The recent bank reporting season was highly anticipated as it was the first since the Banking Royal Commission final report. Although these results were impacted by divestments from non-core operations, remediation charges and Royal Commission related expenses; investors were primarily interested in the underlying trends in the ‘key drivers’ of bank profits. Investors are also looking for whether there is a potential change in these trends going forward.
Given the monthly statistics that are publicly available on credit growth, it was likely that loan growth would be subdued. Availability of credit, or really lack of it due to a “credit squeeze”, and lower demand were behind this slowdown. The lack of availability of credit via a greater scrutiny on the borrower's capacity to service debt and improved expense verification by the banks rather than simply relying on Household Expenditure Measure (HEM) benchmark was apparent in ANZ’s result with housing credit growth actually falling year-on-year (yoy). NAB’s housing credit growth, although stronger, also slowed recently as well.
The banks pointed to housing credit growth remaining subdued and with peers following ANZ’s lead in regards to stricter expense verification rather than using the HEM, this outlook appears likely to persist.
Bank executives did acknowledge that serviceability measures introduced by APRA requiring banks to assess all borrowers against a rise of 2% in interest rates, or a floor of 7%, may not be appropriate in a low interest rate environment. If a reduction in this serviceability requirement did occur, then there is a potential for housing credit growth to improve as more mortgage applicants are approved and this may stimulate a soft housing market.
Net Interest Margin (NIM)
Earlier in 1H19, banks repriced mortgages upwards to ease the pressure on their margins. NIMs were down across the banks in 1H19 with any positive impact being offset by continued price competition in the mortgage market. Along with the mix shift from Interest Only (IO) to Principal & Interest (P&I) loans, which are not as profitable for the banks, NIMs have remained under pressure.
ANZ also flagged increased lending to institutions which had a negative impact on Group NIM as corporate lending is less profitable than retail.
Bank executives noted that underlying NIM pressures will persist into 2H19, even though the banks will get some margin relief going forward as the BBSW (wholesale funding rate) has fallen significantly since the start of the year.
Trading income (a volatile item) bounced back for most banks this half. However, banking fees have remained under pressure and NAB announced recently that they are set to scrap up to 50 fees and charges.
Banking fees have undergone a structural shift downwards post the Royal Commission driven by continued political and consumer pressure.
Given the weak revenue trends experienced by the banks, cost reduction was going to be a key focus. Costs (ex remediation) were down across all banks, as was commonly expected, in reaction to the soft environment.
ANZ set a target to reduce expenses to less than $8bn by 2022 (around a ~8% reduction), whilst NAB reiterated guidance for flat costs over FY19 and FY20. However, a new CEO at NAB may also lead to more restructuring costs.
Westpac was on track to save $400m over FY19 and said that structural cost reduction was critical in the current environment.
This ongoing focus on cost reduction will also need to be balanced against essential IT investment at the banks. There is also a risk that conduct remediation costs will continue.
Managing costs is the one major lever the banks have to offset the subdued revenue outlook.
Heading into reporting season the market was looking for evidence of any early signs of mortgage stress. One of the more concerning aspects coming out of the bank reporting season was the rise in mortgage delinquencies. Mortgages 30 and 90 days-past due (dpd) have deteriorated over the last 6 months.
ANZ saw mortgages 30 dpd rise ~45 bps, whilst NAB and Westpac experienced mortgages 90 dpd increase by ~8 bps and 13 bps respectively.
As mentioned, there has been a mix shift from IO to P&I loans which hurt bank NIMs and this spike in mortgage delinquencies 30 and 90 dpd can partially be attributed to this mix shift where prior interest only borrowers struggle to make principal repayments.
Another concerning data point was the rise in negative equity in the bank's mortgage books. ANZ made particular note of recent delinquencies now being in a negative equity position (ie they owe the bank more than their property is worth).
The rising stress (albeit off a low base) in the housing book is occurring in an economy where the unemployment rate is steady and any rise in unemployment is likely to worsen this trend.
Given the above trends there is increased risk of further bad debt charges for the banks going forward.
Capital and Dividends
The cut to the dividend by NAB of 16% was not a total surprise to the market, although the timing was, as many expected this may happen shortly after the appointment of a new CEO. ANZ and Westpac both kept their dividend flat.
Given the potential capital shortfall from Reserve Bank of NZ’s proposal to increase minimum capital requirements, and the risk of increased bad debt charges, the cut to the dividend by NAB was sensible. This also means any buybacks (if any) for ANZ may be limited and the target payout ratio (70-75%) for Westpac's dividend may be exceeded unless the dividend is cut.
As the Royal Commission has now finished, investors can now return their attention to the bank's earnings momentum. With continued NIM pressure, decelerating housing credit growth, an increased risk in bad debt charges, further remediation and regulatory expenses and potential cuts to dividends, the outlook for bank earnings and share prices remains challenged in our view. The Labor policy on Franking Credits is also likely to contribute to this given the significant weighting the major banks have in many retiree's portfolios.