Feature Stories | Oct 05 2016
This story features AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ
This story was first published for subscribers on September 27 and is now open for general readership.
Are Australian bank returns on equity really too high? What lies ahead for the banking sector?
– Australian banks face a hostile political environment
– Bank returns on equity are falling
– Household indebtedness scare misleading
– No more RBA rate cuts?
By Greg Peel
Australian politicians have apparently learned a new financial buzz-phrase – return on equity. Clearly return on equity benefits the holders of that equity, otherwise known as shareholders. The Labor Party now wants to know why the ROEs of Australia’s banks are higher than those of banks in other developed economies. Surely by default a high ROE implies a benefit to shareholders at the expense of borrowers.
There should be a Royal Commission.
Except that Labor has already tried that one, to no avail, and the government has settled for an annual parliamentary grilling of bank bosses instead. Ahead of that grilling, new RBA governor Philip Lowe was asked to look into this ROE travesty.
It is fair to say the banks have done themselves no favours in areas of wealth management and insurance where alleged rip-offs have recently been discovered on a regular basis. For these crimes they deserve to be punished. But do they deserve to be punished for the crime of attempting to optimise returns for their shareholders? They are not public servants, they are public companies operating in a free market (and indeed in the case of banks, a very heavily regulated free market).
It was the Hawke-Keating Labor governments that deregulated the Australian banking industry and privatised the taxpayer-owned Commonwealth Bank. Coalition governments nevertheless are the flag wavers for capitalism and free markets. But it matters not which colour tie today’s politicians are wearing, one by one they will predictably trot out to tell the country the banks are obliged to pass on all of every RBA rate cut into mortgage rates and to suggest the Big Four operate a a cartel.
In the matter of the first point, why? Does the Australian government tell McDonalds how much to charge for a Big Mac? But if the second point is true, the argument is borrowers cannot vote with their feet because there is no competition. The reality, however, is one of the biggest problems facing the banks since the GFC has been competition between them.
One does have to wonder whether politicians even believe what they are saying or is it simply a matter of bank bashing being politically popular and thus mandatory.
There are further questions which flow.
Why were politicians quiet in 2007-08 when the banks were not putting up their mortgage rates by as much as the RBA was raising? Why are mortgage holders the only Australians that matter, do those relying on deposits and retirement investments not count? Why is there no political outcry when bank share prices tumble, considering just about every working Australian is a shareholder via their superannuation fund. And the biggie – why would anyone want Australia’s banks to be in the same predicament as the banks of the US, Europe and Japan?
For it is those banks used as the benchmark to determine that Australian bank returns on equity are criminally too high. As late as last night, the European banking crisis that has been simmering for eight years took another turn for the worse. Japanese banks have been labelled “zombies” for two decades and carry vast stores of non-performing loans. The US banks had to be bailed out by the taxpayer in 2008.
So for the sake of all parties, when is a bank’s return on equity “too high”.
The Fourth Era
A simple equation for a bank to stay afloat is to maintain a return on equity in excess of the cost of capital. The bank analysts at UBS make a bold statement in suggesting “we believe all parties would agree bank ROEs above the cost of capital is desirable”. Presumably they assume politicians to be one of those parties.
Given the question of bank ROEs has been raised, UBS decided to look back into time.
In the post-war period 1946-72, Australian banks were heavily regulated and interest rates were low. Over that period, bank ROEs were broadly equal to the banks’ cost of capital, UBS notes. The analyst are calling this the First Era.
From the 1970s and into the 1980s, interest rates soared as inflation went through the roof. In 1983 the Australian banking system was deregulated and around the same time central banks began to tackle the inflation problem with monetary policy. By 1993 Australia was in recession. In the period 1973-93 bank ROEs averaged 3 percentage points below the cost of capital. We recall that were it not for Kerry Packer at the time, Westpac would have gone bankrupt. This was the Second Era.
In the period 1994-2015 interest rates steadily fell (with the odd blip), reducing the cost of capital for the newly deregulated, consolidated, and increasingly leveraged banks. The period was punctuated by a little thing called the GFC. Australian banks raised capital, put away hefty provisions for the loan losses expected to come, and importantly, survived without having to be bailed out by the taxpayer (notwithstanding the brief period of government deposit guarantee).
This Third Era saw banks enjoying ROEs of 6 percentage points above the cost of capital, UBS calculates.
As the new RBA governor has pointed out, the post-GFC period of higher ROEs has mainly been driven by the fact Australian banks never had to use those hefty provisions, have significantly cut costs, and have significantly deleveraged. Dr Lowe also pointed out that the banks must now hold a lot more capital, which aside from anything else has led to them competing for deposits. They must also limit their lending to investment property, which has left the banks to compete for mortgages by offering discounts on rates they hadn’t dropped by as much as the RBA cuts.
And notably, Dr Lowe pointed out that recent regulatory changes have meant bank ROEs are now coming down.
And we are still yet to find out just what APRA means, quantifiably, by “unquestionably strong”. Brokers are divided on whether Australia’s banks will be forced to go through another round of capital raisings.
“With a very challenging economic outlook, a hostile political environment and APRA’s broad definition of ‘unquestionably strong’,” says UBS, “we believe we are now in a fourth era for banking returns”.
Taking into consideration the pressure on bank net interest margins from low rates, higher capital requirements and competition among the banks, UBS suggest ROEs of 2-4 percentage points above the cost of capital appear more likely over the next decade.
On that basis, UBS suggests “it is difficult to build a compelling case to hold an overweight position in the banks”. Any share price re-rating is unlikely in the near term.
Politicians accuse the banks of favouring bank shareholders over borrowers (no mention is made of depositors). It has never been so cheap to borrow and shareholders are facing low returns. Yet the RBA governor noted that the banks could have accepted lower ROEs in recent times.
“My assessment,” said Dr Lowe, “is that the borrowers have largely borne the cost of [changes in the regulatory environment], not the shareholders of the banks, and it is an interesting question about who ultimately should bear the cost of that: the shareholders or the borrowers”.
Many an Australian has a mortgage and a superannuation fund. How many Australian borrowers and bank shareholders are actually the same people?
The Housing Bubble
In his parting statements on monetary policy over the past few months, former RBA governor Glenn Stevens seemed relieved that tighter regulatory controls were helping to prevent a possible housing bubble and burst in Australia. Analysts do not foresee a bursting bubble either, but they do see a cooling in the housing market ahead.
It is well known that as housing in Australia has become increasingly less affordable, the ratio of monthly mortgage obligation to monthly wage of the average mortgage holder has increasingly risen, as has the net level of Australian household debt. While a “cooling” in the housing market may not cause too much strife, what about another economic crisis?
Australia has just clocked up 25 years of uninterrupted economic growth, and survived the GFC, so an economic crisis seems remote. But when “Deutsche Bank” is being mentioned in the same breath as “Lehman Bros”, one cannot discount any possibility. Were for some reason the unemployment rate to begin rising once more, the risk is cascading mortgage defaults and a subsequent collapse in house prices, wealth, and confidence.
Credit Suisse has investigated the issue.
There is a “fallacy of averages”, Credit Suisse suggests, in merely examining overall household indebtedness. The analysts highlight some more pertinent, and less worrisome, numbers.
Of all Australian households, 31% have no debt at all. Of all Australian home owners, 32% have no mortgage. Of that 32%, 66% have no debt at all.
Of those with mortgages, the two major risk cohorts are those with both an owner-occupier mortgage and an investment property mortgage, ie double-geared, and least wealthy Australians (lowest 20%) with a mortgage. These cohorts number 5% and 1% respectively.
So stop fretting.
The RBA Factor
When Australia’s March quarter CPI data suggested Australia was suffering disinflation, a shocked RBA cut the cash rate, twice, to 1.50%. Economists assumed at the time there would be more to come, and that the cash rate would ultimately hit 1.00%.
More recently they have begun changing their tune. Ongoing GDP growth at levels that are the envy of the developed world are hard to argue with.
Among those changing their tune are the economists at Goldman Sachs. They no longer see any further RBA cuts, and indeed expect the RBA to begin raising rates in 2018, back to 2.25% by year-end. Goldman’s bank analysts had long warned any cash rate cut, and particularly to rates below 2%, represented a risk to bank earnings. But now, for the first time in a while, those analysts have raised their bank earnings forecasts.
Goldman does not believe bank net interest margins will fall as far as previously assumed in FY17 and their earnings growth forecasts have swung to positive from negative for FY16-19 (note that FY16 ends this month for three of the four majors). With the risk of lower rates dissipating and bad debt risk acting as a mild, rather than severe, headwind, the analysts now see the bank sector valuation as looking more attractive.
Goldman’s order of preference amongst the majors is ANZ Bank ((ANZ)), Commonwealth Bank ((CBA)), National Bank ((NAB)), Westpac ((WBC)). The analysts have a Buy rating on ANZ and CBA and Neutral on NAB and Westpac.
Goldman Sachs is not one of the eight leading stockbrokers monitored in the FNArena database. The current ratings and average forecasts of FNArena brokers appear in the table below.
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For more info SHARE ANALYSIS: ANZ - AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED
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For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION