Banks Still Face Challenges Ahead

Australia | Sep 08 2021

Banks may have surplus capital and appear well insulated against declining asset quality, but deteriorating macro sentiment and low interest rates pose challenges

-Outlook for interest rates has become bearish for the banks
-Businesses reluctant to borrow and banks have funding surpluses
-Macro environment likely to drive sentiment on the banks


By Eva Brocklehurst

Are there clouds forming over Australia's expected economic recovery? FY22 has commenced with severely restricted lockdowns in major capitals, extending beyond what was originally anticipated and causing brokers to reassess the outlook for banks.

Is the market underestimating the risk to credit quality in loan books? This is probably not the case as JPMorgan assesses prolonged lockdowns may affect asset quality for small-medium enterprises but bank provisions appear quite solid.

While expecting conditions will deteriorate from the "unusually rosy picture" that existed before lockdowns, Citi agrees the banks are well prepared. Strong asset prices insulate any risk and current provisioning has high latent capacity.

Nevertheless, the emerging threat from stalling economic momentum and a delay in the timeline for higher interest rates has caused the broker to become more bearish on the banks.

On the other hand, the fall in loan-to-valuation ratios will protect balance sheets and it would require a combination of high unemployment and a serious break in property prices to drive material losses for the banks.

Even after the buybacks that were recently announced, excess capital still provides a buffer to any potential deterioration in loan performance. Credit Suisse notes the decline in credit risk weights in the June quarter as banks experienced an improvement in portfolio quality. Average credit risk weights of the major banks were 33% in June 2021 compared with 37% in June 2020.

Bell Potter agrees the banks can manage the pandemic well by having net interest margins in the 2% range, returns on equity of 10-12% and credit growth back to around 1x system, backed by capital ratios of 11-12%.

This implies Commonwealth Bank ((CBA)) will remain at the top of the pack followed by ANZ Bank ((ANZ)), in the broker's opinion. Bell Potter assesses asset quality metrics are in line with expectations, with the lowest being for Commonwealth Bank.

If property prices continue to rise, Macquarie suggests pent-up demand may result in a better outlook for credit growth in 2022. That is an 'if', and in the short term the broker suspects any upside from credit growth has diminished.

APRA has reported system household deposits increased by more than 2% in July, amid surges in tax refunds and reduced expenditure because of increased conservatism.

By way of comparison, Morgan Stanley notes household deposits increased to $31bn in July 2020 from just $12bn in July 2019. Over the past six months CBA has grown deposits above system and other major banks, albeit below Bendigo & Adelaide ((BEN)) and Bank of Queensland ((BOQ)).

Business loans are still growing, increasing 6% in July, less than June but more than April and May. Nevertheless, APRA has noted extended lockdowns are negatively affecting business confidence.

Wilsons has also become less bullish regarding the banks following a period of sustained outperformance. The broker flags improved system-wide credit growth, pressure on net interest margins from lower rates and worse than expected trading/market income.

Monetary Stimulus

So, will the resurgence of the Delta variant hamper an economic recovery, even once vaccination thresholds are met? Citi considers this more than likely.

Hence, the main risk for the banks, is not provisioning for bad debts or the capital concerns that have preoccupied the market in recent years but the implications of prolonged monetary stimulus.

Monetary stimulus delays interest rate rises, weighs on borrowing and hedging demand and ultimately affects core earnings. This will inevitably be manifest in bank shares. The broker emphasises the commentary around Australia dodging a technical recession in the June quarter is really about the technical part, as 2021 is very different from 2020.

Revenue Trends

Credit Suisse notes variable rate mortgages are back in fashion following the increase in fixed rates recently. Westpac is the only major bank currently offering a variable rate below 2%, -70 basis points cheaper than major bank peers.

ANZ Bank has the highest variable rate of the majors, at 2.72%. Meanwhile, fixed rates have been raised by 30 basis points for four and five-year terms. JPMorgan is particularly concerned about ANZ Bank's struggles in the Australian mortgage market and believes any turnaround will be more protracted than first thought.

In contrast, National Australia Bank ((NAB)) has momentum and more stable margin trends compared with peers. There are also fewer headwinds to its dominance of business lending. The broker expects pressure on mortgage margins over the next few years should have the most impact on Commonwealth Bank and Westpac ((WBC)).

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