Via Deutsche Bank’s Matthew Wilson, my new hero:
The Australian major banks appear cheap on most investment metrics. However, for the first time in a long time, they confront a raft of real challenges and uncertainty. The cosy oligopoly that historically generated healthy returns and essentially uninterrupted growth predominantly from retail banking (deposits and mortgages), underwrote an enviable period of earnings progression and investment return. The Australian major banks became some of the most credit worthy and profitable in the world lauded for credit, cost and profit management.
Excess returns persisted and rich dividends flowed from lower capital intensive growth, increasing operating efficiency and ever smaller credit charges. Regulatory change (most notably – internally modeled granular risk weights) and more “advanced” remuneration systems linked to short-term share price performance and revenue also drove a change in the nature and complexion of bank executive human capital – out went the prudent long-term “bank manager” – in came the short-term sales focused consultant deploying more and more capital into the mortgage product. Compounding success saw the major banks morph from being the essential oil in the economic engine to the engine itself.
Did the sector’s sustained financial success “dull the senses”? Too big to fail?
Anyone anchored to the recent success would have been well rewarded for buying any dips. These were clearly the golden years of Australian banking.
Is today just a dip or a genuine inflection point?
Are the golden years now under threat from a suite of incentives that targeted and handsomely rewarded short term performance? Were the banks simply hostage to paying an ever increasing dividend which also drove sizeable short term bonuses? Were these incentives ultimately grossly miscalculated with respect to their resulting long-term impact on the broader franchise?
Prima facie, the outcome today appears to be – unbalanced business mix, an over-cropped consumer and an underinvested franchise which is vulnerable to economic shock, disruption, obsolescence, litigation and regulatory/ political overreach.
In this note, we explore these issues and present the resulting impact on our earnings expectations and valuation outcomes.
The majors are far from broken, but they have sustained a severe self-inflicted flesh wound, requiring significant cultural attention. Management must now muster the courage to change the mind-set and behaviour of boards, investors and employees in order to win back the trust of the customer. And actions will be more important than apologies.
We believe the following changes would go some way to resolving the predicament:-
1. Cut the dividend… to a more sustainable and balanced pay-out ratio of ~60%
2. Commit to investing well beyond a CEO’s tenure…
3. Curtail the positive jaws narrative to a longer-term pledge… why restrict the franchise to a theoretical accounting period construct?
4. Commutate the executive STI to all LTI… changing behaviour begins at the top
5. Cultivate a better balanced book of credit… credit supply drives activity; but building societies (or savings & loans) don’t generate sustainable productive economic growth
6. Collect and create a suite of growth options… option pay-offs are valuable; don’t divest them because of issues at the core
7. Cull the shrinkage to the core mind-set… banks are divesting because of bad execution (and bad conduct), not because of bad strategy, and
8. Cross your fingers the mortgage market doesn’t implode… it is a material vulnerability
Whilst respective major bank divisional disclosures have their challenges (consistency, comparability and reclassifications inter alia) they can point us in the right direction. From this, it is unequivocal that Retail Banking has dominated major bank earnings and returns throughout the last decade in both absolute levels (~45%) and contribution to positive delta (~75%). New Zealand and Business divisions whilst healthy contributors were well behind. Wealth and Institutional/ Corporate have been disappointing with difficult conditions, shrinkage and divestment.
We think this historical picture is unlikely to be repeated.
We expect conduct, credits’ eventual reaction to gravity and disruption to fundamentally change the nature of return and growth in Retail Banking. Conversely we expect Corporate and Institutional Banking to fare much better.
The focus on conduct is here to stay as the behaviour pendulum typically over corrects. The Hayne Royal Commission is just the beginning. Recall, in the UK, it took the addition of a new regulator plus 10 years (and counting) of conduct management and consequent remediation.
Cost out won’t be enough to offset the revenue headwinds; the major banks are already unquestionably efficient. Alternatively, we believe significant investment is required to make their core platforms, and everything that hangs off them, match fit in a rapidly evolving world with Fintech.
This is all made more complicated by a central bank that appears to have missed its opportunity to align itself with global peers on the direction of monetary policy. The theoretical models may have no problem being out of sync, and indeed in the event of a domestic hiccup, they won’t hesitate to cut rates close to zero (with its own version of QE) but how will our offshore creditors react?
Short Mortgages – we forecast protracted slow growth with material vulnerability. The banking industry has over committed the Australian Household to a long future of paying down debt. Household debt to GDP is a world topping 122% (according to the BIS) and consequently Australian residential house prices have experienced a very rich credit-fuelled boom. The old banking rule of thumb was lend someone 3x their gross income (now embedded in UK regulation; only 15% of the mortgage book can have a loan to income (LTI) ratio greater than 4.5x). This appears to have been forgotten in Australia with LTI’s on average ~6.5x. Further, the simplicity of the LTI – income is easy to verify and thus removes the challenge (and conduct risk) of estimating and verifying expenses.
At best, mortgage growth will continue to slow as deleveraging works its way through the economy constraining house prices and discretionary spend, but it’s unlikely to be beautiful. At worst, we confront the Irish-like scenario. However, we think it’s unlikely to reach the Irish heights of 25% housing NPLs for a decade due to a more independent policy infrastructure. However, a zombie-like mortgage book is possible. It is not politically palatable nor logistically easy to foreclose on vast amounts of troubled mortgages. Capital therefore may not be immediately available to deploy into productive recovery credit.
We also believe longer term that retail banking is more susceptible to disruption from the nimble, innovative and more customer-aware Fintech space.
Long Business – we forecast improving growth and better returns from higher global interest rates, liquidity withdrawal and increasing volatility. In contrast to the mortgage book we have arguably under lent to the more productive corporate sector in Australia over the last decade. Outside of housing (and to a lessor extent property) we see bright prospects in infrastructure, mining, education, tourism, health and technology interalia. Banks with franchise strength in classic business, corporate and institutional activity appear well placed. Granted it’s more capital intensive; but it’s better for the economy by generating more sustainable productive activity.
We summarise the near term earnings outlook as follows:-
■ Slowing mortgage loan growth
■ Improving business loan growth
■ Some recovery in markets income with higher rates, less liquidity and more volatility but still constrained by conduct related behavioural change
■ Continued tight cost management with ongoing conduct impost balanced against the need to invest for the future
■ Mean reverting bad debt charges with lurking mortgage cycle risk In this context, and based on the analysis herein, we like major banks which are heavy on business and light on retail.
The full extravaganza here.