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Major bank’s facing significant headwinds – Implications of coronavirus

Stuart Lucy

Stuart Lucy is an Investment Specialist at the Australian Stock Report, and has gained exposure to funds management and investment banking throughout his career. He draws on this experience to provide macroeconomic commentary and actionable investment insights to clients. Stuart is responsible for writing reports, is involved in delivering Macrovue webinars and provides general advice to our members on portfolio construction. Stuart currently holds RG146 General and Securities qualifications.

Overview of the Australian economy, interest rates and the banking sector

The Australian economy has been growing on average below trend growth over the past decade. Annual GDP growth was reported at 2.2% per to the December Quarter 2019, while trend growth is around 3.0 per cent per annum. In addition, economic growth is likely to be negative in the March quarter 2020. In light of the below average level of economic growth and given the inflation rate has been very subdued, the Reserve Bank of Australia (RBA) has over time been undertaking an expansionary monetary policy, with the cash rate steadily decreasing since from 4.75 per cent in October 2011 to the current level of 0.50 per cent (see Figure 1).

Figure 1: Movements in the RBA cash rate

Over the last decade, profits of the major banks have been stagnated. In addition to modest growth in the Australian economy, there are two other factors that have caused this stagnation in profitability. Firstly, credit growth in the housing, business and personal sectors has been relatively low and falling since around 2015 (see Figure 2). The most recent figures released by the RBA on the 4 March 2020 show that credit growth is continuing to slow following the trend in the early months of 2020 (refer to Figure 2).

Figure 2: Movements in credit growth

Secondly, the net interest margin for the major banks has fallen from around 2010 to current levels (see Figure 3). The main driver for this occurring is that as interest rates have been steadily decreasing, this has caused net interest margin to squeeze as the banks lower lending rates while deposit rates and the cost of other funding has not fallen by as much. It also reflects competitive pressures in the industry.

Figure 3. Movements in the major banks net interest margin

The current environment of low interest rates, squeezing of net interest margins, weak credit growth and increased regulatory burden as a result of the Hayne Royal Commission affected the bank’s profitability this financial year. Commonwealth Bank of Australia (ASX:CBA) reported cash profit for HY20 is A$4.5 billion, down 4.3% compared with the corresponding period. National Australia Bank Ltd (ASX:NAB) reported cash profit for FY19 of A$5,1 billion down 10.6% compared with the corresponding period. Australia and New Zealand Banking Group Ltd (ASX:ANZ) reported cash profit for FY19 is A$6,4 billion, in line with the corresponding period. Finally, Westpac Banking Corporation Ltd (ASX:WBC) cash profit for FY19 of A$6.8 billion, down 16% compared with the corresponding period. Out of the four major banks, Westpac is currently experiencing the most turmoil. AUSTRAC in November 2019 alleged that Westpac contravened the AML/CTF Act on over 23 million occasions. This sparked an investigation into Westpac’s activities, with a fine estimated in the range of A$1 -A$2 billion. Overall, the banks a facing an increasingly challenging environment to operate successfully in.


Recent reductions in the RBA’s cash rate cut and are the banks passing it?

An important consideration is how the lower interest rate environment is influencing banks’ net interest margin. Over the last few years, movements in interest rates and the net interest margin has been slightly correlated. As shown from Figures 1 and 3, from 2011, as the cash rate has fallen, so has the net interest margin. The banks’ capacity to reduce lending rates further without causing the net interest margin to fall is now constrained by the fact there is very little scope for the banks to reduce deposit rates.

Following the most recent RBA rate cut of 25 basis points to lower the overnight cash rate to 0.50% (3 March 2020), the CBA, NAB, ANZ and Westpac announced that they will pass on the rate cut in full, reducing their home loan variable rates by 0.25%. This decision by the major banks will squeeze their net interest rate margin further, as there is limited capacity to reduce funding costs by, for example, reducing deposit rates.

Interestingly, now that the RBA has reduced the cash rate of 0.50%, this leaves the RBA with not many options regarding further monetary easing. The RBA could reduce the cash rate to 0%. However, the major banks are coming to the point where the squeezing of the net interest rate cannot continue without a significant reduction in earnings. The other option the RBA has in its tool kit is to use unconventional monetary policy tools such as quantitative easing. Quantitative easing is where the RBA purchases financial assets such as government bonds, to reduce the long-term interest and inject directly liquidity into the banking system. This form of monetary policy has not been seen in Australia thus far.


What are the impacts of coronavirus for the banks?

In addition to low credit growth and a squeezing of net interest rate margins, the banks are facing further pressures regarding the coronavirus (COVID-19) outbreak. COVID-19 is expected to reduce economic activity and credit growth in the short-term. This is creating a situation where the RBA feels obligated to stimulate economic growth through monetary policy. Thus, future reduction in the overnight cash rate along with potential quantitative easing is becoming more likely as COVID-19 spreads.

The recent upheaval in financial markets may have significant implications for liquidity in the Australian and global markets. Early signs of this is that NAB and Macquarie Group Ltd (ASX: MQG) have both cancelled a capital raising by issuing capital notes. If the major banks have significant liquidity issues, the RBA might have no other option but to use quantitative easing to directly inject liquidity into the banking system.

This easing of monetary policy and potential quantitative easing should allow for further liquidity into the financial sector (specifically the banks). However, easing in monetary policy is unlikely to increase domestic consumer economic activity due to the heightened concern around the economic and social effects of COVID-19.


Overall assessment

The Australia’s banking sector is on a double-edged sword. On one edge, availability of credit to consumers and businesses should increase due to low interest rates and an easing in lending regulations and capital requirements. However, on the other edge, the net interest margins for each bank could be squeezed even more.

The major banks are trading in PE ratios in the low to mid-teens and dividend yields of more than 5%. This means that the major banks are priced more cheaply relative to some other sectors of the market. However, the major banks face significant headwinds including the economic impacts of COVID-19, slow credit growth (also reflecting weak economic growth), pressures on net interest margins (which could lower profitability) and increased regulatory requirements (both capital and lending requirements). That is, in the short term at least, the major banks may have lower growth prospects than other sectors of the market and there is a significant risk that bank dividend payments could fall over the next year or so.



This article has been prepared by the Australian Stock Report Pty Ltd (AFSL: 301 682. ABN: 94 106 863 978)

(“ASR”). ASR is part of Amalgamated Australian Investment Group Limited (AAIG) (ABN: 81 140 208 288 Level 13, 130 Pitt Street, Sydney NSW 2000).

This article is provided for informational purpose only and does not purport to contain all matters relevant to any particular investment or financial instrument. Any market commentary in this communication is not intended to constitute “research” as defined by applicable regulations. Whilst information published on or accessed via this website is believed to be reliable, as far as permitted by law, we make no representations as to its ongoing availability, accuracy or completeness. Any quotes or prices used herein are current at the time of preparation. This document and its contents are proprietary information and products of our firm and may not be reproduced or otherwise disseminated in whole or in part without our written consent unless required to by judicial or administrative proceeding. The ultimate decision to proceed with any transaction rests solely with you. We are not acting as your advisor in relation to any information contained herein. Any projections are estimates only and may not be realised in the future.

ASR has no position in any of the stocks mentioned.


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