Years of investing in technology is starting to pay off at just at the right time for the major banks, with productivity savings helping to sustain dividends even though revenue is under intense pressure and compliance costs have spiked in response to the royal commission.
Despite the banking sector being hit by a severe storm this year – lending growth is at its lowest rate in a decade, return on equity is at its lowest level since the financial crisis, and net interest margins fell below 2 per cent in the second half for the first time – three of the majors were able to keep dividends stable, while Commonwealth Bank increased its by 2¢ per share.
This was possible because bad debts remain at generational lows. At $3.3 billion, the combined bad debt expense was down 17 per cent over the year, according to PwC, and at the lowest level in 25 years. But if credit losses were instead at their average over this period, cash profits would have been $3.5 billion, or 10 per cent, lower.
Pristine asset quality, momentum in business lending and efforts to improve productivity were the highlights of the recent bank reporting season, according to KPMG.
Across the big four banks, it found spending on technology rose 7 per cent to $7.2 billion, and in one of the major themes of the reporting season, the banks remain committed to investing in the IT systems necessary to compete in a new world cloud infrastructure, automated processes, and soon-to-be open banking.
The extra investment means cost-to-income ratios are continuing to rise, for now, but the banks say they will soon reap the benefits of cost savings from these new systems.
Furthermore, National Australia Bank CEO Andrew Thorburn, ANZ Bank CEO Shayne Elliott and Westpac CEO Brian Hartzer all explained over the past week that they have no choice but to keep investing in technology – and find productivity savings elsewhere, including cutting headcount – to be ready for a more competitive future where more financial services are delivered digitally.
More choice for customers
“In the long run though, especially with the introduction of open banking, we will continue to see choice being more clearly put into the hands of the customer,” said Colin Heath, the banking and capital markets leader at PwC.
“Banks that focus on becoming simpler, smaller and more deeply connected to customers should also be able to price more effectively, expand relevant services and maintain market share – as well as being more efficient and less error-prone by design.”
This reporting season also emphasised the strategic rationale for cutting away non-core assets and simplifying operations – indeed, Mr Elliott observed that “simplification” had become the most commonly used word in banking.
“Whether it’s ‘getting back to basics’ or ‘Banking 101’, almost all the four major banks have either divested, or are in the process of divesting, one or more of their life insurance, funds management, wealth management, or offshore operations – and reallocating capital internally to owner-occupied home lending and business banking,” said Deloitte’s senior banking partner Paul Wiebusch.
But having retreated back to the core, the majors are not finding life any easier. Their headline cash earnings fell 5.5 per cent over the year to $29.5 billion and, according to PwC, return on equity plunged 134 basis points to an average of 12.5 per cent.
The lower ROE is explained by regulatory, customer remediation and restructuring costs, the asset sales, and an increase in capital levels required by regulators to protect the banks from rising risks.
Lending and deposit volume growth, which has dominated the banks’ numbers over the last decade, has peaked, KPMG said, and while banks could soften the impact by lifting interest rates on mortgages – net interest income across the majors increased by 2.2 per cent to $62.7 billion – revenue from fees is under pressure. Non-interest income was down 3.7 per cent to $22.4 billion.
This is partly a function of the wealth business sales, but also political scrutiny on the sector and banks’ need to rebuild trust. They removed ATM fees, lowered interchange fees and are also moving on “grandfathered” commissions.
The revenue pressures have put an intense focus on costs. Risk and compliance project spending increased by a substantial 567 basis points to 35.1 per cent of total investment spendings, driving up the cost-to-income ratio by 356 basis points to an average of 46.6 per cent, according to KPMG.
This is despite big cuts in headcount, with full-time equivalent staff decreasing by 5206, or just under 4 per cent, over the year to 149,943, according to KPMG – with more staff cuts to come.
There was also plenty of focus during the reporting season on competition. Over the year the average net interest margin contracted by 2 basis points to 2 per cent and it fell below 2 per cent for first time in the second half, noted PwC.
Non-bank lending is growing much faster than the banks, and the majors are aggressively discounting interest rates on new loans to win new customers. Mr Thorburn called for an end to the practice as analysts suggested it could come under increased political scrutiny.
EY reckons “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”. It suggests an outcome of the royal commission and open banking will be more customers “galvanised into switching”.
“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,” EY said.
Strong balance sheets
Although most bank watchers have suggested for several years now that bad debts couldn’t go any lower, over the past year they have. But there was also a slight increase in some of the closely-watched indicators of credit quality, albeit off a very low base.
For example, the level of mortgages more than 90 days past due grew by 4 basis points to 0.48 per cent of gross loans. If unemployment levels in the economy rise, it is likely this number will too.
With property prices also coming off, banks are aware they are moving into a period of heightened risk.
However, the past reporting season also showed their balance sheets are stronger – thanks to the efforts of the financial system inquiry to increase bank equity buffers.
Westpac and ANZ are already above the APRA target for “unquestionably strong” capital of 10.5 per cent by January 2020, and CBA and NAB are confident they will get there soon.