Big banks shift down a gear as bad debt rises and margins fall

The latest snapshot of how the banks are faring reveals growth is flatlining as margins edge down and bad debts lift.

Westpac chief executive Brian Hartzer. (Picture Gary Ramage)

With Westpac the last of the three major banks that operate according to a financial year that ends on September 30 reporting today, the snapshot of the major banks’ performances is complete. It’s not a growth story.

Westpac reported flat cash earnings of $7.8 billion but, as with its peers, the detail of its result reflected the pressures on margins and returns the banks are experiencing as their top-line growth rates flatten, margins edge down and bad debts edge up.

With their regulatory capital requirements having been raised significantly last year in response to the Financial System Inquiry’s recommendations of mortgage risk rates and the need for the majors to be “unquestionably strong,” their returns on equity have fallen significantly.

Westpac’s return on equity was 185 basis points lower at a creditable 14 per cent but the group, recognising that there have been structural changes in its operating environment — a low-rate environment that is likely to be protracted, the likelihood of further increases in regulatory capital and liquidity requirements and higher compliance costs — has lowered its target for returns.

Where previously the group’s targeted ROE was 15 per cent, in future — for the “medium term” -- it will be between 13 per cent and 14 per cent.

There was a slide in Westpac’s presentations today that captured the evolution of the conditions in which the banks are operating.

A decade ago, just ahead of the financial crisis, Westpac generated a return of 1.23 per cent on its average interest-earning assets. For the year to September the return was 1.08 per cent. In 2006, the ratio of average interest-earning assets to equity was 18.8 times. Today it’s 12.9 times. In 2006, the ROE was 23 per cent. Today it is 14 per cent.

So yields on the bank’s loan book have fallen as a result of lower margins and fees and leverage has been dramatically reduced because of the changes to regulatory capital requirements, savaging the ROE.

With the likelihood of further regulatory capital imposts after the Bank for International Settlements finalises its approach to more standardised risk-weightings later this year, the majors will probably have to raise or retain more capital and their ROEs will remain under pressure in an environment where margins remain compressed and the bad debt cycle is coming off historic lows.

The Westpac result was notable because it generated good growth in net interest income of 8 per cent despite the relatively soft and competitive external conditions but a fall in non-interest income more than offset that increase.

Lower fees in the institutional bank, lower credit cards income, the lower contribution from BT after last year’s selldown of Westpac’s shareholding and lower performance fees were the major factors in the decline in non-interest income.

Over the year, the group’s net interest margin actually rose five basis points but it fell three basis points to 2.11 per cent in the second half, or 2.04 per cent if the impact of treasury and markets income were excluded. That fall was due to an increase in funding costs, with both deposit and wholesale term funding costs rising.

In common with the other majors, Westpac also experienced a sharp increase in bad and doubtful debt charges, which were 49 per cent higher at $1.12bn, although most of that increase occurred in the first half and related to a small number of large corporate exposures.

While the absolute levels of loan impairments may not yet be sufficient to generate concern, across the board they do appear to be rising and are causing the banks to be more conservative in their lending criteria.

Unlike ANZ or NAB, which experienced major structural changes to their businesses during the financial year — ANZ is dramatically shrinking its institutional loan portfolios and has announced the sale of its Asian retail and wealth business and NAB exited the UK after three decades — Westpac’s strategy of focusing on consumers and commercial customers within Australasia remains stable.

The metrics it prioritises are productivity and service levels. The group’s cost-to-income ratio continues to trend down — it was seven basis points lower at 42 per cent in the year to September — and Westpac said it had generated $263m of productivity benefits during the year.

A three per cent increase in the number of customers in its consumer banking businesses and strong growth in home loans and deposits, along with a continuing material decrease in customer complaints, would suggest it is improving service levels while the measurements of employee engagement and the proportion of women in leadership roles (48 per cent) are rising.

Brian Hartzer would be encouraged that his core consumer bank is performing strongly, with costs stable and cash earnings rising, from $2.62bn to $2.98bn. The business bank also held its ground but there were lower contributions from BT, the institutional bank and from New Zealand.

While he is quite positive about the outlook for the Australian economy, the expectation for demand for credit is relatively modest and it is self-evident from the lowering of the target for the group’s return on equity that Hartzer and his board believe the structural pressures that have become increasingly visible in the major banks’ results will persist into foreseeable future.