Major Australian banks’ 2023 half-year results: Walking the tightrope

Reserve Bank data show that both mortgage and business lending growth slowed over the six months to March,2 amid tighter financial conditions.

House prices across capital cities have fallen 9% since the peak in April last year (although price increases in the past two months may indicate that prices are stabilising),3 and the total value of new loan commitments has fallen 26.3% over the year to March.4 In contrast, refinancing continues to drive mortgage activity, up 28.5% compared to a year ago.5

Banks have been competing intensely for mortgage business, offering cash back incentives and discounted rates. In places, certain lenders appear to have prioritised volume over profitability, with industry commentary on loans priced at or below the cost of capital. Discounted rates are reported to have extended into the back book, as banks battle to retain borrowers – a battle that will likely continue well into FY24. However, competitive pressures are showing early signs of easing (e.g., discount strategies are moderating), as banks respond to rising funding costs and expectations that the current monetary tightening cycle will soon end.

As mortgage growth slows, the banks are looking at opportunities for good margins and long-term growth prospects in business banking. While business lending was a strong driver of system credit growth in 2022, growth has eased in recent months. Business confidence remains around pre COVID-19 levels, while business conditions are stronger. But as consumption growth slows, business confidence and conditions are likely to take a hit.

Average NIM has improved, underpinned by interest rate rises and careful management of mortgage versus deposit rate increases. As ongoing competition erodes the margin benefits of higher rates, we are likely to see margins tighten as early as the second half of 2023.

Disciplined management of underlying operating costs and business simplification have continued to improve productivity for the banks. But this has been partially offset by the impact of wage and other cost inflation.

In this challenging operating environment, banks need to engage in structural cost transformation, targeting client segments, products and distribution channels to add flexibility and scalability to the cost base. Simply focusing on cost reduction misses a unique opportunity to move to the type of transparent cost base investors are increasingly looking for.

Funding costs are increasing for the banks, both in household deposits and wholesale funding.

The volatility in overseas markets has led to tighter and more expensive wholesale funding markets. These higher costs coincide with the banks’ upcoming need to refinance funding from the central bank’s low-cost term funding facility.

Higher wholesale funding costs are driving deposit competition. The strong growth rates experienced during the pandemic have slowed. The deposit outflows experienced in the US are leading banks to question long-held assumptions about the ‘stickiness’ of low-cost retail deposits.

Banks have carefully managed loan versus deposit rate increases, limiting the pass-through of cash rate increases on deposit products. However, deposit costs are increasing as competition for cost effective, stable deposit funding rises. Given the first real opportunity for yield in several years, customers are looking for higher-yielding deposits, particularly price sensitive business deposits. Banks are seeing plenty of movement in term deposits offering higher returns than at-call deposit products, which accounted for around 80% of the major banks’ deposit base on average in 2022.6 This switch from low to higher cost deposits will undo some of the funding cost gains the banks have enjoyed in recent years.

The recent turbulence in the banking sector is driving an intense focus on emerging risks in both the financial system and individual institutions.

Fortunately, Australia’s strict capital adequacy regime means domestic banks are well-placed to weather the current market instability. Along with large capital buffers, the banks’ strong holdings of liquid assets, conservative funding strategies and focus on traditional banking activities have bolstered the Australian financial system. Despite the volatile wholesale financing landscape, Australia’s major banks have increased their proportion of deposit funding since the GFC. Deposits now account for around two-thirds of the banks’ non-equity funding.7

However, with information and money moving in near-real time, even Australia’s well-positioned banks must closely monitor and stay ahead of key risk indicators. In the wake of the recent unexpectedly rapid bank failures, banks are examining idiosyncratic risks across three pillars: balance sheet and liquidity management; capital management; and underlying business portfolio weaknesses (e.g., concentration issues), as well as revisiting crisis management capabilities.

Looking ahead, we expect banks to refine a range of their balance sheet and liquidity risk management capabilities. Enhanced early warning indicators will be among the priorities, including incorporating social media channels in crisis identification and response methods to capture customer and investment sentiment early. While the current challenges are largely balance sheet and liquidity driven, banks will also need to revisit capital planning, including risk capture across multiple scenarios.

From a regulatory perspective, the perceived drivers of the bank failures and market stress are reshaping supervisory priorities. In particular, banks need to prepare for APRA’s upcoming resolution planning requirements by assessing potential ‘critical functions’ and interconnectedness.