Australian banking sector update

All major banks have now provided first half results for FY23 that offers some insight into current performance. The following article highlights key drivers of bank earnings and offers our near-term outlook for the sector. Our focus is on the major “Big Four” banks comprising Commonwealth Bank (CBA), Westpac (WBC), National Australia Bank (NAB) and ANZ Group (ANZ).

Looking at growth on a headline level we see credit contracting after a sizeable boom over 2020-2022. Said boom was triggered by stimulus programs notably the introduction of lower cost fixed mortgages funded by the Reserve Bank’s Term Funding Facility (TFF). This facility has since lapsed with fixed rate mortgages increasingly expiring and reverting to the now higher variable rate following the shift in RBA policy since May 2022.

New loan creation (in orange) has softened materially as fewer households are willing to take on mortgage debt in the face of an RBA hiking cycle which reduces their ability to borrow. We are still seeing a material uptick in refinancing activity as households increasingly “shop around” for more attractive mortgage rates. This increases turnover between banks and is driving increased competition.

Annual housing loan growth vs prior quarter; split by type (Mar-07 to Mar-23)

Credit growth is expected to remain challenged while interest rate conditions remain elevated in the near term as higher rates have sizeably reduced household borrowing capacity

The current direction on credit quality is supportive to banking margins with arrears (borrowers behind on their mortgage payments) either flat or trending lower. This means lower provisions (cash held aside) are required to protect against expected loan losses. Those funds can instead be redeployed into the business or returned to shareholders through higher dividends and share buybacks

Source: Company filings; CBA reporting is off-cycle so 1H23 is six months to Dec-22 whereas it is six months to Mar-23 for other majors

The outlook is more challenging, however. Growth both domestically and internationally is expected to slow over the course of 2023 and 2024 with unemployment also rising. Those two views would normally weigh on borrowers’ ability to repay their debts. This is because higher unemployment means households will be less likely to maintain their loan repayments leading to loan impairment. Weaker economic growth typically sees businesses struggle due to depressed demand for goods and services which also increased the risk of loan impairment.

Source: Bloomberg consensus as of 8 June 2023

To emphasise this point we see the historical pattern of impaired loans as a proportion of major bank equity. This is contrasted against the return of banks for the next 5 years. As you can see the shares (the blue line) tend to perform best in periods of distress (when loan impairments are rising) as opposed to periods where distress is low.

Non-performing loans as proportion of equity versus Major Bank index returns (Mar-00 to Dec-22)

Non-performingloansasproportionofequityversusMajorBankindexreturns(Mar-00toDec-22)

Big4Non-performingloans(%ofequity)

MajorBankstotalreturnfornext5years(annualised)

In summary, current credit metrics are positive. The outlook however is unclear but likely to see some deterioration as the economy slows and we see a pickup in unemployment. Anecdotally we are already seeing media reports of household finances becoming increasingly challenged with recent RBA hikes exacerbating this trend. It is reasonable, in our view, to expect more provisioning will be required going forward which will detract from bank earnings and dividend growth.

Net interest margin refers to the spread between the income received on loans made by a bank versus the cost of the funds it borrows to make these loans. In recent periods with the uptick in interest rates banks have been able to expand this spread benefitting from their deposit franchise (by repricing loans higher and being slower to change rates on deposits banks can capture that difference in rates as profit).

Looking ahead though as shown in the chart below this impact is expected to moderate with net interest margins anticipated to decline until FY25 at a minimum. This will likely drive bank earnings lower unless offset by an uptick in credit growth which is seeing a challenged outlook as discussed above. This consensus view is informed by increased competition for mortgage volumes amidst a weaker credit environment. Heightened competition has seen some lenders rely on cash incentives and other forms of inducement to win new customers. This however comes at the cost of reducing profitability to achieve top-line growth

In summary, while net interest margins have been improving in recent years, we expect this tailwind to be less supportive if not outright reversing in the years ahead which will be a net negative for the major banks by reducing profitability and also, ultimately, dividends to shareholders.

Efficiency ratios which measure operating costs relative to revenues and other income are a key driver of overall profitability. Driving greater efficiency can lead to larger profits and ultimately, franked dividends or buybacks that return capital to shareholders.

Currently we have seen sizeable improvement as banks recover from sizeable one-off imposts such as regulatory fines or organisational restructuring. This has helped drive improvement in cost-to-income ratios as shown below.

The current outlook from consensus forecasts is not anticipating material improvement going forward but rather that banks will be able to retain existing savings in their cost structures. One possible downside risk to that view would be larger-than-expected capital spending requirements to upgrade legacy technology infrastructure for example or consumer banking improvements.

The key point though is that going forward this is not anticipated to be a source of “easy wins” for bank profitability across any of the majors. The material improvements are expected to have already occurred. Consequently, it is an area we continue to follow. However, it is not one where we expect material profitability improvements to ensue.

On valuation we have a mixed bag. Price to earnings (P/E) ratios see two of the four majors trade at attractive levels versus their longer-term average while NAB sits at a minor premium. Commonwealth Bank (CBA) stands out as a notable exception. That reflects its stronger retail franchise and better execution following the Austrac scandal that claimed former CEO Ian Narev and cost the bank $700m in fines.

On price to book (P/B) ratios the story is somewhat different. Most are trading at material discounts to their stated book value despite the current earnings profile. This arguably reflects difficulties in execution for the other majors that has seen CBA trade at a material premium to peers.

Source: Bloomberg, long-term average calculated from Sep-05 to Jun-23

On this basis we would say the sector appears somewhat attractive with CBA the main exception.

Credit growth is subdued but troughing with influx of immigration. Materially higher growth would require interest rates to abate or wage growth to improve both of which are difficult to see happening as accelerating wage growth would likely prompt the RBA to maintain a higher rate policy which would limit the amount of credit households could borrow or afford. Meanwhile credit quality has risks to the downside in the near-term given unemployment is expected to rise and there is an elevated risk of higher credit provisioning required after a period of artificially low arrears

Key profitability drivers include moderating net interest margin trends in the face of elevated competition that are unlikely to be a source of material profit growth. Meanwhile, operational efficiency is one area where there are prospects for further improvement in select banks but difficult to materially shift the outlook given the other headwinds we are seeing.

Finally on valuations this is again company-specific, but CBA would still appear to be overvalued on most conventional metrics in both an absolute (versus history) and relative sense (versus peers both globally and domestic). The other majors are looking more attractive on this basis, but we would caution this view presumes current earnings forecasts are not overly disappointed in which case there is more scope for bank prices to decline.

In summary, headwinds remain in place for the sector, the question is whether these have sufficiently been priced in. Further weakness in bank share prices would suggest a positive on that front but in our view, we are not yet at this point though this could change in the near-term for individual institutions.

By Cameron Curko, Head of Macroeconomics & Strategy | Pitcher Partners Sydney Wealth Management