Equities

As highlighted in the recent results announcements from Australia and New Zealand Banking Group (ASX:ANZ), Westpac (ASX:WBC) and National Australia Bank (ASX:NAB), the earnings and profits of our major banks are on the slide. It’s further justification for the investment strategy of The Montgomery Fund and The Montgomery Fund to have an 85 per cent active underweight position in the major banks.

We have been concerned about the ability of the major banks to generate revenue growth given the pressure on credit availability as well as public and political focus on fees stemming from the Royal Commission into Financial Services.

The recent RBA rate cuts have added to our pessimism regarding the outlook for revenue growth as the historical funding cost advantage generated from their material base of low rate deposits is eroded as wholesale funding costs gravitate toward a floor rate of zero.

This issue was certainly borne out in the recently released major bank results for the 6 and 12 months to 30 September 2019.

The chart below shows each bank’s annualised revenue growth for the 6 months to 30 September 2019 relative to the preceding 6 months to 31 March 2019. The revenue figures used exclude one off customer remediation and other notable costs as well as discontinued businesses to provide an indication of the underlying rate of growth.

Figure 1: Major Bank Annualised Revenue Growth 2H19 vs 1H19

Source: Companies

Underlying revenue growth in the 6-month period was negative for all three banks. The driver of this outcome was a combination of factors.

Loan growth continued to slow in the period. In fact, for both ANZ and NAB, their Australian mortgage books actually declined in size over the course of the 6-month period (-3.0 per cent and -1.8 per cent respectively) while Westpac’s grew at an annualised rate of just 0.9 per cent. The lower starting point for the loan books will also see the weak growth in 2H19 flow through as a drag on net interest revenue growth in 1H20.

Of greater concern and surprise was the weakness in net interest margins (NIM) in 2H19. While we have been expecting the recent RBA rate cuts to negatively impact major bank net interest margins, the normal 2-3 week lag between the date the RBA announces a rate cut and the date when the adjustments to major bank standard variable rates come into effect usually provides the NIM with a temporary boost. This does not appear to have been sufficient to offset the impact on NIM from constraints in reducing deposit rates and increased front book discounting.

Figure 2: Major Banks’ Continuing Business Net Interest Margin Excluding Notable Items

Source: Companies

With the full impact of the recent RBA rate cuts yet to flow through, and the potential for further RBA rate cuts to come, the outlook for net interest margins remains challenged for the major banks.

Non-interest revenue continues to be impacted by new low loan demand, falling credit card transactions and reduced fees. This is unlikely to change in the near term.

With revenue flat to down, it puts a lot of pressure on management to reduce operating costs to mitigate the impact on earnings. However, the increasing threat coming from new technology solutions, combined with ever increasing regulatory burdens makes it very difficult for the banks to reduce operating costs in absolute terms.

In the 6 months to September, operating costs before remediation costs and other notable items increased around 2-4 per cent on an annualised basis.

Figure 3: Major Bank 2H19 Annualised Growth in Operating Costs and Operating Profit

Source: Companies

While the major banks have cost reduction targets and strategies, unless they see a recovery in revenue growth, it will remain difficult for them to prevent ongoing earnings declines, let alone achieving earnings growth in future periods.