Banking agenda Striking the right balance in a changing landscape - EY

Overview | Net Interest Margin (NIM) | Financial System Inquiry | Other Income and Wealth Operations | Continuing to focus on the customer | Cost to income | Capital Management | Asset Quality | IFRS 9 is getting closer | Contacts

Banking agenda Striking the right balance in a changing landscape Australian major banks’ full year results 2014 November 2014


Overview Underlying cash earning Total

28.6bn

Increase of

5.7% Total return on equity

15.7%

Net interest margin

2.07%

decrease of 5 basis points

Bad debt expense Decrease of

31.7%

The major Australian banks have again delivered a strong financial performance for the year against a backdrop of a challenging environment, characterised by uneven economic trends, subdued business and consumer confidence and elevated geopolitical, regulatory and conduct risks. This saw majors generate total cash earnings of $28.6bn, an increase of 5.7%. This result has been largely underpinned by credit growth in the housing and construction sectors, reductions in loan impairment charges and further recoveries from credit loss provisions. However, competition in the banking sectors has had an impact on bank margins which have reduced by 5bp from the prior year. Since our last banking agenda, the Abbott Government handed down its first budget, which included tough measures to return the budget to surplus in the near term and maintain debt burdens at a sustainable level. The expansionary monetary policy adopted by the RBA has stimulated demand in the housing sector, which has seen home loans rise by 7.2% from 2013 — to the benefit of the retail banking divisions of the majors. Conversely, ongoing discussions around macro prudential regulation seek to curtail the impact of possible asset bubbles in the housing sector. Loan growth in the corporate/business banks of the majors has been subdued, compounded by low interest rates and margins and strong competition for business in this segment. The propensity for corporates and consumers to save, rather than invest and spend, has seen deposits grow at a higher rate than loans.

This operating environment has also helped banks establish and maintain strong disciplines over cost management and drive further efficiencies and capital optimisation. Much of these savings has been reinvested into strategic initiatives, digital innovation and technology-led transformations, improving cost to income ratios1 by 20bp. Asset quality also continues to improve, with further reductions in credit losses and write-backs from loan recoveries. At the same time, bad debt expense decreased by 31.7%. The year ahead will require the majors to continue navigating through regulatory reforms over capital and liquidity and investing in banking technology eco systems. They will also need to deal with the implications of the Financial System Inquiry recommendations, especially around the dichotomy of competition and financial stability.

Overall a solid performance by the majors and with subdued credit growth, is this as good as it will get with high expectations that the rules of the game may change?

1 The NAB cost to income ratio of 45.6 has been applied (adjusted for specific items as per results announcement on October 30 2014)

1 EY Banking Agenda: Full year results 2014


Net Interest Margin (NIM) Across the board, NIM results reflect pressure on loan margins and increased holding of liquid assets, mitigated somewhat by reduced wholesale funding costs. Housing loan margins remain under pressure, as the banks pursue growth through competitive pricing. In an environment of intense price competition, fuelled by the prolonged low official cash rate of 2.5%, margins have reduced by around 5bps from the prior year. We also note a continuation of the heightened level of fixed rate housing loans and magnified price competition in these products. Also on the asset side of the balance sheet, and in response to the quantitative aspects of APRA’s revised liquidity rules, the big four banks are continuing to increase liquid asset levels, further exacerbating the drag on NIM. These two factors have been partially offset by reduced costs of new wholesale debt issues and pricing pressure easing on retail deposit margins. The latter has been particularly true for CBA, which has a greater exposure to retail deposits, benefiting significantly from improved spreads on term deposits and at call products.


Business lending, which typically returns higher margins, remains somewhat subdued, offering an area of potential growth for the banks. Growth in business lending will release the current margin pressure experience in a highly competitive housing loan market, given underlying reference interest rates having remained at such reduced levels. The magnitude of this opportunity will be determined by the level of business confidence and the corresponding investment into projects, infrastructure, inventories and further leverage. Major Banks — Net Interest Margin (Cash Basis) 2.4% 2.3% 2.2% 2.1% 2.0% 1.9% 1.8% 1.7% 2012 FY

ANZ

2013 FY

CBA

NAB

2014 FY

WBC

Average

Margin pressure on the asset side of the balance sheet is likely to continue in a competitive and low growth environment


Financial System Inquiry Australian financial services industry participants and the broader public await the Financial System Inquiry’s end of November recommendations, to enhance the efficiency, competitiveness, stability and level of public confidence in the financial services system. Although the Australian banking sector demonstrated comparative strength to its international peers during the financial crisis, it has not been immune to some of the fallout and has been subject to the subsequent G20 regulatory reform. Financial System Inquiry Chairman David Murray has indicated that avoiding moral hazard, and thereby strengthening the system to navigate the next crisis, is a key objective of the Inquiry. As a result, the major banks are anxious to discover whether Murray will recommend they hold even more capital, including increasing loss absorbing capital. The Interim Report clearly signalled that the Inquiry would consider other measures, such as increasing Internal Risk Based (IRB) risk weights, modifying the FCS scheme and considering the use of macro prudential toolkits, as used in other jurisdictions, to manage systemic risk.


Given facilitating competition and growth is another of the Inquiry’s objectives. The difficulty will be in striking the right balance of achieving stability without undue cost to competition and growth. The major banks await Murray’s views on the possibility of facilitating regional and smaller banks to gain IRB accreditation faster to promote competition in the residential mortgage market. Improving access, terms and cost of funding for the SME sector is also a focus. We expect the Inquiry to comment on addressing structural impediments, such as information asymmetries, regulation and tax settings. The Inquiry sees technology as a fundamental driver of innovation in the financial system. Murray has been vocal in articulating that he wants Australia’s financial system to embrace innovation and for regulation of the sector to be adaptive to technological change. The banking sector has already introduced a large suite of new products and services in response to consumer demand to manage their financial needs electronically. Product delivery, distribution channels and the use of data and focus on customer segmentation have also been subject to significant development.

However, technology is also enabling the emergence (and speed to market) of new entrants and alternate business models, creating new competitive threats to the banks, particularly in the retail payments industry — highlighting the vulnerability of the banking industry to disruptive technologies and operators. We expect the Inquiry to recommend making regulation more flexible and technology neutral. Although the financial system must be flexible and adaptive, it is anticipated that the Inquiry will also address regulatory efficiency. The cost of regulatory change has been high in the recent past, due to the crisis. We expect the Inquiry will consider de-regulation where possible, including streamlining disclosure where appropriate, and allow for sufficient industry consultation of any recommended changes supported by cost benefit analysis.


Other Income and Wealth Operations In 2014, the major banks’ wealth management businesses have all focussed heavily on innovation, competition and product differentiation. The sector continues to move quickly, with most participants recognising that technology enablement will be central to greater efficiency, better product features and improved customer service. Conduct and reputation also remain significant areas of focus, with all participants putting compliance and transparency at the forefront of decision making. The sector also continues to ensure that the impacts of the regulatory change agenda are embedded into ‘business as usual’ practices. Against this backdrop, the wealth management results show general improvements in performance. Major Banks — Wealth Operating Earnings ($m) 3,000 2,000 1,000 — 2013 FY

ANZ

2014 FY

CBA

NAB

WBC


Average

This has been driven by higher levels of funds management income, which have benefited from better underlying business momentum and markets performance. Moreover, a continued focus on cost containment has, for the most part, improved cost to income ratios. However, these businesses are not without their challenges. The industry continues to deal with: ongoing margin compression across superannuation and wealth products, continued competition between the retail and industry fund segments and the rise of Self-Managed Superannuation Funds. From a life insurance perspective, the sector continues to navigate through both cyclical and structural change as shown in the trend of rising disability claims and challenging customer retention rates. Combined with the capital intensive nature of life insurance businesses, this has resulted in challenging conditions for both the performance and return of these businesses. In spite of these challenges, the sector retains a large degree of upside. Australian wealth management is in the top five globally, as measured by AUM — and expected to double in size over the next 10 years. Financial institutions that successfully align their wealth and banking segments will be able service the entire spectrum of their customers’ financial needs, which will be important for organic growth and retention. In addition, the size of the Australian wealth management sector relative to global peers should position it for a leading role in exporting wealth solutions to the growing markets of Asia.

Major Banks — Funds Under Management ($m) 300,000 250,000 200,000 150,000 100,000 50,000 — 2013 FY

ANZ

2014 FY

CBA

NAB

WBC

Average

Major Banks — Annualised Insurance Premiums ($m) 4,000 3,000 2,000 1,000 — 2013 FY

ANZ

2014 FY

CBA

NAB

WBC

Average


Continuing to focus on the customer Technology is changing the way customers interact with banks, with their increasingly sophisticated preferences driving a distribution and transaction channel revolution. The 2014 EY Global Customer Banking Survey, which reached more than 32,000 customers across 43 countries, concluded that the nature and use of individual channels will continue to evolve in the following ways:

1. Channel usage habits are changing

Providing the omni-channel experience

• C  ustomers expect more convenience — they want to bank when it suits them

• A  s digital comfort levels increase, the type of assistance that customers seek in traditional channels will evolve — recognising customer needs and potential value will become paramount

• H  uman touch channels are critical to assisting the continued migration to a digital-led banking model • M  ulti-channel customers are seeking simple transactions, with no barriers to their channel of choice • I ncreasing digital interaction is driving more human interactions (such as branch visits and customer centre calls), not less • A  s the migration to digital continues, banks will need to utilise all channels to make offers 2. T he role of channels will continually evolve in this ‘transition’ period Increased comfort with online interactions • T  he next decade will accelerate digital capability (and security), increasing the ability to provide digital assistance and self-service options for the research, acquisition and servicing of products • H  istoric digital trends are not a safe proxy for future evolution — the pace of change and innovation will continue to accelerate • A  ‘tipping point’ might come sooner than some banks are ready for, although not within the short-term strategic horizon


• 6  5% of customers today advocate themselves as ‘multi‑channel’ users • H  uman touch channels still key for deeper relationships with 65% of customers still preferring branches for sales-related enquiries and 54% using a branch to receive advice Close monitoring of customers’ transaction needs in stores will be key for informing future footprint options — location, size, CVP


Cost to income During the financial crisis, strong disciplines were set to contain costs. The majors have continued this highly disciplined approach ever since. As a result, although Australia’s major banks have yet to achieve the lowest cost to service models in the world, they have become highly competitive. While continuing to invest in technology, product and process simplification and other strategic initiatives, in 2014 the majors’ have managed to marginally reduce Cost to income ratios2 by 20bp.

Major Banks — Jaws (Statutory) 11.0% 6.0% 1.0% -4.0% 2011 FY

ANZ

Major Banks — Cost to Income (Statutory)

2012 FY

CBA

55% 50% 45% 40% 35% 2012 FY

ANZ

2013 FY

CBA

NAB

2014 FY

WBC

Average

2 The NAB cost to income ratio of 45.6 has been applied (adjusted for specific items as per results announcement on October 30 2014)


2013 FY

NAB

2014 FY

WBC

Average

The majors have continued to maintain strong cost disciplines. Ongoing investment in technology led innovation will drive further efficiencies


Capital Management Capital remains a critical issue for the banking sector, particularly the need to generate organic capital and optimise the allocation of capital to the most profitable products and portfolios. The FSI remains focussed on the level of capital held by the sector in general, despite significant positioning from the major banks around the strength of their Common Equity Tier One (CET1) ratios. Leverage ratios, in terms of assets as a multiple of equity, vary significantly across the big four banks from 15.6 to 18.4 times. Capital remains a key focus area with a number of uncertainties arising mainly from economic and regulatory factors and including: • The extent to and term over which the current low level of credit losses and impaired assets will continue • Varying levels of organic capital generation • Regulatory imposts, such as: • Potentially higher buffers for Domestic Systemically Important Banks (DSIBs), over and above APRA’s planned implementation of the Basel III DSIB buffers, or changes in risk weightings for housing loan portfolios, either in absolute terms or relative to non-majors • APRA’s implementation of the conglomerate rules and its potential impact on capital requirements.


Major Banks — ROE (Cash Basis) 20% 15% 10% 5% 0% 2012 FY

ANZ

2013 FY

CBA

NAB

2014 FY

WBC

Average

The Australian major banks compare favourably to the large international banks on both an ROE basis and in terms of capital strength. Strong management and financial disciplines are going to be imperative to further improvements


Asset Quality Over successive half year reporting periods, Australia’s major banks have generated healthy profit results buoyed by low levels of bad and doubtful debt charges. This has been coupled with an elevated level of write backs and recoveries with credit risk rating scores taking a noticeable shift to the left. The impact of the financial crisis seems to have left an indelible mark, bringing changes in corporate credit risk practices, despite the resilience the Australian banking industry was able to demonstrate. The balance sheet stabilisation of 2009 — 2010 seems to have been vigilantly adhered to, and the dollar value of single exposure lends are significantly lower than they were pre-crisis. Collateral values have also significantly improved, with the banks experiencing a much reduced level of new referrals in their watch books. Although the notable increase in credit quality is a significant contributor to low levels of bad and doubtful debt charges, the lack of growth in the non-retail lending market is also a factor. Current market growth is dominated by the retail sector, with competition in the mortgage market as strong as ever. With interest rates maintaining historical lows and wage inflation outgrowing GDP, asset quality in this sector appears to be holding its own. Any concerns over a housing ‘bubble’ are not yet seeing their way into impairment provisions. Instead, the majors are seeking to dispel such fears.


The flip side of growth is an increase in provisioning. The balance is delicate, but needs to be addressed. As banks seek to stimulate growth, regulators are keeping a keen eye on lending practises, with a focus on the increasing proportion of interest only loans and the potential for the loosening of credit terms and conditions and origination practices. Already, regulators have issued a cautionary note about macro prudential measures for housing loans in the face of the much discussed bubble.

3,000 2,500 2,000 1,500 1,000 500 — 2011 FY

Aggregate Impairment ($m) vs Total Provisions ($m) 25,000

Major Banks — Impairment Charges ($m)

ANZ

2012 FY

CBA

2013 FY

NAB

2014 FY

WBC

Average

35%

20,000 30%

15,000 10,000

25%

5,000 —

20% 2011 FY

Impairment

2012 FY

2013 FY

Total Provisions

2014 FY

Impairment %

Asset quality remains sound — loan loss for the period was $1.6bn lower than prior year


IFRS 9 is getting closer Changes to the basis of loan loss provisions are on the horizon. Although not effective until 2018, the banks are increasing their activity around the impairment requirements expected to arise from the accounting standard IFRS 9. This activity is focused on analysing the potential for advantage in early adoption, as well as assessing the new requirements’ impact on provision levels, ongoing earnings volatility and capital.

Major Banks — Collective Provisions 3,500 3,000 2,500 2,000

In our view, those banks not close to IFRS readiness activity may have overestimated the IFRS 9 impact on provision levels. These are expected to be significantly lower than European counterparts, given the relatively conservative provision levels in the context of the current IAS 39 accounting requirements. In many instances, these are attributable to longer loan loss emergence periods than international counterparts and significant, albeit varying, model overlays. Managing the potential volatility arising under the new regime may require greater focus.

1,500

With this in mind, the banks will need to carefully manage the path to adoption. We recommend the immediate short-term step of creating an implementation roadmap, working backwards from an expected adoption date. This will enable banks to understand when and what level of investment is required in sourcing new data, building new models and methodologies and designing an appropriate go-forward operating model.

2,000


1,000 2012 FY

ANZ

2013 FY

CBA

NAB

2014 FY

WBC

Average

Major Banks — Individual Provisions 2,500

1,500 1,000 500 — 2012 FY

ANZ

2013 FY

CBA

NAB

2014 FY

WBC

Average


Contacts Tim Dring Partner, Financial Services Ernst & Young Tel: +61 3 9288 8054 [email protected]

Gerard Dalbosco

Andrew Price Partner, Financial Services Ernst & Young Tel: +61 2 9248 5946 [email protected]

Stephen Jack

Partner, Financial Services Ernst & Young Tel: +61 3 9288 8658 [email protected] Partner, Financial Services Ernst & Young Tel: +61 2 8295 6636 [email protected]

James Roberts

Partner, Financial Services Ernst & Young Tel: +61 2 9248 5424 [email protected]

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