Bank earnings bounce back, but uncertain outlook requires focus on operating models

8 May

Headline cash earnings at Australia’s four major banks for the six months to March grew by 4.6 percent to deliver $15.7 billion, a turnaround from the 2016 full-year results where the banks experienced their first earnings fall since the financial crisis.

Underlying cash earnings, adjusted for ‘one-offs’ like asset sales, writedowns, and restructures, grew slightly by 3.3 percent on the prior half, and 2.3 percent on the same period last year.

Colin Heath, PwC Australia’s Banking & Capital Markets Leader, described the results as “solid,” saying: “the banks did some heavy lifting to return to growth, with a solid outcome underpinned by strong trading income, good progress on costs and a reduction in bad debt expenses. Credit growth was driven primarily by home lending, although the benefits of recent repricing on mortgages were more than offset by increased funding costs.”

“The results illustrate how reliant the banks are on their retail operations, particularly home lending. When you combine an uncertain economic outlook with regulatory and political scrutiny in this area, there’s no guarantee that home lending will be the growth engine in the future.”

Residential mortgages now represent two-thirds (65 percent) of the major banks’ gross lending, having risen from 59 percent in 2009. 80 percent of lending asset growth for the half to March 2017 came from home lending.

Housing credit grew by 6.5 percent over the year to March, in line with the 6.4 percent figure six months ago. By contrast, business credit grew by only 3.4 percent over the past year, a sharp decline from the 6.5 percent annual growth rate at the end of March 2016.

“The banks have been among the biggest advocates for policy measures to improve business confidence and private capital investment,” said Heath. “Any measures in tomorrow night’s Federal Budget to encourage business investment and growth would be welcomed by the banking sector. Stronger demand for business credit would help rebalance loan portfolios that are getting a little heavy with housing debt.”

Return on Equity (RoE) was 13.96 percent for the half, up 16 basis points on the same period last year and 31 basis points on the prior half.

The combined tier 1 capital ratio of the majors increased by 18 basis points on the prior half and down 2 basis points on the same period last year. Since 2014 tier 1 capital has increased by $37.1 billion.

“Return-on-equity has stabilised below the long-run range of 16 to 18 per cent, reflecting the need to hold enough capital to be ‘unquestionably strong’. We believe current RoEs may reflect a ‘new normal’,” Heath said. “Investors and other stakeholders have accepted higher capital ratios will provide greater prudential stability over the long term, but the trade-off is that dividend payouts will likely come under pressure, especially with further capital reforms in the pipeline.”

Out-of-cycle rate rises and repricing of loans to curb investor lending helped buffer margins from the impact of wholesale funding costs and term deposit competition. Nonetheless, these forces still combined to deliver a fall in the banks’ combined net interest margin to 2.01 percent, down from 2.04 percent in the prior half and 2.08 for the half to March 2016.

According to Heath: “Margins may improve in the second half as we see the full impacts of repricing wash through and a more settled competitive environment around deposits, however over the medium term margin pressure is likely to continue.”

“More broadly, banks will always have a delicate path to tread around pricing, particularly as they seek to achieve balanced growth across their portfolios, and respond to evolving regulatory requirements.

Despite the focus on housing and household debt, overall credit quality remained sound. Bad debt expenses fell to $2.2 billion, down 15.5 percent on the prior half and 12.6 percent on the same period in 2016. Driving this result however was a number of provisions for loans connected to the resources and mining sector in earlier periods which were not repeated in the half to March 2017.

“With the centrality of residential mortgages to the banks’ growth prospects, loan portfolios will be watched closely for any signs of more systemic deterioration,” said Heath.

Efforts to manage costs continued over the half, with the majors’ expense to income ratio falling, on an adjusted basis, to 42.6 percent, down 25 basis points on the previous half and 23 on the same period last year. Average full time employee numbers fell across the banks by 1.1 percent, suggesting efficiency gains from simplification efforts, technology and robotic process automation may be starting to take hold.

“We are continuing to see some rationalisation across the sector, including the sell-down of ‘non-core’ assets, which makes it difficult to assess the full picture on costs,” Heath said. “In that sense it’s probably too early to assess whether the effects of cost management are being seen at the fringes or whether they represent the start of a more fundamental shift in the cost base.”

Time for a re-think on operating models?

Despite earnings growth in the first half, the combination of ongoing regulatory focus, competitive pressures, changing consumer behaviour, and emerging technology-based competitors should preclude any drift towards complacency.

“Our view is that now is the time for a close look at bank operating models, and an honest assessment of capabilities and how they align to the market segments individual banks want to serve,” said Heath. “Far better to tackle this issue now with the benefit of time to experiment and make mistakes, than have your hand forced by unforeseen future events.

PwC’s examination of future bank operating models sets out a series of different approaches that could be taken to help banks ‘win’ in the future. These range from becoming smaller and simpler but more deeply connected to select market segments through to ‘digital only’ approaches that de-emphasise the need for a physical branch network. Other models suggest banks could focus on product development over distribution, or consider a shift towards becoming a ‘platform’ that provides a market for others’ products.

“As the benefit of cost-management under existing models begins to naturally plateau, and growth gets harder to achieve, we expect that banks will continue to evolve business models and align their operating models behind them,” Heath said.

“We can’t predict the future but what we do know is that it’s unlikely that today’s bank operating model will resemble the model a decade or so from now. With strong fundamentals and the capacity to invest, today is the time to move further towards becoming tomorrow’s bank.”

 

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