The past three years have been turbulent for bank shareholders, with each year bringing a new set of concerns that should bring banks to their knees. In 2020, the capital raises of NAB and Westpac missed their first dividend since the banking crisis of 1893, when experts predicted a 30% drop in property prices and 12% unemployment! Then 2021 saw banks grappling with zero interest rates and APRA warned management teams of the systemic issues they could face from zero or negative market interest rates expected to occur in 2022. This year, concerns have shifted to the impact of the sharp rise in interest rates. on loan growth and bad debts.
In this article, we’ll look at the themes of some 900 pages of financial results released over the past two weeks, including Commonwealth Banks’ 2022 results, awarding gold stars based on performance over the past six months.
Net interest margins up
Net interest margins were a major topic during November’s banking reporting season, with most investors going straight to the margin cuts in the voluminous Investor Discussion Pack (in Westpac’s case, that was the page 22 of package 139). Banks earn net interest margin [(Interest Received – Interest Paid) divided by Average Invested Assets] by lending funds at a higher rate than by borrowing those funds from depositors or wholesale money markets.
When the prevailing cash rate is 3%, it is much easier for a bank to maintain a profit margin of 2% than when the cash rate is 0.1%. Rising interest rates increase the benefits that banks derive from the billions of dollars held in zero or near-zero interest transaction accounts that can be lent out profitably. Net interest margins can grow faster if the bank raises lending rates quickly, delays raising rates paid on term deposits, and experiences minimal loan losses. In its result, Westpac revealed that as of September 2022, the bank held $252 billion in transaction accounts earning little or no interest.
The November 2022 reporting season saw net interest margins increase for all banks. The banks most exposed to mortgages (CBA and Westpac) traditionally have higher margins than merchant banks (NAB and ANZ) which face competition from international banks when lending to large corporations.
Westpac posted the highest net interest margin in November at 1.90%. However, the Commonwealth Bank may report a higher margin in February 2023 because its books closed on June 30 and the CBA’s financials did not capture much of the rate increases seen in 2022. Over the past six months, Westpac has increased its net interest margin by 0.05. %; Although that seems like a tiny amount, this small increase equates to $564 million in additional profits when multiplied by the bank’s $740 billion loan book!
After net interest margins, the second most important figure in every bank’s financial reports in 2022 was bad debts, with investors looking to see if rising interest rates caused losses on loans made. A key driver of earnings growth in recent years has been the continued decline in bad debts at a time when they were expected to rise sharply due to rising unemployment and falling real estate prices. Low bad debts increase bank profitability because loans are priced on the assumption that a certain percentage of borrowers will be unable to repay and the bank will incur a loss on the loan. From the chart below, since the 1991 recession, the long-term normalized level of bad debt has been around 0.3% of total loans for Australian banks.
Bad loans remained low in 2022, with all banks reporting negligible loan losses; ANZ reported the lowest level with a positive reading of 0.08%. This positive figure came as new loan losses were offset by reversals and recoveries of previously booked provisions.
As can be seen in the first table, all banks increased their dividends during the last reporting season. However, for all banks there was a catch-up element for the reduction in payouts to shareholders in 2020 after APRA placed a cap limiting dividends to 50% of earnings and the continued uncertainty in 2021 from Covid- 19 and associated blockages. NAB won the gold star by raising its dividend by 16% to 78 cents per share in November, although that remains below the 83 cents paid before the pandemic. Macquarie Bank has increased its dividend by 10% to be the only bank to pay a higher dividend in 2022 than in 2019. As a global investment bank, Macquarie Bank has had a good pandemic, increasing its profits over the three years and taking advantage of market volatility.
Australian banks operate in a competitive oligopoly, selling largely an undifferentiated product (loans) where their competitors have a similar cost of production (depositors’ capital and wholesale capital markets). Therefore, moves to gain higher market share and increase profits by reducing lending are quickly followed by other banks. However, banks can increase their profits by reducing their expense base, which seems to increase every year.
Containing expense growth has proven difficult for banks, with low unemployment contributing to wage growth and the need to hire more compliance staff after the 2018 Royal Banking Commission. compliance teams developed in response to Commonwealth Bank and Westpac being hit with stiff penalties by AUSTRAC for failing to comply with the Anti-Money Laundering and Terrorist Financing Act 2006 .
Although there has been little talk of cutting expenses by closing branches, Atlas believes that streamlining the branch network will be the easiest way for banks to increase profits. On average, major banks have around 800 branches across Australia. Over the past decade, there has been a sharp decline in customer visits to these branches, as most banking transactions are now done online or via smartphones. Indeed, last week, Westpac announced that in the last 12 months the bank had processed 22 million physical in-branch transactions but 690 million digital transactions. Westpac wins Gold Star for Expense Control, reducing its cost base by $766 million by downsizing nearly 5,000 employees and closing 119 branches and 200 ATMs.
Our point of view
Investing in Australian banks is one of the biggest questions facing institutional and retail investors, with banks making up 25% of the ASX 200. We expect banks to see double-digit earnings growth over the coming year, benefiting from higher net interest margins and low bad debt from historically low levels of unemployment. Although earnings are facing headwinds from weaker credit growth, normalization of bad debts and reduced earnings support from provision reversals. However, if investors look at the Australian market as a whole, banks look relatively cheap and are well capitalized.
Banks are in a much stronger position in 2022 than they were in 2008, entering the final cycle of rate tightening. In 2008, the big banks held very meager Tier 1 capital ratios of around 5% of risk-weighted assets (~11.5% in 2022), and the unemployment rate was above 5%, much more higher than today. As the CEO of ANZ said in his presentation, it is not falling house prices that are causing loan losses, but falling house prices combined with job losses. .
Additionally, banks’ loan portfolios are cleaner in 2022 than they were 14 years ago, with greater emphasis on domestic housing and small business loans. In 2022, there were no major corporate collapses and no major companies with obvious problems, such as ABC Learning, Allco, Babcock and Brown or Centro.
Additionally, the foreign adventures in the UK and Asia that caused problems in 2008 have mostly been sold or split up. Over the past decade, Australian banks have retreated to their home market and are now less affected by a recession in Europe or the United States. All of this bodes for a more benign loan loss cycle in the years to come, and in this situation, bank stock prices will be repriced higher.
Hugh Dive is Chief Investment Officer of Atlas Funds Management. This article is provided for informational purposes only and does not take into account the situation of an investor.