Bank Reporting Season – A Preview

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

By Greg Peel

While Commonwealth Bank ((CBA)) reports on a regular June year-end cycle, the other Big Four banks report on a September year-end. They will thus begin to report their full-year earnings next week. National Bank ((NAB)) is due on October 27, ANZ Bank ((ANZ)) on October 28, and Westpac ((WBC)) on November 3.

Macquarie Group ((MQG)) reports on a March year-end and as such will report its first-half result on October 29.

Having had a solid run in the September rally, the Big Four banks have underperformed the index more recently, falling short of the ASX 200 by around 3% in October. Year-to-date up to last week, note the analysts at Macquarie, the banks have underperformed the ASX 200 by over 8%. Over the course of the year, ANZ shares have fallen 3%, CBA 8%, Westpac 15% and NAB 19%.

Such underperformance should come as no surprise given the influence of resource sector stocks within the index. While they are enjoying a boom, their success is not translating into the wider Australian economy on the same scale. Banks do not lend much in the way of funding to miners but are otherwise exposed to households, small to large businesses and institutions. The return of the RBA cash rate to a “normal” level has impacted on everyone bar the resource sector more or less, and the prospect of further increases is daunting for mortgage holders and struggling small businesses.

The overriding story in the banking sector at present is one of funding. The cost of offshore borrowing is rising on a net basis given 5-year loan rollovers are moving into post-GFC pricing from pre-GFC pricing, competition for deposits is making it tough to pick up valuable margin points, and the securitisation market has only just begun to show the first, timid signs of re-emerging. But we will never see a return to the glory days of securitisation markets as they were pre-GFC.

In the meantime, banks have proven reluctant to raise their standard variable rates on mortgages although they are no doubt busting to do so. One can only assume they are waiting for the RBA to raise again so they can add on a few more basis points to SVRs and other loans rather than risking public ire over completely independent increases. But even on the assumption loan rates will increase over FY11 (end-September) bank analysts are forecasting quietly decreasing net interest margins as such increases fail to overcome the increased cost of funding.

The banks are also now facing another problem in a soaring Aussie dollar. They are immune to currency for the most part in their day to day local activities, but a strong AUD/USD means having to increase funding levels to match the same value of Aussie dollar equivalent. Fortunately the Aussie's rise against other currencies (eg Europe) is not as pronounced and so only US funding is a problem.

Goldman Sachs estimates an added cost of funding to the banks of $2-3 billion in FY11 based on the broker's currency target of US$1.05 by next September. However, in the context of some $120-140bn funding requirement over the period, the impact is not sufficient to overly impact valuations.

There was good news recently for the banks on the long awaited release of the Basel III global banking regulations. Requirements regarding capital and liquidity were a lot less onerous than feared and all of the big Australian banks' current levels are well above limits. This does not necessarily mean however, as the Macquarie analysts suggest, that the banks will quickly deploy their excess capital and run balance sheets close to the wind in Basel III terms. They are more likely to stick with comfortable safety margins in Macquarie's view.

Australian banks may have found themselves comfortably inside regulatory limits following their capital raising and dividend cutting spree of 2009, but that is not the case for all banks across the globe. In order to satisfy 7% tier one capital limits, Macquarie is expecting upcoming “significant” capital raisings from banks in Europe, Japan, China and Malaysia and from a handful of large US banks.

With all that fresh capital on offer across the globe, offshore investors are unlikely to be as focused on Australian banks. “Historical precedence suggests,” says Macquarie, “bank share prices underperform during capital overhangs”.

While the Australian banks were busy raising capital as a result of the GFC, they were also busy retaining earnings in provision accounts against the threat of bad debts, and even more earnings into simple “uncertainty” contingencies. With Australia having escaped the GFC relatively unscathed, those provisions are quietly being brought back to the bottom line following the apparent peak in bad debt growth.

This is a plus for the banks to offset some of the lost margins due to higher funding costs, albeit not everyone is completely out of the woods just yet. The banks have also to date elected to keep their “uncertainty” provisions intact in case of, for example, a European sovereign debt default or some other as yet unknown catastrophe that may once again send global credit spreads soaring.

The balance of bad debt provision reductions and net interest margin movements will be the focus of attention in this upcoming earnings season. JP Morgan, for example, is forecasting “modestly” lower margins for NAB since the previous quarterly trading update, “significantly” lower margins for Westpac, and “modestly” higher margins for ANZ.

ANZ is enjoying the benefit of having used the excess capital it raised to increase its banking exposure in Asia. While the other three, and small and regional lenders, have been fighting a deposit “war” to their detriment. ANZ has been able to bring in fresh deposits from Asian customers. ANZ is also currently in the process of conducting due diligence on the potential acquisition of the 57% stake on offer in Korea Exchange Bank.

NAB is more highly weighted to business banking than the others which has proven handy while SVRs have remained tight. Big mortgage lenders Westpac and CBA are hurting the most, which puts their respective GFC acquisitions of St George and BankWest into perspective. The two biggest banks also took the biggest slice of the mortgage spree on offer in 2009 via the government stimulus package.

As we look to the potential of further rate rises from the RBA, we reflect upon the number of mortgages written at a time when mortgage rates were at a historical low, and the government was effectively funding mortgage deposits. While Australia's unemployment rate is comfortably low, and house prices at best stable at present, it is still a matter of concern as to how many stimulus-driven home buyers bought on the basis they would not have otherwise been able to afford a mortgage but for the “emergency” pricing environment. Further RBA rate hikes, and additional independent rate increases from the banks, will squeeze many buyers at a time when Australia's housing market is looking “bubbly” on a globally comparative basis.

For NAB, there is also the problem of its exposure to banking in the UK. NAB would dearly have loved to have exited its UK positions by now but this is not an environment in which UK banks are highly sought after – quite the opposite. So NAB is stuck with its exposure, and it will be interesting to judge the impact of strict UK austerity measures.

NAB also has only minimal provisioning against the “toxic” assets which are still sitting on its balance sheet, although those assets may yet reach maturity without drama.

For Westpac it's all about mortgages, and the rising cost of the offshore funding needed to cover those mortgages. Westpac management estimates that the bank's cost of funding will not peak until FY12. And still Westpac sits waiting, waiting, waiting for an opportunity to raise its SVR. In a sense, it's a bit off a stand-off not just between each of the banks but between the banks and the RBA.

The RBA knows the banks will have to raise their loan rates sooner rather than later, and such increases effectively implement policy for the central bank. Might the RBA be prepared to sit tight again on November for that reason? And the strong Aussie is also working as a policy assistant to the RBA as it affects a slowing of GDP and inflation growth.

If the Fed finally does come in with a large dose of QE2, and the Aussie continues on its rising path, might the RBA even consider a rate cut? That would be a welcome gift for the banks given they could leave their loan rates largely as is and finally pick up some margin relief. But with economists convinced the commodity boom will drive the RBA cash rate up perhaps a total of 100 basis points by end-2011, it's difficult to see any rate cut ahead.

Of the eight brokers in the FNArena database and the four Big Banks, there is only one Sell rating at present. JP Morgan is Underweight in NAB. NAB nevertheless attracts three Buy ratings so is second in the (average) pecking order behind preferred bank ANZ (six Buys) and ahead of CBA (one Buy). All eight brokers consider Westpac to be no better or worse than a Hold prospect.

Despite the spread of ratings, it is interesting to note the upside to average target price for each of the banks is a very consistent 9-11% (based on yesterday' closing prices).

Macquarie Group has already warned that it faces ongoing profit downgrades if activity in financial market trading and M&A activity continues to be tepid. Without the earnings capacity of its once booming infrastructure fund business, Macquarie is now highly reliant on broking and advisory fees and proprietary trading profits to drive earnings.

In short, there is little to suggest the last quarter has been any much better on that front than the previous quarter, so the market has been gearing up for a weak first half result from Macquarie. Macquarie Group shares are down 38% from their twelve-month peak.

As is always the case for Macquarie, the final profit result will be very much dependent on the proportion of profits kept over for staff bonuses. The Group may decide to keep that proportion at the low end (~45%) this year to offset weak revenues but in so doing it would risk encouraging a further staff exodus from what was once the “Millionaires Factory” as is already the case.

Note: For a wider discussion on the current issues facing Australian banks please see Australian Banks: The Battle At The Margin.

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