Credit and money lending have gained bad reputations recently.
Yet, without them the economy would grind to a halt. Innovation would cease, and living standards would drop.
As long as it’s well managed, credit is a virtue.
But as we all know, sometimes it isn’t well managed. And that’s where things don’t always go to plan…
You see, when there’s too much credit, an economy booms. But if it booms too much, it can overheat. Of course, in a free market that shouldn’t be a problem, as an economy has a natural cleansing system.
Firms go bust, investors lose money, but the economy ‘refreshes’ and things move on. The result is capital flowing toward its most productive use. To where it’s useful, rather than being locked up in bad businesses or investments.
This process of boom, bust and recovery is the business cycle.
The thing is, those in government only like the booming part of the process. They aren’t keen on the bust. So as you’d expect, governments tend to interfere in the market to sustain booms and avoid busts.
That’s what the world economy is going through now. The latest European bailout package is a classic example — solving a debt problem by issuing more debt.
But it doesn’t solve anything. Consumers and businesses become too afraid to borrow. And banks won’t lend because they’re too busy shoring up their balance sheets…to make sure they don’t collapse under the weight of bad loans on their books.
That means banks worldwide are seeing their margins squeezed, and profit growth slowing…even going into reverse.
A Slipping Lifeline for Australian Banks
Last week The Age ran a story trumpeting the success of the major Australian banks. The article noted:
‘Australia’s big banks have been ranked the most profitable in the developed world for the second year running by the influential Bank for International Settlements…
‘Commonwealth Bank, Westpac, ANZ and NAB posted pre-tax profits equal to 1.19 per cent of their assets in 2011…’
Australian banks may be top of the pile, but there isn’t much to be proud of.
To put things in perspective, in order for Commonwealth Bank [ASX: CBA] to make a $6 billion profit, it needs a loan book of $500 billion.
That’s a lot of effort and risk to make a tiny 1.19% return on assets. And that’s the pre-tax number. After tax, the return on assets is less than 1%.
Even so, it wouldn’t be so bad, if not for the fact that this profit margin comes at the top of the Aussie banking business cycle.
And remember how the business cycle works. What comes after the boom? That’s right…the bust.
That’s what central bankers and governments the world over are doing their darnedest to avoid.
PS. In the latest issue of Australian Small-Cap Investigator, we took a closer look at the Aussie lending market and discovered a company that not only has a sensible risk-weighted approach to setting interest rates, but is also an innovator in the market. To find out more about this company, click here to take out an obligation-free trial to Australian Small-Cap Investigator.
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Written by Kris Sayce
Kris Sayce is Editor in Chief of Australia’s biggest circulation daily financial email — Money Morning. (You can subscribe to Money Morning for free here).
Kris is also editor of Australian Small-Cap Investigator, his small-cap stock research service, where he provides detailed analysis on some the brightest, smallest listed companies on the ASX.
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