What Happens When a Bank Loses Money? / by Adam Howard

Welcome back to another discussion on the madness and chaos that is the world of finance and economics.

I like looking at this world with a cocked eyebrow and a cynical mind.  It's actually a study of psychology and decision making where we keep score with dollars and cents.

I thought I would try a slightly new approach from now on; make the Updates a little shorter and also to make it clear what advice I was trying to provide; what dark and dingy corner of Corporate Australia am I trying to shed some light on...and why.

So, this Update it is our Big Banks and the single biggest risk they face:  bad debts.  And the specific question is "How does a rise in bad debts affect everyone in the economy?"

First, some background. 

There was a piece in the news this week about ANZ announcing an increase to their provisions for bad debts of $100 Million up to $900 Million.  Here is a link to a story on this, which will hopefully jog everyone's memory.  Or am I one of only a few people who actually give a sh*t about stuff like this???

Story goes like this. 

The banks imply that It's not their fault.  They did the right thing.  Made loans to businesses and companies in the resource sector to help them grow.

Then unforeseeable factors beyond their control resulted in an across the board crash in commondity prices, meaning a lot of those businesses are now stuggling and are beginning to default on their loans.

Like I said, not their fault, or so they say....

It made me curious and raised some cynical questions in my mind, like: Why is it not their fault?  but then, more practical quesitons such as: What was behind this increase in bad debts? and, What do I think will now happen in debt markets? and What does this mean for potential borrowers?

You need a little bit of history here to help you out.  The Big Banks have announced record profits year-on-year since the Global Financial Crisis.

There are three broad reasons for this.

One.  There has been a rpaid growth in home and investment lending in Australia over that time, and home and residential investment loans are relatively low risk, meaning banks make q reasonable margin in this area.

Two.  We didn't really experience the GFC to the same degree the rest of the world did due to Chinese demand for our commodities, and this demand meant there appeared to be a lot of credit worthy businesses out there, and the banks were very happy to lend to them.

And Three.  I did a little bit of research into the Big Fours' provisions: the expense they declare to account for loans that go bad: and Surprise! Suprise! Our Four Pillars have been reducing their bad debt provisions every year since 2008.

In fact, the last time bad debt provisions were reduced this quickly by the big banks was just after "The Recession We Had to Have" in the early 1990s.

And Hey Presto!  We have the Golden Age of Australian Banking!!!  Result?  Gail Kelly, Ian Narev and Mike Smith are lauded as geniuses and titans of business.  We pat ourselves on th back for continuing to be The Lucky Country and continue on our merry way.

Now, however, we have declining business credit growth, increasing provisions and increasing regulation of the home and investment lending sector.

Results?  It's quite likely the Big Four will see a decline in profitability and; it WILL get harder to borrow money from a bank...regardless of purpose.

I don't just say that as a matter of opinion, either. 

Yes, there is some personal experience involved, where I worked for a bank (that shall remain nameless, but may have orange as it's primary colour) that had been involved in some aggressive lending, lost bucket loads, was rescued via a competitor purchase and was then effectively prevented, at least for while, by the new parent from lending.

In addition to my personal experience, there is actually empirical evidence to support my opinion. 

A Reserve Bank of Australia report from 2015 found, specifically, that the increase in bad debt provisions after both the 1990s recession and the GFC was largely attributable to a decline in lending standards.

It also found that it was far more likely for provisions to increase as a result of lending to businesses, rather than households.

No way!  Really?  Looser lending standards applied by our Four Pillars??  Surely not...

But then, I DO recall being told when I joined The Blue Bank that they aspired to be the largest commercial bank in our wide brown land.

My response when I was told this?  "Oh, so you want to buy some risk?"

Because, if you want to grow your share of the pie faster than that pie is actually growing, you need to accept that there will be a few duds in amongst the gems.

Needless to say, the executive I was talking to refuted my assertion, stating lending standards would of course be maintained.

We then proceeded to do some crazy lending over the next 18 months, until Forge Group (a large Western Australian based mining services contractor and ANZ Corporate customer) went bust, and the music stopped.

So, now it is ANZ saying they have been stung by resource focussed customers..

CommBank are also saying they are experiencing increasing bad debts in their home and investment lending book in the resource states of Western Australia and Queensland.

Briefly, on the topic of CommBank; they were the focus of a 60 Minutes story a few weeks back where the bank had made aggressive loans to Mum and Dad borrowers in a regional town in Queensland, where that town had a heavy reliance on the coal industry.

The coal industry took a hit and now CommBank is enforcing it's mortgages and undoubtedly chrystalising some nice, large bad debts.

A similar thing is happening in Western Australia where mortgagee sales have spiked in the North West as demand for rental properties evaporates, now that the construction phase of several resource projects have come to an end.

If we look at this from the perspective of responsible lending (which has been the catch phrase of the banks and the regulator since 2011), both banks' policies seem to have been a little loose.

CommBank were known around town as the best rural post code bank for a long while.  "Best" meaning they were willing to apply the loosest policies to loan applications made involving properties in rural locations.

Now that approach is coming home to roost.

Back to our bottom line.  "What does this mean for borrowers and the wider economy?"

Well, the first thing that happens after losses is a tightening of policy.  Banks call it "greater oversight" or"focussing on fundamentals" .

This means it becomes harder to borrow from those banks.  This is not something the borrowing public is told.  Nor is it something that is explicitly stated to staff.

It's all implied by actions.

Policies which may have previously been treated as guidelines are now enforced with draconian zeal.  Businesses that have declining profits but are still making their loan repayments are sent to bad bank, rather than being closely monitored.

And when we are talking about banks that have between 10% and 20% market share each, this results in a tightening of credit markets in general.

After all, they say a banker is someone who lends you an umbrella when it's sunny and asks for it bank when it starts to rain....

In an economy that is slowing (some say teetering on the brink of recession), this tightening CAN, not does, result in a self-fulfilling prophecy where due to tighter credit at a time of declining economic conditions, recession is exacerbated.

The advice to borrowers, both households and business owners, is to know your bank, their lending history and policies....

Simple, right??

I know, I know.  It's not.  Which is why specialists who are familiar with this information are critical.

The only questions that a borrower needs to answer are:

- "When do you think you will need debt assistance?"

- "What do you need the debt for?"

- "How much do you need?"

- "What type of income do you generate?"

- "What type of asset can you provide as collateral?"

- "How long do you plan to spend in the loan?"

The rest is something to discuss with one of these specialists.  

I wonder where you could find one??

Food for thought....