The banking sector finds itself in turbulent times. The Royal Commission into misconduct, regulatory pressures and a rapidly evolving competitive environment all point to ongoing sector disruption. Challenges are both financial and non-financial. Profits and returns are being squeezed by a slowing housing market, reducing borrowing capacity, remediation programs and higher costs. Reputations have taken a battering by Royal Commission revelations of misconduct, including banks prioritising profits over customer interests.
The banks’ full-year results reflect this difficult operating environment:
Underlying cash earnings: $29.49bn, decrease of 5.5% (total of all four banks)
Average return on equity: 12.2%, decrease of 170 basis points
Net interest margin: 2.0%, decrease of 1.25 basis points
Bad debt expense: Decrease of 17.6%
In this environment, the banks’ strategic priorities will remain to:
- Bolster financial performance by improving cost discipline, finding ways to bring sustainable cost efficiencies through technology and focussing on margin management to sustain revenues
- Restore community trust and align customer, community, and shareholder expectations
Cash earnings decline
The banks reported lower aggregate cash earnings for the year on the back of slowing revenue momentum, and increased customer remediation and compliance costs. Lower earnings have flowed through to lower return on equity (RoE), which continues its downward trend to its lowest level in a decade.
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The past year has seen the banks making sizeable provisions for customer remediation programs. In the coming year, they may need additional provisions to address the repercussions of greater regulatory scrutiny and their own internal reviews of products and services sold in past years.
Remediation and restoring community trust will be prime concerns for the sector over the short to medium term, particularly in an environment where reputation may be the new driver of competitive advantage. As a result, profit growth may remain constrained.
Growth fuelled by home lending is moderating, dragging on revenues. Higher margin investor lending in particular has declined following the macroprudential measures aimed at investor and interest-only lending – and as tighter lending standards take effect.
The banks have been revising lending policies, including risk appetite thresholds for new borrowers. As part of strengthening responsible lending, the banks have introduced measures to more accurately assess borrowers' income and expenses, and are restricting loans to high debt-to-income customers.
Tighter risk appetite is intensifying competition for new, low-risk owner-occupier borrowers. Front book margins have come under pressure as banks look for volume to retain market share via special offers for both new owner-occupier and investor borrowers. Pursuing new mortgage growth in a slowing market may put revenues at risk, with discounted interest rates likely to be a greater constraint than tighter lending standards.
Despite the current intense political and regulatory scrutiny of banks’ pricing practices, most of the banks have been repricing mortgages for existing borrowers in response to funding costs pressures. Average Net Interest Margin (NIM), across the banks declined in 2018, though individual results were mixed. The recent repricing should support NIM the banks’ core revenue driver, into 2019. However, the combination of aggressive front book pricing across the banks, elevated funding costs, the bank levy and the decline in higher margin lending are squeezing retail banking margins.
We may see rates for the front book narrow versus the back book, particularly if the consumer response to the Royal Commission is to shop around. The Productivity Commission report into financial system competition suggested that customers’ very low propensity to switch lenders has enabled banks to maintain higher interest rates for existing customers1. If customers become aware of this, especially in the current environment of distrust, they may be galvanised into switching.
Recent months have seen an uptick in system business credit growth. However, business lending will see competition from foreign banks, particularly Asian banks but also European banks looking to build market share. Anecdotally, the Royal Commission has led the banks to adopt a cautionary approach to SME lending, which may benefit FinTechs, especially at the smaller end of the lending market.
As the banks try to determine what constitutes a ‘good lend’ in the current environment, we believe fewer, more specific measures to monitor risk appetite would help the banks resolve this question.
Cost pressures increasing
Total operating expenses increased, driven by remediation, restructuring and compliance/regulatory-related costs.
Unsurprisingly, slowing revenue and upward cost pressures have seen cost-to-income ratios tick up, as the banks continue balancing investment in digitalisation and automation with rising remediation and compliance costs.
Costs associated with the Royal Commission are likely to continue to adversely affect the banks’ expenses through customer remediation, legal fees (including potential class actions) and potential recommendations for system changes. Proposed enforcement action by ASIC for breach reporting failures could further add to costs.
At the same time, the banks remain under pressure to deliver sustainable reductions to their cost base through digital transformation and simplified operating models. FTE staff numbers continue to decline, with further reductions pending as the banks continue to invest in automation initiatives to support profitability. Funding such improvements requires sizeable investment from the banks, adding to short-term costs.
Meanwhile, external drivers are also pushing up expenses, including policy initiatives such as real time payments, comprehensive credit reporting and open banking. To this point, APRA has recently raised concerns that banks are not investing enough in maintaining existing core technology systems. APRA sees this as particularly problematic given the complex and aging legacy infrastructure on which many banks currently rely.
Note: The Cost to Income result is calculated by EY as Operating Expense (Statutory) over Operating Income (Statutory). The Cost to Income reported by the big four banks is typically reported on a cash basis.
1 Competition in the Australian Financial System, Productivity Commission, August 2018.
The banks are closer to meeting APRA’s ‘unquestionably strong’ regulatory capital benchmark as they build up their balance sheets, supported by continuing sound asset quality.
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The banks continue to grow and strengthen their capital bases via divestments and assets sales, and dividend reinvestment plans as they work to sustain (for some), or achieve (for others), APRA’s CET 1 ratio target of 10.5%. The risk for all is that additional conduct-related expenses could put a dent in capital positions.
Dividend payouts have been maintained but may potentially be squeezed in future periods by the impact of increased capital intensity, the challenge to generate RoE in a low margin/high competition environment and increased remediation and compliance costs. However, banks will be reluctant to reduce dividends, which have traditionally been a key driver of share price.
Asset quality still sound
Low bad and doubtful debt charges, the lowest in a decade, continue to buoy the sector’s result – a rare tailwind for the banks. Bad debt charges have declined across all of the banks. Asset quality should remain good while the economy and employment remain positive and interest rates remain low. But, this is not a sustainable substitute for credit growth on bottom line results.
Mortgages, retail exposures and agri remain key areas of potential stress.
For mortgages, high levels of household debt, increases in back book mortgage rates, falling home prices and stricter lending standards that reduce refinancing options for stressed borrowers are among the contributing factors. Mortgage loan losses may increase over the next two to three years as interest-only mortgages convert to principal and interest loans, requiring higher monthly repayments from highly indebted households.
Retail exposures are driven by factors such as low wage growth and pressure on disposable income, the ongoing transition to online shopping and a shift in consumer preferences to spending on cafes and restaurants rather than goods. Banks have reduced their exposures to retail businesses. However, recent research by the Reserve Bank of Australia (RBA)1 highlights banks’ exposure to retail properties as a potential future stress point.
Agri portfolios may see an uptick in arrears if drought conditions in Australia’s eastern states continue, but asset quality remains sound for now.
1 Reserve Bank of Australia, “Financial Stability Risks and Retailing”, Bulletin, September 2018.
The competitive landscape for banks is undergoing rapid change, as policy initiatives aimed at increasing innovation and competition start to chip away at the entrenched position of the majors.
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Evidence suggests that non-bank lending has been growing, benefitting from the impact of macroprudential constraints on investor and interest-only loans, and the major banks’ tighter lending standards.
As the Government drives reforms to increase competition, new entrants are on the rise. A start-up digital bank has been granted the first restricted banking licence. Three other start-ups are looking to launch new banking operations soon. These new players will not pose an immediate threat to the major banks’ market share. But, unencumbered by legacy IT systems and branch networks, they have pricing advantages that will make them an attractive alternative for retail and SME customers, enabling these new entrants to build a niche market share.
Banks must also factor in the impact of a range of policy initiatives on competition. These include the ACCC’s residential mortgage products price inquiry, mandatory comprehensive credit reporting, open banking and more flexible licensing options to facilitate new entrants. Other start-ups are looking to launch new banking operations soon. These include the ACCC’s residential mortgage products price inquiry, mandatory comprehensive credit reporting, open banking and more flexible licensing options to facilitate new entrants.
The trust deficit
The Royal Commission has reinforced the growing trust deficit between the community and the banks.
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The Commission hearings highlighted many examples of the impact of banks’ inadequate risk systems and controls. The Interim Report also points to potential weakness in the banks’ ability to leverage technology for compliance and risk management internally.
The banks’ focus on growth in past years has added layers of new products, policies, processes and technology, leading to highly complex businesses with complicated IT architecture. Concurrently, the banks have taken a functional rather than end-to-end view of the business. As a result, banks are struggling to implement the necessary end-to-end process control to better manage risk.
The Royal Commission findings highlight the need for the banks to take a “back to basics” view of their operating models. Banks need a holistic, end-to-end view of their business; in particular, with regard to conduct and other non-financial risks. This is key to achieving efficient processes, controls and compliance.
Royal Commission: Interim Report outcomes
The Royal Commission has dominated the financial services agenda for much of 2018. The Commission’s Interim Report makes no recommendations, but poses a number of questions for consideration that provide a guide to possible future recommendations.
Among the possible recommendations are:
- Regulatory reforms to better align commercial and customer outcomes: This may include further restrictions on conflicted remuneration, heightened prescription around the best interests duty, application of the best interests duty to intermediaries and structural separation of vertically integrated businesses. To this final point, the banks are already well under way in their retreat from vertical integration, divesting various wealth businesses and assets, in the process reshaping Australia’s wealth sector.
- Reforms to enhance the effectiveness and capability of ASIC and APRA: This may include simplifying the legislative regime that applies to the financial system and enhancing the powers and penalties available to regulators. It may also include a direction for the regulators to enforce the law more vigorously and be resourced to do so. Any reforms are likely to complement the suite of reforms that the Government has already accepted from the ASIC Enforcement Review, including increased penalties for financial and corporate misconduct, power to enable ASIC to direct banks to establish remediation programs and breach reporting obligation reforms.
However, regulatory reforms alone will not be sufficient. Cultural change will be required, to shift the sector to one that puts people before profit and asks, “Should I do this?” rather than, “Can I do this?” (as the Interim Report puts it). Cultural change cannot be regulated into existence. It is not easy and will take time. Achieving such a change will require vision and commitment, underpinned by constructive industry-wide initiatives.
Banks will also need to resolve how they can align customer, community, and shareholder expectations. Without such resolution, the current challenges will continue. At the same time, banks must also resolve how to measure, monitor and manage conduct for the future.
For further insights on the Interim Report and its implications, see our Royal Commission Interim Report - analysis and insights.