Best days are behind the banks

With unemployment at 3.5% and likely to rise, the full force of higher interest rates yet to be felt in loan losses, and the talk of recession, how should investors be thinking about the banks. 

Those who remember the 1990’s recession which pushed Westpac to the brink due to large commercial lending losses would be comforted to know that Australian banks today are largely focussed on residential mortgages.  Matt Haupt, a portfolio manager at Wilson Asset Management believes this is positive as in times of stress, residential mortgages are the safest place to be.  He says that even in severe downturns, residential loss rates are actually low.

Bad debts are a risk to banks, and the bears on the sector point to the risk of an expensive Australian housing market falling over, thereby increasing bad debts.  Hugh Dive, Chief Investment Officer at Atlas Funds Management quotes from Westpac’s recent profit result where the bank forecast two scenarios.  The base case was for a 7.8% fall in residential prices and 4.7% unemployment, and the worse case scenario was a 27% fall in property prices and 11% unemployment.  Currently Westpac has credit provisions of $4.9bn versus expected credit losses in the base case being $3.4bn and worse case scenario producing expected credit losses of $6.8bn.  Dive believes it is hard to see a 27% fall in property prices as they have already fallen 8.4% over the last 12 months, and providing employment holds up, thinks the banks are adequately provisioned.  

Bank Provisioning

Dive says that at this point in the cycle the Australian banks are more conservatively positioned than they were during GFC.  For example, the average loan to valuation ratio on CBA’s mortgage book is less than 50% according to their most recent profit report.  We would need to see some big property falls before banks actually feel the pinch, but possibly the newer private credit funds maybe where the ‘excitement’ will occur when bad debts tick up as they have been taking on the credit risks the banks have declined.

The other most important number is net interest margins.  Net interest margin is earned by lending out funds at a higher rate than by borrowing these funds from depositors or money markets.  CBA’s margin was the highest in recent reported results at 2.10%, while NAB was sold off heavily on the day of its result after reporting its margins had fallen by 0.04% in the second quarter of 2023.

Haupt believes that bank margins have peaked in this cycle.  Rising interest rate environments are good for bank margins and margins were expected to keep rising until the RBA stopped increasing interest rates.  However aggressive competition for mortgages and deposits started to kick in late last year, resulting in falling margins.

Dive agrees that margins have peaked but notes that both CBA and NAB have dumped their cashback offers for new mortgages and increased their variable rate by 0.1%, which indicates a lessening of the aggressive competition.

The big question is how the banks achieve profit growth against a backdrop of a cautious consumer and falling margins.  Haupt is of the view that bank profitability has peaked in this cycle and that the best days are now behind us.  He says it feels like investors have to wait for the interest rate cutting cycle to start and finish before he can get excited about margin expansion and this feels a long way off.

Migration and the reopening of the Chinese economy however are likely to be tailwinds in the future for the banking sector as they should contribute to growth in lending.

Other risks to the banks include the ACCC inquiry into deposits, competition and liquidity.  Dive says that the ACCC is likely to find that banks have historically been slow to increase deposit rates when interest rates rise, but this has now changed and doesn’t see this as a material risk.  

Haupt says that liquidity issues arise when there is a loss of trust in the financial system.  A credit crunch impedes the ability of banks to rollover existing funding and access new funding.  He believes this risk is low.

So while the banks appear well provisioned for problems in their home loan books, profit growth is likely to be difficult to come by for a while.


Mark Draper (GEM Capital) writes monthly for the Australian Financial Review - this article was published on 30th May 2023