Challenging times for the banking sector

EY’s analysis of the 2015 half year results of Australia’s major banks

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Thursday 7th May - The half year results announcements of Australia’s big four banks reflect a sector that continues to be tested by local and international influences.

The Australian economy is in transition and banks are navigating the ongoing impacts of modest consumer and business confidence, record low interest rates, an uncertain global economy, falling commodity prices, increased regulatory focus and imminent changes to capital requirements. Yet despite these challenges, EY’s analysis shows that, on the whole, the major banks have continued to deliver solid financial results.

A headline cash earnings after tax figure of $15.4 billion represents an increase of 4.7% from the prior comparative period. Growth in net interest income over the first half of the year has been achieved off the back of modest loan growth, although this has been mitigated somewhat by a drop in net interest margins of between 2 and 11 basis points.

EY’s Oceania Banking and Capital Markets Leader, Tim Dring says: “In the current environment, the directors and executive teams of the major banks certainly have a full agenda to manage.”

“During the first half of the year, low bad and doubtful debt charges continued to buoy the sector’s results, with improvements in asset quality across all of the majors – well beyond expectations.  Although the benefit to underlying performance is welcome, this is not sustainable in the long term,” Mr Dring said.

“Housing lending volumes also continued to grow over this period on the back of historically low interest rates and historically high prices in New South Wales and Victoria. The potential for this housing bubble to burst is real, with significant declines in commodity prices and the knock on impact on mining and mining services enterprises, minimal inflation and rising unemployment making it all the more likely.  If both interest rates and unemployment rise, credit quality may well change dramatically,” Mr Dring said.

“There are already early signs that the growth fuelled by the mortgage sector is tapering off. As loan amortisation rates accelerate, banks will need to work harder to retain customers by improving the customer experience.”

“Although largely flat and competitively priced, business and institutional lending is an area of potential growth that may help the banks to relieve margin pressure. However, this will depend on business confidence and the overall health of the economy.”

“On the liability side, price pressure has continued to ease on retail deposits and wholesale funding costs remain favourable compared to prior periods.  This provided some relief to ongoing margin pressure on the asset side of the balance sheet.”

“Operational efficiency is also contributing to the solid profitability of the Australian major banks, relative to their international peers,” Dring said.
 
“Over the last six months, banking jaws have narrowed - for some institutions, trending negative for the first time in many reporting periods. This has been primarily driven by payroll, technology and compliance costs, exacerbated by contracting net interest margins and growth volumes.”

“During the first half of the year, cost to income ratios have also remained relatively flat. The banks’ aspiration to drive well below the ‘glass floor’ of 40% is not proving to be easy – particularly if the aim is sustainability.”

Productivity power

A low growth environment, coupled with increasing pressure on revenue from new fintech entrants, is forcing Australian banks to renew their focus on productivity.

“All of the Big 4 banks are making significant investments in technology to address changing customer habits and defend against digital disruption,” Mr Dring said. “Investment in areas such branch networks, real-time services and the ability to better manage and leverage insights from customer data will continue. Realising the benefits from this major investment in customer experience will be critical to protecting revenue streams.”

“At the same time the pace of technological change is making it increasingly difficult to predict what skills will be needed to drive future growth in productivity and innovation. Technological change means banks will likely need fewer employees. However they will have to carefully consider the right balance between delivering returns to shareholders and their obligations to society,” Mr Dring said.

Conduct remains front and centre

“With the recent Parliamentary Joint Committee and Senate Inquiries into financial advice, ASIC performance and professional standards, the Financial System Inquiry, and the Trowbridge report into retail life insurance advice, the conduct and culture of our major financial institutions remains squarely in the spotlight.”

“Although the industry is responding to these reviews with transformational initiatives, ongoing scrutiny of their wealth management operations is likely,” Mr Dring said.

“To date, Australian banks have been insulated from the scale of overseas scandals. But the recent inquiries, and the resulting loss of consumer confidence, have raised the spectre of damage to the local sector’s social licence to operate. This ‘trust deficit’ is particularly significant in light of greater consumer empowerment, digital disruption and the increasing availability of alternative market competitors.

“In this context, conduct, customer experience and trust are likely to be key battlegrounds for the banks’ future success.”

Socially minded

Australia’s banking sector is leading the way in digital uptake. Smartphones and social media are revolutionising the way banking customers source information, make decisions and interact with their providers.

“The sector’s success in moving the vast majority of customer interactions online – while still offering offline channels – has reduced costs, as well as significantly improving customer convenience and service,” Mr Dring said.

Interactions across the major retail banks’ social media channels are growing at more than 150% per annum – predominantly across Facebook, Twitter, LinkedIn, blogs and community sites. But, as interaction volumes grow, so do customer expectations and the banks can’t afford to lose momentum.”

“In the second half of 2015, we see significant opportunities for the major banks to receive better returns from their ongoing investment in social media. The biggest wins will come from activating social as a mainstream channel and integrating it into their broader distribution strategy.”

A bumpy road

“Looking ahead, the major banks face a number of challenges that will put increased pressure on earnings and the efficient use of capital will become even more important as return on equity targets will be significantly challenged,” Mr Dring said.

“The implications associated with the timing of proposed changes to the capital requirements remain an area of material uncertainty for the major banks and the likelihood of having to increase capital levels is now likely.”

“At the same time though, the economic environment is conducive to raising additional capital and the banks are very focused on improving productivity and sustainable cost reduction through the use of technology and process simplification.

The 2015 half year results at a glance

  • $15.4 billion in cash earnings up from $14.7 billion in the 2014 half year results, an increase of 4.7%.
  • Net interest margins down an average of 6 basis points from the prior comparative period, to 2.03%.
  • Overall reduction in total loan loss provisions of $1.5 billion from the prior comparative period, to $15.8 billion.
  • Return on equity decreases by an average of 37 basis points from the prior comparative period, to 16%.

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