Australia | Oct 04 2019
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
As a record low cash rate prevails, amid weak consumer and business sentiment and only muted improvements in housing activity, Australia's major banks are being squeezed mercilessly.
-Banks more cautious about offsetting lost income from rate reductions
-Rise in mortgages does not mitigate the challenges for banks
-Major banks may need to change approaches to capital management
By Eva Brocklehurst
As the Reserve Bank of Australia sends the cash rate to a record low of 0.75%, and the market prices in at least one more cut, the banking sector is increasingly in the spotlight. All the major banks responded to the cut to official rates in October by announcing changes to residential mortgage rates, and all have re-priced investor interest-only loans by more than other lending rates.
Standard variable rates have been reduced in a range of -13-30 basis points in response to the RBA's latest reduction of 25 basis points. Shaw and Partners compares this with cuts in standard variable rates ranging from -43-45 basis points in response to the prior two 25-point reductions to the cash rate.
The banks have clearly become more concerned about their ability to achieve reductions in funding costs in order to offset the lost income. If the RBA continues to cut the cash rate then banks will be confronted with paying less on transaction deposits and that's something they do not want to face, the broker asserts.
If current trends persist, Macquarie deduces there is downside risk to credit growth forecasts. In theory, interest-rate reductions should lift borrowing capacity which, in turn, should be positive for property prices and credit growth.
However, the broker believes APRA's (Australian Prudential Regulatory Authority) requirement to incorporate debt-to-income serviceability limits will become a severe constraint on the banks. The Reserve Bank of New Zealand capital proposals also remain an overhang for the major banks and Macquarie suspects APRA will look to limit capital outflow to New Zealand.
Moreover, the valuation discount in the bank sector of -10%, relative to the long-term average versus the all industrials, only partially incorporates the headwinds, the broker adds.
Weakness is expected in the near term, and without a surge in credit supply Morgan Stanley agrees it is unlikely the banks can fully offset margin headwinds. The broker's earnings model for the financial sector continues to deteriorate as rate reductions occur alongside declines in business and consumer sentiment.
Brokers are on the lookout for any unconventional policy given, Morgan Stanley suggests, that to be effective the RBA is likely to focus on bank funding costs. The broker puts the bank sector at Equal-weight, believing the headwinds from the interest-rate cycle are finely balanced by overall dividend yield attraction. Furthermore, the credit pulse is the swing factor in the bank scenario.
Investor approvals have fallen considerably over the past couple of years, JPMorgan notes, tracking the decline in house prices. This would suggest that lowering investor interest-only rates in isolation would be unlikely to produce a response in demand. However, given the recent uplift in house prices, the changes to mortgage rates (the gap between investor interest-only rates and other products has reduced) could provide some support for investor growth in the future.
UBS counters this argument by noting that a lot of good news has already been priced into the banking sector. A pick-up in housing lending may be positive, as industry data indicates mortgage approvals have risen 10% from the lows, but this does not mitigate the increasing challenges faced by banks.
Even if mortgage approvals re-accelerate to levels experienced at the height of the housing bubble, which UBS considers unlikely, housing credit growth will only grow to around 5.5%.
Moreover, the benefit to bank revenues would be offset by interest margin pressure given the rate reductions required to re-stimulate the housing market to these levels. With ongoing revenue pressure, UBS expects further dividend reductions and banks to re-base their target returns on equity to more realistic levels.
JPMorgan also points out the changes in bank mortgage rates reflect increasingly large inflexible deposit balances, noting Commonwealth Bank ((CBA)) referenced $160bn of deposits for which the full rate reduction could not be passed on.
Morgan Stanley asserts the major banks will need to go further and change their approach to capital management, targeting higher capital levels and lower pay-out ratios. This stems from more onerous capital requirements from both APRA and the RBNZ. Moreover, each of the four are likely to respond differently in terms of dividends, reinvestment plans and buybacks.
For ANZ Bank ((ANZ)), the broker expects a -10% reduction in dividend in FY20 and no buybacks. ANZ appears the most affected by the RBNZ proposals. Morgan Stanley has upgraded its rating to Equal-weight, noting the bank has underperformed other major banks by -5-10% over the past six months. Investor expectations may be low but the challenges are understood and the broker suggests the relative PE (price/earnings) multiple provide some support.
Shaw and Partners points out ANZ's performance in terms of investor loans has been particularly poor and the bank still has the highest investor interest-only mortgage rates, signalling market share in these loans is likely to continue to slide.
Westpac Bank ((WBC)) is likely to cut the dividend by -15% in the second half of FY19 and underwrite the dividend reinvestment plan to raise $2bn in capital, Morgan Stanley asserts, as it has the highest pay-out ratio and a pro forma CET1 ratio of less than 10.5%.
A flat dividend and $2bn in future buybacks (down from $3bn) is forecast for Commonwealth Bank and Morgan Stanley expects the board will look to hold the dividend steady, given a relatively strong capital position.
Morgan Stanley has downgraded its rating for National Australia Bank ((NAB)) to Underweight becomes number four in the order of preference, as the outlook for revenue is deteriorating and further reinvestment is probably required. The broker suspects the bank will continue to use the dividend reinvestment plan to build capital and there is a risk of another dividend reduction in FY20.
NAB has recently announced additional remediation charges of $1.19bn, bringing its overall remediation provision in FY19 to $2bn. Macquarie considers these charges are low-quality items and, while not incorporating them directly in valuation, acknowledges prior conservative estimates have proven to be consistently low. Hence there is the risk of more remediation beyond FY19.
Recognising the capital implications, and the pending impost from RBNZ, the broker increasingly envisages a need for National Australia Bank to lift its CET1 capital, likely via underwritten dividend reinvestment plans. This will make it difficult to grow earnings.
Morgans forecasts a discounted dividend reinvestment plan in respect of the bank's 2019 final dividend and has always suspected that the rally in the share price since the reduction in the dividend in May was unjustified.
UBS assesses it will take some time for National Australia Bank to rebuild confidence but remains encouraged by the new executive team, agreeing nonetheless the outlook is increasingly challenged in an ultra-low interest rate environment, and the earnings risk appears heavily skewed to the downside.
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