Oz Banks Strongly Positioned Despite Regulatory Risk

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

-Aust business margins improve
-Buffer in mortgage margins
-Strong competitive advantage
 

By Eva Brocklehurst

Australia's major banks are in a stronger position than the recent headline numbers suggest. With the exception of National Australia Bank ((NAB)), momentum is robust, on Deutsche Bank's calculations. NAB, meanwhile, has more heavy lifting to do to get to the level of its peers in FY15. Headline growth for the sector was relatively poor at 0.8% for earnings and 0.9% for revenue in FY14. Growth came from retail and business banking, with institutional banking offering little growth and New Zealand lagging Australia. One-off provisions, asset sales and investments distorted the headline number as well as abnormally low trading income, the broker notes.

Deutsche Bank's number crunching suggests the banks are still generating similar levels of growth to recent years, adjusting for the lack of volatility. While not at their highest starting point for a financial year, the banks are still well placed. Business credit appears to be improving and asset growth is likely to be reasonable, in the broker's view. Banks should enjoy improved margins in Australian business, as wholesale funding costs are now well below 3-4 years ago and the average duration for the mortgage book is substantially longer than the average duration of the funding book. Institutional margins are at greater risk but, the broker notes, institutional banking is becoming a smaller proportion of the group as a whole.

Regulatory risk is the main issue facing the banks, as they are expected to have to hold more capital once the financial system inquiry's recommendations are handed down later this year. Mathematically, this reduces return on equity (ROE) and the capacity to keep raising dividends. Nevertheless, Morgans observes the Big Four should be able to pass on regulatory costs to the consumer which, while not helpful for consumers, reveals the pricing power of the banks. The banks have impressive mortgage margins and, when cash rates were last cut, they did not pass all the savings to the consumer. At the time it was stated that wholesale funding costs were exceptionally high, but Morgans also notes these costs have fallen significantly over the past few years.

That is not to say the broker believes the banks should be forced to hold more capital because of the problems of international peers, nor that ROE around 16%, while impressive, is a super profit. In this the broker compares the banks with BHP Billiton ((BHP)) which generated a ROE of nearly 30% in 2012, although this is expected to fall to 14% in FY15. Australia's banks are great investments, in the broker's opinion, able to extract higher returns at a time when housing credit growth was subdued. This strong competitive advantage is why Morgans believes Australia's four majors are in the top ten highest rated banks in the world.

Defensive earnings, pricing power, lower relative share price volatility and an ability to gradually increase dividends is why the banks should be an important part of every portfolio, in the broker's opinion. On the subject of NAB, Morgans believes, once divestments are made, investors will be left with a quality domestic business with a focus on small to medium business and mortgage lending.

Morgan Stanley expects tougher capital requirements will emanate from the inquiry but also that a transition period will ensure this is manageable. The broker suspects mortgage risk weightings will be lifted and assumes new tier one capital targets are reached by the end of FY17, estimating the major banks will be short of a new minimum of 9.75%, based on pro forma FY15 estimates. Large capital raisings in 2015 are possible as the banks are likely to need to find $38bn in capital via dividend reinvestment plans, asset sales and share placements. Lower home loan discounting and term deposit rates are also highly likely, even if standard variable rates are not re-priced.

The broker forecasts that ROE will decline for the majors by around 1.5 percentage points in the medium term. Dividend growth is expected to average 4% per annum over the next three years. The broker believes the probability of dividend cuts is low, but flat dividends are possible if more onerous rules are implemented.
 

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