Banks Holding On Grimly

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This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies.
For more info SHARE ANALYSIS: CBA
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

Australian banks last week were forced to raise their business loan rates in the face of the ever rising cost of funds. So far standard variable (mortgage) rates (SVR) have remained unmoved, but it can only be a matter of time. The banks are locked in a staring competition on the SVR, and no one has yet blinked. Perhaps they think raising the rate just before Christmas is bad PR. As if bank PR could ever get worse.

In recent years the spread between the cash rate, being the Reserve bank’s published target rate, and the 90-day bank bill swap rate (BBSW), being the rate at which the big banks themselves borrow about half their required funds, has been around 12 basis points. Since September the average spread has been 45 basis points, but the trend has only been up. At the end of last week the spread stood at a ten-year high of 76 basis points.

While the BBSW rate is Australia-specific, it is still representative of a cog in the global credit machine. The basis for all global interbank lending is the London interbank offered rate (Libor), even for Americans. Most of the feared US adjustable rate mortgages are based off Libor.

Since the US subprime crisis turned into the global credit crunch the US Federal reserve has lowered its target cash rate by 100 basis points and its discount rate (at which banks can borrow directly from the Fed) by 150 basis points. While US cash is now 4.25%, Libor remains stubbornly over 5%. What this means is that while cheaper funds may be available via liquidity injections, global banks are not prepared to readily lend funds to each other. There’s plenty of fuel but the machine isn’t turning. As funds are hard to obtain they’ve become more expensive, and that’s reflected in Libor.

The coordinated global central bank plan of fund auctions announced last week was supposed to alleviate this problem, making funds available directly to banks. But instead of the world breathing a sigh of relief, it has simply responded by assuming the situation must be more dire and dangerous than previously thought. The result has been more lending tightness, not less.

The Australian banks have been talking about raising the SVR ever since the credit crunch began, beyond that of the RBA cash rate. We’ve had two RBA increases, but it is the spread over cash that matters, not the absolute value. So the banks have shifted up with the cash rate but will soon shift again. They have been holding out not just because of the competition between each other, but because they have been prepared to take a hit on margins while watching their previous competition suffer. Non-bank lenders and regional banks have already been forced to raise their SVRs over and above RBA cash.

It’s working, because customers are flocking back to the safety and relative lower cost of big bank loans. However, the pillars probably assumed they would be only weathering a temporary storm, and that Fed and other actions would work to send credit spreads back down in due course. The opposite has actually proven true, so there is little doubt 2008 will begin with higher SVRs from all.

Bank analysts are beginning to become frustrated. This “Mexican stand-off”, as GSJB Were describes it, is costing all the banks money and eroding profits. In order to maintain FY08 earnings forecasts at current levels, says Weres, the banks will now have to raise the SVR by a full 25 basis points. So far they have only compensated by raising their business loan rates by between 15 and 25 points last week.

JP Morgan has been the most vocal, right from Day One of the credit crunch, in suggesting the Australian banking sector would not come out unscathed. JPM has this morning reiterated its Underweight call on the sector as a whole in 2008, and if the analysts are right the banking sector will have underperformed the index for the fifth straight year. They do acknowledge, however, that this is as much to do with the recent strength in the resource sector as much as anything else. But Australian banks are expensive, their earnings are under threat from margin reductions, increased costs and increased loan losses even as volume is growing, and they are negatively leveraged to a further blow-out in credit spreads.

Between the big five, JPM sees Commonwealth ((CBA)) and Westpac ((WBC)) as “safer” [their inverted commas] than National ((NAB)), ANZ ((ANZ)) and St George ((SGB)).

JP Morgan is somewhat of a pariah (and, to date, a correct one) among the brokers. Most consider the banking sector should be Overweight as increased volumes and cost cutting measures should offset margin erosion and credit spread pressures. Merrill Lynch, for example, still expects 10% earnings growth for the sector in 2008. There is not a lot of disagreement of JPM’s general rankings, however.

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