Australian Banks: What Now?

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With bank reporting season approaching, and ANZ having already issued a warning, how do brokers assess the situation from here in the wake of the Royal Commission interim report?

-ANZ Bank issues pre-FY18 release profit warning
-Interim RC report asks questions, offers no answers
-Upheaval forthcoming
-How much is priced in?

By Greg Peel

On Monday, ANZ Bank ((ANZ)) issued a profit warning ahead of its full-year earnings result release due October 31. While pre-result profit warnings are common across the market, bank profit warnings are not. But then nor are industry Royal Commissions a common occurrence.

The bank has reduced its profit expectations by -$584m after tax, or about -10%. While part of the amount is related to accelerated software amortisation, the bulk represents Royal Commission fallout – customer compensation costs, associated legal costs, and the cost of restructuring post-RC.

The important point to note is that these are not “known” costs at this stage, merely an estimate.

The charges come as no surprise to bank analysts, although at least one broker suggests they are steeper than might have been assumed. The good news is that ANZ Bank went into the RC with a solid tier one capital ratio, greater than peers. Analysts agree the capital impact of the charges equate to around -10 basis points and this will in no way jeopardise the bank’s capacity to exceed APRA’s “unquestionably strong” capital requirements.

Further good news is there is no need to cut the bank’s dividend, again, but the bad news is a lack of franking credits suggests the dividend cannot be raised from here and the share buyback previously announced will probably have to be reduced, brokers assume.

The question for investors is: Is that it? Can we now start over again from a lower base? Given how far bank share prices have fallen it becomes a matter of whether or not such charges have already been priced in. Brokers assume the other banks will need to follow suit with regard taking on RC-related provisions but any such charges can only be considered pre-emptive at this stage.

Investors should note Westpac ((WBC)) already announced -$235m in extra provisions on the final day of September.

Morgan Stanley notes the quantum of charges taken by ANZ stems from the bank’s reviews to date but these are ongoing. One presumes that given ANZ is due to report earnings in a couple of weeks, it could not do so without including some acknowledgement of just what costs may lie ahead. National Bank ((NAB)) and Westpac report shortly after ANZ and while Commonwealth Bank ((CBA)) reports on a different cycle, a quarterly update will be forthcoming.

The banks need to get the worst of it out there lest no news be considered bad news.

The charges can be considered a work in progress. UBS is one broker who warns this will probably not be the end of it. Estimating customer compensation is very difficult and the tendency is for such costs to escalate over time, the broker notes. We are yet to learn what the ultimate RC fallout will be – what the real cost will be – and on top of that, the banks are now faced with a weakening housing market.

That said, UBS maintains a Neutral rating on the stock, as do Deutsche Bank (Hold) and Morgan Stanley (Equal-weight). Macquarie, Citi and Ord Minnett all maintain Buy or equivalent ratings, while Morgans has in response upgraded to Buy (Add), suggesting the stock has been oversold.

The market, on the other hand, saw it rather differently on the day of ANZ’s warning. The share price fell -2.6% and the other banks suffered similar fates. However, given the market in general suffered what appeared to be a “Sell Australia” hammering of -1.3% on the day, it is unclear whether the profit warning was actually the primary driver.

What we do know is that on the day of the release of the RC interim report, September 28, the bank sector enjoyed a rebound. The report did not pre-empt any recommendations the final report is likely to contain, which investors took as a sign of relief.

For now.

Indeed, the interim report was not about answers, but about questions. Brokers have since attempted to speculate about what might transpire come February when the final report is due (unless the commissioner seeks an extension).

How did it come to this?

If Gordon Gekko has an antithesis, it is Kenneth Hayne. While the commissioner’s interim report runs to over 1000 pages, the underlying theme is that greed is not good.

The misconduct exposed by the RC was driven by “pursuit of short-term profit at the expense of basic standards of honesty,” Hayne asserts. Moreover, such misconduct “either went unpunished or the consequences did not meet the seriousness of what had been done”.

In other words, ASIC fiddled while Rome burned. The final report will have ramifications not just for the banks and other financial institutions but for the regulator as well, which in turn implies further ramifications for the banks and other financial institutions.

But what ramifications? Analysts can only speculate. Indeed, the interim report is itself a rhetorical exercise, outlining the questions the commissioner sees arising from months of shock revelations and pondering just what might be the most appropriate way forward. But while there may have been some relief that the report was more question than answer, it was not only the popular press who bandied about the word “scathing” post release. Bank analysts did too.

Indeed, while no one was expecting a cheery thumbs up from the commissioner, the report is considered more “scathing” than bank analysts themselves had feared.

While the RC investigated a multitude of issues, Bell Potter singled out two main ones: the first being the role of intermediaries in the consumer lending space, with a particular focus on mortgage brokers and aggregators, and their remuneration; and the second being culture and remuneration, especially in financial advice.

Other (stock) brokers agree the RC’s final recommendations are most likely to impact on wealth management businesses and intermediaries (eg mortgage brokers).

One specific target of the final report will be the Household Expenditure Measure used, until recently, by banks to assess loan applications. Citi puts it bluntly: The use of HEM is dead.

The HEM is a benchmark used across the sector to save time in investigating what any given household’s actual expenses and expense commitments are, ahead of assessing whether that household is a viable loan risk. Plug in income, family size, location and lifestyle, and HEM can have a good guess at living expenses, based on averages, beyond those that otherwise must be revealed, such as other loans and credit cards etc.

There is a good deal of responsibility placed on the applicant themselves to reveal that which the bank should know. As recent investigation has found, around a third of loan recipients lie in their applications.

Which should provide a bank with an excuse as it forecloses on a mortgage and casts the bankrupt borrower into the gutter, but as the RC revealed most disturbingly, not only did a lack of sufficient investigation into the capacity of a borrower to repay a loan precede an application, but also a lack of social responsibility, particularly when the vulnerability of the applicant was clear for all to see.

The scrapping of HEM alone suggests a big step-up in costs for the banks if they have to go to much greater lengths to determine what an applicant’s true expenses are, but if I may be permitted to paraphrase the commissioner, “Mate it’s not that hard. Just have a look at their bank statement”.

HEM is just one consideration.

Financial advice, suggests the commissioner, has been driven by a combination of dishonesty, greed and conflicts of interest (promoting self-interest), leading to misconduct. One might respond to this suggestion with “All day ref!” It was Goldman Sachs’ employees credited in the GFC with referring to customers as “muppets”, but such attitudes have prevailed since time immemorial.

On the matter of mortgage broking, and beyond just the brokers themselves, the commissioner suggests remuneration is the issue. Again, and meaning no offence, “Thanks Scoop”. Again looking back to the GFC, we might remember the “NINJA” loans that were prevalent in the US – no income, no job, no assets. For the mortgage broker, no care. Commissions were earned by the broker on writing more and more mortgages required to stack more and more sub-prime collateral debt obligations. The more the merrier.

We can assume that throughout history, the size of a brokers’ commission is adversely proportional to the amount of consideration that broker will give to the viability of the loan.

A final assumption we might make from Hayne’s initial findings, as several brokers point out, is that individual consumers have borne the brunt of such misconduct. The commissioner found issues in the writing of loans to small & medium-sized enterprises (SME) to be relatively minor.

Fewer muppets.

A Brave New World?

In his interim report, the commissioner posed many questions. Morgan Stanley has singled out four that the broker sees as defining:

Are changes in law necessary? How should APRA and ASIC respond to conduct and compliance risk? Should the regulatory architecture change? Is structural change in the industry necessary?

If the interim report itself was full of many questions, it’s nothing compared to the fifty questions the commissioner has put to the banks for which responses are sought soon. Clearly Hayne intends to reach his final conclusions based on the further information he gleans from such a questionnaire. Then, presumably, he will lock himself up over Christmas, better informed, to nut out his final report. The interim ran to over 1000 pages and contained no recommendations.

But what can the RC actually achieve?

“It is easy for investors to read the criticism [within the interim report] and fear the worst,” says Citi, “but we remain sanguine about the consequences as feasible solutions are more difficult”. That said, Citi believes Hayne has “opened the door to draconian changes to dramatically shift the balance back towards the customer”.

Citi analysts were surprised by the severity of Hayne’s critique. He was particularly harsh, they note, on the co-operative regulation model that has existed since the 1997 Wallis Inquiry. Its removal is likely to be the “most radical change” to emerge.

The Wallis Inquiry was commissioned by the then fledgling Howard government in 1996 to assess just how deregulation of the Australian financial industry implemented in the eighties by then Treasurer Paul Keating (who in 1996 was the prime minister Howard knocked off) given technological advances in the interim.

From 2018’s perspective, it’s hard to see the nineties as a period of technological upheaval. But it was the decade in which the mobile phone, the PC/Mac and Windows/OS software began to appear in average households.

As is always the case, technological advance comes first and regulation plays catch-up. The regulatory system in finance was, back then, fragmented and anachronistic. So Wallis came up with a plan.

In 1998, the Australian Prudential Regulatory Authority was established. But APRA was not an omnipotent overseer. Regulatory responsibility for the financial system was still spread around all of APRA, ASIC, the ACCC, the ASX and the RBA.

It is interesting that by association, a recommendation to up-end the Wallis framework is an attack on APRA. But if any institution has been exposed by the RC as having major shortcomings it’s ASIC.

JPMorgan notes that while Haynes’s report was forthright on improvements required to standards, these points largely align with APRA’s own submissions. The broker takes comfort in noting that back in July APRA suggested that the heavy lifting on lending standards had been done (referring to restrictions on investor loans, interest-only loans and so forth that APRA introduced in response the housing bubble, beginning long before the RC), that any tightening from here is expected to be “at the margin”, and that APRA is reluctant to set prescriptive limits on lending standards (as opposed to caps based on bank capital exposure).

So APRA believes it is ahead of the curve. But what of ASIC? That body has been shown up in the RC as being asleep at the wheel, and weak when awake.

JPMorgan expects ASIC to be a “tough corporate cop” from here.

But Citi points out what should be obvious to the Australian electorate. The final recommendations will be broad and a government taskforce will be required to prosecute, reform and redefine business practices over a number of years.

Why are we hearing Sir Humphrey’s voice in our heads? And what happens if there is a change of government, which at this stage seems the most likely outcome, in March – the month after the final report release (assuming no extension)? Do we start again with a more widespread inquiry?

One question raised by Hayne is as to whether the actual laws regarding financial institution conduct need to be changed. Here the commissioner seems to be leading towards “no”. It was not a failure of the law that led to that which was revealed in the RC, it was a failure to adhere to existing law, in the case of financial institutions, and to police that law, in the case of ASIC.

To that end, aside from the likes of ASIC lifting its game, a likely outcome is the recommendation of the establishment of a new, additional regulatory oversight body.

Just like Wallis recommended APRA.

The Fallout

Please note that the analyst reports cited in this article were prepared prior to the general selling the Australian market suffered early this week, including that of the the financials sector.

Macquarie expects the commissioner’s final recommendations to result in higher regulatory and remediation expenses as well as an elevated level of fines. As noted at the beginning of this article, ANZ Bank and Westpac have already begun to pre-empt such costs and others will no doubt follow. The broker expects tighter responsible lending obligations (think back to HEM) to have an impact on the banks’ ability to manage expenses and some impact on their maximum borrowing limits.

The final recommendations are nevertheless more likely to impact the profitability of wealth management businesses and intermediaries, Macquarie suggests, and will also spill over into non-banks and fintechs. We note the major banks have already begun a process of divesting of their wealth management and insurance businesses which had already proven to be more of an earnings burden than a pot of gold for some, long before the RC revealed just how these institutions actually did make their money.

Macquarie believes there is value in the banks, from an investor perspective, at current levels. The sector is trading (as at earlier this month) at a -36% valuation discount to the market compared to a -22% five-year average. However, the analysts recognise that the sector lacks a near term catalyst that would close that valuation gap.

Morgan Stanley takes a more philosophical approach.

ESG (environmental, social and governance) is something brokers often report on and some investors pay close attention to but rarely is it front page news in the financial media. ESG can be used alongside financial metrics as key measures of corporate sustainability, Morgan Stanley notes.

We now have a classic case of ESG being in the foreground. The broker believes investor focus on ESG for Australian banks will continue to increase given developments relating to culture, conduct, compliance, customer and community expectations, accountability and remuneration.

A reduction in bank profitability (bank profit releases are always front page and TV news-leading stories in Australia) may be required over the next few years in order to win back the support of key stakeholders and enhance long term sustainability, Morgan Stanley suggests. The broker sees an increasing probability that practices in relation to home loan re-repricing and front book (new loans) versus back book (existing loans) discounting may need to change, potentially reducing major bank valuations by a further -5%.

In Morgan Stanley’s view, current trading multiples (PE) do not provide sufficient valuation support to offset structural and cycle headwinds to return on equity and growth.

UBS is anything but philosophical.

Positively, the economy remains solid, UBS suggests, supported by an infrastructure boom. But, credit tightening from the RC could be compounded by debt-to-income limits and changes to negative gearing and capital gains tax, reducing borrowing capacity some -30%, and prompting a record-long house price downturn. This could weaken sentiment and demand, raising the risk of a reversal of the household wealth effect and a “credit crunch”.

UBS had long forecast home loans to drop -20% and house prices to fall -5%-plus, dragging mortgage credit to 2% growth year on year, but now the analysts see downside risk of loans sliding -20-30%, prices -5%-10%, and flat credit growth.

The State of Play

The Turnbull government capitulated to popular anger and agreed to the RC in November last year. It began in December. Bank share prices have gone nothing but down, in trend terms, ever since.

ANZ, NAB and Westpac ruled off their books for the half-year at end-March and reported earnings in May, by which point some of the most gruesome details of bank conduct had been revealed. Responding to those earnings reports and accompanying guidance, FNArena’s database brokers provided forecasts and ratings as summarised in the following table:

CBA has reported in between, and beginning at the end of this month, the other three will report full year earnings. Ahead of those releases, this is how the same brokers see the picture now (yesterday’s closing prices):

Having enjoyed a brief bounce through July, the Big Four share prices have (simple average) since fallen -3% since May. The average broker target price has fallen -2%, widening upside to targets.

In May, eight brokers provided, across the four banks, set a total of ten Buy (or equivalent) ratings, eighteen Holds and four Sells. That is now nine/twenty/three, suggesting a minor shift into the centre which likely reflects a balance of de-rating to date against the general unknown that is the pending RC outcome.

Note that 2.5 years ago, ANZ Bank cut its dividend, and to date is the only one of the four to do so. NAB was favourite to be next, but this has not transpired. Dividend yields have edged up in that period but most of the increase was a result of share price falls earlier in the year.

Those yields, fully franked, look very tempting. Who among you is bold enough?

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