Is Negativity Towards Oz Banks Justified?

This story features MACQUARIE GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MQG

-Asset quality, outlook stable
-Equities affected by funding costs
-NZ banks cite higher funding costs
 

By Eva Brocklehurst

The negativity suddenly surrounding Australian banking stocks is not new, but is it justified?

Bell Potter believes not. The sector is performing well on the back of strong domestic GDP growth and tight cost management, while asset quality is considered stable. Recent raising of capital has ensured the banks are now comfortably funded and organic capital generation remains strong.

Bell Potter observes bank sector dividends went backwards on just three occasions in the last 37 years and the economic climate which prevailed in those instances is not the case today. Dividends are expected to be maintained going forward, at the very least.

The broker's top picks are Macquarie Group ((MQG)), Westpac ((WBC)), National Australia Bank ((NAB)) and Suncorp ((SUN)). Citi also finds bank valuations more attractive and has become positive on the sector following reporting season.

The stress that has been evident in debt markets has meant the Australian major banks have underperformed the Australian market, but a counter rally has meat some improvement in this regard although many valuations are still at or near crisis levels, in the broker's view.

Citi maintains that the drivers of recent earnings revisions for global banks are not featuring locally. Market estimates are being revised down for global bank earnings in the context of negative interest rates, oil & gas loan impairments and large restructuring of balance sheets. In contrast, the Australian banks are increasingly looking to asset repricing to grow revenue.

Despite their leverage to the economy, Australian banks are relatively underweight oil & gas exposures and it would require stress in the property sector to drive a major credit event, in the broker's opinion. Moreover, higher funding costs can be better managed now too.

Citi believes the time is right to re-visit the sector and retains Buy ratings for ANZ Bank ((ANZ)) and National Australia Bank and Neutral ratings for Westpac and Commonwealth Bank ((CBA)). Buy ratings are also maintained on the regionals, Bendigo & Adelaide ((BEN)) and Bank of Queensland ((BOQ)).

Macquarie has reviewed is medium-term bad debt expectations for the banks. Bank exposures to the energy and mining sectors have attracted significant attention and while parts of this book appear riskier, the aggregate weighted probability of default appears to the broker to be relatively low. The majority of rated exposures are investment grade.

However, looking at share price changes as a forward indicator of credit quality movements suggest the overall quality profile has deteriorated in the past 12 months. In Macquarie's opinion this justifies increasing the level of provisioning.

Among the majors, the broker believes Westpac and NAB have better quality institutional lending books compared with ANZ and Commonwealth Bank, in part due to their relatively underweight position in energy and and mining and lower exposures to offshore companies. In sum, the broker’s analysis highlights the average credit rating is sound across the rated portfolio.

The pricing of credit default swaps is often taken as a proxy for wholesale pricing by the equity market and, coupled with assumptions that pricing will not improve again, Ord Minnett suspects that equity prices have been disproportionately affected by the implied cost of funding. The broker suggests that as more debt issuance comes to market, and the headwinds to margins are observed as not all that bad, this may rally bank share prices.

Ord Minnett explains that while the spot cost of funding is now higher than the average of the portfolio, term debt maturities partially comprise relatively expensive debt that was issued during the European sovereign debt crisis.

In essence, with expensive new debt replacing expensive old debt the overall headwind to margins will actually be modest in FY16 and the broker believes the challenges will become greater in FY17, when major bank funding portfolios experience maturities of the relatively cheap issuance of 2013 and 2014.

Meanwhile, across the Tasman, New Zealand banks have repriced mortgage portfolios in recent days, following the reduction in official cash rates by the Reserve Bank of New Zealand, by not passing on the full reduction. They cite market volatility which is leading to higher offshore funding costs.

Deutsche Bank believes the changes also reflect the need to recover the impact from customers increasingly moving to fixed rate lending from floating rates. The broker acknowledges the changes are immaterial for the Australian banks but suggests that similar moves could occur in Australia if wholesale funding costs continue to rise.

Of note, one of the proposed changes from the Basel Committee on Banking Supervision – withdrawing the ability of banks to use their internal models for operational risk, such as Australian banks do – is probably a negative, in Deutsche Bank's view.

Yet the broker believes the inclusion of historical loss experience in the committee's preferred standardised measurement calculation is a positive, given Australian banks have a below-industry average loss experience. While there is limited disclosure on historical operational losses from the Australian banks Deutsche Bank still, on balance, believes any impact should be manageable.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms