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Australian Banks: Uncertain Times

Feature Stories | Dec 19 2018

This article was first published on December 5 for subscribers and is now open for general readership.

Bank earnings results met expectations but broker views vary on just how bad things can get from here, with house prices falling and the Royal Commission report still due.

-Recent banks' earnings results unsurprising
-Housing pullback or crash?
-APRA to make it harder still
-RC fallout still unknown

By Greg Peel

Last month’s major bank reporting season provided results largely as expected. Revenue growth was subdued, particularly in retail banking, but business lending growth has strengthened. Short term funding cost pressures over the period, driven by higher US rates, are unlikely to recur, analysts suggest, and these have been offset by mortgage repricing which is supporting net interest margins.

Yet competition for mortgages remains intense and credit growth is slowing.

Results on the bottom line were “lumpy”, on a mix of remediation costs driven by the Royal Commission, divestment of businesses (wealth management/insurance), gains on sale of those divestments, and software update and restructuring costs.

The good news is loan impairments (bad & doubtful debts) remain at low levels. Indeed, as UBS points out, credit impairment charges were the lowest on record since data began being collected in 1980. With low impairments, and slower credit growth, bank balance sheet growth also slowed, leading to a further strengthening of capital positions.

Or is it bad news? UBS notes the banking sector delivered around 7% earnings growth in FY18, taking sector earnings back to 2012 levels. This is despite record low impairments. Profit before provisions for impairments fell to 2010 levels, yet dividends remain at all-time highs.

If impairments are at historical lows, can they go lower, or at least remain low?

In the wider scheme of things, bad debts have been at the low end for several years now. Over that period, bank analysts constantly warned that the only way from here is up, if history is any guide. It hasn’t been. Bad debt levels have simply continued to fall and eventually analysts stopped crying wolf.

However, that all happened before Australian household debt to GDP ratio hit a world-topping 122%, driven by a housing boom in a low mortgage cost environment that has now tipped over. House price falls in November were the sharpest since the GFC. Unemployment is low at 5% but wage growth remains anaemic.

Tighter credit controls forced by APRA mean that investor mortgages – the volumes of which were the key driver of the housing bubble – are in the process of switching over from interest-only to principal-and-interest, implying higher repayments.

Is it likely bad debt levels can remain that low?

The majors have repriced mortgages, meaning raised their variable loan rates for both new and existing mortgages, despite the RBA not raising its cash rate. The reason was the level of capital they need to raise in the US to fund their lending books, and there the central bank is in a tightening phase. Typically, when US rates go up, Australian rates do also. But the RBA cash rate is on hold at 1.5% and still keen for the Aussie dollar to fall. Typically, Australia’s cash rate is above that of the US given a smaller economy comes with a greater risk (even through we’re AAA and the US is only AA). Today the US cash rate is 2.25%.

So the banks have been forced to reprice their lending books to underpin earnings. But how far can they push it before those bad debt numbers are not historically low anymore?

And another thing

In July last year, APRA finally quantified what it meant by the “unquestionably strong” capital positions it will require the “too big to fail” banks to hold. That number is 10.5% of tier one capital by 2020. The long awaited revelation came as a relief as the number was not quite as big as some had feared.

The banks had already been shoring up their capital positions in anticipation, and 10.5% is any easy target. However, APRA has now published a discussion paper on a proposed capital structure for the majors that incorporates “loss absorbency requirements”, consistent with the global trend. The bottom line is APRA is suggesting the banks must also hold 5-6% of tier two instruments.

This means the banks would need to issue subordinated debt. Subordinated debt holders rate behind senior debt holders in the event of wind-up, thus subordinated debt is more risky than senior debt and as a result, more expensive for the banks. Higher coupons need to be offered. Macquarie estimates the majors would have to replace some $80bn of senior debt with sub-debt over the next four years, which would have a -2-4% cumulative impact on earnings.

Analysts are also a little curious as to why a chart in APRA’s paper suggests a tier one ratio requirement of 11% and not 10.5%. Rounding up? Macquarie suspects that while 10.5% is the target, APRA will actually require the banks to hold a buffer above that level, say 11%.

That’s not too much of an issue. ANZ Bank ((ANZ)) and Commonwealth Bank ((CBA)) already have tier one ratios over 11% and Westpac ((WBC)) is not far off. National Bank ((NAB)) is the laggard, suggesting it may need to continue offering a (dilutive) dividend reinvestment plan and/or cut dividends, Macquarie notes.

Citi suggests the banks will not need to raise new equity, but some $100-120m of tier two capital will be required, which is inclusive of the $35bn in tier two instruments already issued which will need to be rolled over.

If the banks are forced to collectively issue some $30bn of sub-debt in each of the four years of the period for compliance, this would be four to five times more than the current rate of sub-debt issue. The question thus is: What will this do to prices?

“This may dramatically alter the supply/demand dynamic,” Citi warns, “and take tier two market pricing into uncharted territory”.

And who is going to line up to invest in such debt in an environment of falling house prices and a potentially deteriorating outlook? Raising the required level of sub-debt may prove difficult, Macquarie suggests.

It is only a discussion paper at this stage, but clearly another impact on earnings capacity looms. Increased funding costs have already driven the banks to reprice mortgages. Will new APRA requirements force another round?

The Outlook

The risk of the current Credit Squeeze in bank lending turning into a Credit Crunch is real and rising, UBS believes, with the housing market now falling sharply. The banking sector is facing a period of “substantial and sustained” earnings pressure which is likely to last several years.

The Credit Squeeze experienced over the last six months is now expanding, with owner-occupier lending now falling alongside investor lending. UBS believes further credit tightening is “almost inevitable” post the Royal Commission final report due next year. The upcoming federal election is likely to reduce credit demand as borrowers contemplate changes to negative gearing and capital gains tax relief.

In the wake of bank reporting season, UBS has downgraded forecasts by -4%. The broker sees not just a house price pullback but a “housing correction” while suggesting consensus views are leaning towards a “muddle through” for the Australian economy. Despite the share price correction the banks have already undergone, UBS remains cautious.

Morgan Stanley notes APRA’s data from September show total housing loan growth was broadly steady at 5.5% year on year, but down from 7% a year ago. Smaller banks saw their loans grow at 8.5% and non-bank lenders at 15%. Growth for the majors eased to a new low of 4%.

Morgan Stanley forecasts 2% for the majors in FY19. The broker believes the impact of interest-only loan restrictions has now played out but emerging to replace that impact is the effect of restrictions on high debt-to-income borrowers and greater scrutiny of income and expenses.

The level of owner-occupier loans is resilient, Morgan Stanley suggests, but investor loan growth has fallen to 3.5% from 8% a year ago. Recent trends are even more stark given the annualised investor growth rate turned negative at all of ANZ, CBA and Westpac in the September quarter. It can only get worse, the broker warns, with house prices falling and the potential for aforementioned changes in government policy.

Is it all doom and gloom?

Citi is not as pessimistic as UBS and Morgan Stanley. Core earnings have been very resilient and asset quality is strong (low bad debts), the broker notes. Capital positions are “unquestionably strong” and dividends are stable.

Citi believes share price underperformance has provided the majors with “much more attractive” valuations given forecast (small) earnings improvements, hence the broker is “more positive” on the sector.

Citi does concede, however, that subdued revenues into the foreseeable future means cost management is now emerging as the key differentiator between the banks.

Despite the modest growth outlook, the sector also appears “highly attractive” to Ord Minnett. The broker cites a forward price/earnings of 11x, a dividend yield of 7% and capital management potential as supporting this view.

Citi and Ords both agree on a preference list between the Big Four, being, in descending order, NAB, ANZ, Westpac, CBA.

While UBS warns of a “credit crunch”, Shaw & Partners notes major changes to bank credit standards for home loans appear to have ended for now. This is consistent with RBA data, the broker points out, that suggest loan-to-value ratios have stopped declining, which should help stabilise house prices.

Shaw also points to RBA data indicating business loan growth is increasing. The most recent set of numbers show annualised monthly growth rates of 4% in June, 7% in July, 10% in August and 8% in September.

Of course the spectre that looms over the banks in terms of their outlook remains the fallout from Royal Commission. Capital has now been stored away in provisions against further required remediation, potential fines and penalties. These are amounts neither bank analysts nor the banks themselves can predict with any level of certainty.

How did it all come to this?

The Death of the Bank Manager

Once upon a time, the local bank manager made prudent and long-term decisions regarding loan applications. Those bank managers have since been replaced by short-term, sales-focused consultants deploying more and more capital into the mortgage product, Deutsche Bank notes.

In the wake of the Royal Commission, Deutsche suggests the major banks are far from broken, but they have sustained a severe, self-inflicted flesh wound requiring significant cultural attention. Management must now muster the courage to change the mindset and behaviour of boards, investors and employees in order to win back the trust of the customer.

Actions will be more important than apologies, Deutsche Bank declares.

The Australian banking industry has over-committed the Australian household to a long future of paying down debt. Yesterday’s bank manager worked on a rule of thumb of lending a household 3x gross income. With this in mind, the long process of UK bank reform post GFC has led to a regulated limit of 15% of mortgages allowed a loan-to-income ratio of greater than 4.5x.

Australia’s average loan-to-income ratio is 6.5x.

At best, Deutsche Bank foresees, mortgage growth will continue to slow as deleveraging works its way through the economy, constraining house prices and discretionary spending.

At worst, the situation could become similar to that of Ireland post-GFC, although Deutsche does not think the percentage of non-performing mortgages could reach the dizzy heights of 25% Ireland suffered for a decade. That said, a zombie-like mortgage book is possible. It is not politically palatable nor logistically easy to foreclose on troubled mortgages, the broker points out.

Not politically palatable? Can you imagine the response if the banks started mass foreclosures on mortgages they wrote and blamed the Royal Commission?

If the banks are stuck with non-performing mortgages, capital may not be immediately available to deploy into a productive recovery in credit demand, Deutsche notes.

And in the longer term, Deustche Bank is not the only broker to note retail banking is now even more susceptible to disruption from the nimble, innovative and more customer-aware Fintech space.

While the banks were highly focused on writing more and more risky mortgages, they were under-lending to the more productive Australian corporate sector over the past decade. This is the one bright light, potentially, to emerge from the present banking predicament. Deutsche Bank sees promising prospects in infrastructure, mining, education health and technology, to name just a handful of industries.

Banks with franchise strength in “classic” corporate and institutional activity appear well-placed. Business lending is more capital intensive but it’s better for the economy than housing market speculation.

Note that between the Big Four, NAB and ANZ lead in business banking over their more retail-focused peers Westpac and CBA.

All up Deutsche Bank expects slowing mortgage growth ahead, offset by improving business lending growth. Bank markets income (proprietary trading) should see some recovery in an environment of higher interest rates, lower liquidity and increased volatility, but this will be constrained by the need for behavioural change. Ongoing tight cost controls and “conduct impost” will have to be balanced against the need to invest for the future.

Bad debts will “revert to the mean” (increase) with “lurking mortgage cycle risk”.

Deutsche Bank lines up with Citi and Ords in having Buy ratings on ANZ and NAB and Sells on Westpac and CBA.


This was the state of play six months ago when the banks reported interim earnings (quarterly for CBA):

With the Royal Commission underway, the prevailing theme was one of uncertainty. Adding up the ratings gave us a 9/20/3 ratio of Buy/Hold/Sell. The heavy weighting to Hold, despite considerable upside to average target prices, underscores that uncertainty.

Fast-forward to now (at yesterday's closing prices):

Upside to target numbers reveal NAB is even more of a standout, ANZ and Westpac are roughly the same while CBA has returned to its familiar position of being overvalued versus peers as far as analysts are concerned. The only certainties in life are death, taxes and the fact CBA will always be relatively “overvalued”.

But despite a net reduction in target, that ratings ratio is now 15/13/4. There are a lot more Buys at this level. Indeed, there are more Buys than anything else, suggesting that despite some doom and gloom predictions outlined above, collectively brokers see value in the sector.

Note that the latter table has now shifted to FY19-20 from FY18-19 in the previous table.

As far as yields on offer are concerned, here NAB is again the standout, despite being the only bank for which analysts forecast negative dividend growth and a notably lower payout ratio than FY18.

We also note that earnings growth forecasts for FY19 have been downgraded for all bar CBA.

Despite the Buy ratings, as I write the financials sector is being hammered once more on macro factors – specifically US banks having fallen heavily last night in the US on yield curve concerns.

Uncertainty is not just local.

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