Outlook for banks deteriorates

Australian banks face a challenging reporting period as they balance the expectations of shareholders and regulators.

Regulatory provisioning relief on deferred borrowers may keep impaired loans down. Picture: AAP

Australian banks face a challenging reporting period this month as they balance the expectations of shareholders and regulators amid a worsening economic outlook after new lockdowns in Victoria.

With Melbourne moving to a stage four lockdown until mid-September, UBS analyst Jonathan Mott warned that the outlook for the economy and banks has “deteriorated sharply”.

After a strong bounce from May until early July, “this is a clear setback”, Mott said.

While the assumptions underpinning the banks’ economic overlays at the time of their March results looked relatively conservative, “this may no longer be the case, especially in Victoria”.

It came as Prime Minister Scott Morrison said Victoria’s lockdowns would cut $10bn to $12bn from national output in the September quarter, causing a third consecutive quarter of negative growth.

While still expecting the banks to reveal lower credit impairment charges, they were “likely to be rewarded for provisioning prudence in this environment”, said Mr Mott. But macroeconomic concerns will override banks’ valuation appeal in the near term.

“Overall, we expect this reporting season to provide significant insights but little clarity on the outlook,” Mr Mott said.

“We anticipate a renewed wave of charges in 2020-21 as the full impact of the recession is felt (which) leads to a ‘W’-shaped earnings recovery.”

The key to the banks’ performance will be Australia’s small businesses — which may drive unemployment and house prices — as well as the level of government stimulus.

The Reserve Bank will flesh out economic scenarios for the economy in its quarterly Statement on Monetary Policy at 11.30am Friday.

The RBA’s “base case” is for a 6 per cent contraction in the economy in the year to December, pushing the unemployment rate up to 10 per cent, followed by a 5 per cent rebound next year.

Banks also face an “awkward decision” after the Australian Prudential Regulation Authority’s “vague guidance” that they can pay out up to 50 per cent of their earnings as dividends, yet these must be “offset” by measures to bolster capital, like dividend reinvestment plans or equity capital raisings.

“Should banks return cash to shareholders, then immediately issue new shares to offset the hit to capital just to create an artificial yield — an ‘artificial dividend’?” asked Mott. “Unless shareholders participate in the capital raising, the board is effectively reducing investors’ holdings — via dilution — to give cash back to them.

“With every bank excluding CBA trading below book value, we believe this is economically irrational.”

Mott also saw “lots of moving parts” in the results and trading updates which start with Commonwealth Bank’s full-year report next Wednesday.

Positive impacts from mortgage repricing, cheaper short-term funding and deposit costs may offset negative impacts of rate cuts and a changing loan mix on net interest margins, and trading income may spike along with the global banks. But fee income may be hit by lower activity and waivers of merchant fees, elevated costs and lower credit growth as Australia enters a deleveraging cycle.

Similarly, Citi’s Brendon Sproules warned reporting season would be “the eye of the storm” for banks.

Amid deferred loan-loss recognition, declining economic activity and lending demand, and the prospect of continued lockdowns, it would be hard for banks to give a true picture of performance. Victoria’s lockdowns would keep investors “laser focused” on how loan losses had evolved since May, and the unknown impact of those lockdowns should lead to modest top-ups to provisions.

“All the banks took significant collective provision top-ups in May,” Mr Sproules said.

“The common theme across these estimates was that all the banks painted the weakest economic conditions since the 1930s. Despite this outlook, the estimated losses are very mild relative to recent economic downturns in Australia.”

Regulatory provisioning relief on deferred borrowers may keep impaired loans down.

However, there is some chance that the Australian banks see the economic environment as performing in-line with May estimates since the economy has performed better than expected.

But bank shares are “priced for a ‘V’-shaped economic recovery, which sees the real risk of a ‘U’ or ‘L’ not captured,” warned Jefferies analyst Brian Johnson.

He said monetary policy settings are “not good for bank earnings and could get worse”.

Johnson said that if the economic impact of Victoria’s lockdowns are worse than expected, the RBA may shift the focus of its yield curve control program to target five and 10-year bonds.

“A lower five-year bond rate would reduce bank net interest margins, disintermediate banks and reduce market opportunities, particularly so for CBA,” he cautioned.