Banks Still Face Challenges Ahead

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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)).

Morgan Stanley expects better revenue trends in the second half of FY21 for the banks, albeit still weak for the year. The weakness is partly because of treasury and markets income, which is expected to fall around -20%. Excluding treasury and markets income the broker forecasts revenue growth of around 3% in the second half.

The broker notes bank growth rates have been volatile month-to-month and Bendigo & Adelaide dropped dramatically to be broadly in line with the system, while ANZ Bank's housing loan balances fell in July and no growth was sustained over the past six months.

Bank of Queensland appears to be the only one besides Suncorp's ((SUN)) bank division that grew above system in July. Australian housing loan growth for NAB and Westpac is tracking ahead of Morgan Stanley's forecasts in the second half while Bank of Queensland is on track to achieve an annualised growth rate of 12%.

As banks deploy their term funding facility (TFF) balances, margins will improve. Then, as banks will need to refinance these balances in the medium-term, margin benefits will unwind, Macquarie points out. These TFFs are designed to provide liquidity and stimulate business credit, yet businesses are reluctant to borrow and strong deposit growth has left banks with a funding surplus.

Moreover, major banks managed to arrest market share declines where non-banks could not match fixed-rate offers. With the removal of TFFs, Macquarie expects fixed-rate offsets will ease back and the major banks' ability to maintain share will diminish.

Macquarie retains a neutral view on the banking sector and prefers NAB, noting the risk to CBA's valuation premium. In the short term, the broker believes macro trends will drive bank performance given the leverage to rates and the outlook for impairments, while regionals should continue to take share.

Bank Shares

Banks outperformed the broader market by 1% in August as the resources sectors de-rated. Yet, there appears to be some complacency in the way bank share prices have traded since lockdowns reappeared, Citi suggests.

The broker muses over whether the retracement in large resources stocks may be affecting the recent performance of banks. A sell-off in resources in a market that is underpinned by stimulus is probably going to give the banks a nudge.

Yet the sector rotation can only occur for so long. As lockdowns persist, more stimulus occurs, interest rates stay low and writing back provisions becomes harder. The broker reduces the weighting on ANZ, noting the balance sheet has not grown since the first half of FY21 so prospects of above-sector growth in FY22 and FY23 look more challenged.

That said, bank earnings continue to be supported by lower bad debts and impairment charges and Citi suspects there is some upside risk to earnings from further capital management initiatives that are not reflected in market estimates.

With bad debt costs not expected at more than 0.15% of assets in any given year to FY24 the broker assesses there could be 2-3% in additional upside in bank earnings on faster writebacks. In summary, it is not a particularly ambitious earnings profile if banks can show better revenue and cost performance, which has been hard to achieve over the last few years.

Net interest margin pressure remains a feature of forecasts, and if there is some relief on this front both bank earnings and returns will be materially higher, the broker adds.

Credit Suisse concludes reporting season was affected by pressure on underlying profit, amid lower markets income and some pressures on expenses, while banks managed margins well and credit quality was benign.

The major banks either announced or indicated capital management activities, which would reduce individual share count by -2-4%. The broker expects balance sheet momentum will improve incrementally and margin pressure will be determined more by competition in mix than lower rates.

Rolling buybacks are expected over the next two years with a total of $26bn forecast for the majors. Credit Suisse believes stock specific aspects will dictate relative share performance versus the macro economic environment.

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