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Australian Banks: New Horizons?

Feature Stories | Jun 03 2019

Thanks to a surprise election win, a surprise APRA announcement and a big hint from the RBA, the skies are suddenly looking a lot brighter for Australia’s banks. But have the fundamentals really changed?

-Banks' earnings results weak as expected
-Election surprise/APRA announcement improve sentiment
-Sector outlook remains challenging
-RBA cut(s) may not help

By Greg Peel

Back in early May, before the federal election, ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) all reported first half results, with Commonwealth Bank ((CBA)) providing a quarterly update. The mood at the time was dark.

It was dark because house prices were collapsing, the fallout from the Royal Commission was ongoing and it looked for all the world that Labor were going to romp home in the election. Were that to have happened, negative gearing for property investors would have been restricted, the capital gains cash discount would have been halved to 25% from 50% and franking credits paid a cash refunds would have been abolished.

The policies were seen as adding further downside fuel to an already tumbling housing market, reducing loan demand and increasing potential mortgage defaults, as well as making banks less attractive to investors – a double whammy.

Long before Scott Morrison called the election, indeed long before Scott Morrison stepped over Turnbull’s corpse, the Australian Prudential Regulatory Authority had sown the seeds of a housing market pullback by introducing stricter lending rules, prompted by Reserve Bank of Australia fears we were seeing a housing bubble that may well burst.

Be careful what you don’t wish for.

Then along came the Royal Commission, following Turnbull’s capitulation to growing public anger. Anger turned into shock and horror. The fallout has been severe, both financially, given the banks and wealth managers are preparing to hand out billions in remediation to, shall we say, “ripped off” customers, and in terms of the the more esoteric notion of “brand damage”.

The RC has forced banks to clean up their acts, cut fees and apply much stricter lending standards, while at the same time discounting loan rates in order to attract at least some new customers. All of which impacts on earnings.

Adapting to a new post-RC regulatory world itself costs money.

So the scene was set for some weak earnings reports from the big banks.

Earnings Results

And weak they were. Not much more than analysts had forecasts, but downgrades to earnings expectations did indeed follow.

Over the prior couple of years the banks have had been granted two separate “excuses” to “re-price” their loan books. Typically banks re-price by not fully passing on RBA rate cuts into loan rates while fully cutting deposit rates, thus increasing their net interest margins (NIM) – the primary driver of bank earnings.

But this time banks were forced to re-price investor mortgages as a result of APRA’s requirement to reduce the proportion of bank mortgages to investors, in order to stymie the housing bubble. And banks later re-priced again due to rising funding costs – a reflection of rising US bond rates back when “synchronised global growth” was the buzzword and Trump’s USA was an economic powerhouse.

So after two shots at mortgage re-pricing, increasing NIMs, the banks should have seen the benefits flow through to revenues in their first half FY19 numbers. They didn’t. “In fact every revenue line item saw pressure,” UBS noted, “with the exception of a bounce in trading”. Financial markets trading profits are seen as volatile and of low quality.

This puts the focus more clearly on costs. At a time revenue growth is flat, banks are being forced to spend more money on keeping up with technology, and on a greater regulatory and compliance burden post-RC. The results also indicated the credit cycle has now turned, with mortgage arrears and corporate delinquencies back on the rise.

The good news is the cycle is turning from very low levels. Actual credit impairment (loan default) charges remain at record lows given banks were able to release funds from provisions against bad debts they have kept for some time, thus insulating the profit impact.

More worrying was the sharp slowdown in business loan growth during the period. Net growth in loans to SME/business customers slowed to zero, with three of the Big Four actually reporting business book shrinkage, UBS notes. On the plus side, institutional banking provided an offset, apparently driven by increased M&A activity and infrastructure investment.

All this leads to expectations of lower earnings ahead. CBA has now re-based its earnings profile, Credit Suisse believes, but the other banks have different degrees of cyclical and structural downgrades to come. Credit Suisse also noted current asset quality (extent of bad and doubtful debts) was “alright”, but is gradually deteriorating.

Adding to weak earnings outlook is pressure on fee income, brought about by a need for banks to cut fees in order both to alleviate some of that aforementioned “brand damage” and also to stave off competition from new non-bank disruptors.

And then there’s “front-to-back book gap” pressure.

In order to attract new loans, the banks have had to discount mortgage rates to new borrowers, while not offering the same discounts to existing borrowers. This has resulted in angry existing borrowers looking to take their loans elsewhere. Part of the “brand damage” stemming from the RC is customers no longer feel a need to be loyal to their bank.

In response, the banks have had to move to match discounts for existing customers, closing the gap between rates on the front book (new loans) and back book (existing loans) that provided at least some earnings buffer.

Finally, while an RBA rate cut will throw up the opportunity for further mortgage re-pricing, the lower the rate the lower the revenue nevertheless. And just how game will the banks be to further anger customers by not passing on the cut in full to mortgages?

The good news is with interest rates now falling again across the globe, leading to lower bank funding costs, offsets to that benefit are being provided by all of the above.

And let us not forget weak bank revenues in the first half is a separate story to the extent of RC-related remediation provisions announced by the banks alongside their operational numbers. Morgan Stanley estimates customer refunds and remediation will cost the banks upward of $7bn by FY21. So far some $5.3bn has been set aside in provisions and Morgan Stanley believes another $1.9bn is yet to come.

The Election

Labor’s shock loss in the federal election has been attributed, outside of coal mine equivocation, to the fear generated by Bill Shorten’s aforementioned negative gearing, capital gains and franking credit refund policies. They would have led, it was believed, to exacerbation of the housing downturn and a significant loss of income for retirees.

The look on Antony Green’s face around 8pm on the Saturday night said it all – Labor had blown it. When the stock market opened on Monday morning bank shares prices immediately shot up. Not only were Labor’s policies no longer a threat but the government had offered no new policies of its own which would upset the status quo, beyond a last minute first home buyers’ (FHB) deposit scheme announcement.

The shock loss will ensure that not only will Labor never deign to go down that policy road ever again; nor will anyone else.

The sharp response in bank share prices reflected only a bounce-back from the assumption Labor would win, as the polls suggested, which had been priced in by the market. The return of the government does not in itself provide bank earnings upside. However, more than one bank analyst believes the real benefit to banks will derive from a return of confidence, and indeed a rekindling of “animal spirits” in the property market.

Beyond the relief of negative gearing being here to stay, the removal of the threat of dividend franking cash refunds means the demand for solid, fully-franked yields will remain robust. And even more so if the RBA does indeed cut rates, taking the alternate retiree income option of term deposit rates into negligible territory.

The lure of bank yields of 6% or more, fully franked, is undeniable. But with a weak outlook for bank earnings, there is always a risk the banks will be forced to cut those dividends.

First, we note NAB already has cut its dividend. Secondly we note all four majors are expected to comfortably reach or exceed APRA’s new “unquestionably strong” tier one capital requirements which come into force next year. Dividend cuts will not be required to reach capital targets. However, there is one spanner in the works.

The Reserve Bank of New Zealand is still contemplating raising its own capital requirements for banks operating in New Zealand, where Australia’s Big Four control the bulk of the market between them, not just ANZ. If anything is to threaten dividend yields, a further step-up in capital requirement could be it. However, Citi is one broker who suggests “dividends will remain sustainable as capital requirements remain low”.

That said, Westpac was seen to have delivered the weakest earnings performance in the first half and with the outlook remaining weak, a targeted payout ratio of 70-75%, down from around 90%, looks increasingly unlikely on earnings growth, which suggests a dividend cut may be inevitable.


The champagne corks were still popping in bank board rooms after the election when another shock announcement rocked the market. APRA was planning to revise its mortgage serviceability requirements.

Back in 2014, a new APRA regulation required mortgage applicants to be assessed on their capacity to service a loan with an interest rate of at least 2.0% above the prevailing standard variable mortgage rate or at least 7.0%, whichever the greater. The “at least” part led to banks setting those rates at either SVR plus 2.25% or a flat 7.25%. Back in 2014 the RBA cash rate was 2.5%.

The well-meant intention here was to avoid borrowers overstretching in a low interest rate environment only to be caught short when interest rates began to rise, leading to default. We recall that up until late last year the RBA was insisting the next move in rates would likely be up.

The cash rate is now 1.5%. The RBA has finally changed its tune. The prevailing SVR rate is currently around 4%, a full 3.25% (or thirteen 25 basis point rate hikes) below the 7.25% serviceability rate. Nevertheless, as late as last January APRA stated the serviceability rules were “permanent”.

Which is why the announcement came as a shock, despite all and sundry recognising that 7.25% now looked a very long way away.

APRA is considering dropping the fixed target of 7% altogether while sticking with the SVR plus target, albeit the “plus” will rise to 2.5% from 2.0%. In other words, a mortgage applicant currently would need only to satisfy serviceability capacity at 6.5%, or maybe 6.75% if banks retain the buffer, instead of 7.25%.

The decision plays right into RBA policy. If APRA did not change the serviceability requirement, a further RBA rate cut would not prevent mortgage applicants being rejected on their incapacity to service at the 7% plus rate, regardless of lower monthly payments. It matters not whether SVR rates fall to 3.75% or 3.5% or even lower, 7% will still have been 7%.

The RBA has been concerned that the lower rates go, the less impact each cut will have. Now that APRA is set to revise its requirements a rate cut does have the potential to open up the housing market to new borrowers.

Macquarie, for one, estimates the changes will increase owner-occupier borrowing capacity by 9%. But the change will not be a panacea for the housing market.

It was investor demand that sent the housing market into bubble territory and it has been the loss of investor demand, due to tightened restrictions, that has burst the bubble. Most investors will not be the beneficiary of APRA rule changes. Macquarie estimates investor borrowing capacity will increase only by 3-6%.

Furthermore, the true beneficiaries of the changes are those who borrow at maximum capacity, and the banks have indicated only around 10% of borrowers do so. And the serviceability requirement is only one measure impacting on borrower capacity. UBS believes debt-to-income restrictions will remain a more binding constraint for highly leveraged borrowers.

And since the RC, banks have been forced to tighten their Household Expenditure Measure (HEM)) assessments with regard borrowing capacity. In short, lenders must now pay closer attention to a borrower’s monthly household expenses in assessing loan serviceability.

Brokers agree a combination of the election victory and the proposed APRA changes go a long way to restoring confidence, and those aforementioned “animal spirts”.

“Upgraders and investors alike may be spurred to increase their loan size still within the increased capacity,” suggests Citi, “bringing more firepower to asset markets”.

“And the prospect of two rate hikes this year could accelerate the uplift in confidence”.

Westpac’s economists now expect three cuts this year. JPMorgan is suggesting four over twelve months.


Back in 2015, then Reserve Bank of Australia governor Glenn Stevens declared “monetary policy alone cannot deliver everything we need and expecting too much from it can lead, in time, to much bigger problems”.

“Monetary policy’s power to summon up more demand with lower interest rates could be less than it used to be”.

The RBA went on to estimate a 1.0% cash rate was as low as one could go before “unconventional tools” would need to be considered.

If current RBA governor Philip Lowe makes good on his big hint that the cash rate will be cut to 1.25% in June, that leaves only one more cut to 1.0%. JPMorgan’s forecast implies 0.5%. Perhaps we can consider APRA’s change of heart akin to an “unconventional tool”. But what Glenn Stevens was really getting at is monetary policy cannot alone save an economy in a low interest rate environment. Support is required from fiscal policy.

Fiscal policy acts as a drag if it’s based on a blind ambition to return the federal budget to surplus.

But just what impact might one or more further RBA rate cuts have on the banks?

Research by Morgan Stanley of rate cuts delivered in 2013, 2015 and 2016 shows the major banks usually outperform the market leading into the first rate cut but then subsequently underperform. The analysts suggest bank outperformance was already evident back in April as consensus expectation shifted towards a May rate cut.

Consensus did not wane when no cut was forthcoming, given the election could have changed the scene substantially and hence the RBA was likely stalling. Expectation then shifted to June, before Philip Lowe all but confirmed that would be the case.

Morgan Stanley calculates that every -25 basis points of rate cut reduces bank margins by -2-3 basis points and earnings by -1.5-2.5%, all things being equal. But the banks can offset margin loss through re-pricing, cutting SVRs by only -10-15 points. However, the analysts believe it will be more difficult, this time, for the banks to cut term deposit and savings account rates by the full -25 basis points.

Thus on balance, Morgan Stanley believes RBA rate cuts in 2019 would put further downward pressure on margins.

Macquarie feels that in the current environment, post-RC, it will be increasingly difficult for the banks to re-price to protect margins.

Mortgage Stress

For several years the banks have enjoyed record low levels of bad and doubtful debts (BDD) on their balance sheets, likely reflective of historically low interest rates, low unemployment and, until recently, rising house prices. With house prices now falling, the first signs of the credit cycle now turning were evident in last month’s bank earnings results, as noted earlier.

Mortgage arrears levels are now rising, along with corporate delinquencies, albeit from low levels.

The banks attributed rising mortgage arrears to an increase in customers switching from interest-only loans to principal-and-interest loans – the result of separate APRA clampdown. Not only do P&I loans imply higher repayments than IO loans, stricter lending standards in response to the RC mean some borrowers are finding it difficult to refinance, Credit Suisse notes, which is also attributing to increasing arrears.

A worrying issue for Macquarie analysts is a lack of clarity on the number of bank mortgages that are now in “negative equity” (money still owed on the mortgage is more than the potential sale price of the house now prices have fallen). Based on RBA data, Macquarie estimates 2.5-3.5% of bank mortgages are now in negative equity.

“These estimates are likely to be understated,” the analysts warn, given ongoing falls in property prices.

Negative equity implies a loan-to-value ratio which now exceeds 100%.

 ANZ Bank has disclosed that 5% of its portfolio now has LVRs in excess of 100%, while NAB and Westpac disclosed only 1.0-1.6%. In Macquarie’s view, ANZ’s approach appears to be more conservative.

While the proportion of loans in negative equity is not particularly an issue in isolation Macquarie concedes (if a mortgage can continue to be serviced then there’s no need to sell), in the event of increased unemployment and economic stress, loans with negative equity will drive banks’ mortgage-related losses.

Museum Attractions?

Recently NAB joined ANZ and CBA in offering ApplePay to their customers. ANZ, which has a smaller retail customer base, moved first, and subsequently gained market share, thus forcing the others to follow.

Initially the banks resisted ApplePay because the bank has to pay a fee to Apple for every credit/debit card transaction. Under Apple’s contract, these fees cannot be charged back to the customer. But now the banks are biting the bullet.

“This pricing structure,” says CLSA, “reflects the reality that the Apple brand is stronger than the brand of any Australian bank”.

The deterioration of bank brands is not confined to Australia, irrespective of the RC. Globally, banks are now manufacturing products for stronger non-bank brands such as Apple, airline credit cards, deposit joint ventures between banks and telcos, and mortgage brokers. “Externalisation” of distribution margins is bad for banks, says CLSA.

The rise of mortgage brokers, price comparison websites, social media, stronger tech-driven financial brands and the ageing of customers who are loyal to one bank branch is also bad for banks, says CLSA.

“The oligopoly pricing of home loans is breaking down”.


It is undeniable that the skies are now looking brighter for Australian banks. But just how much impact will the election win, APRA and RBA rate cuts have?

Moreover, given the sharp rally enjoyed by the banks last week, has that relief already been priced in?

Bell Potter suggests the return of certainty in the political landscape and the fact the banks underperformed in the lead up to the election, including the initial RC impact and subsequent remediation provisions, “some” value has returned, especially for the retail & home loan-oriented banks.

Morgan Stanley doubts the election and RBA rate cuts will meaningfully change the outlook for bank fee income, expenses or capital requirements. What should follow from the election is nevertheless an improvement in the outlook for the housing market and the broader economy, which could drive better home loan growth and lower-for-longer loan losses.

RBA rate cuts will only serve to reduce bank margins.

Morgan Stanley also believes the regional banks will benefit less than the majors given they have failed to gain market share despite tighter lending standards at the majors and negative publicity from the RC. It might be time, the brokers suggests, the regionals rethink their branch strategy. Macquarie Group ((MQG)) has grown mortgage volumes at a rate in excess of 10% yet has no branches.

Morgan Stanley has Underweight ratings on both Bendigo & Adelaide Bank ((BEN)) and Bank of Queensland ((BOQ)).

Credit Suisse believes the election/APRA is likely to remove the majority of tail risks for the sector, but the broker still believes there is a rebasing of revenue required on the back of fee income, given changed community expectations. This was already evident in CBA’s recent announcement, and Credit Suisse expects more such announcements to follow.

Ord Minnett cautions against being too optimistic on the benefits, given demand-side factors and the fact maximum borrowing capacity for Australians is already high compared to many other markets, for a given level of income. Ords does concede, nonetheless, that the outlook does appear to have brightened.

Headwinds including front-to-back-book margin compression, fee pressure and margin pressure from lower rates remain, suggest Macquarie. In this context the broker sees limited upside from current levels, while recognising that in the near term relative share price outperformance may follow from investor repositioning.

In other words, investors who have been shying away from the banks may now step back in, reducing positions in outperforming stocks elsewhere, such as resources.

Macquarie believes downside risk to credit growth has moderated thanks to an improved outlook for the housing market, but notes the majors are bleeding market share. The broker further suggest mortgage re-pricing post an RBA rate cut may not be necessary given the fall in offshore funding rates.

CLSA notes that the swift bounce in bank share prices last week likely is reflective of short-covering. Despite a long period of underperformance, the bounce means the banks are not cheap.

Let CLSA count the ways:

Slowing credit growth, fading margins, normalising financial markets earnings, reduced retail banking fees, higher regulatory costs, rising software amortisation charges and normalising loan loss charges.

A “bleak” capital and dividend outlook, due to the RBNZ’s proposed capital requirement increase and a further increase if APRA adopts the new global total loss-absorbing capacity (TLAC) requirement as proposed.

And finally, low global interest rates. If sustained, recent plunges in two, three and five-year bond rates pose a major margin headwind, and this will only get worse if rates go lower.

For UBS, it’s all about the post-election rally.

UBS believes the downside risk for the banks has been significantly reduced by the election/APRA, but the fundamentals of flat to falling revenue, elevated technology and compliance spend, NZ capital requirements and normalising bad debt impairment charges remain.

The banks rallied to a 14.3x price earnings ratio in the wake and have rarely been able to sustain such multiples for more than a few weeks. UBS remains cautious, seeing limited upside.

As usual, individual banks attract different ratings from different brokers. The current state of play:

FNArena Major Bank Data FY19 Forecasts FY20 Forecasts
Bank B/H/S
Close $
Target $
% Upside
to Target
% Payout
% Div
% Payout
% Div
NAB 4/3/1 26.49 26.60 0.42 – 3.2 – 16.2 79.5 6.3 6.3 – 0.7 74.3 6.2
WBC 2/3/3 27.44 26.99 – 1.65 – 12.7 0.0 91.2 6.9 10.3 0.0 82.7 6.9
CBA 1/4/3 78.51 69.83 – 11.06 – 9.0 0.1 88.7 5.5 5.4 1.8 85.7 5.6
ANZ 0/6/2 27.88 27.83 – 0.17 5.7 0.2 68.4 5.7 – 2.1 1.9 71.2 5.9

The most notable change in this post-earnings results and post-election table from previously is that ANZ Bank has rocketed to the bottom of preferences, despite CBA trading significantly higher than its consensus target as is typically the case. (Note share prices as of Friday’s close.)

Indeed only NAB is yet to surpass its consensus target.

Also standing out is Westpac’s superior forecast yield, but it is the fact the bank’s FY19 payout ratio is also a standout that has brokers warning of a possible dividend cut.

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