Australian Banks: Earnings Results And The Great Big Tax

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

The big banks had already posted disappointing earnings numbers before Scott Morrison dropped his bombshell. What does the future hold now?

This article was first published for subscribers on May 15 and is now open for general readership.
 

By Greg Peel

Before The Levy

Ahead of the bringing down of the federal budget, ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) all reported first half earnings and Commonwealth Bank ((CBA)) provided a quarterly update.

Bank analysts were disappointed in the results.

Profits fell short of forecasts. More disturbingly, profits were boosted across the sector by trading income, being proprietary trading in volatile financial markets. This is considered a “low quality” source of income by analysts given its volatile nature. Revenue growth from commercial banking operations was basically non-existent.

Analysts had expected an improvement in net interest margins – the primary driver of commercial bank earnings – given the round of mortgage repricing undertaken by the banks over the period. While the banks did pick up margin basis points from repricing loan books, this was offset by points lost on the deposit side of the equation. Deposit competition remains a drag.

It was not all bad news. Bad debts were benign, with previous “pockets of stress” having appeared to relax. Cost controls were impressive. Most impressive of all was organic capital growth.

As to whether there will actually be a Basel IV round of global bank regulation tightening in our lifetime is anyone’s guess. The committee simply cannot agree, and have pushed any final decision out to at least 2019. This takes some pressure off Australian bank balance sheets, easing the prospect of further capital raising requirements. However, APRA’s requirement of “unquestionably strong” remains, as yet, a quantitative mystery.

APRA had been holding out to see just how far Basel IV would go, and whether the major banks in the minor economy of Australia would require an additional capital buffer against another GFC, befitting a small population. Now APRA is on its own, having to define “unquestionably strong” from its starting point.

All along the delays involved have bought the banks time. Capital generation in the first half FY17 exceeded analyst expectations, leaving three of the four with tier one capital ratios in excess of 10%. Might 10% be a fair benchmark for an “unquestionably strong” balance sheet? Analysts have no clue, but suggest 10% would at least go a long way towards that magic number.

Looking ahead, from a pre-budget perspective, analysts struggled to see a bright spot for the sector beyond solid capital positions. They agreed there is little scope left for further mortgage repricing. In the “front book”, meaning new loans, increased rates will impact on demand. In the “back book”, meaning existing variable rate mortgages, further increases risk tipping debt-laden Australian households over the edge.

The banks have been able to milk their investor mortgage books with rate repricing because APRA has forced them to do so. The latest regulatory restrictions on investor loan growth, and particularly interest-only loans, have meant banks have to slow down their current rates of growth. Higher rates and tougher lending standards not only achieve this, they provide immunity from the typical “bank bashing” response from the government and the populace endured every time out-of-cycle rate rises are applied.

But they also risk killing the goose. With business credit demand remaining subdued, mortgages are the banks’ golden eggs. As demand falls, so do the prospects for bank earnings growth.

And in that sense, the tighter regulations applied by APRA appear to be doing what they’re meant to – “cooling” the housing market and, maybe, easing the affordability crisis. This implies “cooler” growth opportunities for the banks.

On the subject of bad debts, while analysts find ongoing low rates of defaults a relief, they also warn the only way is up. Previous “pockets of stress” may be abating but new “pockets of stress” are threatening to rise. WA consumers provide one area of concern, for example.

And if the housing bubble burst, rather than cooled?

After the Levy

Then along came the budget. If a subdued earnings growth environment was not enough for the banks to have to cope with, they never saw the 6 basis point levy on liabilities coming. The levy, the Treasurer was quick to point out, will not be imposed on mortgages or deposits under $100,000 (thus government guaranteed).

In isolation, analysts estimate that the levy, which is forecast to net the government $6bn over three years, will cut bank earnings forecasts by 4-5%. As to what the net impact will be depends entirely on how the banks respond to the levy, and that is as yet unknown. Crying foul will not work. The levy is very popular with the people and has the support of both sides of parliament.

The obvious response, in order to shore up earnings, would be to pass the levy on through further mortgage repricing. But there are two issues here. The first is as discussed above: even before the levy was imposed, the risks around further mortgage repricing were growing. And secondly, in order to avoid the levy being paid by bank customers, the government has instructed the ACCC to investigate any mortgage repricing shenanigans.

But there is one way around the latter. As noted earlier, the banks have been able to reprice investor mortgages at will because no one is complaining. Investors, along with foreigners, are being held responsible for Australia’s housing affordability crisis. The analysts at UBS therefore believe the best way to push back against the levy is for the banks to “go hard” – pass it on in full to investor borrowers and foreigners. Some offset could be provided by offering discounts to first home buyers.

The benefits of such a move, apart from “firing a shot across the bow of politicians”, would be increased negative gearing tax reductions, effectively making the government bear some of the cost, and to further slow a dangerous housing bubble, UBS suggests. The banks would not lose investor loan market share to the unlevied smaller banks, given they must also adhere to APRA restrictions on investor loan growth.

The risks are that rather than slow the housing bubble, increased rates burst the housing bubble, and that the government is antagonised by the audacity. A Royal Commission, which in theory the levy is an alternative to, would be back on the cards.

An alternative response from the banks would be to share the love around, UBS offers. Engage in repricing, but only of those products directly levied (hence not mortgages). Offset with cost cutting, through staff reductions and lower executive bonuses. And cut dividends. Customers, staff and shareholders would all contribute.

Or the banks could just cop it on the chin – smile and say how pleased they are to be helping out the government with reducing the budget deficit. This takes us back to the forecast loss of 4-5% earnings per share, which, via payout ratios, reduces dividends per share, and implies the shareholders carry the can.

The capitulation alternative would at least reduce the risk of a Royal Commission, UBS notes, but there is possibly a far more sinister result.

If the banks simply roll over then the government will see them as easy targets. And given both parties support the levy, future governments of either stripe would find budgets easy to prop up by simply increasing the levy. There is a similar levy in place in the UK. It has been increased nine times.

Despite the risks, Bell Potter expects the banks will respond in the usual manner – push through a range of subtle mortgage price rises, further reduce costs, and look for other sources of income increases. The broker estimates a “manageable” 10-15 basis point repricing of mortgages along with a -5% cut in costs would do it, the latter not too difficult given the majors’ large branch networks.

Goldman Sachs is not yet adjusting its bank earnings forecasts given uncertainties relating to the calculation of the levy and the impact at bank level. The broker does agree that the banks will redouble their efforts to reduce costs, but sees limited ability to offset through mortgage repricing.

Macquarie had already considered further mortgage repricing opportunities to be limited.

The Fallout

Macquarie had thus already been cautious on the sector. Post-levy, the broker moves to a sector Underweight. Earnings growth upside is limited, balance sheet growth is slowing, trading income is currently elevated and bad debts are at cyclical lows implying, as noted earlier, the only way is up.

Macquarie acknowledges that Big Bank shares have copped a decent de-rating both post-results and post-budget but notes the sector is till trading in line with its long term average PE relative to the market.

Ord Minnett agrees the banks have now de-rated back towards fair value. But the broker suggests further downside is limited as once again the attraction of yields comes into play.

Ords was not as disappointed as peers with the round of earnings results, believing consensus was factoring in too rapid a boost to margins from recent mortgage repricing. The benefits will be more obvious in the second half, the broker believes. And given the levy doesn’t actually come into effect until July 1, the impact on FY17 results will be limited. (Note: CBA’s FY17 ends June 30, the other three September 30.)

The banks thus have around six months to assess their responses, Ords suggests, by which time it is assumed “unquestionably strong” will also be settled. If it means further capital requirements then the banks may just have the excuse they’re looking for further repricing, offsetting the levy.

Citi had an Underweight rating on the banking sector going into the budget, and nothing has changed.

There are nevertheless notable changes when we start to break down the sector.

FNArena last published a sector update back in April when the latest APRA restrictions were announced (Australian Banks And The APRA Impact). Back then, our consensus forecast table (of the eight major stockbrokers in the FNArena database) looked like this:

Points to note: the database showed ten Buy (or equivalent) ratings on the Big Four, eighteen Hold and four Sell. The four banks were all trading 4-6% in excess of consensus target prices, and the net order of preference (based on ratings) was Westpac, NAB, ANZ, CBA.

Now to today’s table:

Points to note: Only two banks are now still above target, just. Yet downgrades have meant there are now only eight Buy ratings, with sixteen hold and eight Sell. The order of preference is now NAB, ANZ, Westpac, CBA.

Given that CBA perennially trades at a “size” premium to the other three, and that analysts perennially believe this is unjustified, CBA has spent about 90% of its life as last preference. Otherwise, the preference order of the other three has flipped over.

It is also worth noting that each bank, understandably, is now offering a higher yield.
 

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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