Australian Banks: Back To The Future

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The Treasurer has re-eased bank lending restrictions recently tightened as a result of the Royal Commission, in order to stimulate the economy. Will it work?

-Royal Commission reversed
-Borrowers still telling fibs
-Will the plan work?
-Negative rates, perhaps

By Greg Peel

It is a truth universally acknowledged that banks lend money too freely at the top of an economic cycle and not freely enough at the bottom. When things look good, they’ll hand it out to anyone. When things look bad, they keep it for themselves.

It’s counter-cycle impact that’s been going on for years, decades, centuries…probably back to the benches (bancs) set up in Italian piazzas in the fourteenth century, and it only exacerbates economic boom and bust. As each decade brings a new generation of CEOs, history repeats.

It repeated most recently in Australia as the result of the housing bubble, which was aided by profligate bank lending, and led the RBA to encourage APRA to tighten lending restrictions to ward off an inevitable bust. When APRA first tightened the screws on risky mortgage and investor loans, nothing happened. So APRA tightened them again.

It worked. By the second half of last year the RBA was back in rate-cutting mode, looking to ward off a housing crisis-led recession.

In between was the Banking Royal Commission, initially established to investigate issues regarding exorbitant fees, redundant insurance policies and other tricks of the trade aimed at customers alive or dead. But when the rock was lifted, the country was shocked by what else was found.

One element the Commissioner recommended should be swiftly resolved was a very lax approach by the lenders to assessing the servicing capacity of the borrowers. For the most part this involved no fact checking at all with regard a prospective borrower’s other financial commitments. Too much time, too much effort, too costly.

The result was a “lender beware” approach applied in the National Consumer Credit Protection Act, placing the responsibility on the banks to confirm a borrower’s servicing capacity rather than taking a borrower on their word.

Then along came covid. No longer need we worry that the housing crisis might lead to a recession. Having already become “aware”, now the banks became “wary” about whom they might lend money to. Here we were, back at the bottom of the economic cycle, and once again banks were clamming up.

Which was making things difficult for a Treasurer who was having nightmares about ranks of militant “Back in Black” coffee cups invading his bedroom. While not even Labor was prepared to blame the government for the virus, and did not stand in the way of swift and substantial fiscal stimulus that killed off any idea of a surplus (this is not America), clearly Josh did not want his name forever associated with the biggest budget deficit in Australian history at a stage when more stimulus is still undeniably needed.

It was not helping that while the government had to date done the right thing, and the RBA had done its best up to the point of pleading for the government to do more, shell-shocked consumers and businesses simply were not coming to the party on everything from credit cards to business loans. The Australian savings rate has soared, and corporate capex plans have been shelved as fast as dividends have been suspended.

Even if consumers and businesses were prepared to take the risk and borrow at this uncertain time, the banks were not about to lend any money without the closest of scrutiny.

And even before the banks were forced to put away significant provisions for anticipated virus-related loan losses, they had to put aside significant provisions for anticipated RC-related remediation and fines. Moreover, they had to spend a lot more in terms of “cost of doing business” in complying to the “lender beware” requirement. And now the cash rate is as good as zero, so earnings capacity is all but zero too.

Fearing the government would be stuck topping up fiscal stimulus into the distant future, the Treasurer saw an opportunity – let the banks provide the stimulus. But to do this, the banks had to be encouraged to lend. How?

Throw out the RC recommendations.

Okay, the RC has not now been rendered a complete waste of time, and the banks know they will still be under close regulatory scrutiny (APRA regulations still stand), but under Josh’s new rules the responsibility of determining a borrower’s loan servicing capacity is now back in the hands of the borrower and not the bank.

It will be the “borrower’s responsibility” to, in a nutshell, tell the truth.

This will reduce banks costs, and open the door for growth in lending, and thus earnings. The question now is: will it work?

Pros & Cons

The market thought so, at least on Monday in response to the Treasurer’s announcement. The financial sector rose 3.7%. It’s been giving that back ever since, but this does not necessarily imply a change of heart, rather other macro issues.

Morgan Stanley has weighed up the new order, and sees both pros and cons in terms of bank earnings.

Firstly, the loan approval process will be sped up. The onus is now back on the borrower to provide requisite information which the bank can take as gospel, unless there is good reason to be suspicious. The bank does not itself have to undertake extensive verification. Faster loan process times will be a positive for both borrowers and mortgage brokers, notes Morgan Stanley, and some of the cost of mortgage origination will be removed, which is incrementally positive for the banks.

Secondly, harping back to the Royal Commission, the risk of litigation against the banks for lax loan scrutiny will be reduced. However, this was only one aspect of the RC findings, with resultant remediation and fines relating more to poor financial advice, financial crime and the over-charging of fees, Morgan Stanley points out, and those aspects are still being watched.

On the other hand, the Treasurer highlighted in his announcement that the new rules will “reduce barriers to switching between credit providers, encouraging consumers to seek out a better deal”. This is not good for banks.

Australian bank customers are notoriously “sticky”, preferring to stay with the bank they’ve been with for some time rather than go shopping for a better deal. This could be put down to “too much effort”, “couldn’t be bothered”, “don’t have the time”, “don’t like to make a fuss” or “don’t understand it all anyway”. But now the Treasurer is giving consumers a nudge.

If consumers respond, the banks are at risk of net interest margin erosion (the spread between deposit rate and lending rate) as they lose their “front-book/back-book” advantage.

The “front book” consists of new loans, the “back book” refers to existing loans. Competition demands the banks must offer an attractive deal to potential new borrowers, but unless they kick up a fuss, existing borrowers do not enjoy the same offer. New mortgages are set at lower rates to old mortgages. This spread is even more important today than when it was when bank analysts first started highlighting the risk that banks would not be able to hang on to what was increasingly a yawning gap of a front/back spread.

For today, the cash rate is 0.25% (and tipped to go to 0.1%) but the banks cannot drop their deposit rates to zero or lower, lest they lose all their deposits. Competition forces banks to offer lower mortgage rates, which reduces the net interest margin from which bank earnings are mostly derived.

Margin pressure is already bad enough, Morgan Stanley notes, without everyone shopping around for a better deal.

Finally, and most importantly, will the banks now rush out in the Days of Covid with bags of cash, throwing it around with gay abandon, just because the Treasurer says they can? We don’t need Morgan Stanley to suggest this is unlikely, as high debt-to-income ratios for borrowers and high loan-to-value ratios on mortgages are more of a risk now than arguably any recession in memory.

And on that basis, a little aside…

The more things change…

The RC placed the onus squarely back on the banks to determine if a prospective borrower was telling complete porkies or not with regard to financial income and obligations. When UBS six years ago first started surveying Australians who took out a mortgage within the year, a disturbing number admitted, under a cloak of anonymity, that their mortgage application had not been “completely factual and accurate”.

And that’s just the ones who were prepared to anonymously admit it.

Of course, the RC changed all that. At least, according to data since provided by the banks and by APRA. Not, however, according to the UBS survey.

The issue is that of the “front book”. New home buyers are more likely to be younger and more highly leveraged than existing mortgage holders in the “back book”. And yet again, this year’s survey found 37% of respondents admitted their mortgage application was not completely truthful. More concerning, albeit not so surprising, was that credit quality of the “liars” was significantly weaker than that of the truthful customers.

UBS found of those “liars” between them have seen a -13% fall in household income as a result of the virus, 36% have deferred their payments, 66% have a household member on JobKeeper/Seeker and 71% have withdrawn super.

Aside from JobKeeper/Seeker payments now notching down, six month deferral periods offered by the banks are now coming to an end. UBS found 47% of those with deferred payments intend to revert to normal payments, 32% intend to start paying again but on an interest-only basis, and 21% intend to ask for an extended deferral.

The banks have indicated that extended deferrals will only be granted to customers who can prove hardship. Oh what a tangled web we weave. Will “hardship” include “I lied to you the first time”?

Drilling down further into the 21% intending to request a deferral, UBS found 40% had overstated their income in their mortgage application (by 21% on average), 15% understated their other debts, 67% are on JobKeeper and 25% are on JobSeeker. On average this group has seen their income fall by -19% since the virus hit, not counting their initial overstatement.

The story for those requesting interest-only loans is a better one, UBS notes, but not by much.

So…just how keen are the banks going to be to lend to all and sundry while totally relying on what the customer declares, and not verifying? The banks may well be able to blame Pinocchio, but he’ll still lose them money.

More importantly, these astonishing survey findings have led UBS to suggest many of these deceitful customers should be considered delinquent, which in theory should imply increased bad loan provisions (reducing dividend capacity).

What is the upside?

Having weighed up the pros and cons, Morgan Stanley suggests that given the challenging revenue outlook faced by the banks in a low growth/low rate environment, any measures which lead to stronger loan growth could improve their investment case.

All else equal, the broker’s major bank valuations would increase by 4-6% if an extra 2% per annum in housing loan growth for the next five years is assumed. That breaks down as 4% for ANZ Bank ((ANZ)), 6% for Commonwealth Bank ((CBA)), 5% for National Bank ((NAB)) and 6% for Westpac ((WBC)).

JPMorgan agrees the Treasurer’s changes are likely positive for loan growth, but admits it’s hard to say by how much. Morgan Stanley applies a caveat of “all else equal”. JPMorgan bases its forecasts on several assumptions.

Using FY20 earnings as a base, and assuming a 1.75% net interest margin on home loans, JPMorgan estimates that every 1 percentage point of additional home loan growth adds around 0.8% on average to a major bank cash profit.

Westpac is most sensitive, the broker suggests, given its large home loan book and lower profitability versus CBA. ANZ is least exposed given its smaller home loan book. One could argue, JPMorgan suggests, the banks that have struggled the most on mortgage processing recently, being ANZ and Westpac, may stand to gain relative to the likes of CBA and Macquarie Group ((MQG)), which have managed the demands of customer due diligence more effectively.

You can lead a horse to water…

The Treasurer’s attempt at backdoor fiscal stimulus aside, this week has still been dominated by ongoing speculation as to what the RBA might yet do. Late last week Westpac chief economist Bill Evans was convinced the central bank would cut its cash rate from an historically low 0.25% to a mere 0.10% at next week’s board meeting, only to this week shift that assumption out to November.

In a brief note, Evans declared the RBA is now likely to defer its policy changes to November 3 to give the government "clear air" to sell its budget, due to be delivered on Tuesday night after the board announces any policy decision earlier in the day.

It would seem fair to the government, given the work that must have gone into the final budget make-up. Evans made no mention of the Treasurer’s new lending rules with regard the RBA’s thinking.

To date the RBA has not adopted QE (buying government bonds) as an unconventional policy measure to accompany a 0.25% cash rate, rather it has adopted “yield curve control” by targeting a three-year bond rate of 0.25% to match the cash rate. This has been achieved through the Term Financing Facility, the purpose of which is to “set” a low, 0.25% three-year borrowing cost for businesses via banks accessing central bank funding.

The reality of central bank targets is they are just that. The RBA may not have to actually do anything to maintain the target because the market will adjust, on the assumption the RBA will enter the market if necessary. Having said that, Citi has made some interesting observations about the cash rate.

If the cash rate rises notably above/falls below the target cash rate the central bank will inject/withdraw cash from the overnight market to bring the rate into line. The current target is 0.25%, but Citi notes that since April the average overnight cash rate has been 0.13%.

This suggests the RBA is letting the cash rate drop lower anyway, which implies a cash rate cut to 0.10% is redundant, other than to perhaps spark up sentiment.

What’s more, while the RBA can inject money into the system as a stimulus measure, it can’t force anyone to actually borrow it. Given no one much is borrowing it, liquidity is “sloshing around the system”, Citi notes. The overnight cash market used to average $3.5bn in transactions a day. On September 8, when Citi last checked, the day’s transactions totalled $8m.

Furthermore, remember when pollies used to get all in a lather when the RBA cut the cash rate but the banks didn’t pass it on in full? Ah, happy days. They kept their traps shut, however, when APRA was trying to head off a housing crisis with stricter lending rules that in effect raised mortgage rates. When the RBA cut, and the banks didn’t, there was not a peep out of the pollies.

Nor was there a peep when the RBA cut from 0.75% straight to 0.25% in March, and the banks again didn’t pass the cut fully through. They couldn’t – to remain in business they need a positive spread of lending rate over deposit rate. Maintaining any sort of viable spread would imply cutting deposit rates into the negative. Not too many takers, one might assume, for paying your bank to hang onto your retirement savings.

Sales of mattresses may have sky-rocketed though.

So the simple argument from Citi is what the hell difference would a 0.1% cash rate make? Cash is already changing hands at roughly that level, and the banks can’t budge any further on loan rates.

If 0.1% will make no difference, might negative rates achieve as a means of further stimulating a desperate economy?

Those in the negative

A bit over a week ago, RBA deputy governor Guy Debelle outlined possible policy tools the central bank could yet implement, including moving the TFF target out the curve to ten years (effectively QE) as well as three years (where most maturities are concentrated), and/or cutting the cash rate further.

Prior RBA governor Glenn Stevens once suggested a cash rate below 1.0% was ineffectual. It’s now 0.25%, because Philip Lowe has considered this as low as it could be before becoming ineffectual, and thus has all along suggested a negative cash rate is “highly unlikely”.

Which is why the market is assuming 0.10%. But Debelle last week added the possibility of a negative cash rate to his list of possible tools, while pointing out the “evidence is mixed” of their effectiveness.

(It’s working to some extent in Europe. It has never worked in Japan.)

The biggest issue for the RBA, Debelle noted, is the stubbornly high Aussie dollar. Bring that down and the Australian economy would be stimulated. But with the Australian three-year bond yield at 0.25%, and the US equivalent at 0.16% (as of last night), to actually force the Aussie down the Australian yield has to go notably lower.

Perhaps into the negative, unless the iron ore price crashes, in which case the game will be out of the RBA’s hands. The market will go negative itself.

Theoretically, Citi suggests, negative rates, or an equivalent tax on excess funds held by banks, may drive those funds into the economy via new lending. However, Australia is a different kettle of fish to either Japan or Europe, or even the UK, where the Bank of England is now giving negative rates serious consideration.

In Australia, there simply aren’t enough households and businesses depositing money in banks to cover the amount out on loan. Indeed, notes the Citi, the deficit is currently around a tidy -$1trn. To cover that deficit, Australia’s banks have to go offshore for funding.

Cutting the cash rate into the negative will thus make no difference. Even if the banks could somehow encourage Australians to deposit money at 0%, they’d still need to borrow offshore, and while Australia may still be AAA-rated, its banks are AA-rated. In other words the banks themselves are higher risk to lenders than the sovereign nation, hence lenders require a higher rate of return.

Even if the banks could somehow encourage households and businesses to borrow more by providing lower lending rates, which households and businesses haven’t shown any interest in yet (pardon the pun), the banks would still have to go offshore for funding at the same rate as it is now to bridge the gap.

In so many ways, negative rates would thus be bad for the banks, potentially lower Aussie notwithstanding.

Ironically, Citi notes, the RBA is providing cheap funds for the banks (TFF) for the purpose of lending to businesses as a means of stimulating the economy, but businesses don’t want it. Hence, the banks are lending the funds as mortgages instead, because that’s the only source of growth at present.

House prices are on the rise again.

Over to you Del Amitri (1989):

And nothing ever happens, nothing happens at all,
The needle returns to the start of the song and we all sing along like before…

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