Australia Banking Sector Update

This story features WESTPAC BANKING CORPORATION, and other companies. For more info SHARE ANALYSIS: WBC

By Greg Peel

First up, FNArena has been receiving queries from readers as to why it is the Australian banks continue to assert that their funding costs are rising. While I have often explained this point in previous articles, it is not a surprise to receive such queries given the political frenzy being whipped up in Canberra at present with regards to the big banks.

Let me just say that Australian politics have become so pathetically popularised it makes emigration look like a worthy option. The only way to describe it is as a “dumbing down”, both in the approach taken to policy, which is mostly driven by focus groups in marginal seats, and in the quality of Australia's parliamentary representatives, as exhibited by this link.

Last week the Senate approved an inquiry into the banking industry. Having watched the above video (granted, an MP not an MLC), what hope a rational outcome?

In their weekly bank sector wraps, many analysts have pointed to interference from populist politics as being the banks' greatest concern at present, beyond even that of rising funding costs. But let's return to the latter subject.

Banks provide everything from short term business and personal loans to 25-year mortgages, such that the peak of their loan exposures into time is about 4-5 years. Banks do not match every loan they issue with an offsetting funding instrument, they simply raise funds required beyond the deposits they receive typically by issuing 5-year bonds to US or European investors funds in particular, so as to lump the offset.

They do not then wait five years and make another issue, they review their funding requirements as they go and issue further 5-year bonds. Let's just say for argument's sake they make one 5-year issue every year. This provides “rolling” funds such that each time a 5-year bond reaches maturity, another is required in its place.

The global “credit crunch” began in late 2007 and escalated to the ultimate Lehman-inspired GFC in 2008. The credit crunch came about because no one was game to lend money, particularly to banks, meaning credit spreads (the additional interest rate required to justify risk) blew out substantially. They peaked in late 2008, began to quietly subside in 2009, but then had another, smaller, jump in early 2010 when the European crisis hit. But put simply, those credit spreads were unrealistically cheap before 2007 and have since increased to levels which still reflect a certain fear element as we approach 2011. They are not likely to return to pre-2007 “cheap money” levels in a generation or more.

We are now two years out from Lehman and three from the beginnings of the credit crunch. That means Australian banks still have, as a proportion of their funding portfolios, 5-year bonds issued at very low rates. But as the 2005 issues mature to be replaced by 2010 issues, cheap 2005 rates are replaced by much higher 2010 rates. Thus the banks' net funding cost will continue to rise through time until the rates experienced in the credit crunch/GFC are from five years ago and are actually higher than today's rates. Only then will the banks' funding cost peak.

Westpac ((WBC)) has suggested that its funding cost peak will not occur until FY12 (note that I am simplifying things by assuming only 5-year issues and one each year).

Hopefully the above will explain that while bank funding costs have come down since the heady days of the GFC, there is a lag in the peak for Australian bank funding. Currently, we're still in the upswing.

Now, the Big Banks have made the case that because funding costs are rising, profit margins are falling. To stem the fall the banks must respond by finally increasing the most political of rates – the standard variable rate (SVR) on home mortgages. Elsewhere, in business and institutional loans, the banks did not drop rates as far as they did for SVRs in 2009 and have since increased them.

The ability to increase business and institutional loan rates is one reason that ANZ Bank ((ANZ)) posted a strong result last week. ANZ's margin actually increased by five basis points when National Bank's ((NAB)) equivalent margin fell. It is expected Westpac will also report a fall in margins in its full-year result due on Wednesday. But the major reason for ANZ's outperformance was quite simply the NZ in ANZ. The bank has been able to happily increase its loan rates, including SVRs, in New Zealand. Without political interference.

ANZ also has an advantage over its Big Bank peers via its Asian expansion strategy. Loan rates in Asia have also not been met with attacks from Comrade Joe equivalents, and Asia has proven a valuable source of new deposits for ANZ at a time when its peers are fighting a heated, competitive battle locally for deposits.

It is this comparison of ANZ loans and deposits versus NAB loans and deposits which provided the highlight after both reported their full-year results last week. While both saw profit increases in the order of about 50% over last year's results, bank analysts were forced to increase their FY11 earnings forecasts for ANZ but reduce their NAB forecasts. NAB may be building a solid base for future years, but its result featured a greater rise in costs than revenues, while ANZ is simply firing on all cylinders right now.

The obvious man-on-the-street point of confusion here is: how can the banks increase their profit by 50% and then cry poor on funding, such that SVRs need to go up? How much money do they need? And it is exactly this naïve (in the true sense of the word) response that provides fodder for populist, and largely ignorant, politicians. Why do this year's profit performances look so good compared to last year? Because last year's were so bad, that's why.

In bank year FY09 (ending September), Australian banks were forced to raise capital, cut dividends and shift vast amounts of earnings into provisions against the bad debt wave assumed to be ahead, as well as general provisions against ongoing global disaster. What little earnings were left over, they declared as profit.

In bank year FY10, not only did banks see strong government stimulus-based mortgage demand, but the Australian economy has fared pretty well. Unemployment is much lower than it was ever expected to be at this time, meaning the risk of bad debts is much diminished. On that basis, not only is it not hard for FY10 profits to look a lot better than FY09, but much of those provisions have been reinstated as earnings, that is, profit declared this year. The banks have also lifted their dividends payouts back up towards previous levels, but most importantly if one were to net the FY09-FY10 results one would find that FY10's 50% jumps are not really that spectacular at all. A lot of it is just provisions coming back.

Hence we do not have a situation where ridiculously rich banks are crying poor over funding costs at the expense of the Australian everyman.

And that is exactly what the Senate inquiry will find, once it is fully explained. However, that does not mean the ongoing arguments over bank fees cannot persist despite strict reductions over the past year. As the Macquarie bank analysts put it:

“We believe it is unlikely that we will see controls placed on interest rates charged or paid by banks, but fees remain a fertile ground for political agendas”.

To sum up the NAB and ANZ results, analysts were largely in agreement that NAB had built a solid base from which it would bounce back once local business loan demand bottomed out and started rising again. However, this will take longer than previously assumed so patience is required. For ANZ, it was a case of marvelling at the bank's contrary margin movement (meaning up, not down like everyone else) but wondering whether that gap can be maintained.

For example, since March 2008 notes UBS, local bank sector margins have expended by 7 basis points (now in a downward trend) while ANZ's have increased by 51 basis points. Never before has one major sustained such a high level over its peers. UBS is thus assuming that gap can only now reverse, and ANZ management itself has suggested institutional loan margins appear to have peaked.

On the other hand, Deutsche Bank says “We see little risk of ANZ margins normalising to the peer average”.

Either way, bank analysts mostly agreed that the re-rating of ANZ which has occurred in recent months, mostly at the expense of the more mortgage-laden Westpac and Commonwealth ((CBA)) banks, is not only justifiable but perhaps still too lean. For NAB, forecasts depend entirely on exactly when the various bank analysts see the long awaited turnaround in business lending occurring, and just how “V-shaped” that bounce will be. For the most part, analysts are confident.

Which brings us to Friday's September private sector credit data released by the RBA.

At 0.1% net growth, private credit demand disappointed and provided plenty of room for the RBA not to raise tomorrow. Within the result, housing demand grew 0.6% but business demand fell 0.9%. Annualised housing credit demand is running at plus 0.8% so September suggested a slowing in trend, while annualised business credit demand is minus 3.7% and has been negative ever since the GFC.

Not a lot of reason to believe this Holy Grail of a bounce in business credit is just around the corner. The good news, nevertheless, is that business demand growth is quietly becoming less negative, so the trend shows a bottom is near. However, it's a bit like turning around the QE2 (the ship, not the other one). It will still be a long haul towards improved earnings in the business sector for the banks, one presumes.

And that brings us back to SVRs. If it's not enough for business credit to be slow, and funding costs to be on the rise, a good proportion of bank analyst valuations at present for the Big Banks assumes a level of “asset repricing”, which is another way of saying it is assumed the banks will increase their SVRs by more than the RBA cash rate increases, or that they will independently increase their SVRs if the RBA sits tight.

Are the banks honestly game enough to do this (particularly totally independent increases) in the current political climate? Maybe once upon a time the banks could thumb their noses at politicians and and tell them to keep out of the free market, but we mustn't forget the banks are still subject to the long process of post-GFC regulatory review, irrespective of knee-jerk Senate shenanigans. It's not a good idea to upset the regulators, or those who pay the regulators' wages, during a review which is most likely to impact on profitability.

RBS Australia has run some numbers on what the impact on the analysts' FY11 profit forecasts would be if they didn't add an extra 15 basis points to SVRs independently. CBA's would be trimmed by 4.8%, Westpac by 4.5%, ANZ by 2.8% and NAB by 3.7%.

And that's why, as suggested at the beginning of this article, the greatest risk to bank share prices at present is not necessarily rising funding costs, or a slow business credit turnaround, or an easing in mortgage demand. It is quite simply politics.

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