Feature Stories | Apr 14 2023
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
Australia’s banks are expected to report solid earnings in the coming weeks but enjoy it while it lasts, analysts suggest, as clouds build and headwinds pick up.
-Little fear of systemic risk for Australian banks
-Bank crisis will nevertheless impact credit conditions
-Peak margins and earnings now upon us
-The mortgage cliff is just one problem
By Greg Peel
On March 8, Silicon Valley Bank in the US announced it had sold securities at a loss and would thus look to raise capital. The opposite occurred. Fearing bank insolvency, depositors rushed to withdraw their funds and within 48 hours, the US regulator shut the bank’s doors.
The SVB experience set off a chain reaction across the US and global banking systems. Both US government bodies and US major banks were forced to step in to avert another Financial Crisis. Then in an unrelated matter, Credit Suisse announced accounting discrepancies and in the prevailing mood, also threatened to go under before being rescued by compatriot UBS.
Investor nerves were left very raw, and Australia was not immune. The ASX200 plunged -6.3% between March 8 and March 20, led by the financials sector.
Following assurances from central bankers there was no longer anything to fear, particularly in Australia, the ASX200 has since returned to the level from which it fell. However, the rebound has been led more by the resource sectors than financials, which have to date recovered only around a third of the lost ground.
Investors remain nervous as to what’s ahead for the banking sector globally, and locally.
Australia by Comparison
Deposits have been flowing out of all US banks since early last year, as interest rates have risen sharply. Deposit rates have failed to keep up with other “cash” investments on offer, such as money market funds and short-term notes/bonds. In SVB’s case, when outflows started to be an issue, it was forced to sell part of its investment US Treasuries.
At a substantial loss, given the investments were made at near-zero rates and the subsequent surge in yields has significantly reduced their value. The announcement it would be raising capital sounded an alarm bell to depositors, and there followed a run.
As at end-March, US deposits had fallen -US$655bn or -3.6% since peaking in April 2022, notes Jarden, primarily driven by the withdrawal of term deposits for which banks failed to pass through higher rates. I think we’re all familiar with the concept.
But that said, Australian banks have passed through relatively more rate hikes to deposit rates than their US counterparts, Jarden notes, and options for cash management outside the Australian banking system are limited. There are no large Australian money market funds (MMF).
Australia's large and competitive term deposit market means that while the cost of deposit funding is on the increase, Jarden does not see a risk of material outflows from the banking system. That said, we are seeing a shift out of at-call and into term deposits. While this presents downside risk to bank margins and profits, the deposits are maintained within the system and do not raise risks of insolvency.
Comparing US Fed and APRA data, Jarden finds 60% of RBA rate hikes have been passed through to Australian deposits compared to 25% in the US. The average deposit yield locally rose to around 2% compared to only 1% in the US. The spread from US deposit rate to cash rate has arisen to around 3% — the highest since the late 1980s Savings & Loan crisis (See: Australia And The US Banking Crisis; https://www.fnarena.com/index.php/2023/03/23/australia-and-the-us-bank-crisis/).
The Australian spread has risen to around 1% post-GFC, reducing any incentive to seek better returns on cash investments outside banks.
US MMFs have seen the highest weekly inflows on record, outside the initial covid panic, to a level reaching 28% of bank deposits. Not only are Australia’s MMF options negligible by comparison, the size of Australia’s short-term security market (government bills, commercial paper) is tiny compared to the US. Jarden finds the total value of other “cash” investments equates to 3.6% of bank deposits, compared to in excess of 20% in the US.
But wait, there’s more.
Deposits with US banks represent some 85% of total bank funding, compared to 67% in Australia. Whilst this has meant a higher liability yield relative to deposits in Australia (Australian banks rely more on borrowing via bond issues), it gives the banks great flexibility.
But on the other side of the ledger…
Australian banks may not be facing a liability (deposits) issue but they are facing stress on the asset (loans) side, thanks to surging rates.
Housing arrears (falling behind on mortgage payments) are on the rise from prior very low levels when the cash rate was near zero. Mortgages originated since 2020 are showing greater increases in arrears, notes Morgan Stanley, which could be exacerbated as fixed rate roll-off accelerates.
The so-called “mortgage cliff”.
The RBA has raised interest rates 350bps over the past year – representing the sharpest tightening in conditions through the inflation targeting period. This represents a significant increase in mortgage costs – Morgan Stanley estimates around 50% for the average mortgage-holder, or an income headwind of some -8%.
Citing data drawn from residential mortgage-backed securities (RMBS), the broker notes 30 day-plus arrears metrics for prime RMBS edged up to 1% as of March – a low absolute reading but a noticeable upswing since the lows in late 2022. Weakness is more apparent in non-prime RMBS, where arrears stand at around 5%.
There has been a more noticeable increase in recent transactions and Morgan Stanley suggests the post-2020 cohort is worth keeping an eye on as fixed rates expire. There is little differentiation between investor and owner-occupier arrears.
Given the historic speed of the current tightening cycle, the broker expects the RBA will be watching the trajectory in arrears closely, particularly as the roll-off from fixed rate mortgages accelerates in the June quarter and unemployment begins to rise from a 50-year low.
But Morgan Stanley is not panicking. While more than 80% of the major banks' mortgage customers will be subject to the full impact of rising rates by September 2023, and monthly mortgage repayments will go up in excess of 40% for some 35% of borrowers, the broker expects housing loss rates to remain at low levels and bank impairment charges to be manageable.
Morgan Stanley’s estimate of more than 80% of the major banks' Australian mortgages being subject to the full impact of rising interest rates by September 2023 splits into 68% variable rate loans and 13% maturing fixed rate loans, with another 13% of total loans being fixed rate loans maturing by September 2024.
Recent RBA data revealed fixed rate borrowers are more likely to have larger loans relative to their incomes (loan-to-income multiple of 6x or more) or high loan-to-value ratios, in excess of 80%, and they are more likely to have newer loans or be first home buyers.
Some 25% of fixed rate borrowers will have a loan servicing ratio greater than 30% once they roll on to a variable rate loan, and some 70% of maturing fixed rate borrowers have increased their repayment buffer by only one month or less.
Back to Front
A bank’s “back book” refers to loans already existing on the balance sheet, while “front book” refers to new loans written recently. In a rising rate environment, front book rates will be ever higher than back book rates.
But due to stiff competition, Macquarie notes front-to-back book spreads are now some -80-90bps below FY21 levels. Feedback from mortgage brokers also suggests competition is broad-based amongst major players and cashbacks remain a prevalent feature of the market, which arguably incentivises churn (switching banks) in the environment where customers are more price sensitive than in the past.
This will likely result in ongoing reduction in banks’ back book mortgage profitability, the broker suggests, as front book returns on equity are below the banks’ cost of capital, based on estimates. Macquarie expects SME and institutional margins to be more resilient in FY23 and sees Commonwealth Bank ((CBA)), Westpac ((WBC)) and the regionals as more exposed to near term margin headwinds than ANZ Bank ((ANZ)) and National Bank ((NAB)).
Term deposit rates increased materially in March, notes Macquarie, as the majors other than Westpac raised their three-month TD rates by some 100bps. One-year TD spreads are now back to almost the same levels as pre-covid and shorter duration spreads are also declining.
Coupled with attractive savings deposit offers, the broker expects an ongoing churn to more expensive deposits, unwinding some of the funding benefits that banks have enjoyed in recent periods. Furthermore, despite slowing credit growth, the funding gap across most banks under Macquarie’s coverage widened, indicating a greater reliance on wholesale funding. With funding markets remaining tight and more expensive, Macquarie expects banks to compete for deposits.
As noted earlier, deposits represent around 67% of bank funding. The balance reflects borrowing in corporate bond markets. As the bonds banks have issued reach maturity they, too, will roll over to higher rates, or higher cost for the banks.
UBS is singing from the same song sheet. One of the main themes to come out of the recent bank reporting period and the UBS Mortgage Day hosted in Melbourne is on the economics of front book pricing. Given extreme levels of competition coupled with elevated refinancing, banks on UBS’ estimates are writing business at an internal rate of return of around 4-5%, which is below their cost of capital.
The recent events in the US and Europe serve as a stark reminder that most bank instability likely stems from liquidity shortfalls driven by deteriorating confidence, UBS notes.
In the Australian and global context, the broker believes this makes it more likely that banks will compete more aggressively for deposits (to avoid being the bank with the worst deposit dynamics). Macquarie Group ((MQG)) has been successful at gaining share but CBA and Westpac's recent deposit pricing points now sit ahead of Macquarie’s, and ditto for Bank of Queensland ((BOQ)).
Which brings us to…
In the current environment, Morgan Stanley believes Bendigo & Adelaide Bank ((BEN)) is better placed than Bank of Queensland to manage growing margin headwinds.
The broker notes deposits make up a slightly higher proportion of funding at Bendigo than Bank of Qld, and low-cost transaction accounts make up a lower proportion of Australian deposits at the two regional banks than they do at the majors, although the broker believes Bendigo has relatively “'sticky” customers and a greater skew towards household deposits.
Bank of Qld relies more on term deposits than the other banks, Bendigo’s deposit rates are generally lower than Bank of Qld's and the majors', and Bank of Qld has more term wholesale funding maturities than Bendigo in FY23, although the latter has more maturities in FY24 due to its greater use of the RBA's term funding facility.
Commercial Real Estate
One of the fallouts from SVB’s collapse and the subsequent de-rating of US regional banks are the flow-through implications to commercial real estate (CRE), to which regional banks are major lenders.
CRE is already suffering from higher rates given landlords borrow to acquire properties with the aim of rents charges exceeding borrowing and maintenance costs. Existing loans are rolling over to higher rates, and tougher lending conditions resulting from the SVB crisis will further put CRE borrowing at risk.
Australia’s listed real estate sector, which includes REITs, property fund managers and property developers, has fallen some -17% over the past year as rates have relentlessly risen. Falls have been exacerbated since early March on US CRE-risk fears reaching across the Pacific.
But with Australian bank balance sheets now strongly focused on domestic exposures, Citi finds that system CRE lending on bank balance sheets has declined as a percentage of total exposures since the GFC. Additionally, underwriting standards have generally improved, particularly since an APRA review around 2016.
In recent years the broker has noted strong growth in foreign branches funding CRE projects in Australia, as we saw pre-GFC. Private funding on top of this is difficult to gauge. But should issues arise in CRE, Australia’s major banks are in a strong position to manage exposures through, Citi suggests.
For funders of private assets and foreign branches, their ability is opaque and less certain, which could create an issue. Hence, the broker continues to prefer the relative safety of the major banks.
When the Levy Breaks
Not oft mentioned in dispatches is the levy imposed by the then Coalition government in 2017 on Australia’s big banks, which is currently set at a -6bps impost on banks with total liabilities above $120bn, being the four majors and Macquarie.
Macquarie (the broker) highlights the potential risk of the new Labor government considering an increase to that levy in the wake of the covid-driven federal budget deficit and the recent global banking crisis, perhaps as early as the upcoming May budget, or maybe otherwise some time down the track.
The levy’s initial objective was “ensuring that the banking sector makes a fair contribution to the economy given its unique role in Australia’s economy and the associated systemic risks that it imposes”. Systemic risks that have arguably become more elevated.
While the Assistant Treasurer has refuted the idea of lifting the levy, as suggested in the press, Macquarie is not dismissing the risk.
While difficult to fundamentally justify, says Macquarie, an adjustment could take some -$0.5-1.5bn away from bank shareholders. In the medium term, the broker expects additional bank tax to be reflected in pricing decisions, but in the short term, it would likely result in earnings downgrades and further multiple de-rating.
Recent events in the US and Europe have in UBS’ view lowered the confidence threshold of investors for banks in their portfolios. Australia is no different.
UBS now expects funding costs to move higher, fiercer deposit competition, bad debts higher than expected, and a tightening of bank regulations. In late March the broker updated its earnings forecasts to reflect some of these dynamics, on aggregate cutting forecasts for the majors by -6-8% and target prices by around -18%. The UBS Strategy team downgraded their sector recommendation to Underweight.
Individually, UBS downgraded NAB to Sell from Neutral and Westpac to Neutral from Buy while leaving Buy ratings on ANZ and Macquarie.
Macquarie (the broker) is also Underweight the sector, but was so before SVB.
Banks are set to deliver record results in the first half of FY23, Macquarie forecasts, underpinned by around 10-20bps of margin expansion. The broker expects the market to focus on the outlook for margins, expenses, and credit quality. While banks have successfully managed to optimise deposit margins until earlier this year, competition has recently stepped up, and coupled with mortgage pricing headwinds, Macquarie expects the banks to guide to lower margins in the second half.
Not all halves are created equal, nonetheless. For CBA and Bendigo & Adelaide, the halves end in June and December. For Bank of Queensland its February and August, and for ANZ, NAB, Westpac and Macquarie Group, its March and September.
Bank of Queensland will report first half earnings next week, followed by ANZ, NAB, Westpac and Macquarie next month, while CBA and Bendigo will provide quarterly updates. Bank of Queensland pre-released some key data this morning and the initial response has been a weaker share price in an overall positive market.
Macquarie (the broker) sees potential upside risk to bank share prices in the upcoming reporting season. However, on a medium-term view, Macquarie continues to see risks from net interest margin (NIM) headwinds and potential credit quality concerns, which forms the basis for the Underweight sector view.
Note that Macquarie, the broker, is forbidden from having any opinion on Macquarie Group, of which it is part.
Citi is slightly less pessimistic.
The pause in the cash rate tightening cycle in April has Citi forecasting a longer hiatus at 3.60%, before the RBA starts cutting rates in 2024. A peak cash rate means that peak bank NIMs have likely arrived, but the broker believes a substantial pause at 3.6% will mean that a dramatic fall-away is unlikely.
Competition is the new inflection point in FY24, in which both asset yield (mortgage) and liability yields (term deposits) turn negative. The broker has adjusted bank forecasts to reflect a lower peak cash rate and lower long bonds, leading to minor earnings and target price revisions.
Citi maintains a positive view on the sector, with the resilience of NIM and asset quality in the remainder of 2023 likely to deliver a positive surprise.
In the near term, there is no change to Australian banks fundamentals, being strong liquidity and capital and asset quality. The events of the GFC showed the banks tend to underperform late-cycle. As such, Citi suggests it is early to dismiss the sector at this juncture, while also suggesting investors should favour the majors over the regionals.
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|CBA||0/3/3||99.23||89.69||– 8.69||– 2.6||11.3||70.3||4.4||– 1.8||5.6||75.6||4.6|
As the table outlines, consensus ratings from FNArena database brokers are now at eight Buys (or equivalent), twelve Holds and four Sells which historically is a weak balance.
Westpac and ANZ are showing solid upside risk, based on consensus targets, and all of Westpac, ANZ and NAB are offering solid dividend yields. If bank share prices fall, those yields will appear to be more solid, until earnings ease or provisions for bad debts rise, undercutting dividend payout ratios.
Note, these are forecast yields.
CBA sits, as always, in last place because bank analysts refuse to bow to the premium perennially afforded to Australia’s biggest bank, over and above the other majors. The value premium is nevertheless reflected in a weaker yield.
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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