Margin pressure: Can banks keep bringing in the big bucks?

There were two distinct narratives swirling around Australia’s major banks this week.

On one hand, rumblings from politicians about the extent to which banks are cashing in on the painful rise in interest rates are getting louder.

CBA chief executive Matt Comyn.Credit: Louie Douvis

As the Commonwealth Bank reported record half-year profits of $5.15 billion, Treasurer Jim Chalmers formally ordered the competition watchdog to probe how banks set interest rates for $1.3 trillion of household deposits.

“I understand that people are furious, when mortgage rates go up more or less immediately, and savings rates go up much slower or not at all,” Chalmers said on Thursday.

Earlier that morning, CBA chief executive Matt Comyn was asked on ABC radio how he justified making such high profits while many people were struggling.

Comyn acknowledged many customers were finding it tough, but he argued all banks were benefiting from rising rates, and said Australia needed strong lenders to support customers as the economy slows. “It has always been a source of concern when financial institutions make strong profits,” Comyn said.

In a further sign of the political heat on banks over rising rates, NSW Premier Dominic Perrottet earlier in the month took aim at banks for their enthusiasm in passing on rate rises to mortgage customers.

The financial markets, meanwhile, have the opposite concern. They are worried the sugar hit that bank profits received from rising rates may be wearing off. CBA’s strong December half earnings were overshadowed by worries that this is as good as it gets for banking giants, with CBA shares plunging 5.7 per cent on the day, dragging down the sector.

The common thread in the two opposing narratives is rising interest rates, which have given bank revenue a powerful boost, without yet causing a rise in bad debts (though analysts believe that is coming).

The big question for investors is whether the good times can continue for banks for a bit longer, or is this as good as it gets?

‘Game changer’: How a record profit sparked downgrades

Bank shares have been a winning bet for investors in recent times.

Since the COVIID-19-induced stockmarket lows of 2020, all of Australia’s major banks have outperformed when measured by total shareholder returns (share price changes plus dividends).

A key reason for the sector’s strong performance last year was the sharp widening net interest margins – which compare funding costs with what lenders charge for loans.

Margins have fattened because although the 3.25 percentage point increase in official rates has been passed on to borrowers in full, bank funding costs have not risen by as much. A key reason for this is that the pass-through of rate rises to savers has been more patchy, with banks raising rates on certain deposit products, rather than the whole suite. So, many investors assumed margins would keep rising for as long as the Reserve Bank governor Philip Lowe continued to raise rates.

However, this narrative took a sharp turn this week.

While CBA’s December half results confirmed the bank was benefiting from sharply wider margins, the lending giant also said its margins had peaked in October, sparking a series of earnings downgrades from analysts.

Barrenjoey analyst Jonathan Mott, who is underweight on CBA, cut his forecasts for the bank’s outlook, saying the tide had turned. Mott argued that each rate rise from here would start to weigh on lenders, but fuelling stiff competition, slowing loan growth, and leading to more delinquent loans.

“This is a game changer for its earnings trajectory, with each additional rate rise now an incremental headwind,” Mott said.

Macquarie’s analysts also said the cycle of bank earnings upgrades – where market analysts lift their profit forecasts – had turned.

“While we see CBA as a high-quality franchise, in our view, its valuation is hard to justify given emerging headwinds and macro uncertainty,” the Macquarie analysts said.

So, what’s changed? How did rising rates shift from being a tailwind to a headwind?

CBA’s boss Comyn points to major changes in the $2.1 trillion mortgage market, where a cohort of customers are refinancing to get a more competitive interest rate. With house prices and new lending falling, banks are hungry to win these refinancers, so they’re trying to lure people with cut-price rates and cashbacks worth thousands of dollars.

“The home lending market is undergoing a period of extreme change and intense competition,” Comyn said.

It also appears that as interest rates rise, more consumers are starting to move their money to higher-interest savings accounts. That makes sense: a customer has more to gain from switching out of a zero interest transaction account to a savings account with rate of 4 per cent, than say, a savings rate of 1.5 per cent. CBA said there had been a “steady increase” in such switching, reporting that consumers moved $4 billion out of deposit accounts paying zero interest.

These changes - increasing lending competition and deposit switching - were always expected as interest rates rose. The surprise was that CBA reported them happening earlier than many thought.

However, not everyone is convinced the CBA margin has peaked: Citi’s Brendan Sproules believes the peak will come in this half, as the bank’s management was actively trying to protect market share in mortgage in late 2023. But at any rate, he says the peak is close.

The other big risk on investors’ minds is what will happen to bad and doubtful debts as the economy weakens and rates continue to rise. Historically, bad debts are the big swing factor that can cause bank profits and dividends to fall sharply, which tends to occur in severe recessions.

There is little doubt bad debts will increase by some amount as more households inevitably feel the squeeze. The question is how steeply these charges will increase, and when it will happen.

In the last fortnight, CBA, Westpac, NAB and ANZ Bank have all reported falling numbers of customers falling more than 90 days behind on their repayments - the main measure of mortgage delinquency. Yet more stress could be around the corner, and Westpac on Friday said there had been a small rise in 30 day delinquencies due in part to the rising cost of living.

Bankers’ commentary has generally been cautious, vowing to support customers through a tough period, while emphasising there are no immediate signs of major distress.

ANZ chief Shayne Elliott earlier this month pointed out that while some people were in financial pain, the home loan arrears rate was at record lows of about 0.5 per cent - half its long-term average. “They are still extraordinary low those levels. Is it starting to increase – perhaps? But it’s very hard to see that there is a trend of an increase,” he says.

Westpac’s Peter King on Friday said the key drivers of mortgage defaults were historically unemployment, sickness and divorce. But he conceded rising interest rates could play a role for some borrowers this time around because banks assessed how many customers would fare with a 3 percentage point interest rate rise, and that buffer has now been exceeded.

The risks are well known: Australia’s households are highly geared, and most economists expect significant belt-tightening this year, which is likely to make life harder for discretionary retailers especially.

Mott says he expects to see loan quality “deteriorate sharply”, as interest rates rise, with the pain starting with highly geared households and spreading to the business sector. He’s tipping a spike in bad debt charges in the 2024 financial year.

However, others say this downturn could be different to past soft periods for banks, in part because they are less exposed to big business lending.

Hugh Dive, chief investment officer at Atlas Funds Management, says things will get harder for banks in the second half, but he believes there are key differences between now and past recessions, and is not convinced bad debts will rise as steeply as has occurred in the past.

“The banks’ books have changed quite dramatically. There’s much less corporate lending on the books, and fewer offshore adventures,” he says.

Dive also points to the relatively low level of unemployment, though this did rise from 3.5 per cent to 3.7 per cent this week.

Westpac’s King also stressed the bank was watching unemployment closely - both for its impact on household spending, and on debt repayment.

“If people have jobs, or people can get jobs, they’ve got income and therefore they can pay their debt. If they don’t have jobs, then they can’t,” King said.

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