Bank competition heating up

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Cut-throat competition is lowering bank margins, forcing New Zealand banks to adopt risky levels of leverage to stay profitable, a finance professor says.

Thursday, October 6th 2011, 7:02AM 1 Comment

by Niko Kloeten

AUT Professor Ming-Hua Liu showed that, contrary to popular opinion, New Zealand's banking scene is competitive.

Profit margins have been trending down for 20 years, he said, while banks' average return on assets is under 1% and dropped to zero during the financial crisis in 2009.

"What other type business would accept a return on assets of less than 1%?" he said.

To make up for this low rate of return, banks have to use leverage, Professor Liu said - New Zealand banks have an average equity to asset ratio of only 5.7%, meaning they are 17.6 times leveraged.

"This means that for every $1 of equity you can have $17.5 of assets - this is considered quite okay," he said.

Although this may sound like a lot of leverage, New Zealand's banks are actually quite conservative compared to their overseas counterparts, he said.

Professor Liu showed that in 2007 a number of major US investment banks were well above 30 times leveraged (all of them have subsequently collapsed or required a bailout), while one European bank was a whopping 73 times leveraged in 2006.

However, he said New Zealand banks are still potentially at risk despite their relatively conservative equity to asset ratios.

This, he said, is because of their heavy reliance on short term "hot money" from overseas money markets, which New Zealand banks rely on for about 35% of their funding.

And Professor Liu said New Zealand's banks have actually increased their lending on mortgages since the financial crisis began, leaving them at greater risk if this country sees a housing market collapse like those experienced in other countries such as the USA.

About 57% of all bank lending in New Zealand is on mortgages but he said the figure doesn't tell the whole story as many other loans, particularly to small businesses, use houses as collateral.

He said banks like mortgages partly because they are easier than small business loans, but also because Basel banking regulations allow banks to lend on mortgages with only half the capital adequacy ratio required for other types of lending.

"It's the same for all other types of lending, from companies like Apple and Microsoft down to papa and mama's shop. It doesn't make any sense."

Niko Kloeten can be contacted at niko@goodreturns.co.nz

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