Major Banks thrive despite margin pressure

The major banks (Majors) have successfully used the recovery of the Australian economy and the strong housing market performance to deliver improved financial results. After the disruptions of recent years, profits have almost returned to pre-COVID levels for the Majors.

KPMG’s Major Australian Banks First Half Year Analysis Report 2022 finds the Majors reported a combined cash profit after tax from continuing operations of $14.4 billion, up 5.1 percent on 1H21 with improved profits and returns for the first half of the financial year 2022, despite ongoing pressure on their interest margins. This result reflects strong growth in lending and reductions in large one-off notables including remediation/regulatory and impairment expenses.

Off the back of this earnings growth, the Majors’ return on equity (ROE) has risen to 10.6 percent from 10.4 percent in FY21.

As Australia powered ahead in the first half of FY22, both mortgage and business lending saw continued high demand. The value of mortgage loans was up 2.5 percent on 2H22, growing to $1,874 billion. At the same time, other lending (including business lending) grew 4.8 percent in the last half year, to a figure of $1,011 billion.

Low interest rates and margins

As expected, given the continued low interest rates (the RBA only just increased interest rates for the first time since November 2010), net interest margins (NIM) have continued to decrease and have acted as a drag on financial performance. For the majors, the average NIM dropped to 175 basis points, down 13 basis points from FY21. The industry-wide depressed NIMs have been the primary brake on the Majors’ profit growth.

The market dynamic has been dominated by the NIM decrease resulting from low lending rates in a very competitive market and strong demand for low margin fixed rate mortgages. This downward pressure has only partially been offset by lower funding costs from near-zero deposit rates. The impacts of an extended period of low interest rates are deeply baked into net interest margins.

In the context of both Australia’s COVID recovery and a higher inflation future (driven in part by the war in Ukraine), the story on loan loss provisions has changed from recent times. On a net basis, provisions of $218 million have been released during the period to bring overall provisioning closer to pre-COVID levels due to the strong performance of the economy.

Balance sheet strong but declining

Another interesting development has been the decrease in balance sheet strength, with the average CET1 ratio declining by 90 basis points to a still very strong 11.8 percent. While in recent years the Majors have been shoring up their capital position through divestments and lower dividend pay-out ratios, this trend appears to have ended.

We may have reached an inflection point on balance sheet strength. This signals the Majors have left the recent disruptions behind them and are now charting a new course. They are starting to ‘draw down’ on the balance sheet ‘deposits’ they have been making since 2020.

Cost to Income Ratio – Cash Basis

Operating costs remain flat

With strong operating income growth and lower margins, the third major profit lever is cost performance. As has been the case in recent years, the Majors have again struggled to structurally reduce costs. Total operating expenses across the Majors decreased by 1.0 percent to $4.9 billion. As a result, the average cost-to-income ratio decreased from 2021 by 73 basis points to 49.6 percent.

While the overall outcome has been an almost flat cost trajectory for the Majors, there are three things happening which are netting each other out. Inflation has driven up ‘run-the-bank’ costs, further growth and transformation costs have been added and meanwhile some cost reductions from efficiency programs have been realised. Unfortunately this means that the Majors are not on a path of significant sustainable cost improvements.

Uncertain outlook

The RBA rate rise on 3 May signalled the end of a prolonged period of ultra-low interest rates. There is a general expectation that this will support a recovery of NIMs. The impact of interest rate increases will likely be tempered by continued strong competition for lending volumes, the recent peak volumes of fixed rate loans and the upcoming unwinding of the COVID-related cheap Term Funding Facility funding from the RBA. In addition, a combination of higher interest rates and high household debt levels will over time result in increased mortgage impairments.

We expect to see the dual impacts of both net interest margin relief and higher levels of mortgage book stress, as RBA interest rates are expected to increase several times. However, these impacts will take their time to pull through as both margins and book quality have built up their momentum over a long period of low rates.

Additional input from Steve Jackson, Partner, Head of Banking and Capital Markets

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