The Outlook For Australia’s Big Four Banks

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

By Greg Peel

At the end of the day, a bank's profits reflect the margin between its lending and borrowing rates, with mortgages, business and other loans on one side and deposits and wholesale funding on the other. Proprietary trading and wealth management businesses offer additional revenue, but banks are not going to outperform when margins are under pressure.

Which is the situation they finds themselves in now.

Over the past month, ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) have all provided earnings results for the six months to March while Commonwealth Bank ((CBA)) has completed the picture with a March quarter update. And over the past month, the world has slipped back into Europe-related “risk off” mode yet again. In wrapping their reporting season views, bank analysts have had to contemplate both events.

The books closed on a buoyant global marketplace at the end of March, albeit Australia's performance was tempered by the two-speed economy factor. The RBA has since provided a 50 basis point cash rate cut as a result, which impacts on the banks' margin picture going forward.

The buoyant market nevertheless provided the banks with a more positive trading environment, which helped offset weak ex-market revenues. The picture would have been pretty bleak without trading profits, Citi suggests, but all in all the banks' results were largely as expected. 

It was no surprise that margins were lower. Ignore what the idiot, vote-seeking politicians have said, bank wholesale funding costs are higher now than they have been in recent times albeit lower than they were at the depth of the GFC crisis. To settle on “higher” or “lower” one must first set the terms of reference. In the meantime, the banks continue to pay up for deposits, particularly popular term deposits, given stiff competition for this cheaper form of funding. With the wider Australian economy subdued to say the least, loan growth has been anaemic. Hence the margin crunch.

The good news is that bad debt provisions are reasonable, overall sector loan quality continues on an improving trend and the Big Four are very well capitalised in the context of the new Basel III requirements coming into force in January. The bad news is there appears further pressure on margins ahead.

As to how the six months to March and the relative price movements of bank shares has impacted on analysts' sector preferences, it is interesting to first take note of the following table. It indicates how the FNArena broker database perceived the Big Four following the previous half results posted in November.

Six months ago, NAB was number one pick amongst the sector. NAB is seen as the riskiest of the quartet but thus offering, at the time, greater upside from earlier weakness. NAB had seen the benefits of its “Your dumped” ad campaign which attracted new loans, and the feeling was all the bank had to do was exit its dragging UK operations and the world would be a happy place. CBA was, is, and pretty much always has been considered the least risky of the four, but also the most-overvalued on this basis. Hence it was, six months ago, firmly planted in last place. Now let's fast forward to the latest table, based on yesterday's closing prices.

A number of changes immediately stand out, but let's start with stock prices. Bearing in mind we've just had another savage euro-based sell-off, each bank's stock price is not much changed from six months ago. If we compare prices to consensus targets using the up/downside measure, we also note not a lot of difference in the readings for all of CBA, NAB and Westpac. NAB, on the other hand, has seen its upside to target halved.

It was suggested by at least one broker six months ago that NAB's competitive loan rates might just come back to bite the bank on the backside, and with wholesale funding costs having drifted higher, and competition for deposits remaining elevated, they have. Perhaps NAB's biggest problem, however, is an even steeper deterioration in the banks' UK business under government austerity measures and the realisation NAB may simply not be able to exit for some time.

It is thus no surprise NAB has now crashed to the bottom of the table (rankings based on Buy/Hold/Sell ratios). Perhaps more surprising is that CBA's share price has risen 4% over the six months yet suddenly analyst consensus has the lumbering giant in equal first. CBA's premium to the bunch has seen some easing, but where the bank stands out is on its investment to date on new technology, offering a lower cost structure ahead than its slower moving rivals. And at the end of the day, not all analysts suggest CBA's premium is unjustified.

Costs are considered one of the more significant headwinds for Westpac, while in the deteriorating local economy ANZ's Asian exposure provides it with sufficiently positive point of difference to bump it into equal first with CBA.

We should also take heed that analyst forecast adjustments to date have been confined to a result season response, with any further forecast changes pending on the escalation of euro-fear. The exception is Macquarie which has this week moved to trim bank target prices, but I'll address Macquarie's reasoning shortly. Target trimming may also be ahead for the other brokers but in the meantime there has been much discussion about what the whole “Greek exit” story may imply. Europe adds an additional element into domestic-based expectations for bank margins over the second half.

Let's just hold wholesale funding costs steady for the moment. Led by ANZ, the banks have been attempting to shift the average Australian's focus away from the RBA overnight cash rate and toward the cost of overall funds when it comes to mortgages, primarily, and business loans thereafter. Banks quite simply do not borrow overnight cash in order to provide 20-year loans. A cut in the overnight rate helps to shift rates down across the yield curve, but one needs to go out to 90 days to find the banking sector's short-term borrowing cost, known as the bank bill swap rate (BBSW) and one needs to reflect on why the banks have been recently, and always have been, issuing five year paper in various forms. The reason is because that's where a bank's loan exposure is concentrated.

ANZ has thus been bold enough to make “out-of-cycle” increases to its mortgage rate, meaning unrelated to any RBA rate change, to reflect the bank's true borrowing cost. The 50bps RBA cut also provided scope for the banks to reprice their loans and pick up some margin relief. On the other side of the equation however, we are yet to see the banks reduce their deposit rates.

While an RBA rate cut provides the banks with every excuse to drop term deposit rates, such cuts usually follow a couple of months later once the loan book impact has played out. The problem is that demand for term deposits remains strong but so does the competition amongst the banks for this cheaper form of funding. It might be difficult for average Joe to switch mortgage providers mid-stream but it is very easy to switch term deposits at every rollover. Cut the TD rate too far and a bank will suddenly find it is isolated in the deposit funding market.

Were it not for TD market tightness, bank analysts suggest net margins could improve over the second half even as credit demand sags as room is provided for loan repricing at more favourable levels. But ongoing tightness rather nips this possibility in the bud. 

Now consider how things will look if offshore funding costs really do shoot up again as another global credit freeze descends.

Just to add to the gloom, offshore funding risk was not the primary reason for Macquarie's target price cuts this week, albeit “tight funding conditions” are a factor. The Macquarie analysts have drawn on analysis from East & Partners to paint a weak picture of net margin expectations ahead. Let's divide the Australian economy into its two dominant sectors. We'll call them Mining and Not Mining (with energy part of mining for the sake). Due to the geographical luck of the draw, we thus have two Mining states while everyone else is in a Non Mining state.

East & Partners' analysis show weak borrowing intentions from Not Mining in the next year, particularly from SME and micro business cohort. Macquarie suggests “the outlook for business margins is bleak”. In the meantime, bank exposure to Mining states has doubled over the past three and a half years, with WA and Queensland now representing some 40% of net interest income. Mining is now conceding more subdued conditions, and Macquarie sees risk to the downside. At best, the analysts suggest, margins could be weak as Mining stalls. At worst, the banks may find their Mining state exposures now providing risk.

The news is, however, not all bad. Analysts agree there is no reason the banks would need to decrease their dividends. Not only are capital positions comfortably within the new Basel III requirements, they are significantly higher on a ratio basis than most developed world banks, particularly those deemed “too big to fail”. Asset quality is also improving and bad debts are under control, so while the outlook for earnings growth appears very subdued, very attractive yields will remain the order of the day.

This is comforting when confronted with yet another possible period of serious global “risk off”. Yet while Australian banks to date have not tended to materially underperform in such times, BA Merrill Lynch is concerned the Big Four may just be a little more vulnerable this time around. This time around the underlying domestic growth backdrop is weaker, margins are not set to recover and may even be squeezed further on RBA rate cuts if there is no room to lower TD rates. Deutsche Bank sees scope for reduced TD rates but upside risk to wholesale funding cost would provide a counter, as would continued competition for deposits. Merrills also notes bank valuations have come off sharply again across the globe but not so for Australia's Big Four, making elevated price to book values on a peer comparison an easy target.

Citi notes that on their own, the Big Four are currently trading on undemanding multiples. Yet Citi can't get too excited given valuations reflect the anaemic credit growth outlook ahead and further volatility in markets is likely.

So just how bad could it get? 

Following last week's CBA quarterly update, bank CEO Ian Narev addressed the implications of a Greek exit. He believes they would be “material”, but notes there has been a degree of forward planning. Narev was speaking only for CBA, but one assumes the others haven't ignored the possibility either. Narev is confident of CBA's settings with respect to counterparty risk.

He is also “confident the Australian economy is in pretty good shape” but is also wary of the further overflow of negativity into consumer sentiment, impacting on credit demand. In particular, Narev suggested CBA is carrying sufficient funding to carry it through any potentially deepening crisis in Europe.

This is true for all banks, which have pretty much secured their funding requirements for FY12 (year ending September). They will soon have to think about FY13, however, and the risk is we'll see another bout of sustained credit spread elevation, pushing up wholesale funding costs.

So to summarise:

The outlook for Australian bank margins, and thus earnings, is weak, based on ongoing subdued credit demand, rising offshore funding costs, ongoing deposit rate competition and the risk of a more significant blow-out on a Greece-led crisis. Were sentiment to turn sour again Australia's banks are likely to be hit. However capital positions are strong, dividend payments are not under threat, asset quality has improved and bad debt levels are not overly concerning.

It is interesting to note at this point that last week's unsecured note offer from NAB (supposedly the weakest of the four) was so well subscribed the bank doubled the size of its intended borrowing. (See: Yield On Offer From NAB Note Issue). NAB is offering at least 2.75% over BBSW which puts the note's initial floating coupon at over 6.5%. On yesterday's closing price and analyst forecasting NAB is offering a 7.8% equity yield, but also equity risk. You would only lose your capital on the note if NAB went bust.

Citi suggests waiting for a further market correction before buying Australian bank shares. The public is saying bonds are a safer bet than equities.
 

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