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Investors say Canberra is underestimating banking risks
Australian Financial Review Aug 5 2016 11:45 PM
James Eyers
With the Prime Minister and Treasurer joining Canberra's favourite sport of bank bashing this week, Australian bank investors and analysts want politicians to keep an idiom in mind: be careful what you wish for.
While the banks' swift decision to reprice loans in their favour by holding back part of the Reserve Bank's cash rate cut on Tuesday provided an example of their oligopolistic pricing power, the backlash has some seasoned share market investors concerned that politics may imperil the financial system.
One such investor is John Abernethy, director of Clime Investment Management.
"Normally in the first quarter after an election, a government mobilises an economy, business leaders, the financial community and intelligentsia, and says 'What are we going to do for next three years?' But what we have seen this week is bank bashing," he says.
"But Canberra doesn't understand the funding of banks. And given banks represent 35 per cent of the sharemarket and account for something like 40 per cent of our foreign debt, I think it is extraordinary the government doesn't understand the risks involved in Australia through the banking system and the repercussions of what can go wrong in the world today."
Bank bosses might agree. National Australia Bank chief executive Andrew Thorburn is just back from a trip to Britain, where global bank investors were pointing to big contrasts between stable and healthy profits generated by the big banks in Australia and their European counterparts, which are languishing in the doldrums.
Right balance
"You just have to look at returns in the UK banking system, in Italy, Greece, Spain and even Deutsche Bank in Germany – when you don't get the balance right between customers, depositors and particularly shareholders in this case, they can't raise capital," Thorburn says.
"Last year, NAB raised $5.5 billion of capital from shareholders very quickly because they had confidence in our ability to manage and grow the bank and to produce sustainable returns."
Thorburn hit back at the bank bashing pre-occupying Canberra this week, saying if banks are not able to set their own mortgage pricing, which requires the needs of borrowers to be balanced with those of depositors and investors, then there is a risk banks will struggle to provide the lending required to fund economic growth.
Morningstar banking analyst David Ellis (who happened to report directly to Thorburn when both worked at St George) concurs that Australia does not want weak and undercapitalised banks like those in Europe "where dividends are a thing of the past".
"It is important to the economy, and everyone in Australia, that we have a strong financial system and a strong banking system with four major banks that are profitable and robust – we can't get away from that fact," Ellis says.
But he now sees increased public scrutiny and tougher regulatory oversight as a new risk to the profits of the major banks, because it might make them more reluctant to use loan repricing to support the net interest margin. However, other levers will be pulled to support returns – like reducing costs.
Lower dividends
But low interest rates, rising bad debts and lower returns on equity from higher levels of regulatory capital and more expensive sources of funding are also weighing on the sector.
These dynamics will flow through to lower dividend payouts in the coming years, Ellis predicts. In a recent report, he said "unsustainably high dividend payout ratios" will fall from an average of 75 per cent in 2016 to 68 per cent by 2020. But even at this lower level, banks will trade on dividend yield of 6.6 per cent, grossed up to 9.4 per cent (when adjusted for franking credits).
The health of the nation's biggest bank, Commonwealth Bank of Australia, will be revealed on Wednesday when it releases full-year results; JP Morgan analyst Scott Manning is tipping full-year cash earnings of $9.4 billion.
But behind that headline number Manning expects CBA's net interest margin – the difference between what a bank charges to borrowers and pays to its lenders, a key driver of profit – to contract by 3 basis points in the second half, to 2.03 per cent. Morgan Stanley's Richard Wiles forecasts CBA's profit in the June half will fall 2 per cent compared with the December half, to $4.7 billion – with skinnier margins a key reason.
Indeed, bank net interest margins are on a long-term downward trajectory: NIMs were above 3 per cent 15 years ago but now just sit above 2 per cent, according to figures released this week by the RBA.
Banks are also facing a contraction in return on equity, a function of bad debts increasing to more normal levels and with regulatory changes. These include requirements to carry higher levels of more expensive equity capital against mortgages, a recommendation emanating from the financial system inquiry; and a new global rule known as the "net stable funding ratio", which requires banks to fund their loans with more longer-term deposits, which are also more expensive to raise.
Wiles reckons "higher funding costs are an emerging margin headwind" for the banks, and moves by the banks this week to lift interest rates paid on some term deposits "reflects a need to lengthen the duration of funding ahead of the introduction of the net stable funding ratio requirement in January 2018".
Complex dynamics
As Westpac chief executive Brian Hartzer argued this week, more expensive deposits along with elevated costs for funding raised in offshore markets were the key driver for holding back part of the RBA cut from borrowers this week.
One indicator of short-term wholesale funding costs, the BBSW-OIS spread, traded at an average of 30 basis points for the six months to June compared to 25 basis points for the six months to December 2015, although it has narrowed in the past month.
Westpac's cost of short-term wholesale funding in international markets is now about 15 basis points higher than the level of a year ago, while the bank is now paying about 100 basis points above wholesale interest rates for term deposits compared to 35 basis points in July last year.
It remains to be seen whether having the CEOs of the major banks come to Canberra at least once a year to explain themselves to the House of Economics Standing Committee on Economics will help politicians understand the complex dynamics of bank funding markets.
Clime's Abernathy says the government "needs to protect, instruct and navigate our banks and stop making mindless comments about pricing".
"I am not saying the banks aren't without criticism. They are in a competitive market and need to be regulated but they don't need to be abused," he says.
"The government needs to understand there is a recapitalisation of banks occurring and it is important banks remain strong and viable. You don't want to go anywhere else than having a viable and strong financial system. It is in everyone's interest in this country. If banks make profits and pay tax, the government will get that revenue - and they can spend it on public services."