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Earnings rebound but revenues and profitability remain under pressure.
Australia’s big banks have shrugged off lengthy lockdowns to deliver a much-improved full year headline result, with aggregate earnings increasing by 55% to $26.8 billion. The result was underpinned by strong housing market activity, better-than-expected impairment outcomes that enabled the release of pandemic-driven provisions, and fewer notable expenses.
However, underlying earnings remained under pressure. Revenue growth was subdued and costs remained elevated, reflecting ongoing remediation, compliance and digitisation programs. Interest margin declined, driven by low interest rates, asset mix and intense mortgage competition. Funding tailwinds are starting to fade with the final draw down of the central bank’s Term Funding Facility (TFF).
Asset quality remains benign. While the full impact of extended lockdowns in Sydney and Melbourne is yet to play out, impairment risk should decline as businesses reopen, border restrictions ease and the economy recovers. Notable is the low level of loans subject to repayment deferral relative to previous lockdowns.
Average return on equity (ROE) increased to 9.9%, from 6.6 %, boosted by share buybacks undertaken by some of the banks.
The pandemic has presented a unique opportunity for the banks to speed up their transformation journey and cultivate the innovation required to remain competitive against nimbler brands. Among the banks’ immediate priorities are continuing simplification and digitisation strategies to boost efficiency. At the same time, they must also improve customer experience in the face of increasing competition from fintechs and bigtechs who are disrupting financial services. This is especially evident in payments, where the rapid expansion of ‘buy now, pay later’ (BNPL) options are prompting the banks to invest in BNPL providers or develop their own BNPL solutions.
Climate change risks are also front of mind in the wake of COP26 and the Federal Government’s recent commitment to a target of Net Zero by 2050, particularly as the major banks participate in APRA’s first climate vulnerability assessment exercise.
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Net interest margin (NIM)
Average NIM declined, reflecting low interest rates, asset mix and intense competition
The asset mix shift towards lower margin fixed rate housing loans has added to NIM pressures. Customers have been refinancing from higher variable rate loans to lower short-term fixed rate loans. But fixed rates are now moving higher and variable rates are moving lower, as the banks look to manage margins amid changing expectations on future interest rate rises.
The challenging interest rate environment is expected to place ongoing pressure on the banks’ profitability over the medium term. Interest rates will move higher but timing is uncertain, though most economists anticipate an increase in 2023. The RBA has removed its 3-year bond yield target and its forward guidance that the cash rate will not rise before 2024, in recognition of the improving outlook and stronger-than-expected underlying inflation outcomes.
To some extent, a favourable funding cost environment has offset the impact of low interest rates. Household savings rates remained highly elevated, with deposits from consumers and small businesses surging as cautious households and businesses shored up their financial position. Banks have recently lowered deposit rates to help counter the squeeze on margins. Pressure has also been eased as the banks use deposits for funding and benefit from the final drawdown of the central bank’s TFF. But funding costs are set to rise with the end of the TFF, the Committed Liquidity Facility phase-out and an anticipated interest rate increase. Competition for deposits is also likely to intensify as elevated liquidity positions subside.
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Housing credit
The banks are investing in process digitisation and automation to reduce the ‘time to yes’
Housing credit growth at a system level almost doubled over the 12 months to September 2021, reaching 6.5%[1]. Most of this growth was due to owner occupier lending, up 8.7% over the 12 months; investor lending growth was a more modest 2.4%[2]. The flow of new home loan commitments remains high, up 35.5% over the year to September, but momentum has slowed in recent months, driven by a fall in new loan commitments for owner-occupier housing; new loan commitments for investor housing continue to grow, up 83.2%[3] over the year.
Refinancing increased for the five consecutive months to August 2021[4], reaching record highs as borrowers moved to lenders offering lower rates and took advantage of cashback deals. However, refinancing declined sharply in September, for both owner occupiers and investors[5].
Strong demand coupled with limited supply has led to a rapid rise in house prices, which have increased by more than 21%[6] over the year to October. In October, housing prices increased a further 1.5%, equivalent to 18% annualised, but down from their peak monthly growth rate of 2.8% in March – as affordability constraints and a lift in stock on market has slowed price growth.
This historic house price growth has spurred renewed policy concerns over housing affordability. Australia is not alone in this concern. House prices are also rising rapidly in countries like Canada, the US and the UK, where prices all experienced double-digit growth over the year to June[7], while prices in New Zealand increased by nearly 29%[8].
Rising house prices have also led to rising household leverage. Over one in five new loans now has a debt-to-income ratio of over six times.
APRA is scheduled to release a framework for applying macroprudential standards to the housing market in the coming months. Already though, APRA has increased the minimum interest rate buffer it expects banks to use when assessing the serviceability of home loan applications. The buffer, which has been raised by 50bps to 3% above the loan product rate, is expected to reduce borrowers’ maximum borrowing capacity by around 5%. The impact of this change will be marginal, with many borrowers not borrowing at their maximum capacity. Some banks are introducing additional lending controls over and above those set by the regulator to address potential emerging risks. In New Zealand, the RBNZ has recently introduced new macroprudential measures aimed at reducing high risk lending. It has also increased the cash rate for the first time in seven years in response to inflationary pressures, including strong house price inflation.
Not all the major banks have benefited equally from the surge in housing credit. Strong competition and volume processing challenges for some banks have resulted in home loan performance diverging markedly between individual banks.
The broker channel continues to drive application volumes, accounting for around 60%[9] of home loan transactions. Banks with strong broker propositions are more likely to achieve market share growth.
Pressure from competitors, brokers, regulators and challenging macroeconomic conditions has pushed the banks to strengthen their home loan propositions to remain competitive. They are investing heavily in improving the home lending experience for customers, including simplifying loan application approvals and reducing turnaround times by increasing process digitisation and automation – the key levers to increase operational ‘flex’, drive cost efficiency and deliver market-leading service timeframes.
Speed and simplicity are important factors in winning new home loan customers. By investing in technology to reduce the 'time to yes', some of the non-major banks have grown their market share significantly. Several digital lenders and fintechs are using big data and automation to offer faster mortgage lending propositions.
We expect the home loan market to evolve rapidly over the next few years as open banking initiatives, big data and other digital innovations drive more customised customer experience. Winners will be lenders that design their value proposition to deliver a more personalised customer experience.
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Business credit
Business credit is picking up momentum
System business credit grew 4.6% in the 12 months ending September 2021, compared with 1.9% in the preceding 12 months[10]. Growth has picked up in recent months, supported by the Federal Government’s instant asset write off scheme and improving business conditions. In a further positive sign, business confidence rebounded in September as the pathway to reopening the economy became clearer. One of the banks notes early signs of a resurgence in business credit demand as businesses in NSW and Victoria emerge from lockdown.
Small businesses say access to finance has become less difficult since mid-2020 as the economic outlook has improved. Banks report seeking more opportunities to lend to businesses following a period of tightened access to finance at the onset of the pandemic[11].
Competition for business loans among the major banks is intense, and fast-growing challengers continue to augment their digital capability. According to a recent EY survey[12], banks remain the preferred credit provider for SMEs in Australia. But, if they don’t want to lose their market share, banks need to pay attention to what SMEs really want from their providers. SMEs cite interest rate and speed of access to funds among their top priorities when sourcing finance. The survey also offers insights on how banks can serve SMEs better, with advisory services, faster access to credit and business management functions identified as key areas of opportunity for banks, where some SMEs are willing to pay for such services.
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Costs
Banks continue to invest heavily in digital transformation
The banks continue to manage their underlying operating costs well, focused on productivity, process optimisation and business simplification initiatives. However, ongoing investment in digital transformation, risk and compliance initiatives, higher processing volumes, and customer remediation of historical wealth and AML issues continued to impact costs.
As COVID-19 accelerates digital transformation across the economy, banks have been forced to boost investment spend to remain competitive. Technology, automation and digital investment are top strategic imperatives for the banks, to improve client experience, drive growth and boost productivity. Cloud solutions, APIs and data science, including machine learning and artificial intelligence, are among the priorities.
Disciplined management of underlying operating costs and business simplification initiatives have delivered further productivity benefits for the banks. But this has been partially offset by higher investment spend.
The need for ongoing technology investment to remain relevant in an increasingly digital world, coupled with increasing regulatory compliance costs has led smaller banks to seek out merger partners. This trend is expected to continue as smaller players strive to achieve the scale necessary to remain competitive.
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Asset quality
Asset quality remains resilient
Key measures of asset quality remain resilient. Bad debt charges were lower due to provision releases and low write-offs, and impaired and past-due loans improved.
Extended lockdowns have seen the banks offering loan deferrals to homeowners and small business owners alongside a range of fee waivers and other measures. APRA has provided a further round of temporary regulatory treatment for loans impacted by COVID-19 to assist regulated institutions in supporting their customers through this period.
APRA’s resumption of publishing loan deferrals data showed that 0.6% of total loans outstanding were subject to payment deferral as at 30 September. However, deferrals remain at significantly lower levels than at the height of the COVID-19 crisis in 2020, when they peaked at around 10%.
Investor loans appear to pose an elevated risk. Data submitted to APRA by regulated institutions with more than $50 million in loan deferrals has revealed that the share of investment loan deferrals is significantly higher than the those for high LVR and interest-only loans.
The recent extended lockdowns in Victoria and NSW are likely to increase pressure on borrowers who were already finding repayments difficult. However, high employment rates, a strong housing market and low interest rates that enabled borrowers to build up repayment buffers are likely to limit more widespread loan defaults.
APRA’s Climate Vulnerability Assessment (CVA) is underway with Australia’s largest five banks, assessing their financial exposure to climate risk. The assessment also seeks to understand how banks may adjust business models and implement management actions in response to different scenarios, and foster improvement in climate risk management capabilities. Banks will be required to assess residential mortgages, corporate and business lending exposures as part of the CVA. As the first exercise of its kind in Australia, we expect that the CVA learnings will play a formative role in shaping the target future state climate risk modelling capabilities for Australian banks.
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Capital
Banks have taken action to manage their capital surpluses
The major banks have accumulated large capital buffers, with the average CET 1 ratio at 12.7%, well above the regulator’s unquestionably strong benchmark of 10.5%. The sale of non-core assets, lower levels of risk-weighted assets, lower dividends and the impact of APRA’s concessional capital treatment of deferred loan repayments have all contributed to strong capital positions.
To address their capital surplus, each bank has undertaken or announced a share buyback. Buybacks undertaken by two of the banks during FY21 contributed to average ROE increasing from 6.6% in FY20 to 9.9% in FY21.
APRA’s proposed capital reforms, which take effect from January 2023, will strengthen Australia’s already robust regulatory framework. The reforms mainly impact the banks’ credit risk capital requirements, with higher capital buffers providing greater flexibility for periods of stress.
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Payments
Disruptions in the payment sector are picking up
Tech-enabled platforms and innovation are creating more opportunities for fintechs, bigtechs and niche players to effectively target new revenue streams and customer acquisition, challenging traditional banking. Most notably, payments disruption is picking up pace as the pandemic takes all generations of consumers online.
Payments support accelerated industry convergence, enabling non-financial players to expand into financial services. Bigtechs in particular are stepping up their involvement in payments, leading the way in embedded finance by leveraging contactless payments, P2P and mobile wallets to embed themselves in consumers’ everyday life. This makes payments a perfect focus for disruptors keen to establish a primary financial relationship that can then be used as a springboard into the broader financial services landscape.
Banks can address this risk by partnering with disruptors to create new business models and value chains. Major banks continue to wield inherent advantages over new entrants, with strong balance sheets, deposit funding, regulatory expertise and trusted local brands. They also have unique access to data on both the retail and business needs of customers, enhancing the opportunity to monetise data.
Open banking provides the opportunity for banks to diversify revenues by providing platform services and banking-as-a-service (BaaS) to ecosystem partners. The third amendments to the Consumer Data Right (CDR) rules will accelerate increased business participation – and increased collaboration opportunities for banks. At least two of the major banks have highlighted BaaS initiatives as a means of diversifying their revenues. For example, one is collaborating with a BNPL fintech, offering its Australian customers transaction and savings accounts, and cashflow management tools on a BaaS platform. This partnership sees the bank responsible for managing direct relationships, with the fintech focusing on innovative customer experience.
Such ecosystem strategies can make banks more relevant to customers, helping them to forge deeper relationships and capture larger wallet shares by providing the speed, scale and differentiated products to compete in a digital world. According to the latest EY NextWave global consumer banking survey, 54% of Australian consumers would value their primary financial provider more if they partnered with other brands to expand their products and services. This is particularly important for younger consumers, with 70% of Gen Z and millennials indicating they would like their financial provider to partner with other brands.
Conclusion
Despite the year’s improved results, banks must be mindful that elevated consumer expectations, the upsurge in digital technologies, competition from disruptors, and regulatory developments have transformed the playing field.
In a new, hyper-competitive environment, banks must become more agile, innovative, responsive and resilient if they are to compete in the fast-evolving financial ecosystem. This includes accelerating a digital-first approach and leveraging smart technologies and ecosystem collaborations to reduce cost-to-serve and deliver more personalised financial experiences for customers.
Summary
Australian banking earnings remain under pressure from increasing competition, despite much-improved full year results. Tech-enabled platforms and innovation are creating more opportunities for fintechs, bigtechs and niche players to effectively target revenue and customer acquisition opportunities. Banks can use their inherent advantages to partner with these disruptors to create new business models and value chains, accelerating a digital-first approach.