CBA’s challenges are mounting

THERE was an underlying tone of real concern in Ian Narev’s assessment of the economic backdrop in which CBA is operating, despite continuing strong performance.

THERE was an underlying tone of real concern in Ian Narev’s assessment of the economic backdrop in which Commonwealth Bank is operating, despite the continuing strong performance of his group.

He knows that the major banks can’t grow strongly into a weakening environment.

He referred to some of the bank’s customers facing “challenges”; the volatility of the global economy and its effects on confidence; the “significant economic threat” posed by weak confidence; the need of business for certainty in order to invest; the requirement for a “coherent long term plan” to address government debt levels, infrastructure priorities, foreign investment, business competitiveness and job creation.

While he didn’t explicitly say it, it was a plea to government and, perhaps, Canberra more generally, to get its act together.

A superficial glance at CBA’s (CBA) result would raise the question of why Narev is so concerned. At face value it is a strong result, with cash earnings up 8 per cent to $4.62 billion and income (up 5 per cent) growing faster than costs (up 3 per cent). Another typically clean CBA performance.

There were, however, a couple of discordant notes. While cash earnings were 8 per cent higher than the same half previously they were up only 5 per cent against the June half of last year — the rate of earnings growth slowed.

Net interest income might have been up 6 per cent on the previous corresponding half but it was only 3 per cent higher than in the June half.

CAB did get solid volume growth in the half, with average interest-earning assets growing 7 per cent, but that was marginally higher than the growth in net interest income (and slowed to 2 per cent growth relative to the June half).

That minor disparity reflected margin compression. CBA’s net interest margin was down two basis points to 2.12 per cent despite a significant fall in bank wholesale funding costs. Competition, particularly in business lending but really across-the-board, is intensifying into a market where demand is relatively weak.

CBA said it lost 10 basis points of margin in the half, the majority of which relates to home lending. Competition in business lending intensified towards the end of last year. The lost margin in asset pricing more than offset the seven basis point gain from lower funding costs.

Narev’s commentary and its reference to the challenges facing some of CBA’s customers aren’t reflected in the group’s credit quality, which remains pristine. The charge for bad and doubtful debts, already at historically low levels, fell 4 per cent against the previous corresponding half and 11 per cent against the June half. At 0.15 per cent of average loans, there is not much scope left for further improvement.

There also aren’t any indications of emerging stress in CBA’s loan book, with its 90-day plus arrears in its consumer book continue to trend down.

The Reserve Bank’s recent 25 basis point cut to the cash rate, however, signalled its concern about a weakening outlook and rising unemployment. Narev would have as good an insight as anyone into the condition and sentiment at the coalface of the economy.

He and his board would also be acutely aware that CBA’s share price is being supported by investor thirst for dividends. The interim dividend of $1.98 a share (up 8 per cent of the previous corresponding period) and a payout ratio of almost 70 per cent was a smidgen more than the market expected.

That might distract from the 10 basis point reduction in CBA’s return on equity (20 basis points relative to the June half), albeit to a still stellar 18.6 per cent, despite a slightly lower common equity tier one capital ratio relative to the June half.

Given that it is almost taken for granted now that, in the wake of the Murray inquiry into the financial system and the latest messaging from the Basel committee, the major banks will face significant increases in their capital requirements, it will be a struggle for CBA and its peers — CBA and Westpac, with the biggest exposures to mortgage lending, in particular — to maintain their returns on equity.

The one lever the banks do have to pull on that is within their own control is costs and those continue to trend down. While in nominal terms operating costs were up three per cent, as a proportion of income they continue to decline, with CBA’s falling 70 basis points to 42.2 per cent in the half.

Overall, it was another strong and clean result. Narev, however, looking forward would see a slowing economy and therefore less volume growth and potentially a reversal of the bank’s recent bad debt experience. Less volume growth implies an increased intensity of competition. Higher capital requirements mean lower returns and a reduced ability to sustain continuing growth in dividends.

The growing question marks over the near to medium-term outlook for the economy and the ability of governments at both federal and state level to deliver sensible and effective responses to them probably explains the disparities between Narev’s commentary and CBA’s numbers.

He’s not, of course, the only one pleading with increasing urgency/desperation/frustration for decent and stable government. There an entire business community that can see a light at the end of the tunnel — and it isn’t sunlight coming toward them.