Margin squeeze to persist as majors tackle credit ‘headwinds’

Consultancy firm Ernest & Young (EY) has reviewed the performances of the big four banks over the first half of their 2019 financial year, noting a combined statutory profit reduction of 11.8 per cent, down by $1.9 billion to $13.9 billion.

According to EY, the results reflect higher remediation costs, weaker economic conditions, and the residual impact of the banking royal commission.     

“The growth outlook for Australia’s major banks looks increasingly uncertain, with profits down, remediation costs up and margins under significant pressure,” EY Oceania banking and capital markets leader Tim Dring observed.  

“The financial services royal commission has disrupted the banks’ risk appetites and business flow, propelling them to reshape their processes, simplify products and address compliance obligations, as they prepare for more intensive levels of regulatory supervision and enforcement from APRA and ASIC. It has also revealed issues in their back books.”

Mr Dring noted the impact of remediation costs realised in the banks’ financial performance, which totaled $1.9 billion over the first half of 2019 and $4.8 billion over the past 18 months.

“So far, remediation costs have related mostly to misconduct issues within wealth management divisions,” he said. “But ongoing investigation into product design and compliance will likely see further increases in the banks’ remediation burden that will put cost-to-income ratios under increasing pressure.”

The EY analyst also pointed to the regulatory and compliance burdens placed on the big four banks.

“Adding to this pressure, the major banks are facing a stricter executive pay framework (BEAR) and more onerous regulatory regime at the same time as the market is opening up to increased competition from non-banks and foreign banks,” Mr Dring continued.

Weakening demand for credit was also reflected in the 1H19 of major banks, which all reported slowing mortgage volumes when compared to the previous corresponding period.

ANZ, in particular, reported a contraction of approximately $2 billion to its mortgage portfolio, which CEO Shayne Elliott attributed to a “massive shift” in the mortgage market as well as a “conscious decision” by the bank to revise its mortgage strategy.

Funding cost pressures also strained the banks’ margins, with out-of-cycle rate hikes not enough to reverse the drop in the big four’s net interest margins (NIM), which according to EY, collectively decreased by an average of 11 basis points over 1H19, falling to 1.95 per cent.

“Returns on mortgages have stagnated over the last 12 months and, although repricing should have supported net interest margins, a combination of aggressive front book pricing and a decline in higher margin lending saw average NIM across the banks decline in the first half of the year,” Mr Dring observed.

He continued: “Overall, we’re seeing slower loan growth driven by a tightening of risk appetite and credit standards, falling house prices and arrears starting to tick up slightly.

“Non-performing loans remain well secured but, if housing values continue to fall, some past-due housing loans could become impaired. Further risks are also likely to emerge as interest-only loan periods expire and borrowers struggle with higher repayments.”

Mr Dring stressed the importance of technological enhancements in accelerating verification processes and countering inefficiencies in the mortgage application process.

Commenting on the outlook for the big four banks, EY chief economist Jo Masters said that economic conditions would continue to present the sector with challenges.

“After 28 years of uninterrupted growth, Australia’s economy has lost considerable momentum reflecting a softening housing market – particularly in Sydney and Melbourne – and fragile consumer confidence,” she said.

“The economic outlook now is more challenged than it’s been for some time and this will present some headwinds for the banking sector.

“Credit growth is slowing alongside the housing market. While the environment remains relatively benign at present, the headwinds are mounting as low-saving households face anemic wage growth, record-high debt, increasing portions of budgets being taken up by non-discretionary spending and, now, falling housing prices.

Ms Masters concluded: “It seems inevitable that we are in for a period of slower economic growth and this will present another challenge for the major banks’, especially if households look to deleverage.”

However, according to Steven Cunico, Deloitte’s financial services treasury advisory lead, the banks have reduced their exposure to cost pressures by cutting their operating expenses by $18.9 billion (3 per cent), when compared to the first half of 2018.

“The current cost and resource squeeze, however, is taking place in the context of the considerable work Australian banks have done on efficiency over the last two decades,” he said. “The majors have successfully delivered positive jaws – the gap between income growth and cost growth – over the last decade.”

Mr Cunico continued: “As a result, their cost-to-income ratios sit between 42 per cent to 49 per cent, significantly lower than their American and European peers (60 per cent to 63 per cent). 

“Nevertheless, there are opportunities to trim the absolute cost base further to deliver sustainable long-term returns.”

[Related: Rate cuts not the solution: Westpac CEO]