Banks set for another challenging year

Australian Financial Review 09 Jan 2019 5:33 PM

Sarah Turner

Investors should prepare for another "very challenging" year for the banking sector, according to a fund manager, which puts the prospect of a banking crisis at between 40 per cent and 50 per cent.

The S&P/ASX 200 Banks Index dropped 16.5 per cent over 2018, taking the sector to a level not seen since early 2013. JCP Investment Partners continues to steer clear of bank stocks, and believes there are fairly high chances of a banking crisis and adverse credit cycle emerging.

"With negative asymmetric risk around a credit crunch and therefore capital risk, the environment for the Australian banking sector seems at best, very challenging," JCP wrote in an investor update.

If JCP is right, it means last year's royal commission into the financial services sector, tighter funding markets and falling house prices are not the end of the banks' problems. It identifies pressure on bank sector loan growth and net interest margins.

The funding backdrop has deteriorated for the banks since November, JCP notes, with the bank bill-OIS spread widening sharply. [OIS stands for ‘overnight indexed swap’, which involves exchanging an overnight (e.g. RBA cash rate) for a fixed interest rate. You can read Investopedia’s explanation here if interested. –RJB]

Higher funding costs would normally be passed on to customers, but high levels of household debt are likely to prevent that from happening this time without borrower distress, the fund manager concludes.

"The divergence of US and Australian central bank rates is likely to continue to push short-term funding away from Australia, which is needed to support the mortgage market," JCP wrote.

"One of the medium-term challenges for the Australian financial system is the ability to continue to attract offshore debt to fund the $1.7 billion mortgage market."

Wall of negative sentiment

Underscoring the divergence of views in the market, one broker painted a more optimistic picture for returns given how far valuations have already fallen.

Citi banking analysts are more positive on the sector. The most difficult 12 months in a generation for the banks will probably give way to a more benign environment in 2019, they believe.

The broker argues that the sector is oversold and that banks are facing a wall of negative sentiment that hasn't been this high since the global financial crisis in 2008.

"Investors will look back at 2018 as one of the most difficult years for the sector in a generation," the analysts acknowledged.

The broker also expressed surprise that banks' earnings and capital drivers remained relatively solid.

Mortgage credit growth was still a "robust" 5.1 per cent while loan losses had improved from about 18 basis points to 11 basis points, lead analyst Brendan Sprouleswrote.

The banks have also managed to get growth in operating costs below revenue growth even as they grapple with a stricter regulatory environment while common equity tier one ratios are "broadly unquestionably strong".

"After a golden age, the Australian banking sector is transitioning to a lower level of sustainable return on equity, bottoming at around 12 per cent by the early 2020s," the broker said. "While we would expect the sector to de-rate over time, however, multiples are approaching GFC-levels and appear overdone."