The continued bashing of the major banks,most recently in relation to their failure to pass on in full the recent Reserve Bank rate cut,and the commissioning of yet another inquiry (by the Australian Competition and Consumer Commission) into the way they make their pricing decisions only adds to perceptions that Australia's banks,the pillars of the financial system,are besieged and facing even more regulatory interventions.

Two sides to a balance sheet

The ultra-low interest rate environment is throttling their profitability. The core of a bank’s profitability is its net interest margin – the spread between what it pays its depositors and wholesale funding providers and the interest it generates from the loans it makes.

With interest rates so low there is a limit to how much of the RBA rate cuts it can pass on to depositors if it wants to retain those deposits – and prudential regulations mandate that the banks have to hold a high proportion of deposits in their funding bases. And the pricing of wholesale funding from offshore isn’t affected by the RBA’s cash rate.

It speaks volumes about the financial literacy,or perhaps the cynicism,of our politicians that they don’t appear to understand that there are two sides to a bank balance sheet and that depositor interests are as important as those of home buyers. Without funding the banks can’t lend.

And without decent profits they won’t be able to lend and the vulnerability of the system to external shocks will increase.

Australia's banks are required by APRA,after guidance from the Financial System Inquiry headed by David Murray,to be"unquestionably strong"by global standards.

That has been read as having capital adequacy levels in the top quartile of banks globally. The banks have raised a lot of capital from shareholders to meet that goal.

Profits matter

Bank profitability matters at a number of levels. It matters in terms of their credit ratings,which influence their access to debt markets and the price of that access. If they lose their AA- ratings,the four major banks would have reduced access to debt markets and have to pay more for their funds,which would have to be passed on to borrowers through higher interest rates.

It also matters because they need to be solidly profitable to attract or create equity capital to shore up or expand their balance sheets.

In the aftermath of the financial crisis the major banks raised vast amounts of shareholder capital and have continued to do so – to the tune of tens of billions of dollars – to meet the new and more demanding prudential requirements.

If they weren’t profitable,and profitable enough to offer investors attractive dividends,their access to that external capital would be constrained.

Their profits also create organic capital through retained earnings,which enable them to be able to grow their loan books while meeting their capital adequacy requirements.

Shrinking their profitability through ever-more-intrusive and politically-driven interventions raises banks'cost of capital while reducing their access to it,which means higher interest costs for borrowers,or constraints on the amount of credit available in the economy,or both.

Seen from a distance – from the viewpoint of the investors the promoters of the Latitude float tried to solicit – the Australian banking system would appear to be in disarray and under siege from regulators and politicians.

Indeed,while those investors appear to have confused the prudentially regulated parts of the system with the unregulated,it’s hard to argue against that perception,with the massive costs of the self-inflicted damage exposed by the royal commission overlaying the margin compression being created by the low interest rate environment.

If the banks are to retain access to offshore funding and,indeed,local deposits and equity,the simplistic focus on their home loan rates and the threat of some further form of political intervention in their decision-making won't help.

Overseas perceptions of the state of our banking system might be overly pessimistic,but they aren’t completely out of kilter with the path of poor profitability the politicians and regulators are trying to coerce the banks into taking,increasing the vulnerability of the system and leaving it exposed in any new financial crisis.