Westpac: Through the eye of the storm

Over recent times Westpac Bank (WBC) has been underperforming the Australian equity market; since 2015, WBC’s share price has fallen 30% whereas the ASX200 has gained 3%. The poor performance period coincides with APRA’s release in 2014 of APG 223 - Guidelines for Residential Mortgage Lending. 

These guidelines ultimately led to Australian banks taking a more conservative approach to lending practices while concurrently elevating the amount of capital needed to support existing credit exposure. Today WBC released its 1Q FY2019 Pillar 3 report and we believe that there are three important findings.

1) Today's release highlights that WBC currently has $5.7b of non-performing loans (NPL). Importantly the NPLs have now been relatively stable for 8 quarters despite 15 consecutive monthly declines in national residential property prices. This current drawdown in property prices is the worst since Australia deregulated the financial system back in the mid-1980’s. Accordingly, it would appear that WBC’s historic loan origination processes have been relatively prudent.

2) As of Dec’18, WBC held $62b of capital. This has risen 47% since Mar’15 and now covers 14.8% of Risk Weighted Assets. It is also worth noting that WBC’s risk weighting of credit exposure has increased from 39% to 41% over the past 4 years. WBC appears to be suitably capitalised.

3) WBC’s Pillar 3 report demonstrates that 48% of funding is classified as stable. Ultimately WBC generates the majority of its funding requirements from retail deposits. This is very important. Stable funding ensures that WBC can efficiently meet regulatory liquidity guidelines. It also provides WBC with a competitive margin advantage; WBC’s net interest margin rate is 2.13% versus the peer average of 1.94%. This ensures that WBC can price loans at more competitive levels without sacrificing too much margin. This is particularly relevant when wholesale funding markets exhibit volatility.

We believe that today’s Pillar 3 release signals that WBC has now moved through the “eye of the storm”.

The K2 Australian Fund has been under-weight Australian banks since 2014. We were mindful that regulatory overlays would dilute future bank earnings and, when combined with highly indebted households, the prospect of higher bad debt charges seemed unavoidable.

Given that the Royal Commission (RC) has now presented the government with its final report, we feel that the regulatory risk of earnings dilution has most likely peaked. The RC emphasised that boards and senior management within the financial services industry were primarily responsible for the misconduct in the past. However, instead of recommending significant legal burdens, the RC opted for a more balanced approach that centred on culture, governance, remuneration practices and the norms of conduct.

The most pressing issue at hand is now the determination of whether an uptrend in the bad debt cycle is imminent. Forecasting bad and doubtful debt charges for the banks is never easy. Bad debts experiences tend to follow decaying employment conditions.

However, the incidence of unemployment is normally only visible 6 months after a reversal in the employment market. Hence it is important to analyse various employment lead indicators such as ANZ job ads, business confidence and movements in foreign exchange rates. At present, our assessment is that Australia’s unemployment rate could well rise over the coming 12 months. Hence, we feel that sell-side forecasts that future banking bad debt charges will impact 9% of underlying profits may be too conservative. Historically bad debts have tended to reduce underlying profits by 11% so if employment conditions do not continue to strengthen as economists expect then bank profits will be challenged.

Today’s bank share prices already reflect the risks associated with policy adjustments to negative gearing, capital gains tax and refundable franking credits. We also now believe that regulatory risk has been quarantined.

Hence, we have recently added to our banking exposure and WBC is now our largest major bank holding. However, we remain underweight the banking sector and are wary about the ability for banks to generate meaningful profit growth in coming years.

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