Little Upside And Mostly Downside For Australian Banks

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

By Greg Peel

The timing of National Bank's ((NAB)) payment system corruption, the fallout from which is still continuing, could not have come at a worse time. It's hard to imagine a public even more angry at Australia's banks than they already are. But such anger only serves to highlight the dichotomy of opinion in this country between the view of an ignorant (in the true sense of the word) public and the political frenzy being whipped up by ignorant (take that as you see it) politicians in order to leverage off such anger for political gain, and the opinion of those who actually do have an understanding of how commercial banks work. The latter group includes bank analysts, the governor of the Reserve Bank, bank competitor John Symond, and anyone else not beholden to misguided herd mentality.

The political strategy is simple. The only people in Australia now served by the federal government are those in swinging seats, which just so happen to contain a concentration of struggling mortgage holders, and whose views are articulated by small focus groups and interpreted by spin doctors. The rest of the population can pretty much go and get stuffed.

The rest of the population includes anyone with a non-resource-sector related business who is suffering from the RBA's rate rises and government disinterest. It includes the growing number of Australians who rely on investment in bank deposits – the other side of the ledger – who benefit from rate rises and also from aggressive bank competition in this space. A great number of this group are self-funded retirees who are saving the government pension costs as Australia's population ages. And it also includes bank shareholders. And bank shareholders include everyone with a superannuation scheme, that is, most of Australia.

RBA governor Glenn Stevens alluded to the latter group in his regular testimony to the House of Representatives committee last week when he suggested that one “need be careful not to forget the capital that is invested in these institutions”. Stevens came out in defence of bank profits, which he suggested were a much safer proposition than lack of bank profits. He also stated the obvious on the competition issue in suggesting “Competition that pushes down lending standards, ends up lending money to people who really shouldn't get it, that's not a good thing”.

John Symond founded Aussie Home Loans in the nineties with the specific agenda of offering competition to the entrenched “four pillars” on mortgage rates. He should thus be a champion of the current bank bashing and competition drive, yet on Sky Business last week he defended the banks' out-of-cycle rate rises.

There is a current obsession with what is perceived as collusion from the banks on mortgage pricing, thus suggesting a lack of competition. Yet one of the biggest problems facing the banks over the past year and into next year is the aggressive level of competition between each which has pushed up deposit rates and thus pushed down margins at a time when offshore funding costs are still on the rise. There is also anger over a perceived exploitation by the banks of the government's deposit guarantees, to the point of which the cost to banks of such guarantees is now under review.

As misguided as the likes of Wayne Swan, Joe Hockey and Bob Brown (the Greens shadow minister for everything) are on the role of publicly-listed commercial banks in a capitalist society, the bottom line is any reviews and resultant regulatory changes are certainly not going to be to the banks favour.

And then there's the potential for some mandated increase in competition, perhaps with some form of subsidy. Competition is indeed healthy in any market – that's why we have four major banks and a plethora of smaller institutions while the government endorses a supermarket duopoly and protects a single international carrier, among other inconsistencies of policy. But while some competition is healthy, too much unfettered and subsidised competition is dangerous, as Stevens has pointed out. To support this argument I need only say the words “US subprime crisis”.

JP Morgan's bank analysts currently see the Big Four as “stumbling along a corridor of uncertainty”, which is constrained by ongoing tightness in funding, regulatory uncertainty surrounding how APRA will interpret the Basel III liquidity requirements, and “political risk in the shape of the federal government considering the deployment of 'social capital'”. The “corridor” manifests itself as a relatively tight share price trading range between yield support at the bottom end and lack of earnings growth potential at the top end.

To the disappointment of the banks, another government institution in the form of the Australian Prudential Regulatory Authority is threatening to throw a spanner in the works in an ill-conceived policy move. Australian banks are all comfortably capitalised under the new Basel III international requirements, but Basel III also requires newly tightened liquidity ratios. Capital may bolster a bank against a financial market crisis, but when backs are against the wall only the rapid conversion of liquid investments into necessary daily funding can prevent an insolvency crisis, particularly when counterparties run away in fear as was the case in the GFC.

The preferred “liquid” asset is government bonds, so realistically Basel III is saying that all banks must hold certain level of government bonds on their balance sheets. This is okay for banks in those countries which are so heavily in debt there are vast amounts of government bonds on issue, such as the US and Europe, but problematic for banks in a country where a comparative lack of debt means a lack of government bonds. Ironic really.

Yet Basel III is not inflexible, such that concessions can be made under such circumstances. The RBA is fully supportive of certain exemptions to be made for Australia's banks. Yet APRA is not. APRA wants to “harmonise” Australia's liquidity rules with those of the rest of the world – the rest of the effectively bankrupt world. This can only suggest some new cost Australia's banks will have to bear.

It's probably a good time to remember that people who work at government bodies related to financial markets are usually those who weren't smart enough to be accepted for positions at private sector financial institutions.

JP Morgan notes that the recent out-of-cycle rate rises from banks have at least restored the potential for a recovery in banks' return on equity, which would otherwise still be negative had such increases not been implemented. But that potential is somewhat snuffed out by a lack of earnings upside.

Deutsche Bank's analysts are happy to declare the Australian banking sector as “competitive” despite government attacks. Competition for deposits and the recent removal of a number of fee categories drives such a view. Deutsche agrees with JP Morgan that government interference is likely to impact on future bank earnings. BA-Merrill Lynch is concerned the banks will be unable to accommodate lower revenue growth ahead, and “threats from disintermediation [corporates looking to issue bonds to the investment market rather than borrow from banks], Basel III [or APRA], foreign banks [competition] and government interference”. Merrills warns bank earnings multiples could de-rate further despite Australia's listed banks being “not expensive” at this time.

Macquarie has thrown another consideration into the mix, that of the government's deposit guarantees, or deposit insurance scheme as it is known. Were this to be overhauled into a bank-funded, risk-adjusted scheme it would “represent another 'hit' to bank earnings,” Macquarie notes.

With all of the above going on, one would be forgiven for assuming Australia's banks are so rich in profits and their prospects so assured for even greater profits in a booming Australian economy that it makes sense a government would wish to review the means by which those banks are making so, so much money. Unfortunately, all the Australian public and their political representatives have been able to latch onto are the big jumps in percentage terms in bank profits in FY10 from FY09, and the thus “offensive” mortgage rate hikes which followed.

Never mind that the percentage gains were in comparison to the depths of the GFC within FY09, and that much of the reported profit has come from bringing back provisions against bad loans rather than from raping and pillaging an Australian public. Indeed, nothing could be further from the truth.

Morgan Stanley's bank analysts don't expect FY11 to look any better for the banks than FY10. The second half of FY10 featured slowing home loan growth, margins still in decline despite asset re-pricing due to increasing funding cost, a reduction in bank treasury department profits now that markets have quietened down since the volatile GFC period, reduced fees due to public outcry, and increasing business expenses which include ongoing technology overhauls.

Not specifically mentioned is credit demand in the business sector. The rate of decline is such demand may now be slowing, but the reality is business credit demand is still in decline despite the GFC now being over two years old and Australia's economy never officially falling into recession. Bank analysts have been continually forced to push out the timing of the expected eventual recovery in such demand.

And such a recovery rather hinges on Australia's supposedly “booming” economy. It is at this point one is reminded that Australian banks have little business dealings with the risky mining sector.

The only offset to earnings weakness ahead in FY11, other than the mortgage rate rises, is the potential to continue to bring back earlier bad debt provisions into the earnings line. But even that source of earnings is now struggling.

In short, the bulk of the true “emergency” provisions, or provisions against whatever calamitous disaster may still be around the corner for the global financial markets, is now back on balance sheets. What is left is largely the sort of provisions against bad debts a bank would normally hold anyway. And returning to the reality of still-falling business credit demand, it's no stretch of logic to assume Australian businesses are not growing earnings either on a net basis. And that means greater risk of loan default.

In other words, as the RBA hikes rates while the non-resource sectors of the economy struggle in the face of falling revenues, bad debts are at risk of growing from here, not reducing further.

Morgan Stanley expects no more than “flat” earnings growth for the banks in FY11 outside of whatever happens to provisions.

Last week the banks underperformed in a weak stock market, or outperformed on the downside of you will. Driving bank underperformance at present is not simply all of the above, but more immediately the ongoing blow-out in European sovereign debt spreads which flow through to the funding costs of every bank on the planet. In the current global situation, all these Australian domestic and government-related problems may yet prove to be no more than background noise.

There is at least some flipside. With Australia's big banks offering earnings risk, Macquarie believes Bank of Queensland ((BOQ)) is in a good position to benefit from any government pro-competition initiatives and has thus promoted the stock to its list of “marquee ideas”, which is a list of those stocks with “conviction” Outperform ratings.

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