Major Australian banks’ 2023 half-year results: Walking the tightrope

Reserve Bank data show that both mortgage and business lending growth slowed over the six months to March,² amid tighter financial conditions.

House prices across capital cities have fallen 9% since the peak in April last year (although price increases in the past two months may indicate that prices are stabilising),³ and the total value of new loan commitments has fallen 26.3% over the year to March.⁴ In contrast, refinancing continues to drive mortgage activity, up 28.5% compared to a year ago.⁵

Banks have been competing intensely for mortgage business, offering cash back incentives and discounted rates. In places, certain lenders appear to have prioritised volume over profitability, with industry commentary on loans priced at or below the cost of capital. Discounted rates are reported to have extended into the back book, as banks battle to retain borrowers – a battle that will likely continue well into FY24. However, competitive pressures are showing early signs of easing (e.g., discount strategies are moderating), as banks respond to rising funding costs and expectations that the current monetary tightening cycle will soon end.

As mortgage growth slows, the banks are looking at opportunities for good margins and long-term growth prospects in business banking. While business lending was a strong driver of system credit growth in 2022, growth has eased in recent months. Business confidence remains around pre COVID-19 levels, while business conditions are stronger. But as consumption growth slows, business confidence and conditions are likely to take a hit.

Average NIM has improved, underpinned by interest rate rises and careful management of mortgage versus deposit rate increases. As ongoing competition erodes the margin benefits of higher rates, we are likely to see margins tighten as early as the second half of 2023.

Disciplined management of underlying operating costs and business simplification have continued to improve productivity for the banks. But this has been partially offset by the impact of wage and other cost inflation.

In this challenging operating environment, banks need to engage in structural cost transformation, targeting client segments, products and distribution channels to add flexibility and scalability to the cost base. Simply focusing on cost reduction misses a unique opportunity to move to the type of transparent cost base investors are increasingly looking for.

Funding costs are increasing for the banks, both in household deposits and wholesale funding.

The volatility in overseas markets has led to tighter and more expensive wholesale funding markets. These higher costs coincide with the banks’ upcoming need to refinance funding from the central bank’s low-cost term funding facility.

Higher wholesale funding costs are driving deposit competition. The strong growth rates experienced during the pandemic have slowed. The deposit outflows experienced in the US are leading banks to question long-held assumptions about the ‘stickiness’ of low-cost retail deposits.

Banks have carefully managed loan versus deposit rate increases, limiting the pass-through of cash rate increases on deposit products. However, deposit costs are increasing as competition for cost effective, stable deposit funding rises. Given the first real opportunity for yield in several years, customers are looking for higher-yielding deposits, particularly price sensitive business deposits. Banks are seeing plenty of movement in term deposits offering higher returns than at-call deposit products, which accounted for around 80% of the major banks’ deposit base on average in 2022.⁶ This switch from low to higher cost deposits will undo some of the funding cost gains the banks have enjoyed in recent years.

The recent turbulence in the banking sector is driving an intense focus on emerging risks in both the financial system and individual institutions.

Fortunately, Australia’s strict capital adequacy regime means domestic banks are well-placed to weather the current market instability. Along with large capital buffers, the banks’ strong holdings of liquid assets, conservative funding strategies and focus on traditional banking activities have bolstered the Australian financial system. Despite the volatile wholesale financing landscape, Australia’s major banks have increased their proportion of deposit funding since the GFC. Deposits now account for around two-thirds of the banks’ non-equity funding.⁷

However, with information and money moving in near-real time, even Australia’s well-positioned banks must closely monitor and stay ahead of key risk indicators. In the wake of the recent unexpectedly rapid bank failures, banks are examining idiosyncratic risks across three pillars: balance sheet and liquidity management; capital management; and underlying business portfolio weaknesses (e.g., concentration issues), as well as revisiting crisis management capabilities.

Looking ahead, we expect banks to refine a range of their balance sheet and liquidity risk management capabilities. Enhanced early warning indicators will be among the priorities, including incorporating social media channels in crisis identification and response methods to capture customer and investment sentiment early. While the current challenges are largely balance sheet and liquidity driven, banks will also need to revisit capital planning, including risk capture across multiple scenarios.

From a regulatory perspective, the perceived drivers of the bank failures and market stress are reshaping supervisory priorities. In particular, banks need to prepare for APRA’s upcoming resolution planning requirements by assessing potential ‘critical functions’ and interconnectedness.

Signs of stress are emerging following the rate rises, with arrears ticking up. However, NPLs remain low. The labour market has remained more resilient than expected, with low unemployment a key contributor in keeping bad loans at bay.

Despite market speculation of a pending ‘mortgage cliff’, the banks are not anticipating a sudden wave of home loan defaults. However, they remain cautious in their outlook, especially given the current market uncertainty. All have increased their collective provisioning levels compared with 2H22.

Many borrowers have been making significant top-ups into offset and redraw facilities. Many have equity buffers thanks to strong house price growth in recent years, which should help minimise loan defaults. But households’ ability to save and contribute additional mortgage payments has diminished. Interest payable on mortgages rose 23% in the December quarter 2022. At 4.5% for the quarter, the saving ratio was well below the 7.1% recorded in the September quarter, and the lowest since September 2017.⁸

A proportion of financially stressed customers will ultimately translate into troubled loans. A significant cohort of borrowers will be unable to refinance due to falling equity and tougher serviceability hurdles. The banks will need to work with these customers on customised payment strategies and solutions.

While commercial real estate exposures have emerged as a key concern for US regional and community banks, Australian banks have limited exposure and non-performing exposures to commercial property remain very low.⁹ The major banks have progressively tightened lending criteria for commercial property loans, with lending books more weighted to residential mortgages than commercial property lending.

2022 was the year of the data breach, as hackers penetrated cyber defences and stole millions of Australians’ personal data.

Banks have withstood the threat better than other industries, thanks to regulation driving 15-plus years of investment in robust cyber defence. However, a recent major data breach at a non-bank financial services company is a stark reminder that financial institutions are not invulnerable to cyberattack, nor immune to contagion from other compromised institutions.

To fight back against cyber threats, banks are adopting more powerful technologies powered by artificial intelligence (AI). The 12th annual EY/IIF global bank risk management survey found 35% of CROs using AI and machine learning to identify cyberattacks.

As well as direct attacks, customer data breaches at third-party institutions can have flow-on effects for banks. Scams, for instance, cost Australians more than $3.1 billion in total combined losses in 2022, a 79% increase on losses recorded in 2021.¹⁰

The growing problem of scams highlights the need for Australia to develop a framework that mobilises the entire ecosystem to combat scams efficiently with a balanced compensation, prevention and response model that is fair to all parties. Banks certainly have a role to play in protecting consumer funds. But so do other financial institutions, telcos, digital platforms and messaging services, social media companies and payments system providers. Consumers, too, should share the responsibility, as incentive to remain vigilant and cautious.