to commit significant parts of their career to working with the same customers. The CEO of a US bank where I worked earlier in my career once said to me: “We are not a major player in middle market banking in the US or overseas because success in this market requires long-term continuity of people who are part of the local community. We do not attract people who want to go to Kenosha, Wisconsin, and live there for 25 years”. Thus, SME banking has tended to be the domain of those domestic banks that are willing to make long-term commitments to local communities.

The Integrated Financial Services (IFS) banking model introduced by NAB has this core idea at its heart. As the biggest bank to the SME sector in Australia, NAB understands how important IFS is to relationship banking. In my opinion, it’s a good illustration of the “church spire principle” of banking mentioned in a recent article in The Economist.

This principle says only lend to those within sight of the church spire; businesses and communities that you know. Unlike Australian banks, it’s a principle US and UK banks largely forgot in the heady days pre the sub-prime crisis, and it helps explain why our banking system is proving more resilient in the face of the GFC. For me, relationship banking is a large part of why I enjoy my job. I get to hear wonderful stories of businesses that came to the bank with nothing more than a dream (and in the case of migrants, an empty suit case) and received the financial support that has not only transformed their lives, but created employment opportunities for many Australians.

The willingness of the bank to support entrepreneurs, including thousands of migrants, is a source of enormous professional pride as is the fact that for many businesses facing challenging times, NAB is willing to back them. Since the onset of the credit crunch, a lot has been said about banks not lending to SME’s and we have certainly seen some withdrawal from foreign banks, non-bank lenders and the regional banks.

However, I am pleased to say that at the NAB, we continue to be very much open for business.  In fact we have lent over $20 billion to SME’s in the past 12 months. This capital, which excludes lending to Institutional customers, largely goes into supporting the productive capacity of Australia’s economy. We have also continued to work on a program that goes to the very heart of lending to small businesses – a not-for-profit program called NAB’s Microenterprise Loan.  This program looks at ways to provide business finance to those people who have a great business idea, a well thought out business plan and the work ethic to achieve success but may have trouble accessing traditional business finance. It’s been something we’ve been working on since 2007.  Since then we’ve helped establish 200 microbusinesses, something we are very proud of.

This reassures me that our quiet contribution to the success of this country is something that makes my chosen vocation one of great personal satisfaction. Institutional clients also value the relationship banking commitment, although the nature of that commitment tends to fluctuate.  When there is much liquidity and new entrants in the market, institutional clients tend to select specific services on product pricing alone – the mantra here is shareholder value, so the best price often gets the deal. Institutional clients still value the benefits of relationships, but many large businesses treat the relationship with their bank as a “call option”. This is the paradox of relationship banking in the institutional market. In more challenging times, the nature and commitment to the relationship changes as liquidity dries up and businesses approach other banks seeking to build relationships.

The current crisis has provided many examples of this and it has also addressed the fallacy of one view that has gained much currency over the past decade: that banks and capital markets may be perfect substitutes. The way in which the capital markets can close for companies reminds all executive teams and boards of directors of the importance of strong banking relationships.

For me, it is hopefully a return to relationship banking as it should be and to sensible pricing for risk. These are the concrete benefits banks bring to Australians, whether it is to businesses, individuals or investors. What has underpinned the banking system in achieving these goals is a tough regulatory system, particularly necessary as it relates to the banks’ role in the payment systems.

Let me conclude by saying that I have no doubt that Australia’s banks can and must lift their game at better engaging with their customers and the broader community. We need to be more transparent, whether it be fees, interest rates, profitability, or services.  A commitment that has already been made by NAB’s CEO, Cameron Clyne. We have nothing to fear by doing so because the NAB has – I believe – a balanced story to tell. Our customers and depositors get stability, security and credit – the lifeblood of the economy. We employ tens of thousands of Australians and our investors receive a dividend flow, many of whom rely on this to maintain their lifestyles in retirement.

Make no mistake, we and the industry we work in and represent, need to do better.  But the Australian banking system, working in cooperation with government and the Reserve Bank, deserves credit for its handling of the Global Financial Crisis, and how it is now positioned to play a crucial role in the nation’s economic recovery.