Australia’s highly prosperous banks are entering a new era of tighter capital rules, slower economic growth, and competitive pressure on margins, making it increasingly difficult for them to deliver stellar profits. The country has a highly concentrated market with the four biggest institutions – Commonwealth Bank of Australia, Westpac, ANZ, and National Australia Bank – accounting for 80% of banking business.
The Big Four could soon be the best capitalised banks in the world following moves by the local regulator – the Australian Prudential Regulation Authority – to make the banks “unquestionably strong” by placing them in the top quartile of institutions globally in terms of capital adequacy.
APRA is in the process of responding to a raft of recommendations made by a wide-ranging financial systems inquiry which delivered its blueprint for the nation’s financial sector at the end of last year. This is on top of new Basel Committee initiatives being formulated to standardise internal modelling of risk-weights for banks globally (that is, Basel IV).
“Given the large number of moving parts in these interrelated regulatory proposals it is very difficult to estimate the impact on the banks,” Jonathan Mott, an equities analyst at UBS in Sydney, told FinanceAsia. “The only definitive conclusion is that the increased capital requirements are likely to be substantial and the longer this debate continues the larger the potential capital shortfall becomes.”
APRA appears likely to introduce its reforms one rule at a time. In July it announced a plan to impose a floor of 25% under the risk-weightings for home mortgage portfolios for the Big Four. This compares to the average risk-weight of about 16% today. The rule comes into effect on July 1 next year.
The new risk-weight floor for property loans means the Big Four banks have to add about 200 basis points in common equity tier one capital, or a total of about A$13 billion ($9.3 billion) in new capital between them.
To plug some of the hole, Mott at UBS said the banks will sell non-core assets – a process that has already begun. In June Westpac offloaded A$700 million worth of shares in BT Investment Management and ANZ will soon dispose of its car leasing business Esanda Dealer Finance, which has about A$8.3 billion in loans.
ANZ has also flagged the sale of minority stakes in two or three Asian banks over the next couple of years, starting with its 39% holding in Indonesia’s Panin Bank. NAB, meanwhile, plans to float its poorly performing UK business by the end of the year, including Yorkshire and Clydesdale bank branches.
But asset sales alone aren’t sufficient to meet the new capital bill so the banks have been taking advantage of favourable market conditions to tap investors for more cash. Between May and August this year NAB raised A$5.5 billion from a rights issue, Westpac executed a A$2 billion dividend reinvestment plan and a A$750 million capital notes offering, CBA completed a A$5 billion rights issue, and ANZ raised A$3 billion.
All told, the banks have extracted A$16 billion from existing shareholders, well above the A$13 billion projected by analysts.
The impact on the banks’ common equity tier 1 (CET1) ratios has been swift. Using APRA’s conservative approach to measuring capital adequacy, analysts estimate NAB has increased its CET1 ratio from 8.87% to 9.94%, while CBA’s ratio has jumped from 9.1% to 10.4%.
These figures are even higher when the banks apply counting methods used by international peers. For years Australia’s banks have been critical of the way APRA measures capital and have called for a standardisation of counting practices.
CBA, for example, reckons its CET1 ratio is 14.3% using international benchmarks, making it the third-best capitalised bank in the world. That is a grandiose claim for a bank that is of no global systemic importance, leading some to argue that APRA has established a new threshold for conservatism.
Steven Münchenberg who heads the Australian Bankers’ Association, believes Australia is in danger of entering a capital arms race.
“We agree the system needs to be unquestionably strong but we don’t think this means our banks need to be in the top quartile of international banks,” he said. “We got through the global financial crisis on more than just capital strength. It was a combination of strong regulatory supervision, cautious lending by the banks, and a robust local economy. Sometimes this is forgotten.”
Supernatural profits
So far shareholders have been eager to support the banks in their fund-raising efforts.
Australia has one of the largest per capita retirement savings pools in the world with A$2.1 trillion in workers’ money invested in local and global securities and investors have a long-standing love affair with bank stocks, mainly due to their reputation for paying handsome dividends.
There is also a perception that banks have a supernatural ability to grow assets and earnings year after year. Since the global financial crisis of 2008, the Big Four have recorded nearly six consecutive years of record profits.
The country’s largest bank, CBA, made a full-year profit of A$8.63 billion in 2014, while Westpac clocked up A$7.56 billion, ANZ made A$7.27 billion, and NAB made A$5.29 billion (see table).
CBA is the only bank to have announced full-year results for 2015 – announcing a dizzying return of A$9.1 billion in mid-August.
“When you compare net income of banks around the globe, Australia has one of the most profitable banking systems in the world next to Canada, New Zealand, and Singapore,” said Ilya Serov, a banking analyst at Moody’s in Sydney. “The key to this profitability is the [Big Four] banks’ strong pricing power in a concentrated market.”
But the recent round of capital raisings have a dilutive effect
on returns. CBA’s return on equity slipped to 16.8% from 18.2% following its right issue in August, while NAB saw its ROE drop to around 11.8% from about 14% prior to its rights offering. “Average ROEs peaked in the high-teens to low-20s before moderating after the global financial crisis,” Serov said. “Looking ahead, we think ROEs in the low-to-mid teens will become
the new normal.”
The thorny question faced by the banks is who should pay for the increased costs of regulatory capital. Either shareholders are asked to stomach lower returns or costs are passed on to customers through higher product prices.
“A third option is to change the risk profile of their portfolios and write riskier loans, but we think this would be negative for the sector,” Serov said.
Serov also isn’t convinced that Australia’s love-struck shareholders will be prepared to tolerate lower ROEs. “We’re watching the investor community closely to see how it reacts. We don’t know yet how the market will respond, particularly if ROEs drift down towards the low teens or even lower.”
Customers are already being asked to carry some of the load and in July several banks raised interest rates on property loans for investors. It is rare for the banks to move out of step with the Reserve Bank when raising rates, and the market reacted with incredulity. Serov said Moody’s detected an immediate uptick in customers showing interest in products offered by smaller regional banks and non-bank lenders.
These second-tier players have been “sharpening their competitive pencils” since APRA announced its new risk-weight floor for home mortgages in July, Münchenberg at ABA said. Prior to that, smaller banks and non-bank lenders had to hold more than twice as much capital as the major banks against the same type of loans.
“The smaller banks had been vocal for some time about these different capital treatments and they gained sympathy for that view,” Münchenberg said.
A more level playing field is likely to put pressure on already-compressed net interest margins, which are the best predictor of bank profitability. In the 12 months to August, the Big Four reported a net interest margin shrink of five basis points to just above 2%. Ten years ago, average margins were as high as 3.5%.
Some of this compression has been offset by lower deposit costs; for several years the banks have dealt with eroding margins by boosting the size of their loan books.
CBA, for example, reported a 7% increase in interest-earning assets in the 12 months to August, mainly owing to the booming residential property market. Home prices in Australia’s major cities have been soaring due to record low interest rates, a rise in property speculation, and a surge in overseas buyers.
In July this year, Sydney’s median house price topped A$1 million for the first time.
Credit growth too slow
The ability for the banks to achieve growth by expanding assets is diminishing, according to Serov at Moody’s. “Outside of the home loan market, credit growth in Australia has been subdued. We see some downside risk to overall credit growth,” he said. “The banks themselves are predicting 6% to 7% credit growth over the next 12 months but we think it could be lower.”
If CBA’s 2015 full-year results are any guide, there is already evidence that earnings momentum is tailing off.
The results also show a potentially worrying shift in borrower health. In the June half, CBA’s charge for bad and doubtful debts rose a jaw-dropping 25% due to higher arrears in its unsecured portfolio of personal loans such as credit cards and car loans.
“We expect bad debts to go up, reflecting the generally subdued economic conditions,” Serov said, pointing to particular pockets in the corporate sector currently under strain. “Mining services companies are weak and at a higher risk of default, especially in Western Australia and Queensland – two states which have been impacted most by the end of the mining boom. This is also where mortgage delinquencies are on the rise.”
The biggest risks facing the banks are a correction in residential property prices and a spike in unemployment.
At this stage property prices remain stubbornly steady, but in July Australia’s unemployment rate skyrocketed, reaching its highest level in 13 years at 6.3% and placing it well above the US rate of 5.3%. The latest reading is cause for concern because it also masks a disturbing increase in underemployment measured by the number of full-time workers being replaced with part-time or casual contractors who receive fewer benefits and experience poorer job security.
As well as breeding a new generation of casual contractors, a large proportion of Australian borrowers have never experienced anything other than abnormally low interest rates.
Homeowners are now more exposed to interest rate movements than they have been for 25 years. And there is little doubt that a normalisation of rates is on the way, suggesting APRA’s move to dial-down latent risks in the banks’ loan books is a sagacious step.
Credit growth too slow
The ability for the banks to achieve growth by expanding assets is diminishing, according to Serov at Moody’s. “Outside of the home loan market, credit growth in Australia has been subdued. We see some downside risk to overall credit growth,” he said. “The banks themselves are predicting 6% to 7% credit growth over the next 12 months but we think it could be lower.”
If CBA’s 2015 full-year results are any guide, there is already evidence that earnings momentum is tailing off.
The results also show a potentially worrying shift in borrower health. In the June half, CBA’s charge for bad and doubtful debts rose a jaw-dropping 25% due to higher arrears in its unsecured portfolio of personal loans such as credit cards and car loans.
“We expect bad debts to go up, reflecting the generally subdued economic conditions,” Serov said, pointing to particular pockets in the corporate sector currently under strain. “Mining services companies are weak and at a higher risk of default, especially in Western Australia and Queensland – two states which have been impacted most by the end of the mining boom. This is also where mortgage delinquencies are on the rise.”
The biggest risks facing the banks are a correction in residential property prices and a spike in unemployment.
At this stage property prices remain stubbornly steady, but in July Australia’s unemployment rate skyrocketed, reaching its highest level in 13 years at 6.3% and placing it well above the US rate of 5.3%. The latest reading is cause for concern because it also masks a disturbing increase in underemployment measured by the number of full-time workers being replaced with part-time or casual contractors who receive fewer benefits and experience poorer job security.
As well as breeding a new generation of casual contractors, a large proportion of Australian borrowers have never experienced anything other than abnormally low interest rates.
Homeowners are now more exposed to interest rate movements than they have been for 25 years. And there is little doubt that a normalisation of rates is on the way, suggesting APRA’s move to dial-down latent risks in the banks’ loan books is a sagacious step.
