Despite delivering another generally positive set of results for the 2023 half-year, Australia’s major banks are facing challenges that will see them needing to manage competing demands from investors, customers, regulators and government against an increasingly uncertain and volatile backdrop, according to the latest analysis from Ernst & Young, Australia (“EY”).
EY analysis shows the big four banks reported combined statutory earnings of $16.77 billion for the half-year – up 10.8% from the same time last year – with cash rate rises supporting revenues and net interest margins. Higher earnings have also pushed up return on equity, to an average of 12.6% across the banks. Some signs of mortgage stress are emerging across the sector though, with arrears ticking up following interest rate rises, although non-performing loan levels remain low overall.
Doug Nixon, EY Oceania Banking and Capital Markets Leader said: “Australia’s major banks are walking a tightrope as headwinds for the sector intensify. The resilience of the Australian economy continued to support credit growth and quality throughout the first half of the year. However, intense competition in response to retail credit growth compression, coupled with rising funding costs, amplified by the recent dislocation in financial markets, will likely erode the benefits the banks have gained from the higher interest rate environment.”
“Asset quality deterioration is also a real risk, as interest rate increases and inflationary pressures squeeze both households and businesses. At the same time, costs around staff, technology, cybersecurity, and remediation continue to drive up the banks’ operating costs.”
“So, while Australia’s major banks remain strong and resilient, pressure on net interest margins, combined with the increasingly uncertain operating environment, means they face a complex high-wire balancing act when it comes to managing profitable growth, customer expectations, investment priorities and shareholder returns,” Mr Nixon said.
Loan momentum slowing
“Retail credit growth compression has created highly competitive pricing practices for mortgage business, with some lenders appearing to price loans at or below the cost of capital,” Mr Nixon said.
“Banks have been offering significant cash back incentives and discounted rates in the battle to attract new, and retain existing, borrowers. However, competitive pressures are showing early signs of easing, as the banks respond to rising funding costs and expectations that the current monetary tightening cycle may soon end.”
“Average net interest margins improved in the 2023 half-year results, underpinned by interest rate rises and careful management of mortgage versus deposit rate increases. But, as ongoing competition erodes the margin benefits of higher rates, we may see margins tighten as early as the second half of 2023.”
New approach to cost transformation needed
“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. As operating cost pressures continue amid the challenging operating environment, a new and more holistic approach may be needed,” Mr Nixon said.
“Simply focusing on cost reduction misses a unique opportunity to drive greater operational effectiveness and move towards the type of transparent cost base investors are increasingly looking for. Banks need to engage in structural cost transformation, targeting client segments, products, geographies and distribution channels to add flexibility and scalability to their operating models.”
Funding costs increase in both household deposits and wholesale funding
“Funding costs are increasing for the banks, with volatility in overseas markets leading to tighter and more expensive wholesale funding markets. Meanwhile locally, with inflation still uncomfortably high, a resilient labour market and business conditions sitting above pre-COVID-19 levels, we may see further monetary tightening.”
“Deposit costs are also 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 and banks are seeing plenty of movement in term deposits offering higher returns. This switch from low to higher cost deposits will likely undo some of the funding cost gains the banks have enjoyed in recent years. In this environment, Australian banks are taking a more granular look at their deposit mix, including the proportion of insured to uninsured deposits.”
“The recent turbulence in the global banking sector is also 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. However, even Australia’s well-positioned banks must closely monitor and stay ahead of key risk indicators. Looking ahead, we expect the banks to refine a range of their balance sheet and liquidity risk management capabilities. Banks will also need to prepare for APRA’s upcoming resolution planning requirements by assessing potential critical functions and interconnectedness,” Mr Nixon said.