House prices, offshore funding key risks for banks
As Shirley Bassey once sang, it’s all just a little bit of history repeating.
Exactly a year ago, we observed the global chase for yield had lit a rocket under the share prices of Australia’s banks for most of the prior year. But back then the big question for investors was whether the run could continue in the face of weak demand for loans and uncertainty about the economic outlook. The question remains.
As 2013-14 comes to a close, bank share prices remain near record levels, having put on about 20 per cent for the year, outperforming the benchmark index, which added about 15 per cent.
Dividend yields of between 7 per cent and 8 per cent have again underpinned share-price performance, as the big four backed up record annual profits of $27 billion in 2013 with interim profits of $14.7 billion for the first half of 2014.
And just like this time last year, investors continue to ponder whether this great banking purple patch will continue in the face of benign credit growth (the banks reckon housing credit will grow by between 6 per cent and 7 per cent this year) while concerns about the economic transition from mining have continued to linger.
“The big four banks are relatively expensive and their earnings levers are optimised, so it is hard to be very positive on valuations over the long term,” said Credit Suisse analyst James Ellis. “However, the dividend yield looks sustainable. There is no burning issue ahead for the banks.”
NO OBVIOUS CATALYST
After the bank reporting season in April and May, Credit Suisse, like many other brokers, generally upgraded bank earnings forecasts. Earnings per share and revenue growth are expected to slow in the coming years but there is no obvious catalyst pointing to an imminent sell-off of banks.
Over the recent reporting reason, all the major banks reported improving asset quality, with the low interest rate environment pushing down the rate of impaired loans and low bad-debt provisioning boosting profits.
A deterioration in bad and doubtful debts and rising interest rates are two potential catalysts that could drive a de-rating of the banking sector, Goldman Sachs analyst Andrew Lyons said recently. But he added that bad and doubtful debts are expected to remain benign, and interest rates are rising off a low base, suggesting a material deterioration in bank asset quality remains unlikely. “We think current multiples can be held, particularly given relative valuations do not look stretched,” Mr Lyons said.
ANZ’s interim result was generally regarded as the strongest among the big four during the reporting season.
Mr Lyons upgraded ANZ to a buy on June 13, citing the improving capital intensity in Asia as it begins to harvest the rewards from its regional growth strategy. Credit Suisse’s Mr Ellis also has ANZ as his number one pick, citing its superior lending growth momentum. He says ANZ and National Australia Bank are likely to outperform Commonwealth Bank of Australia and Westpac if there is a decent pick-up in business credit growth, given their orientation towards corporate lending.
Fitch Ratings affirmed the stable ratings of each of the big four banks in a report published on June 17, which pointed to their “dominant franchises in Australia and New Zealand, and straightforward and transparent business models. These in turn support strong and stable profitability, generally robust risk management, solid liquidity management and adequate capitalisation.” Fitch said it also takes comfort “from the conservative and hands-on approach of the Australian prudential regulator”.
TWO KEY RISKS
Two of the key risks for the bank according to Fitch, are their reliance on offshore funding – increasing their susceptibility to global economic shocks – and a potential housing price shock combined with a spike in unemployment.
Offshore wholesale funding comprised two-thirds of total bank funding at the end of the first half, a much larger proportion than global peers, as borrowing costs have declined to six-year lows and the war for deposits has cooled. The banks have put this “funding gap” issue – they currently lend about $600 billion more than they hold in deposits – on the agenda of the financial system inquiry, suggesting it will grow as the economy recovers, which can create dangers if global capital markets seize up.
Regulators are also closely monitoring lending standards to ensure undue risk is not being created in the highly-competitive home loan market. In May, the Australian Prudential Regulation Authority issued tough guidelines on how it expects banks to monitor and manage mortgage risks.
Fitch reckons if house prices inflate further and underwriting standards weaken, “bank asset quality [is] susceptible to deterioration, especially if unemployment were to rise substantially.” However, it says that at present, underwriting standards are “broadly stable despite price competition in a relatively low credit growth environment.”
Two key events are looming on the horizon for the banking sector in the coming month. The federal government’s financial system inquiry, which is being chaired by former CBA chief executive David Murray, publishes its interim report on July 15. It will examine the policy settings for competition, regulation and technology in the sector.
Meanwhile, the market will be closely watching NAB when Cameron Clyne passes the baton to new CEO Andrew Thorburn on August 1.