November Economic Update “We need to talk about banks”

Banks have been the mainstay of most Australian equity portfolios over the last thirty years, and rightly so. Since the deregulation of our financial system in the early 1980s followed by the privatisation of the Commonwealth bank in 1991, the major banks have powered to the top 10 of our listed companies and stayed there.  Our major banks have held four of the top six positions by market capitalisation in our market for almost three decades.  The rankings of our top four banks have changed but they are all still there. The Commonwealth Bank has been the best performer and today is Australia’s largest company by market capitalisation.

To date Banks have been an excellent fit with our long-term investment philosophy of investing in companies with enduring competitive advantages, above market earnings growth and operating in industries with high barriers to entry.  In Australia banks have a strong moat and for many decades have operated in a regulated and rational (some would say cosy) oligopoly. The concentrated nature of Australian banking gives our top four banks significant scale advantages plus control over the majority of bank deposits, consumer and business lending.  Post deregulation and particularly in 1990s and 2000s banks grew rapidly by absorbing most of the major building societies and smaller banks including the state savings banks and through diversification into the wealth management and insurance. Post the 1991 recession through to the start of the Global Financial Crisis (GFC) in 2007, banks for the most part delivered year on year income and dividend growth and consistently outperformed the all ordinaries index. Our banks also performed well relative to global peers in the GFC and recovered strongly supported by the Government guarantee on bank deposits and wholesale funding.

Figure 1:

Over the last three years banks have underperformed the broader market as top line growth, earnings and dividend growth stalled (Figure 1).  This year almost every important performance metric turned negative.  Three of our four major banks (ANZ, Westpac and NAB) have year-end September balance dates and reported their full year results this month.  It wasn’t pretty.  Combined with the CBA June 30 results the numbers and the commentary were sobering. It was hard to find anything positive in the results other than the relatively honest recognition of the sheer number and magnitude of issues the banks now face, and the cost, time and effort required to fix them. Here are some of the lowlights from the annual results of our major banks this month.

• For the four major banks the combined cash profit after tax from continuing operations fell 7.8% percent on FY2018
• Top line revenue growth/operating income fell by close to 4%.
• The average net interest margin across the banks continued to fall and fell to below 2% for the first time to 1.94%
• After trending downwards for over two decades the cost to income ratios of the banks jumped sharply increasing from an average of 46.6% to 48.7%
• Remediation costs (let’s call it refunds to customers for dishonest and unethical behaviour) were a staggering $4.5 billion in FY2019 up four fold from just over $1billion for FY2018
• Return on equity continued to trend downward falling 1.31 percent of an average of 11.0%
• Non-interest income or fee income was down by a 12.2% on FY 2018
• After flatlining for the last 2 years dividends fell.  NAB cut its interim dividend in March by 16%. Westpac lowered its final dividend by 15% to 14 cents per share and ANZ maintained its final dividend but reduced the franking of its final dividend to 70%.  CBA was the only bank to maintain its dividend.
• Loan impairment expenses increased by 10% albeit off an historically low base.

Banks now face a number of headwinds we believe are more structural than cyclical.  They include a more competitive operating environment, a low interest rate environment and operational changes in the wake of the Royal Commission.

Competitive operating environment – All of the banks commented in their results on the intensely competitive operating environment they now find themselves in.  Slow economic and wages growth and a highly indebted and stretched consumer are contributing factors but it is new competitors in their traditional areas of strength such as Macquarie Bank and non-bank lenders (e.g. AFG, Liberty, Pepper) in mortgages and new Fintechs taking market shares across a range of other product offerings that are really starting to bite.  As so often with incumbents, banks are incurring the wrath of their older customer cohorts for closing branches and reducing face to face customer services while at the same time not responding fast enough to the service requirements of the current digital generation in both business and consumer banking.  Banks haven’t invested fast enough in their digital capabilities and are now trying to play catch up at a time they are facing unprecedented challenges.

Interest rate environment. – The historically low and declining interest rate environment is a major negative for banks.  As noted earlier the net interest rate margin for banks fell for the first time to under 2% in FY2019.  With a significant proportion of bank deposits now earning zero to negligible rates any further reductions in borrowing rates will continue to squeeze margins. This month the Federal Reserve in the USA reduced rates again. The Reserve Bank of Australia kept rates on hold this month, but further cuts are forecast.

Bank Operations and strategy – Shrinking to greatness now appears to be the mantra of the banking sector.  After spending the last three decades building integrated financial conglomerates across banking, insurance, funds management and financial advice the banks are now dismantling this model in record time with three of the four major banks announcing plans to exit the funds management and all four exiting the financial planning space completely in the wake of the Banking Royal Commission. Many would argue it was not the strategy but the implementation that went awry with the complete failure of banks to have the right systems and processes in place to manage financial and non-financial risks (particularly reputational risk) and more importantly to always act in the best interests of their clients.  The scale and complexity of the remediation programs to address the past misconduct of the banks is mind blowing with further provisions expected to impact earnings in 2020 and beyond.  Ongoing litigation, increased compliance expenditure and other regulatory imposts are all adding to the cost of doing business for the banks.

Dividends are also under pressure.  Over the four years to FY 18 three of the four banks maintained but did not increase dividends per share. Only the CBA managed a slight increase in dividends per share in FY2017 and FY2018. Generally, the banks have maintained dividends by increasing payout ratios rather than earnings over the last three to four years. The fall in earnings in FY19 meant this was no longer sustainable and three of the four banks reduced dividends this year. Again, only the CBA maintained its dividend with no changes to franking in FY2019.

With the fall in earnings the banks are now looking fully priced and they are trading well above the valuations (price to earnings and price to book multiples) of global peers.

In summary we believe the banks now face a period of structural decline that will see them grow at a slower rate than the economy and our market over the medium term.  We are adjusting our exposure to the banks accordingly.

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Sources:  Commbank Global Markets Research, RBA, Morningstar.