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Australian Banks: Navigating The Mine Field

Feature Stories | Sep 11 2019

The Royal Commission has changed the face of Australian banking, the housing market bust has killed loan demand, and ever lower RBA rates are not much helping. Nor are increasing capital requirements.

-Better than expected earnings results
-Ongoing margin pressure
-Falling market share
-More capital headwinds
-The rise of the disruptors

By Greg Peel

Reporting Season

While Commonwealth Bank ((CBA)) was alone among the big three in officially reporting earnings in the August result season just past, the others provided updates to provide a picture of the state of play for Australian banks following a period of substantial upheaval. Upheaval which included the fallout from the Royal Commission, increased regulator scrutiny and capital requirements, the housing market bust and interest rates crashing around the globe.

Despite all of the above, investor sentiment for the major banks has remained relatively upbeat, Bell Potter notes. The analysts suggest this is due to the alignment of some positive factors amongst all the negatives.

The bank’s underlying numbers were actually “surprisingly good”, Bell Potter declares, although this may have a lot to do with market expectations being set very low. The Coalition’s surprise win in the election was a confidence booster, given negative gearing is now untouchable, as are franking credit cash-backs.

APRA’s relaxing of too-tight mortgage serviceability requirements has increased borrowing capacity, and RBA cuts help to relieve potential mortgage stress. While not that helpful for bank margins, the RBA cuts are at least offset by falling offshore rates, meaning lower funding costs.

At the end of the day, who doesn’t love a good yield?

Of Rocks and Hard Places

It looks like the Australian housing market may have turned the corner, which we can attribute to the above list of positive factors. Up until this week bank analysts were cautious about suggesting the bottom has now been seen, and about just what sort of rebound would transpire. There was no expectation of an immediate reinflation of the prior housing bubble.

Then along came this week’s housing finance numbers for July, which left analysts rather shocked at the extent of the spike. It appears loan demand is back.

Average bank loan growth is currently in the range of 2-3%, Shaw & Partners notes. Bank earnings are driven predominantly by the net interest margin (NIM) banks can achieve from the spread from their average rate of funding cost (deposits and borrowings) to their average lending rate. But while a lower RBA cash rate is a positive for loan demand, too low is an issue for NIMs. Banks cannot offer a deposit rate of zero.

The good news is the RBA is not Robinson Crusoe. Around the world, central bank cash rates are dropping like stones. The Fed has cut once this year and is expected to do so again next week. The ECB is expected to cut further into the negative tomorrow night and perhaps even reinstate QE. The Bank of Japan supposedly stands ready.

The further global cash rates fall, the more attractive Australian bank debt (these days predominantly convertible bonds) appear to offshore investors, meaning our banks can offer lower rates to lenders. This provides an offset to the problem of a too-low domestic cash rate.

But the bad news is also stacking up.

Firstly, on the other side of the ledger, bank costs are rising. The majors were already in the process of spending heavily on IT to drag their management systems kicking and screaming into the twenty-first century. Then along came the RC. Now the banks have to spend heavily to be able to satisfy increased and more frequent scrutiny from the regulator. And they have to meet the regulator’s new capital demands, to the extent, Shaw & Partners notes, that required capital growth is exceeding loan growth.

Secondly, not only did the RC result in such regulatory headwinds, it also opened the door to the competition. Let’s just say the RC didn’t go a long way to enhancing the reputation of Australia’s longstanding majors.

Shaw & Partners believes that even if the RBA cash rate goes to zero, it will not necessarily be a poor outcome for the banks. However, investors will be unlikely to enjoy any share price appreciation, just dividends.

UBS remains cautious on the banks, finding it difficult to foresee any upside. UBS has focused on the issue of competition.

Would the last bank customer to leave…

While the slowdown in mortgage approvals since 2017 is well documented, UBS notes (as regulations were tightened and the housing market soon rolled over), the decline in the major banks’ mortgage sales is “stark”. Branch mortgage approvals have fallen by a third since 2015.

The majors currently account for only 37% of mortgage sales, down from 48% in 2013. UBS estimates ANZ Bank’s ((ANZ)) proprietary sales have now fallen to just 4% of all system approvals, down from 9% in FY13. National Bank’s ((NAB)) approvals have fallen to 8% from 13% and Westpac’s ((WBC)) to 9% from 11%.

CBA’s share has surprisingly remained stable at 15%, despite the bank arguably being the Big Bad Wolf of the RC, and even beforehand.

There has not been much in the way of existing mortgage holders shifting to other lenders, nonetheless, probably because their mortgages were approved when assessments were far more lax pre-RC, and they might risk being rejected under post-RC strictness. The majors still control 79% of existing mortgages, known as the “back book”, but competition is heating up for new mortgages, known as the “front book”.

Reputational damage post RC is likely to accelerate this trend, UBS suggests.

With a front book share well below their back book share, the majors’ loan growth is likely to continue to lag the overall system. The banks attempt to prop up their NIMs by not fully passing through further RBA rate cuts to mortgage rates, but any benefit may quickly be eroded, UBS points out, as mortgage brokers find cheaper loans elsewhere for their customers.

Beyond the matter of new loans, that lack of existing loans shifting to new lenders may also turn around if proposed new rules applying a “duty of best interest” upon mortgage brokers has them out finding new and cheaper mortgages for customers, particularly if annual reviews become “best practice”.

If sales out of bank branches continue to diminish, this will put pressure on the majors to rationalise their costly branch footprints. But this may result in a negative feedback loop, UBS warns – who wants to borrow from a bank which has no nearby branch?

UBS goes as far as to ponder whether the majors may simply become mortgage underwriters to the competition rather than mortgage distributors themselves. If so, this could drive bank return on equity towards their cost of capital.

All up, sufficient reason for UBS to remain “cautious”.

And loan growth is just part of the problem.

Australia v. New Zealand

Hanging over the heads of Australia’s majors in recent months has been an intention by the Reserve Bank of New Zealand to increase the capital requirements of banks operating in the country, that is the level of capital banks assign to their New Zealand operations. Australia’s banks have already been hit by APRA’s new “unquestionably strong” capital requirements, and just when they thought they were now safely on target, along come the Kiwis.

All four majors have operations in NZ, but one is substantially more exposed than the other three. They don’t call it the Australian & New Zealand Banking Group for nothing.

The RBNZ has yet to make up its mind about exactly what that capital requirement should be, but the decision became a lot more complicated last month when APRA countered with a new rule for Australian banks (as of January 2021).

Since the GFC, APRA has been concerned that given today’s global banking system is so intertwined, chaos theory can come into play. The collapse of one small operation somewhere in the world can potentially trigger a chain reaction across the entire global banking system, and a subsequent financial collapse. This is what we saw in 2007-08. What started as an initially trivial scare in the US sub-prime mortgage market led to the US government having to step in and bail out the US banking system with taxpayer funds. JPMorgan was forced to acquire Bear Stearns. Bank of America was forced to acquire Merrill Lynch.

Lehman Bros was left to the wolves.

The problem for APRA is it has little to no control over banking jurisdictions outside of Australia, and thus would be unable to prevent another round of GFC contagion reaching these shores. The regulator now wants Australian banks to regularly update on “step-in” risk – the risk it (or RBA or government) may have to “step in” to stop an Australian bank going under.

The only way APRA can retain some control over that which it has no control – foreign subsidiaries – is to limit the amount of capital Australian banks can commit to foreign subsidiaries as a percentage of total capital. Call it a “buffer”.

Do you see where this is going? APRA is in the gold jersey running left to right. The RBNZ is in the black jersey running right to left.

From the beginning of 2021, Australian banks will only be permitted to commit 25% of tier one capital offshore, down from 50% today. It now matters not what requirement the RBNZ may desire.

Australia & New Zealand

Last month ANZ Bank sold its 55% stake in a banking joint venture in Cambodia. Just as well. The sale was in line with an intention to simplify the bank’s Asian exposure down to fully-owned operations only. ANZ has a presence in 14 different jurisdictions in the region. Of those, 13 are insignificant as far as APRA is concerned.

As the Citi bank analysts see it, ANZ is the largest Australian bank in NZ, with the largest problem and the least number of solutions. The other three are less exposed so the APRA/RBNZ conflict is not so much in play. The issue for ANZ is one of the RBNZ’s new capital requirement exceeding the 25% of offshore allocation APRA will allow.

It will likely end up a problem for the RBNZ, which may simply have to come up with a concessionary solution.

Meanwhile, all four banks will need to act to meet RBNZ’s proposed levels. Citi suggests this can be done by, among other things, repricing NZ loans by an average 35 basis points and cutting NZ dividend payout ratios to 35% from 80%. There is scope to absorb much of the capital at group level, the analysts believe, but lower dividends back from NZ will keep Australia-only capital ratios tighter than the banks had previously assumed in their progress towards “unquestionably strong”.

As ANZ Bank attempts to reduce its offshore exposure to 25%, any material capital return for shareholders will likely result in a breach. Hence Citi believes a buyback has now been scuttled. CBA has enough headroom to continue with capital management.

Westpac is the one bank for which analysts in general believe the dividend payout ratio is already unsustainably elevated. So before the NZ factor, this ratio is under question. Citi believes it will not be NZ capital requirements that force a cut to the ratio, but rather bad debts.

Bank dividend levels will be under pressure if credit stress – which has been historically low ever since the initial GFC wash-out – returns to haunt. The good news is RBA cuts, and more to come, along with a housing market that appears to be on the mend and still relatively low unemployment, reduce the likelihood of a spike in credit stress.

That said, Australian households are mortgaged up to their eyeballs at historically low rates. A recession would not be helpful right now.

Bad Advice

It is not only customers who have been abandoning the majors. So too have banks’ wealth management advisors, post-RC. And in this instance the Big Four becomes the Big Six – we can include AMP ((AMP)) and IOOF Holdings ((IFL)).

924 financial advisors left the wealth management businesses of the Big Six over the three months to end-August. This record exodus has occurred, Bell Potter notes, despite the Big Six already having seen their advisor base reduce in recent years, from 39% of the sector in October 2016 to 28% last month.

FY19 was the “year of shock” for wealth management, thanks to the Royal Commission and the subsequent sudden rush to reduce fee levels the RC had exposed as being bordering on criminal. Bell Potter believes the shift in the sector will be on “in earnest” in FY20.

This is all the major banks need – a loss of fee income alongside a loss of NIM income. The RC sparked an immediate cascade of lower fees as the rush was on to retain customers. If the RC did nothing else, it thrust previously little known wealth management “disruptors” into the spotlight. Those who already exist in the New World and who inhabit cyberspace rather than operating an expensive network of branches.

The good news for the shareholders of the major banks is the banks have already responded to the inevitable. Westpac is in the process of exiting the financial advice industry. CBA is largely on its way out. ANZ Bank is in the process of selling most of its business to IOOF.

Thus IOOF has gone the other way, and to boot has also finalised a purchase of Bendigo & Adelaide Bank’s ((BEN)) adviser network. The offset is nevertheless a divestment of around 300 advisers from its Ord Minnett network.

Any loyalty the likes of AMP and IOOF once enjoyed has now evaporated, not just from customers but from advisors. This is feeding an industry shift to independence, playing right into the hands of the fledgling independent platform space.

AMP and IOOF are now in the midst of a multi-year reform process. Bell Potter sees AMP as further into the process, having set aside “meaningful” provisions against the RC-fallout and set about rebasing its pricing. IOOF has taken an initial step towards provisions, but there will be more to come, the analysts warn.

Suffice to say Bell Potter has Sell ratings on both. On the flipside, the broker has Buy ratings on the independent upstarts Netwealth Group ((NWL)), Praemium ((PPS)) and OneVue Holdings ((OVH)).

Bell Potter is not one of the seven brokers in the FNArena broker database. As far as the banks are concerned, the database brokers line up their ratings and consensus forecasts as such:

FNArena Major Bank Data FY1 Forecasts FY2 Forecasts
Bank B/H/S
Close $
Target $
% Upside
to Target
% Payout
% Div
% Payout
% Div
WBC 3/3/1 28.85 28.78 – 1.17 – 13.5 – 1.8 90.4 6.3 8.7 – 1.8 81.7 6.2
NAB 3/3/1 28.03 26.93 – 5.45 – 5.0 – 16.2 81.1 5.8 5.3 0.4 77.3 5.9
ANZ 1/4/2 27.20 27.69 1.67 4.5 0.2 69.2 5.9 – 6.3 0.4 74.1 5.9
CBA 0/3/4 79.81 72.44 – 9.33 0.9 0.0 87.9 5.4 3.4 – 2.0 83.4 5.3

Between them, the seven brokers can only scrape together seven Buy ratings across the Big Four, against eight Sells. Thirteen Hold ratings suggest a balance of the pros, such as yield, and cons, such as, well, just about everything else.

The table has a familiar look to it, if several years of FNArena’s tabulation are anything to go by. CBA is perennially considered to be overvalued (trading 9% above consensus target), yet perennially remains that way, because apparently size does matter. The more recent outperformer within the sector has been NAB, which still commands three Buy ratings to CBA’s none despite being 5.5% above consensus target.

ANZ, NAB and Westpac all close their books at the end of this month, and report in November. In between we are expected to see one more RBA rate cut. Maybe even two.

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