Mounting Risks Confront The Major Banks

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

Are risks for Australia's major banks increasing? Several brokers believe so while others consider the outlook more benign.

-Regulatory scrutiny, credit rationing and a softer housing cycle bode poorly for the banks
-Upside could rest with an ability to re-price home loans or further reduce deposit rates
-ANZ, Westpac could improve productivity by reducing branch numbers
 

By Eva Brocklehurst

Australian banks are in the spotlight, enduring scrutiny from regulators while facing headwinds from a softening housing cycle. The Royal Commission into banking has increased the focus on responsible lending requirements and this is expected to weigh on loan growth while also increasing costs.

Meanwhile, the mortgage market is softening under the weight of more onerous capital rules, tighter lending standards and credit rationing. Morgan Stanley has decided the prospect of lower returns for the banks looms large, reducing its targets for the majors by an average of -7% to reflect these risks.

Despite the recent underperformance, trading multiples have not yet de-rated enough to underpin valuations. As a result, Morgan Stanley downgrades estimates for earnings per share by an average of  -2.5% in FY19 and -5% in FY20. Australian housing loan growth forecasts for the majors are also lowered, to an average of around 2% in both FY19 and FY20.

While not envisaging a material downgrade from mortgage loss rates in the near term, Morgan Stanley is more concerned about the potential for a credit crunch to drive weaker economic outcomes and an increase in the banks' non-housing loss rates.

Morgan Stanley also suspects National Australia Bank ((NAB)) could review and reduce its dividend policy in FY19.

Downward pressure on margins is weighing on revenue and profit growth prospects, yet there could be upside if the major banks use their pricing power to lead a new round of home loan adjustments or a further reduction in deposit rates.

The broker concedes that political and regulatory scrutiny would make it difficult for the major banks to contemplate more re-pricing, although this could change if margins declined more than expected and/or the risk of an adverse regulatory response is reduced.

UBS largely agrees with this negative outlook, noting the Australian banks have now underperformed the broader Australian market on a rolling three-year timeframe.

The broker's analysis suggests an ability to rebound from the current lull in earnings will be difficult, even if there is a soft landing for house prices and credit growth. Margins are likely to be at least under modest pressure and bad debts, at best, will be a neutral influence.

Cyclical Matters

Morgan Stanley believes a combination of high house prices and high levels of household debt means the prospect of a significant housing downturn has increased.

UBS agrees, as even if banks can effectively use costs and capital levers on a longer term basis this assumes that the credit cycle stays benign long enough for banks to accelerate earnings. The broker considers the risk/return relatively unappealing and, while the short relief rally would not be surprising, remains underweight on the sector.

Macquarie takes a longer term view and continues to envisage value in the banks at current levels, although accepts that the current environment is challenging. System credit growth is still expected to slow and the major banks will probably obtain a smaller piece of a smaller pie.

Should banks deliver around 3% revenue growth growth and maintain costs broadly at current levels, then mid single-digit underlying earnings growth is still considered likely. Furthermore, circa 6% dividend yields and scope for capital returns, in the broker's opinion, underpin an attractive long-term investment thesis.

Another aspect Macquarie considers is that, if non-bank operators provide credit to the riskier end of the market, this should alleviate the pressure on housing and the risk of a sharp correction. In the longer term, the broker observes, this riskier end of credit appears to be shifting away to unregulated players.

Bank Branches

Bank branches are costly to maintain and Bell Potter suggests the major banks need to figure out exactly how many they really need in order to provide services that are economical in a challenged environment.

The broker assesses that reducing branch numbers is the best option to create value for the major banks, particularly ANZ Bank ((ANZ)) and Westpac ((WBC)). The urgency to reduce costs has escalated, amid increasing margin pressure and slowing volume growth.

The broker calculates it costs, on average, $5.5m to operate a major Australian bank branch, although this may be skewed by National Australia Bank's recent accelerated expenditure as well as higher regulatory costs. So, excluding these items, costs may be closer to $5.1m.

ANZ has the fewest number of customers per branch, at 8223 versus 9104 for National Australia Bank, and should be able to close the gap just by reducing the number of branches by -66. The expected cost savings, Bell Potter calculates, would be $337m, or a material 10% of the retail and business banking cost base.

Similarly, Westpac would also have value upside from reducing its branch numbers. Benchmarking Westpac against Commonwealth Bank ((CBA)) indicates, to achieve 12,310 customers per branch, Westpac could lose -181 branches. Again, using Bell Potter's calculations the expected cost savings would be $923m, or a very material 17% of the retail and business banking cost base.

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
ANZ	4/4/0	26.66	29.41	10.61	4.1	0.4	70.1	6.0	2.8	2.0	69.5	6.2
CBA	1/5/2	70.39	73.75	5.83	– 7.0	– 0.6	79.4	6.1	4.8	2.7	77.8	6.3
NAB	6/0/2	26.68	30.78	15.94	– 6.0	0.0	92.3	7.5	10.2	– 3.6	80.7	7.2
WBC	4/3/1	27.78	31.41	13.24	2.0	0.4	77.8	6.8	– 0.5	2.2	79.9	7.0
BEN	0/5/2	10.44	10.84	3.76	– 2.1	2.9	80.8	6.7	– 0.7	1.2	82.4	6.8
SUN	5/2/1	13.72	14.25	3.07	– 5.4	– 2.1	90.0	5.2	23.3	6.7	77.9	5.5
BOQ	1/3/3	10.10	10.67	5.55	– 6.7	3.9	86.7	7.8	– 3.8	– 1.9	88.4	7.7

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms