Feature Stories | Nov 24 2021
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
Analysts agree FY22 will be another tough year for bank margins before sentiment begins to improve and the RBA eventually raises rates.
-Australian banks' net interest margins surprised to the downside
-Little relief apparent in FY22, but dividends not under threat
-RBA rate hikes will save the day
-Big retail banks to struggle more than smaller commercial banks
By Greg Peel
The bank reporting season has now wrapped with three of the four majors reporting full-year FY21 earnings and Commonwealth Bank ((CBA)) providing a first quarter FY22 update. Suffice to say, it was a disappointing season overall.
Yet there was a clear distinction between the performances of the two big mortgage-dominating banks, being Westpac ((WBC)) and CBA, and those of the two smaller, less mortgage-exposed ANZ Bank ((ANZ)) and National Australia Bank ((NAB)). While share price responses to the latter two’s results on the day were fairly muted, Westpac dropped -7% and CBA -8%.
Analysts agree that CBA actually posted a relatively solid performance but not one that could justify the significant valuation premium it has long enjoyed over the other three banks. For Westpac, it was just a poor result.
A near-zero RBA cash rate and historically low bond yields out to fifteen years does not provide banks with much opportunity to profit from their basic earnings driver – the difference between what they can borrow at and what they can lend at, known as the net interest margin (NIM).
While equally low global rates have meant the opportunity to borrow in corporate bond markets at low cost, with regard deposit rates – the other prime source of borrowing – banks have been backed up to a cliff. The current everyday deposit rate is 0.01%. That’s as low as it can go unless banks decide they will charge you to deposit with them, which is not particularly attractive when inflation is running at 3%.
In other words, they can’t.
What they can do is keep their mortgage and other lending rates higher to ensure margins are protected. This would work if there were only one bank. But there’s four majors, two main regionals, and a host of other non-bank financials and fintech disruptors ready to take market share.
Competition has thus been fierce. Throw in a raging Australian housing market, and the need to retain market share if not increase it has meant rates on offer have been the battlefront, with margins the casualties.
Typically, Australians have paid more to lock into a fixed rate mortgage which removes upside interest repayment risk for at least two to four years. Standard variable rates (SVR), which shift up and down with the RBA cash rate, have usually been cheaper and more popular. But given the economic and employment uncertainty created by a pandemic that won’t go away, banks decided in FY21 to offer fixed mortgages at lower rates than SVRs, thus removing some of the bad debt risk an RBA rate hike would represent.
But Australians aren’t fools. With an RBA cash rate effectively at zero, what are the chances fixed rates could move lower still, after you’ve already locked yours in? What are the chances of rates moving higher? Confronted with this binary scenario, Australians rushed to lock in their mortgages on fixed rates – some 40% of new mortgages.
Which means it is the banks that will have to wait two to four years before they can adjust to any RBA rate hike in that period.
Analysts were surprised by the extent of NIM compression reported by banks, but not at all befuddled. Perhaps most surprising is that investors did not take the initial warning from Westpac’s -10 basis point fall in NIM as a read-through to CBA – the biggest mortgage lender. Instead, investors saw further reason to maintain CBA’s significant premium.
Until CBA reported a -7 point fall in NIM.
And this reduced revenue capacity is only one side of the equation. The astonishing acceleration of digital technology this century has led to new lending start-ups (including BNPLs) moving into the banks’ traditional territory of tellers behind windows and five days to clear a cheque. If you can’t beat them…
Westpac is the most glaring case in point of a bank which announced plans for substantial costs-outs at the beginning of the year, only to produce a result including cost increases due to necessary technology investment – more so than forecast.
Hence not only were bank revenues hit by weaker NIMs, earnings were hit again by increased costs. There was some saving grace in solid “market income” aka “trading income” amidst volatile financial markets (trading securities) but this is by definition a volatile source of earnings.
The question is: Have banks now seen the worst of it?
Divergence in Prospects
The good news is that despite negative earnings trends, bank capital positions have remained solid. The Australian economy has surprised all, including the RBA, with its resilience during the pandemic, largely thanks to super-easy RBA policy, solid government support from fiscal handouts and a relatively low impact from covid in a global context.
We may have been one of the most locked down countries in the world that has only meant saving up the pennies when there’s nothing to spend it on and then unleashing as soon as the shops reopen. JobKeeper/Seeker have prevented a major increase in actual unemployment and a major surge in business failures (I say major – of course there have been plenty).
This has fed into a lower than expected, indeed much lower than feared, increase in bad debts and mortgage foreclosures (along with last year’s mortgage payment furloughs offered by the banks) for which the banks provisioned (put aside earnings onto the balance sheet) when uncertainty was at its peak.
This means the banks still have retained earnings they can release, and this means solid dividends can be maintained and even share buybacks pursued.
The same thing happened in the GFC – banks put away vast amounts just for uncertainty only to find they didn’t need them, and hence showered shareholders with dividends in subsequent years – something they came to regret when the Royal Commission came along. They are still paying remediation, and still have to spend on upgraded compliance.
The bad news is that until the RBA begins to hike its cash rate, shifting the banks back away from the cliff and allowing for higher NIMs, this financial year looks like being much the same as the last.
While the recent reporting season highlighted the distinctions between the banks (for example mortgage exposure versus business lending exposure), Credit Suisse notes underlying profit continues to be under pressure across the entire sector.
Despite strong bank balance sheets, competition and expense headwinds continue to dominate. Credit Suisse is Neutral on the sector given a still significant valuation premium to the rest of the market.
Citi suggests FY22 will be a “transition” year, as banks suffer from more of the same (low rates, competition, costs) ahead of the prospects of higher rates. However, the broker does foresee some abatement of FY21’s difficult conditions, expecting “green shoots” in business lending and an easing off of fixed rate mortgage demand. Further bad debt provision releases are also anticipated, and solid balance sheets still allow for capital returns.
Yet Citi, too, sees current valuations as full.
Goldman Sachs also expects business lending to pick up amidst improvement in sentiment as we put lockdowns behind us (we hope) and the economy becomes a bit more normal, while mortgage growth will continue its positive momentum for now.
The banks are also focused on trying to reduce their absolute cost bases, although each bank is in a different stage of reaching this goal.
Ord Minnett concurs with the more-of-the-same theme in FY22 and also points out cheap funding provided by the RBA in light of the pandemic, through its Term Funding Facility, has expired. But the broker does see upside from rising rates.
While Ord Minnett's forecast is for the first RBA rate hike in the first half of 2023, the broker notes Australian short-end yields have been rising since September in anticipation the RBA will be forced to move earlier than its 2024 (maybe late 2023) insistence. Whether it is the market that proves to be right or the central bank, rising rates provide for higher bank mortgage rates.
Brokers mostly agree, and here we can add Macquarie’s view to the list, that the FY22-23 outlook favours the commercial banks (NAB, ANZ) over the retail banks (CBA, Westpac). NAB is the biggest business lender, hence should have the best prospects, although Macquarie and Credit Suisse both point out ANZ will be the greater beneficiary among peers of rising rates.
Citi does not disagree with this thesis but has Westpac as its sole Buy among the four, as its weakest overall performance has led to a more realistic valuation.
As usual, everyone loves CBA, but no one wants to buy it at the price, even after its de-rating. The bank has always enjoyed the highest return on equity – the primary measure of bank valuation – but on that basis has been afforded a greater premium than is justified.
See: CBA: On How The Mighty Have Fallen (https://www.fnarena.com/index.php/2021/11/18/cba-oh-how-the-mighty-have-fallen/)
Now, over to the RBA…
The divergence between the expected timing of the first RBA rate hike the market is currently pricing in and the RBA’s own stoic guidance is stark. The market is pricing in no less than five rate hikes over the next 18 months, Jarden notes, reaching 1.25% by April 2023.
The RBA still foresees the first hike in 2024, or maybe late 2023. The board’s dual target remains that of inflation above 2% (September quarter core CPI 2.1%) and wage growth of 3% (September quarter 2.2%). With inflation basically in place, it’s all about wages.
As yet, inflation pressures have not meaningfully flowed into wage increases despite a shortage of labour. Clearly the market assumes this will eventually have to occur as we leave lockdowns behind and government support expires, and that price inflation will linger for longer than the RBA expects.
Typically, Jarden notes, the central bank raises rates when it is a strong economy leading to higher inflation. The last five rate-hike cycles since the 1990s show that while higher rates do have an impact on housing, credit and the economy, each time the impact was modest because of that strong economy underpinning the need for the RBA to cool things down.
But this time we are at the end of a decades-long structural decline in interest rates, and household debt is materially higher. And current inflation pressures are more about supply-side problems (supply shortages, delays, surging freight costs and labour shortages) than demand-side pressure on prices in a strong economy.
Jarden estimates that each one percentage point increase in mortgage rates, in line with increased cash rates, would imply -10-15% downside risk to house prices. But add in the “wealth effect”, or positive feedback loop from solid house prices to consumer sentiment to the real economy, and the impact could be greater.
Note that average house prices are up 22% over 12 months so some sort of a blow-off would not be the end of the world. But as Jarden notes, elevated household debt at historically low rates imply households are much more sensitive to higher rates than previously, increasing the risk to the economy.
Jarden’s base case is for the first rate hike to come in mid-2023. Jarden also suspects that were there to be an earlier hike and a big fall in house prices, APRA could respond by lowering the required mortgage “buffer rate” it has recently increased to cool runaway house prices and mortgage risk.
The buffer rate, or serviceability floor, is the rate a bank must stress-test a borrower’s mortgage servicing capacity above that of the mortgage rate on offer, for when rate hikes eventuate. It’s currently at 3%.
But APRA’s not done yet
While forecasts vary in quantum, economists generally expect house prices to rise around 7-8% in FY22 before falling up to -10-20% in FY23 when the first rate hike is announced. Of course, if prospective buyers take heed of these forecasts, FY22 may not see demand as solid as assumed.
APRA does not specifically target house prices, it influences house prices indirectly by enforcing certain restrictions on housing loan risk. There are already various measures in place but with mortgages being the dominate part of elevated household debt and rate hikes looming, the regulator is now proposing further measures.
There are already limits on investor loans and interest-only loans, but APRA still has these in its sights for further restrictions. More notably, the regulator is proposing limits on loan sizes based on debt-to-income ratios above 4x, and above 6x, and loan-to-value ratios of above 80% and above 90%.
None of these proposals have surprised economists who have been tipping exactly such measures pretty much all year. However, while reaffirming its 3% buffer rate requirement, APRA has said this could vary from 2% and right up to 5% for certain loans.
Jarden estimates, at face value, a 5% buffer rate would reduce borrowing capacity by -19%. But Jarden expects any increase towards 5% would be a gradual process rather than an immediate one as the regulator monitors the impact.
(Note that so far these are only proposals, with industry responses due by February next year. Actual changes may not eventuate until mid-2022.)
Jarden also points out that a face value assumption is overstated because less than 10% of borrowers actually use their full capacity, and many customers borrow more than they need and leave the excess cash in offset accounts, which inflates their apparent debt.
The conclusion is that while further macro-prudential tightening, as such APRA measures are known, is clearly a risk, tightening will likely be modest in the near term, reducing the upside risk for credit growth.
The regulator will also be fully aware 2022 is an election year.
The State of Play
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|CBA||0/1/5||96.82||87.25||– 10.72||– 14.2||7.0||76.0||3.8||5.7||6.2||76.3||4.1|
Above is comparative table of bank consensus forecasts and ratings among FNArena database brokers.
The table initially ranks the banks based on number of Buy, then Hold, then Sell ratings first, before differentiating on upside risk to target.
As the above text noted, brokers concur that NAB and ANZ are better placed than CBA and Westpac in FY22, and that NAB’s greater exposure to business lending puts it in the box seat, although ANZ’s greater exposure to RBA rate hikes could put it in the box seat, while Westpac’s de-rating now suggests value, and CBA’s de-rating has not been sufficient to close the premium gap to a realistic level.
The result is CBA being placed in a fourth spot it has owned for a very long time, other than very brief periods. Thereafter, all of the other three attract the same ratings spread among Buy, Hold Sell and equivalents, which reflects the above mix of views.
The suggestion of Westpac now showing value is reflected in table-winning 20.6% upside to consensus target (based off yesterday’s closing price). ANZ and NAB are close, but ANZ wins. Downside of -11% for CBA is very typical.
Of course what is also critical to investors is dividend yield, and again it’s clear why Westpac is top of the table.
For those looking to invest in banks and are now scratching their heads about which one, longer term investors may be best served by just buying them all, or buying a bank ETF. Over time, performances and preferences come and go with the tides.
The one exception is CBA, which has outperformed the rest of the pack in significant fashion since the 1990s, but steadfastly carries the risk of losing its relative premium. That relative valuation premium only rarely disappears and thus far it has quickly re-appeared after each of the few de-ratings that has occurred over the past 2.5 decades.
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
FNArena is proud about its track record and past achievements: Ten Years On
For more info SHARE ANALYSIS: ANZ - AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED
For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA
For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION