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Bank Recovery Likely To Be Drawn Out

Australia | Sep 15 2020

This story features BENDIGO & ADELAIDE BANK LIMITED, and other companies. For more info SHARE ANALYSIS: BEN

The current state of the economy suggests a recovery for Australia's banks is likely to be a drawn-out affair, featuring margin headwinds, weak credit growth and elevated costs.

-Bank valuation still “reasonable” compared with historical downturns
-Large increases in household savings, expenditure below long-run averages
-Risk to the downside until more clarity on credit quality, dividends, capital

 

By Eva Brocklehurst

While the current state of the economy appears manageable for Australia's banks, a recovery is likely to be drawn out. Asset quality is dominating discussions and margins are under pressure amid subdued credit growth and elevated costs.

Yet JPMorgan finds asset quality trends actually hard to ascertain, given the subjectivity of bank provisioning and vastly different reporting of arrears, credit risk and loan loss charges. Still, in an international context, Australia's major banks appear relatively attractive, CLSA asserts, given their income perspective compared to the rest of the market and bond yields.

Regional banks continue to be challenged, nevertheless, and the broker points out both Bendigo & Adelaide Bank ((BEN)) and Bank of Queensland ((BOQ)) are trading close to long-term averages. Valuations appear reasonable among the major banks when compared with historical downturns and CLSA prefers National Australia Bank ((NAB)) and ANZ Bank ((ANZ)) over Westpac ((WBC)) and Commonwealth Bank ((CBA)).

While NAB's provision coverage is at the low end of peers, its capital position is strong. Meanwhile, ANZ offers greater leverage to an improving economy as and when asset quality concerns subside. Bank stocks appear too cheap to short, JP Morgan asserts, as most are trading below book value, and greater macro certainty is required in order for stocks to re-rate meaningfully higher.

Recent guidance from APRA (Australian Prudential Regulatory Authority) provides some clarity on what investors can expect in terms of dividends. Still, a re-emergence of dividends, while helpful, is not enough in JP Morgan's view.

Morgan Stanley believes ANZ will show the strongest recovery in dividends over the next two years, although assumes major bank dividends in FY22 will still be at an average of -25% below pre-pandemic levels.

On the other side of the ledger, CLSA, while acknowledging it deserves a premium, believes CBA is too stretched and there is more leverage from an improving economy in the other banks. The broker assesses Westpac continues to face underlying earnings pressure and there is uncertainty surrounding the matters raised by the Australian financial intelligence agency, AUSTRAC.

Asset Sales

Morgan Stanley agrees Westpac appears to have the smallest margin for error on capital but notes a preference to sell assets in its specialist division. CEO Peter King has indicated there is plenty of interest in these assets although a sale process is likely to take time.

Citi agrees that asset sales hold the key for Westpac, analysising a potential sale of Westpac's BT business. Westpac is the laggard in offloading of wealth management, a process undertaken by the major banks over recent years.

The complete exit by other major banks has represented sound strategy and execution but the broker believes the implications for Westpac are mixed. BT remains the “jewel in the crown” of those assets that are still in bank hands.

BT is number two in Australia terms of funds under administration. Moreover, there are options available to improve, such as shutting down and migrating Asgard, along with synergies from combining with any platform that is below it in terms of industry structure.

There is also the issue of whether Westpac could sell the whole business. It is not straightforward for a buyer to find what Citi calculates could be a $3bn price tag. Hence, the strategic value of BT is growing in terms of its scarcity value.

Westpac remains the broker's top pick in the sector, given the quality of its book, potential long-term returns and the feasible asset sales that can unlock capital.

Loans

The state of the economy will be the biggest driver of the outlook for loans. CLSA notes the banks all have slightly different definitions of deferral arrangements. Still, the majority have experienced a greater proportion of home loan deferrals from Victoria and, unsurprisingly, fewer in Queensland.

Major bank deferred loans range across 7-12% of balances for home loans and 14-16% of balances for business loans. The most affected sectors for the latter are those in consumer and property-related industries.

The next date of significance comes at the end of September when the initial six-month deferral period ends. The banks will then find out whether deferred customers are able to move to some form of repayment.

Morgan Stanley notes ANZ and CBA are winning share in mortgages while growth rates at NAB and Westpac have bounced around. Bendigo & Adelaide and Macquarie Group ((MQG)) continue to win share in the mortgage market, growing at double-digit annualised rates.

Meanwhile, there has been a large increase in savings, with household deposits up 3% in July, month on month. Expenditure intentions remain well below the long-run average and the national savings rate was up to 20% in the June quarter, from 6% in the March quarter. This also likely reflects a significant one-time boost to cash flow from superannuation withdrawals.

Morgan Stanley highlights deposit growth is less beneficial for the banks when interest rates are low and loan growth is subdued. The recent reporting season suggests there will be further headwinds in this regard and higher liquidity has reduced margins by more than -5 basis points in the June quarter. Meanwhile, the decline in lending to corporates continues.

However, JPMorgan notes spreads on savings products and term deposits have improved over the last three months and this should provide a meaningful tailwind for major bank interest margins. It remains to be seen whether management commentaries, which pointed to pressures from competition and low rates during the August reporting period, are overly conservative.

The broker's top pick remains NAB, although its position on small-medium enterprises (SMEs) feels like "right place at the wrong time". In the longer term, JPMorgan believes the bank's status as a lender to SMEs will be the positive differentiator that will allow revenue to outperform peers.

CET1

CLSA expects FY21 CET1 ratios to be weaker across the sector, with the exception of CBA, because of the benefits from divestments. This in turn reflects expectations that bad debts will remain elevated.

Major banks should be able to accommodate this scenario, and the ratios are still envisaged on average at around 10.9% by the end of FY22. Beyond the current crisis, banks are expected to face headwinds to revenue which justifies them still trading at a discount to historical averages, CLSA concludes.

Morgan Stanley continues to assume there will be no more capital raisings from the banks and that CET1 ratios will remain above 10.5%. Nevertheless, the potential for lower profitability and higher risk weight density creates uncertainty about the outlook for capital.

While estimating higher risk weight density is likely to have a negative -120 basis points impact on ratios over the next 2-3 years, the impact is diffused, the broker assumes, as the regulator has provided temporary relief for loans, allowing deferred payments or restructured loans.

Moreover, APRA has indicated it would be comfortable with CET1 ratios dropping below 10.5%, if this is needed to absorb the impact of stress. Morgan Stanley asserts the risk for banks is to the downside until there is more certainty on credit quality, capital requirements and dividend pay-out ratios, considered unlikely before 2021.

Negative Rates

Amid increased discussion around negative interest rates, Credit Suisse notes the Reserve Bank of New Zealand  has asked its banks to examine the ability to cope with zero or negative rates, although the Reserve Bank of Australia continues to view negative interest rates as highly unlikely.

In New Zealand, Australia's major banks are still the largest operators. The NZ operations of ANZ and NAB contribute around 20% to group earnings while the other two major banks take a smaller contribution.

The broker describes a negative interest rate, in its simplest form, as a tax on reserves held with the central bank which impacts the profitability of the bank. Negative rates are used to influence the short-term wholesale money market rates.

However, the transmission mechanism is uncertain, as banks would be reluctant to charge a negative interest-rate on deposits, particularly retail. It would also impact the willingness of the bank to lend, as deposits would be switched to cash and therefore affect funding. Net interest income was a driver of 81% of Australian bank revenue in FY19. Moreover, deposits are the main sources of funding for banks and also one of the cheapest.

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CHARTS

ANZ BEN BOQ CBA MQG NAB WBC

For more info SHARE ANALYSIS: ANZ - ANZ GROUP HOLDINGS LIMITED

For more info SHARE ANALYSIS: BEN - BENDIGO & ADELAIDE BANK LIMITED

For more info SHARE ANALYSIS: BOQ - BANK OF QUEENSLAND LIMITED

For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA

For more info SHARE ANALYSIS: MQG - MACQUARIE GROUP LIMITED

For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED

For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION