The complexities of banking

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By Ken Howard

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10 January 2020, 1:35 PM

Every bank, which has survived (and many have failed), has had to balance the demands of savers with the demands of borrowers, and typically they are opposites.

Savers want:

1. Access to their funds 24 hours a day, 7 days a week, from anywhere in the world,
2. 100% security, and 
3. The best possible return.

While borrowers want:

1. To be able to take decades to repay,
2. Simply offer their word (promise) as their bond, so nil or limited security, and
3. All at the lowest possible price (or to put it another way, lowest possible return to savers).

To give this some context, the big four banks in Australia (ANZ, CBA, NAB & Westpac) currently look after, in excess of, $2 trillion in savings, while at the same time, facilitating $2.7 trillion in lending.

One obvious question, is how can you lend $2.7 trillion if you only have access to $2 trillion in savings? Well, that question may not be that obvious, but it is true, you cannot lend what you do not have. So, in-order-for the big four banks to lend $2.7trillion, they will need access to; in excess of $200 billion of shareholders equity and the balance, being in excess of $500 billion, will need to come from global wholesale investors.

So, there is a lot at stake and the numbers are large. Australia’s big banks employ over 145,000 staff, who look after tens of millions of accounts, through which tens of millions of transactions happen every day, worth tens of billions* of dollars, every day.

In very simple terms the big 4 banks look after; $3 trillion in assets, $3 trillion in liabilities and $10 trillion in transactions every year, and in return, during 2019, after paying $11 billion in tax and absorbing $16 billion in bad and doubtful debts they made $26 billion in profit (which is approximately an 11% return on shareholders equity).

Yes, the big banks are profitable and $26 billion is a lot of money, but if less than 1% of the transactions, assets or liabilities were to go bad, a $26 billion profit, could become a multi-billion-dollar loss, and almost by definition, an unprofitable bank;

1. Cannot guarantee depositors will be able to access their savings,
2. Will not be able to lend money to credit worthy borrowers,
3. Will not have access to global wholesale investors, and
4. They will struggle to convince shareholders, that they should absorb the losses, and then recapitalise the bank, so that it can continue to facilitate; saving, lending and investment in Australia.

In theory, banking should be simple, but even simple things done billions of times, involving millions of people and trillions of dollars can very quickly become complex. Not only can each transaction be uniquely different, the macro environment is constantly changing (competition, technology, regulation, the economy etc) and what might have been okay one day, may not be the next.

I know that for some politicians, regulators and media commentators, the big banks are enemy number one, and every error is seen as deliberate, motivated by a desire at the highest level to maximise profits regardless of the consequences.

But I have a different view. The complexity is real, the competition is intense and the reason why the big banks are so profitable, is they are very, very large.

To illustrate the scale of the “complexity” challenge; one of the claims by AUSTRAC against Westpac (page 14, item 26 in the statement of claim) is that they failed to report some 19 million transactions with Bank A (which I understand, from reports in the media, to be Citi Bank), between the period November 2013 and September 2018, and that these transactions had an aggregate value of 0.72% of all reportable international transfers during this period (or an average of $4 per transactions X 19 million = $80 million out of $11 billion of reportable transactions) and that each breach is a breach of s45(2) of the ACT (Anti-money laundering and counter-terrorism financing Act of 2006) and can potentially carry a penalty of between $17 million and $21 million per breach or an eye watering $323 trillion, for what is potentially a single programming error.

I obviously have no idea what the ultimate fine will be for Westpac. The Morgans analyst has speculated that it could be in the range of $2 billion or approximately $0.60 per share, and the basis for this, is the $700 million fine paid by the CBA for some 50 thousand breaches of the same ACT during a similar period. The irony is that in both cases, it would appear to be a computer system error, which was running undetected in the background for an extended period, while the rest of the bank was probably 100% compliant. Regardless, in both cases the CEO and Chair have lost their jobs and multi-million-dollar fines have been / will be paid.

I certainly understand that in some areas of the law, particularly banking, the only acceptable standard is 100% compliance. But I also understand that, at some level, every system was designed and implemented by a person, or a team of people, and that garden variety human error is a real risk. Regulators and politicians may want 100% compliance, but they will have to accept something less, if Australia is to have a functioning economy. The banking system is at the foundation of every transaction, every loan and every savings plan, you cannot simply tax the banking system out of existence, without destroying the economy.

In short, despite the regulatory handicap, I believe Australia’s big 4 banks represent a sound long term investment. They provide an extremely valuable service to the economy, and they do invest billions each year in technology to ensure they comply with the relevant regulations.

*Over 80% of the value, will come from less than 10% of the transactions e.g. property purchases, refinancing loans, term deposits etc. while most of the transactions will be low value e.g. a cup of coffee, refuelling the car, buying the groceries.

Find out more

Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.

If you would like to learn more about assessing your finances, you can contact your closest Morgans branch.

General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.