Feature Stories | Nov 29 2019
This article was first published fro subscribers on November 22 and is now open for general readership.
In the wake of bank reporting season, disappointed brokers cannot see how dividend levels can be sustained given the gale force headwinds blowing in FY20.
-FY19 revenues weak and getting weaker
-FY20 cost guidance worse than forecast
-NIMs under pressure from all sides
-Capital may yet not be sufficient
-Dividends under threat
By Greg Peel
Stop Press: On Wednesday AUSTRAC launched legal proceedings against Westpac for alleged breaches of anti-money laundering regulations. While the news clearly took the market by surprise, it did not surprise Westpac, nor bank analysts who note the bank had identified this contingent liability in its financial statements released this month.
What neither Westpac, nor analysts, at this stage can know is exactly what the level of cost will be. However it is noted that such a contingency was considered in the decision to raise $2.5bn of new capital.
CLSA notes that back in 2017, pre-Royal Commission, a similar suit was launched against CBA which was settled for -$700m. The broker nevertheless points out there are differences between the two, with the CBA case involving fewer transactions but greater amounts related to money laundering/criminal activity whereas for Westpac it is a case of insufficient due diligence on larger amount of small transactions relating to child sex offences.
Not sure how that translates into a dollar amount, but then no one is.
NAB has also set aside a provision for AUSTRAC risk, and provisions for RC-related remediation risk, such as a class action brought by those sold allegedly fraudulent insurance policies, which the bank yesterday settled for -$49.5m.
The point here is yesterday's news was not a bolt out of the blue in either case, and arguably no reason to sell banks down further, but for the risk of ultimate RC and AUSTRAC-related penalties being unknown
With that in mind, be advised that the following article was in the process of being written before that news broke. The news does not nevertheless render the content redundant, rather can be considered as part of "ultimate remediation costs" referred to within.
Back in August, Commonwealth Bank ((CBA)) reported FY19 earnings and all of ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) provided updates to complete a June quarter snapshot of the state of the banking sector. The response from analysts was that earnings results/updates were surprisingly good.
Expectations had, admittedly, been marked down quite low. But there was light at the end of the tunnel. The RBA had at that point made two cash rate cuts, to 1.00%, APRA had eased its mortgage serviceability requirement, and the election win had taken the risks to franking credit cash-backs and negative gearing off the table. Given the global downward trend in rates, Australian bank funding costs had also fallen.
All of the above suggested perhaps a bottom in house prices might be seen, and indeed there were some early positive signs at the time. Analysts were not expecting a return to bubble conditions, just a quiet recovery from the depths. Despite lower house prices, it had become a lot harder, post Royal Commission, to be approved for a loan.
However, it was not all a case of blessed relief following the torrid period of the RC. The fallout was ongoing, and was set to impact heavily on bank costs. At the time the banks were already being forced to update their IT systems to catch up to the twenty-first century, and such investment is expensive. Tougher regulations post-RC meant more money needed to be spent on compliance and risk assessment. And there remained an issue of just how much capital the banks would be required to hold, with APRA now worried about offshore exposures and the RBNZ signalling it, too, would require greater capital buffers.
But the big unknown was just how much the banks would ultimately have to pay out in RC-related remediation. The banks had begun to direct earnings into provisions held to cover whatever that cost may be, but bank analysts were quick to point out ultimately remediation costs were not something they could predict with any level of accuracy.
Three months later, as ANZ, NAB and Westpac released their FY19 earnings results and CBA provided a quarterly update, that amount remains unknown, but what is known is just how much money the banks have decided to put aside. A lot.
The next step for analysts was to determine just how the banks performed in the period on an underlying basis, beyond provision costs. In August the response was "surprisingly good". This time responses included "disappointing" and "poor". "There were no winners," said UBS.
More worryingly, after a shocker of an FY19, is that FY20 is shaping up to be even worse.
Analysts still have no idea what ultimate remediation costs will be. Credit Suisse, for one, is forecasting further provision top-ups, but with the caveat "[We] acknowledge ours, and the market's, ability to accurately forecast this item has been historically poor".
Beyond this obligation, every bank suffered declining revenue in the period. KPMG provides some stats:
-Total operating income down -3.7% (year on year)
-Total profit after tax down -7.8%
-Net interest margin down -8 basis points to 1.94%, marking the first sub-2% result in history
-Cost to income ratio up 210 basis points to 48.7%
-Return on capital down -131 to an average 11.0%
-CET1 capital ratio up 21 basis points to an average 10.79%
The last stat – tier one capital – is the only bright spot, if one could call it that. Never mind the RC, the banks are still under the impact of the GFC, which you may recall happened over ten years ago, which has led APRA to demand "unquestionably strong" capital positions, as well as buffers related to risk-weighted assets and offshore exposures, and the RBNZ is set to announce its own, stringent capital requirements as the cherry on top.
So at a time when the banks are obliged to build up their capital positions, they have also been forced to spend heavily on IT upgrades, and now they have to spend more on regulatory compliance and risk management, and, most damagingly, have to put away funds ahead of as yet unknown levels of RC-related remediation.
The banks were thus forced to act on capital management.
ANZ Bank retained its dividend but cut the franking level to 70% from 100%. Westpac cut its dividend by -15% and announced a $2.5bn capital raising. NAB retained its dividend but announced a partially underwritten dividend reinvestment plan, which is an indirect form of capital raising. CBA only provided a quarterly update, which is not a time capital management changes are made.
Lower dividend payouts and capital raisings reduce shareholder yields. Lower franking reduces grossed up yield.
One is reminded that in the immediate wake of the GFC, all the banks put away large amounts of funds (and raised capital) as provisions against the surge in bad debts that was about to follow as the country went into recession, and further provisions against ongoing uncertainty as life as we know it collapsed around us. None of which happened.
Indeed, so benign did the tide of debt defaults prove to be, as the country did not plunge into recession, the banks decided to give most of the provisions back to shareholders in the form of elevated payout ratios and even special dividends.
Bet they're wishing they hadn't.
Mind the Gap
One saving grace for Australian banks is that interest rates are falling again across the globe, not long after we all assumed (the RBA included) that we'd come out for the GFC downdraught and were returning to economic growth. Globally synchronised economic growth what's more. The US was leading the charge, as the Fed delivered no less than nine rate hikes from the end of 2015 to the end of 2018.
The Fed has since cut three times, while any thought of raising rates in Europe or Japan has since been abandoned. The RBA never got to the point of hiking before it had to start cutting again.
Lower global interest rates provide the opportunity for Australian banks to borrow money at a lower cost. This goes some way to supporting net interest margins (NIM), which is the difference between at what rate the banks pay to borrow and at what rate they choose to lend – the primary driver of bank earnings. But the other primary source of borrowing for the banks is deposits.
Some readers may be too young to remember, but once upon a time the RBA used to occasionally put its cash rate up. This was great for banks, because they could expand their NIMs by putting their mortgage rates up but not putting their deposit rates up by as much, or they could become more competitive by holding back a bit on mortgage rate increases – something politicians never congratulated them for.
When rates are going down, banks can be competitive by passing on all of the RBA rate cut, or increase NIMs by not passing on all of the rate cut and thus prompt politicians into demanding reasons as to why not. The RBA has now cut three times since May, and the banks have on each occasion taken the opportunity to expand their NIMs.
Well actually, they haven't expanded their NIMs, as KPMG's data above notes. Despite the benefit of lower offshore funding costs, all they have managed to do is ward off some of the impact of the deposit side of the equation.
The KPMG data notes NIMs fell to below 2% for the first time. Were the banks to always maintain a fixed NIM gap, and march their deposit/mortgage rates down a full -25 basis points every time the RBA cuts, the lower the cash rate goes, eventually the deposit rate will hit zero. There won't be much demand at zero deposit rates. It's hard enough, in terms of attracting funds, to offer very low deposit rates. So the gap must close.
Term deposit rates are a popular form of investment, particularly for retirees requiring a reliable income stream to live on, whereas otherwise most of us just deposit money into an everyday account that is cleared out by the end of the month, shifting investment funds elsewhere (which may just be the mortgage). Term deposits pay fixed interest rates for the term of the deposit.
So each time there's a rate cut there's a lag. A bank can immediately cut its term deposit rate to new customers, but not on existing deposits, until they expire. There is also a lag the other way, for fixed mortgages, which is a positive for the banks. But so low has demand been for fixed mortgages in recent times, given expectations the RBA would have to, as it has, cut rates, the banks have been forced to lower rates on fixed mortgages to below that of standard variable rate (SVR) mortgages. So no joy there.
Thus bank NIMs have been squeezed this past twelve months and that's before the possibility of yet another rate cut, which consensus has as inevitable before long. The banks can move on the deposit side of their NIM spreads, but with inflation a 1.6%, zero interest or less on a term deposit is hardly appealing. The balance has to come from not passing on all of an RBA cut into mortgage rates, Treasurer be damned, while still attempting to remain competitive on both the mortgage rate and deposit rate sides.
It has long been suggested the Big Four are an oligopoly that thrives from collusion. That's rubbish for the most part. The Big Four compete heavily for deposits and loans — mortgage, business and personal. Whether or not you believe that is by the by. Remember John Symonds? He threw the cat among the pigeons years ago on mortgages, and credit cards.
Today the Big Four are under a greater competitive threat than they've ever known. Never mind from each other. As KPMG notes:
"With the introduction of an Open Banking regime, scaled fintech companies entering from international markets and the launch of a number of new non-bank players, the competitive landscape is set to benefit consumers."
At the expense of the banks.
One problem is the so-called "front-book/back-book spread", which we could call the new mortgage/existing mortgage spread.
We all know that while a bank might publicly announce it is passing on, say, -20 points of the RBA's -25 point rate cut there are actually a whole range of rates the one bank will offer. Specifically, new mortgage customers will be enticed with discounts to the mortgage rates now being paid by those who already have an SVR mortgage.
It's a common scam these days, used by everyone from insurance companies to utilities to cable TV providers – new customers are offered cheaper rates that are not advertised to existing customers unless existing customers actually ring up and complain. Banks can take comfort that the average person really doesn't like to make a fuss, or is intimidated by the concept, or really just could not be bothered to do anything about it. Despite even the government now imploring borrowers to "shop around" for a mortgage rate, Big Four bank customers are notoriously "sticky".
Not to mention the issue of those receiving mortgage approval pre-RC fearing that in a post-RC world they would not have received approval, given far more strict scrutiny, and thus feel it best to just shut up.
The front book/back book spread banks get away with is a source of NIM support. The problem is that spread has been widening, by differing degrees among the banks, and beginning to gain more attention as aforementioned new-style lenders enter the market. This at a time when the Big Banks have suffered severe "brand damage" from the RC.
Analysts suggest the banks simply can't get away with this much longer in today's market. Addressing the spread in the face of competition means even more pressure on NIMs.
So bank earnings are under pressure from rising costs – analysts were surprised at to just what extent costs are forecast by the banks to rise in FY20 – being IT investment and RC compliance, along with remediation costs yet to be determined. At least FY20 should see far lower totals in the "notable" items column relating to remediation provisions given the level of provisions taken in FY19, but as the price action of the past two days attests, the market is not going to feel safe investing in banks until such numbers are confirmed.
Then there are increased capital requirements, coming at a time all of the above is impacting on earnings, and there's NIM pressure brought about by lower RBA rates, with little more room left to move.
And all of the above is before we get to the matter of revenues. In other words, actual demand for bank services.
As noted earlier, in a typical world, banks like interest rate increases, as they provide the opportunity to expand NIMs. Rate decreases go the other way, but there is a balance on the demand side. If rates get too high in a too hot economy, demand for loans will abate. If rates become more attractive in a weak economy, borrowers may feel safe to step in.
But what if the economy is just too weak, and rife with uncertainty? Clearly a historically low cash rate of 0.75% suggest an economy that is too weak, even if it's still, at this point at least, growing. The US-China trade war may not directly impact every Australian household, but there is a flow-on effect into businesses. Similarly Brexit, Hong Kong, Iran sanctions et al seem a world away, but they are forever on the news.
Australia is now famously the world's most indebted economy at the household level. We just saw the bust of the housing bubble – enough to strike fear into a prospective buyer's heart. House prices are now on the move back up again after three rate cuts and various other stimulus measures, but is this encouraging a rebound in mortgage demand? Apparently not.
If global uncertainty is driving restraint from businesses that might otherwise be looking to borrow, recession fear and already elevated debt levels are holding back households even at the lowest interest rates in history. One Catch-22 for banks is that they can't relax loan approval criteria to attract more business – indeed they have to go the other way post-GFC. So while the banks bemoan what little demand there is for loans, they are also turning away many of those who actually want one.
Recent weak retail sales and jobs figures suggest the RBA cuts are not working as they might under more "normal" circumstances, which realistically comes as no surprise to the RBA. Back when RBA rate cuts recommenced from a long held 1.5%, the central bank was already warning the lower you go the less likely the impact.
Households may often be irrational – that's how bubbles occur. But we're not all complete idiots, so when the nightly news screams recession fears as rates fall ever lower, it's time to batten down the hatches. Debt servicing is already a big enough strain on the household budget.
House prices are now on the rise again, but is this enough to rekindle demand and drag bank revenues back out of the mire? Analysts were anticipating a rebound but not a swift return to runaway house prices. Suddenly house prices are running away again, much to analyst surprise, but why? Hong Kong refugees paying cash?
It is widely assumed the RBA will cut again to 0.5%, if not next month at least February next year (which will be the next meeting). The governor has oft declared that there's no point in cutting below 0.5%, rather "unconventional measures" will be required, which implies QE of some nature.
If we're into unconventional measures, we will be staring down a recession. The government is finally starting to wake up to the problem, but most suggest it's a case of too little, too late on the fiscal stimulus front.
The outlook for loan demand and thus bank revenue growth in FY20 remains subdued. To that end, and given all of the issues heretofore outlined, analysts suggest FY20 will be all about the banks desperately trying to hang on to what dividends they are now paying. Analysts are largely agreed more dividend cuts are on the horizon.
Which puts into perspective the greatest element of appeal to the bank investor – yield.
The following table represents the state of play as it was a quarter ago following the August reporting season:
A couple of quick calculations tell us the average forecast yield for FY19 at the time was 5.85%, fully franked, against a net Big Four share price of $163.89. (Note FY1 in this case is the current year, which was FY19, and FY2 was FY20).
Here's the current table (yesterday's closing prices, with FY1 now FY20):
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|WBC||2/4/1||25.16||27.05||8.42||– 14.0||– 8.0||80.6||6.4||2.3||0.5||79.2||6.4|
|ANZ||0/6/1||24.81||26.31||6.36||– 2.7||– 3.6||75.5||6.2||3.1||0.0||73.2||6.2|
|CBA||0/3/4||79.33||73.30||– 7.53||– 0.4||0.0||89.1||5.4||2.7||– 3.0||84.2||5.3|
The average yield is now 6.08%. Yes, despite dividend cuts it's gone up. But the net share price is now $155.63, -5% lower than it was three months ago. And ANZ is only offering 70% franking.
What hasn't change is consensus order of preference among FNArena database brokers. It remains in the order of Westpac, NAB, ANZ, CBA. As always, there are divergent views among brokers, as reflected in each bank's spread of Buys, Holds and Sells. But three months ago there were a total 7 Buys, 13 Holds and 8 Sells, and now three of those Buys have pulled back to Hold for a 4/16/8 ratio.
What perhaps is most notable is if we compare upside to consensus targets. Back then, three of four banks had already overshot their targets and ANZ was close by, while now only perennially overpriced (in analyst opinions) CBA is the only target exceeder, with Westpac streets below.
Yet a prior 7 Buy ratings have now become a mere 4.
Westpac is the most preferred on a consensus basis largely because it bit the bullet and cut its dividend and raised capital. Even with the latest AUSTRAC news, Westpac is least worst placed for the future at this point.
NAB performed better than ANZ and Westpac but announced a partially underwritten DRP, which is a backdoor capital raising and thus earnings/dividend dilutive. Dividend sustainability is under question.
ANZ's main issue is its greater exposure to whatever capital requirements the RBNZ imposes, as the bank's name suggests. With capital under pressure, a dividend cut is increasingly a possibility.
CBA will not reset its dividend or capital positions until February, if at all, and put in the best performance in a bad bunch. But as always, analysts cannot justify CBA's premium over the other three, with a dividend increasingly more difficult to sustain.
The common theme is clear: Stand by for further dividend cuts in FY20.
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