Banks struggle to cover costs in new era of high rates and AI
For the first time since the late 1980s, we enter a rising interest rates era in a period where there is a clear weakness in parts of the banking sector.
It is not a solvency weakness but, in housing and business banking, many banks are not earning at a sufficient level to match their cost of capital.
My colleague Eric Johnston in The Weekend Australian detailed the forces driving interest rates higher.
My simplified version of those forces is that in a stretched economy, Energy Minister Chris Bowen has an agenda to meet emission targets but has insufficient concern about the cost of achieving those targets. And Jim Chalmers is not strong enough to block Bowen’s high power cost strategy and its obvious impact on inflation.
During the last two decades Australian banks have earned vast sums lending on housing. But part of those big returns were created because banks allowed brokers to dominate customer gathering because brokers’ costs in assembling borrowers’ data were lower than bank costs. But now with better systems, set to be enhanced via artificial intelligence, banks can now respond much more efficiently to potential borrowers.
But the brokers have captured the market and customer loyalties are with the broker rather than the bank. Meanwhile, borrowing margins have fallen and will fall further if interest rates rise.
The brokers “own” the customer so are not allowing their margins to fall, so bank margins are squeezed. The banks are trapped because if they refuse to deal with brokers, the brokers will simply take their clients to other banks.
Banks must find ways to attract people to their branches and website rather than going to brokers.
That will almost certainly involve “housing loan specials” and other retail enticements, which may also impact margins.
Banks have been suffering progressively less in returns, to the point where only Commonwealth Bank (which has a low broker content) now covers its cost of capital in home loans. Higher interest rates will make the situation worse.
In business banking, National Australia Bank achieves the profits because it is the largest business lender and so far has maintained its position because business lending is about personal relations, which makes it harder for rivals and brokers.
Neither ANZ nor Westpac seem to be covering their costs in this area.
The stockmarket prices Australian banks above equivalent banks overseas, reflecting the enormous index related pools of Australian capital.
In superannuation, most industry and retail funds believe they must have a substantial share of their portfolio in local shares, which gives them liquidity and franked dividends. Among the family and private capital sector, index related EFTs have grown market share, so there is a significant part of the sharemarket closer to the index than fundamentals.
Only a short time ago, the expectation was that interest rates would fall, which would boost volumes in the housing market and give the banks the opportunity to restore some of their margins.
There is a community perception that the cost of living is decimating economic activity. It certainly is happening to those in mortgage stress, but a large number of Australians are managing well, creating banking opportunities.
Not surprisingly, ANZ, Westpac and CBA eye the profits NAB is making in business banking and seek to gain a greater share. While that is good for the business community, successful business banking requires a personal contact – very different to mortgage financing.
Westpac and ANZ were once the country’s leading business banks, but in the 1980s and early 1990s, both banks became financially stressed. And NAB, first the under the late Neil “Nobby” Clark as CEO and then when Don Argus became CEO, NAB took major business banking share from Westpac and ANZ.
Argus tried to take over both ANZ and Westpac but was blocked. Now 40 or so years later, in trying to regain some of the market share loss to Clark and Argus, Westpac and ANZ are using brokers.
At the same time, both NAB and CBA are trying to recruit talented disgruntled business banker executives to counter the thrust.
Analysts following global bank fundamentals are pricing banks on the expectation that artificial intelligence will substantially reduce the costs of banking.
In Australia, artificial intelligence-driven cost reduction is certainly starting to happen in areas like software and initial call-centre contact. What is happening in Australia is similar to the US on this front. But it will not be easy for artificial intelligence to substantially change in the Australian bank cost structure, and will require another year or two.
There is little doubt that among those smaller banks not meeting their cost of capital, the higher interest rate environment will cause them to become takeover targets.
If Westpac and ANZ remain unable to recoup their cost of capital despite artificial intelligence, then once again the NAB and/or the CBA may seek mergers, but that will face staunch opposition.
Get ready for a different banking scene in the era of inflation, high interest rates, artificial intelligence and banks struggling to cover their costs of capital on housing and business loans.
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Looming rises in interest rates next year will not only hit many mortgage holders but will also have a profound impact on the ASX and bank shares.