Australia’s major banks have delivered solid but mixed results for 1H18, reflective of the reshaping of their businesses. However, performance remains under pressure from softening growth, profitability constraints and rising costs.
The results reflect the impact of an increasingly complex and challenging operating environment, shaped by:
- Transformation imperatives – the banks are accelerating simplification and digital transformation initiatives as multiple forces bear down on performance, including a changing competitive landscape and demanding regulatory reform agenda
- Subdued growth outlook – competition and regulation are dampening revenue growth and profitability outlooks
- Regulatory and policy impacts – the banks face unprecedented regulatory and government measures driven out of APRA, ASIC, AUSTRAC, ACCC and the Financial Services Royal Commission
As an array of internal and external forces buffet the banks, employing the right combination of levers and effectively managing the competing trade-offs and stakeholder interests will be critical for success. Balancing the execution of strategic imperatives with regulatory demands will continue to stretch management and resources for the foreseeable future. At the same time, new technologies and the drive for digitalisation are adding different risks and trade-offs into the mix.
Simplification and digital transformation underpin much of the banks’ strategic agendas.
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Changing capital requirements have rendered certain businesses and products less attractive than others. Using the balance sheet lever to improve capital efficiency and profitability, banks continue to review wealth-related businesses, divest non-core assets and rationalise product lines.
With simpler business structures and portfolios, management can focus on investing in future areas of growth and transitioning to lower cost operating models. While many of the ‘big ticket’ changes have been completed or are in progress, further incremental change opportunities remain.
Digital transformation remains top of the banks’ agendas, not only to deliver customer experience transformation but also drive efficiencies and reduce costs. Automation and digitalisation offer the banks the opportunity to reduce FTEs and branch networks, and the possibility of applying new technologies to bring cost-to-income ratios to less than 40%.
The banks are at the very early stages of seeing digitalisation benefits. Now they must make themselves truly nimble by creating truly digital businesses for the future, not just the digitalization of processes to be quicker for the present. This means accelerating their digital maturity to create scalable and flexible digitally-enabled business models.
Digital transformation will reshape the workforce, including a shift in the type of talent needed and a redefined workforce with new ways of working and new types of workers. FTE staff numbers continue to decline, with further reductions pending as the banks continue to invest in productivity and automation initiatives to support profitability.
Subdued growth outlook
Softening housing credit growth (the major driver of the banks’ lending), competitive pressures, higher capital requirements, and regulatory and policy impacts on volumes and costs point to constrained earnings growth for the banks.
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The banks have been reining in investor and interest-only residential housing loans, using levers such as repricing and stricter loan-to-value ratios for some time now. Residential mortgage growth has softened as macroprudential measures take effect.
In the face of strong competition and finding themselves well below lending caps, banks are now once again turning to the pricing lever to offer discounts for new investor and interest-only borrowers. APRA’s pending removal of the 10% growth cap for investor lending is unlikely to spur greater competition for investor loans given stricter loan serviceability requirements and the ongoing regulatory focus on home lending risk. Increased first home buyer activity, underpinned by stamp duty concessions, has also led to intense competition for new borrowers.
Stricter standards for loans look set to act as a brake on new lending by reducing customers’ borrowing capacity. Following discussions with APRA, the banks have already stepped up their scrutiny of borrowers' living expenses, and further tightening may be required. Stricter lending standards may also contribute to slower house price growth. House price inflation is already moderating, attributed in large part to the macroprudential measures aimed at investor and interest-only lending. Muted wage growth, affordability constraints and a possible uptick in interest rates in the short-to-medium-term may depress prices further.
Business credit is yet to pick up a sustained pace, despite generally stronger levels of confidence and business conditions. While improving conditions should ultimately spur business lending growth, small business access to finance can be hampered if business loans require property as security. In the medium term, data-driven lending decisions made available by open data initiatives may broaden lending options for small business.
Disciplined pricing will be required to preserve future earnings as banks balance the need to grow market share with sustaining margins and returns.
Home loan repricing has provided a short-term net interest margin (NIM) tailwind for the banks. Competition for new owner occupier borrowers, the major bank levy, reduced scope for loan repricing in the face of intense scrutiny and future higher risk weights for investor and interest-only housing loans all weigh on margins. If recent increases in short-term wholesale funding costs persist, banks may be compelled to reprice upwards to address margin (and profit) pressure, despite the negative response this will likely generate.
Average return on equity (RoE) has declined, reflecting low interest margins, a high competition environment and strengthening of regulatory capital. RoE is likely to come under further pressure from the impact of increased spend on compliance and customer remediation.
The banks continue to use cost management as a key lever to improve profitability. However, cost to income ratio outcomes were mixed and average jaws turned negative, reflecting in part restructuring and divestment-related costs for some of the banks. Costs incurred in responding to the Royal Commission have been relatively limited to date. Potential further remediation of customer and conduct issues will deliver a much higher cost impact.
Technology is the fundamental lever to drive down costs and, therefore, to drive future profitability. The next phase of efficiency improvements is coming from advanced digital technologies to streamline processes and reshape the cost base.
But the banks are yet to prove they can take out costs in a sustainable way. Rather than shrinking the cost base, they risk simply shifting costs around. The key will be effective benefits realisation and new ways of measuring digital value creation to drive the conversion of the traditional to the digital. For instance, the cost benefits of a significant reduction in FTE requirements as a result of automation may be offset by an increase in contractor fees to fill unforeseen gaps.
Capital ratios remain strong, supported by sound organic capital generation. All the banks remain well-positioned on CET1 ratios.
Now that APRA has provided greater certainty on capital requirements for residential mortgage lending, it appears there will be no increase in absolute capital, although risk-weighted assets may go up. In response, business models and product lines will require review. Strategies and pricing models will need to address the changing capital requirements across different portfolios to ensure appropriate returns on equity.
Asset quality remains generally sound, continuing to provide an earnings tailwind for the banks.
Provisioning levels have remained relatively stable. Risks in the domestic economy continue to point to potential increases in credit losses arising from the banks’ concentration in housing lending and increased levels of loans in arrears. Deterioration in mortgages, particularly in Western Australia and Queensland, and retail sector exposures are still the main areas of stress.
Regulatory and policy impacts
A range of regulatory levers will continue to drive management focus on operating and capital expenditure, such as the RBA deploying macro-prudential policies and the various reviews and reforms coming out of APRA, AUSTRAC, ACCC and the Financial Services Royal Commission.
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The banks are experiencing much greater scrutiny and a shift in the expectations of the community, government and regulators as the spotlight on competition and conduct intensifies through the Royal Commission. It remains to be seen whether the resulting regulatory and policy outcomes will challenge the banks’ market dominance and pricing power, and their vertically integrated business models. It appears likely that, just as the market is opened up to new entrants, incumbent banks will face increased regulatory constraints to growth.
The Government’s push to increase competition in financial services is breaking down the longstanding barriers to entry that have protected the major banks’ structural advantages. The ACCC’s residential mortgage products price inquiry, mandatory comprehensive credit reporting, open banking, more flexible licensing options and proposed legislation to ease bank ownership restrictions will all support financial services innovation and encourage greater competition. New entrants are leveraging opportunities to address gaps in the market, not only with purely digital offerings but also solutions that combine digital with traditional banking values and expertise.
The regulatory and policy agenda on competition must balance the risks and opportunities posed by technology innovation. While technology offers the banks new opportunities, it also brings new strategic risks such as cyber security. New risks in turn require new governance and risk management processes, and add to the banks’ costs; for example, the rising cost of effective cybersecurity.
Increased competition also places greater pressure on conduct and lending standards as banks compete harder for new business.
Conduct and culture
The banks must also respond to a far-reaching conduct and culture agenda.
The Royal Commission has highlighted ongoing problems with bank culture, governance and remuneration. Evidence presented to the Royal Commission points to breaches of customer trust by banks and a failure to protect customers from conflicts of interest arising from staff and broker remuneration models. It remains to be seen to what extent the Commission’s recommendations will impact the banks’ future operations and business models.
In the meantime, APRA’s review of remuneration practices has identified shortcomings in the design and implementation of performance-based remuneration frameworks. The regulator is now urging institutions to re-evaluate their frameworks and policies. The implementation date of the Banking Executive Accountability Regime (BEAR), aimed at strengthening accountability of senior bank executives, is also fast approaching. All of these requirements will challenge the banks to extract business value from what may be seen as a compliance exercise.