"We are a young country that has to use its capital smarter" - Don Argus

Some wise words from one of our most experienced business people. Lending to small-medium sized businesses is shrinking at a time where we need them to grow.

There needs to be a real focus on what is constraining growth and the answer is not found talking to economists, we think. Any discussion with the management of a growing business turns to working capital very quickly. No growth finance, no growth.

What keeps former NAB boss and BHP chairman Don Argus up at night?

One of the most experienced executives in the country, Don Argus has concerns about lending standards. Nic Walker

by Stewart Oldfield

What scares the "hell out of" Don Argus, a former chief executive of National Australia Bank and former chairman of BHP Billiton?

Iron ore prices? Interest rate rigging scandals? No. It is interest-only home loans.

"It scares the hell out of me – the size of the debt people are taking on without principal repayments," he says.

The famously forthright executive says banks giving million-dollar home loans to young people had lost perspective. "It used to be very difficult to get a home loan in the old regulated banking environment," he says. "Now it's like a commodity."

According to data compiled by the Australian Prudential Regulation Authority, interest-only mortgage loan approvals peaked at a record 46 per cent of total mortgage loan approvals in the June quarter of last year. 

Since then, their proportion of total mortgage approvals has reduced to 37 per cent, still much higher than the level of five years earlier.

NEGATIVE GEARING

The Reserve Bank said last month that further falls were possible in the proportion of interest-only loans being written as some banks continued to phase in the tighter lending standards being demanded by regulators.

"Some further falls in the share of high-LVR [loan-to-value ratio] lending and interest-only lending in the period ahead could be expected," the RBA says.

Interest-only loans have been particularly popular among those buying homes for investment purposes. Such loans can allow high-income earners to maximise the benefits of negative gearing.

Argus' views on interest-only loans are taken seriously in banking circles because he built his career around being rigorous on lending standards in the late 1980s and early '90s, avoiding the disastrous commercial loan exposures that hobbled his peers.

He was appointed head of NAB's credit bureau in 1986 and took over the top job from Nobby Clarke in October 1990,  remaining in the role until 1999.

He became chairman of what was then called BHP Limited from 1999 until 2010, when he oversaw a tremendous period of expansion as the company reaped the rewards of the resources boom.

INDEBTED CONSUMERS

The level of indebtedness among Australian consumers and the government is a drag on economic growth, according to Argus. This is already being seen as stimulatory monetary policies around the world fail to inspire consumer spending.

 He says Australian consumers are among the most indebted in the developed world and the governments that have been  embracing interest-only loans will leave a terrible legacy for future generations.

Argus says a correction in house prices is inevitable, starting with the apartment market. But he is not predicting a severe credit cycle as last seen in the early '90s when corporate losses and inflated asset values brought several Australian banks to their knees.

"It may not be as severe because bankers these days do understand that free cash flow is important when assessing the risk profile of corporates," he says. 

"But it remains to be seen how their risk-assessment processes stand up when interest rates begin to rise again for small business and consumer customers."

 Argus says a target of a 15 per cent return on equity for banks could prove difficult to sustain. "In today's diminishing return world, one should not forget that our large bank balance sheets rely on funding from offshore markets and this can become expensive at maturity if overseas banks falter in the wake of slower economic growth."

SPOOKED

That said, he believes it is prudent for banks around the world to rely more on tier 1 capital rather than debt instruments such as hybrids, which could be questionable in terms of tax deductibility and subordinated to other forms of funding. 

"You can never have enough equity capital," he says.

Australian banks have been strengthening their capital positions in recent years in anticipation of APRA's measures to address the financial system inquiry's recommendation for their capital ratios to be "unquestionably strong" by international standards. The big banks raised $5 billion of common equity over the past six months. This increased their common equity tier 1 capital to about 10 per cent of risk-weighted assets as of December 2015, 1.25 percentage points higher than a year ago.

The capital positions of some are also being supported by asset sales.

Argus says Australian banks have an important advantage over overseas ones, particularly in the US, given their relatively high level of non-interest-bearing and fixed‑term deposits. He attributes this to Australian consumers still seeing banks as safe havens compared with some of the collapses that have occurred offshore.

He has previously warned that a royal commission into banking conduct in Australia could spook foreign lenders at a time when domestic banks depended enormously on offshore lending.

GEOGRAPHICAL ADVANTAGE

He highlights the strengths of several Australian-listed companies. Macquarie Bank's fee-based business model, he says, is "probably as good an investment banking model that you will see".

BlueScope Steel has successfully reinvented its business model, while Amcor has demonstrated a record of consistent wealth creation. He also applauds Transurban's initiative in taking new infrastructure proposals to the Victorian government.

Argus says Australia's geographical position on the doorstep of Asia ensures the nation has a magnificent future as long as we take full advantage of its strengths, for instance in primary industry, education and health. 

"We are a young country that has to use its capital smarter," he says.

However, he is critical of the performance of governments since 2007. "We have managed to record a series of budget deficits, which leaves us with public debt, which will get the attention of the rating agencies, and the investments undertaken have hardly been productive.

"Going forward, if one thinks that one can ramp up GDP growth by spending billions on non-productive initiatives and promising unfunded activity, which only add to our fragile financial position, then we are in for some rough times ahead."


Read more: http://www.afr.com/personal-finance/shares/what-keeps-former-nab-boss-and-bhp-chairman-don-argus-up-at-night-20160420-goayvr#ixzz49Aqrvks9 
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