Holding on, but looking for upside

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June Quarter Snapshot 2018

August 2018

Banking Matters | Major Banks Analysis

PwC Banking Matters | 2

August 2018

Bank earnings (excluding special charges) continued holding on through the June quarter in the face of the considerable economic, competitive and conduct challenges we have been monitoring and writing about for some time. Given the industry outlook in place for so long, this is something of an achievement. Nevertheless, signs of future stresses are beginning to flow through to financials – even before considering the significant charges incurred for risk management and remediation dominating the banking agenda.

What’s more, as important as risk and remediation may be, they are not really going to drive significant long-term value creation. In this environment, with the outlook continuing to be unfavourable and risks to the downside, it is more important than ever for banks to identify and create catalysts for upside. In this report, we highlight price and cost management as two key opportunities, and drill down into the pricing opportunity in our Hot Topic: The Price is Right - What should we pay?.

Turbulence emerging, but bank performance hanging onIn May we reported that we saw ‘turbulence emerging’ in bank half-year results, with the impact of economic, competitive and conduct challenges beginning to materialise in financials (see our May report Turbulence Emerging: Major Banks Half Year 2018). This has been on the radar for a while but had previously been staved off by fortuitous circumstances including the surprising durability of the synchronised global ‘Goldilocks economy’ described in our December snapshot (Goldilocks redux – for everyone but the banks).

The combination of margin challenges, conduct, remediation and restructuring charges, compounded by a continued, but gradual slide in asset growth, are all well in train. They have conspired to deliver three consecutive quarters of flat or falling cash earnings relative to the prior-year period1. Although diminished relative to the record levels of the prior year, they have not fallen dramatically but have continued to track within the same broad quarterly band for the past five and a half years. In short, bank earnings are hanging on.

This is perhaps because the Australian and global economies are holding up, continuing to show surprisingly robust growth in the face of material economic and geopolitical challenges. In fact, markets seem steadfastly optimistic, with volatility back down and the Schiller PE Index2 nearing record levels, as shown in Exhibit 1.

Risks to the downsideUnfortunately, it is hard to hang on forever, and we see risks to the downside for both major bank financials as well as the global economy. Like the banks, the global economy is showing its own signs of emerging turbulence, most recently in Turkey.

Exhibit 1: Fear and greed: historical stock price volatility

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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

VIX Schiller PE

Source: Bloomberg and Chicago Board Options Exchange. Data represented above ends 17 August 2018.

2. Schiller PE Index is the US share market price-to- trailing 10-year earnings ratio

1. Based on three banks’ reporting of quarterly earnings: CBA, NAB and ANZ. WBC does not report quarterly earnings and so is excluded from the earnings and bad and doubtful debt expense analysis for our December and June-quarter updates.

Seeking catalysts for growth in a sea of risk and remediation

PwC Banking Matters | 3

August 2018

For this reason, though we expect continued volatility in bank earnings, we should be cognisant of the risk to the downside should the global environment turn. Accordingly, margin and cost remain paramount. As mentioned, in this quarter’s Hot Topic we dig deep into the first imperative, which is the pricing of standard financial services and products. In the future, we shall address new products and services (especially payments) and the promise of automation, data and artificial intelligence (AI) to improve both revenue and cost. Accordingly, our analysis of the June quarter major banks financial announcement3 focuses on the following relevant messages:

• Australia continues to benefit from ongoing global expansion;

• The decades-long reliance on credit-led growth is being felt in the face of rapidly decelerating business lending, slowing mortgage and consumer spending, and some early signs of credit stress;

• The previous points, coupled with existing challenges on cost and revenue, have driven earnings down relative to 2017; and

• The imperative for managing price and efficiency is greater than ever, with a continued unfavourable outlook for most drivers of return.

1. Synchronised global expansion benefiting Australia

Continued global growth in the face of risks and headwindsThe global economy continues to demonstrate healthy growth with the US perhaps even on the cusp of overheating and in the face of the challenges described in Exhibit 2 below.

3. CBA, NAB and ANZ only; for CBA ‘June quarter’ financials derived as the difference between full-year results and, where reported, half-year plus third-quarter (March) results, and for NAB and ANZ as the difference between the third-quarter trading update and half-year results

Increasing trade tensions are especially worrisome. Although the recent US threat to impose tariffs on up to $500bn of Chinese imports may seem like a bilateral issue, the disruption to global supply chains that such a move could entail would affect almost every part of the global economy. What’s more, with the money supply in most markets still much higher than it was before the GFC, such supply-chain disruption could create just the inflationary spark needed to ignite fears that have long been latent. These events are occurring in the context of a global tightening of (advanced economy) monetary policy as central banks reverse ‘quantitative easing’ and interest rates recover from post-GFC lows. In short, the scene is being set for increasing interest rates and stronger advanced-economy currencies to drive down asset values globally and, as Turkey’s leadership is now discovering, hammer indebted emerging-market economies. None of this would be positive for Australia.

Australia continues to benefitFortunately for Australia, until the risks and headwinds described above materialise in an economic slowdown or full-blown financial crisis, Australia continues to be a beneficiary of healthy global economic growth, confidence and risk appetite.

Australia’s trade deficit has swung to surplus thanks to surging resource exports, its budget deficit closed, and its domestic industry (especially exports) supported by monetary policy that has gone in relative terms from one of the most conservative to among the most accommodating of the major economies. Accordingly, although Australian house prices have begun giving back the gains of recent years, there has been no ‘hard landing’ and Australian households, though stretched, are still spending and borrowing.

Geopolitical turmoil

Continued geopolitical turmoil and abandonment of longstanding norms of the global order in areas such as trade, diplomacy and immigration potentially increasing existing inflationary pressures underpinning central bank tightening

Leverage

Global consumer and business leverage back at pre-GFC levels, with highly-leveraged emerging markets a special point of vulnerability (including China, Turkey and others with significant US dollar-denominated debt)

Market exuberance

Ebullient asset valuation and credit underwriting around the world, with the Schiller PE ratio nearing historic levels (comparable levels only previously reached in 1929 and between 1997 and 2002)

Stressed housing

House prices showing strain in specific regional markets such as Australia, Canada, New Zealand and global urban centres such as London, Stockholm, Oslo, Shanghai and Beijing

Exhibit 2: Challenges in the current environment

PwC Banking Matters | 4

August 2018

2. Repercussions being felt from multiple decades of credit-led growthRegardless of the pace of economic growth in the short term, Australians are now reckoning with the consequences of three decades of credit-led asset-price growth and leverage. Mortgage originations continue to slow, as they must, to bring household leverage down towards levels sustainable in different interest rate environments. Fortunately for the banks, the rate of this slowdown has been gradual, especially for owner-occupiers whose borrowing is holding up reasonably well. Unfortunately for the banks, this means that, without a dramatic acceleration of nominal income growth, the slowdown will have to continue for a very long time. This is illustrated in Exhibit 3.

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Housing – Owner-occupier Housing – Investor Housing Personal Business

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Housing – Owner-occupier Housing – Investor Housing Personal Business

Exhibit 3: Annual lending growth by category, seasonally adjusted

Annualised % growth - 3 month rolling average

Domestic credit growth: Annual % growth - 12 month rolling average

Source: RBA

PwC Banking Matters | 5

August 2018

By contrast, investor mortgage growth has fallen substantially, which is consistent with prudential intent, as has business lending, which is not. In fact, so far in 2018, business credit growth has once again fallen below the growth in nominal GDP, something that has happened only a few times in the past generally following major downturns as shown in Exhibit 4. That it should have happened again so long after the last financial crisis, and with employment and business conditions so healthy, is a testament to how much leverage remains to be worked out of the system and to how the impact of regulator actions to dampen this leverage are working.

Exhibit 5: Non-majors continuing to gain share

Source: APRA

-5%

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25%

78.4%

78.6%

78.8%

79.0%

79.2%

79.4%

79.6%

79.8%

Major banks market share of ADIs Major bank credit growth (annualised) ADI credit growth excluding majors (annualised)

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What’s more, as we’ve observed in the past, in this environment of slower lending growth, non-majors continue to gain share as illustrated in Exhibit 5. If it were possible to track loss of share to non-bank lenders, one would suspect this picture to be starker still.

3. Earnings down for a third quarter in a rowIn such an environment, it is no surprise that quarterly earnings are under pressure, down 8 per cent on the prior-comparable period (pcp)and flat or down on pcp for three quarters in a row (see Exhibit 6). What’s more, although reported earnings may be up in the quarter relative to prior quarters, this is only due to the non-repetition of significant itemised charges in both December and March for risk, remediation and restructuring. Underlying profits excluding these charges show a downward trend since October 2017.

5%

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Exhibit 4: Business lending growth once again lower than nominal GDP

Source: RBA, ABS

Business lending growth minus nominal GDP growth, Australia

PwC Banking Matters | 6

August 2018

Exhibit 6: Estimated underlying cash earnings for three of four major banks by quarter

Source: Company statements and PwC analysis

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PwC Banking Matters | 7

August 2018

In addition to slowing loan growth, margins are being put under pressure by the rise in short-term funding costs. 1,3- and 6-month Bank Bill Swap Rates (BBSW) are increasing as shown in Exhibit 7, and competition for owner-occupier mortgages is intensifying. Balancing that, however, was the opportunity to increase rates for interest-only and investor mortgages consistent with their greater perceived risk and the prudential intent to reduce their share of the Australian market. As the large wave of interest-only loans written in 2014 and 2015 approach mandatory 5-year rollover, into principal-and-interest, this will be a headwind for margin but also, in the case of borrowers unable to service the increased payments, on loan losses as well.

1.40

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Interbank Overnight Cash Rate 1-mth BBSW 3-mth BBSW 6-mth BBSW

Jul-2

016

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6

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2017

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018

Exhibit 7: Emerging pressure on short-term funding costs

Source: Company statements and PwC analysis

PwC Banking Matters | 8

August 2018

To date, however, loan losses continue to decline, as shown in Exhibit 8, and are in fact down 3 percent from the cyclically high March quarter. This is despite rising arrears and ongoing restraint in consumer spending. Should the trend of rising arrears continue (especially among the wave of interest-only borrowers coming to the end of 5-year terms forced onto amortising loans), this will become another headwind to bank earnings.

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Exhibit 8: Consolidated bad and doubtful debt charges for three of four major banks by quarter

Source: Company statements and PwC analysis

PwC Banking Matters | 9

August 2018

Finally, notwithstanding the effort and focus on cost reduction, digitisation and productivity, the tangible progress to date on this agenda has been less than compelling. With continued pressure on margins from competition and public scrutiny, as well as the conduct and reputational challenges so poignantly evident in the Royal Commission hearings, the opportunities to roll out new products and services have been limited. Reflecting this reality, Australian bank shares substantially underperformed both local and global markets. It is worth noting however that they have recovered somewhat since the end of the quarter in June, with a mini ‘bull run’ commencing in mid June and continuing until the time of writing. This is shown in Exhibit 9.

BanksMSCI

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Exhibit 9: Australian bank shares vs global equities

Source: Company statements and PwC analysis

4. Imperative for managing price and efficiency greater than everUnfortunately, given all that we have discussed above, the outlook for most drivers of future earnings remains negative, consistent with the outlook we highlighted in the half as shown in Exhibit 10. This makes current efforts to reduce cost and maintain pricing more imperative than ever.

PwC Banking Matters | 10

August 2018

Exhibit 10: Headwinds in all drivers – cost and pricing crucial

Cost reduction has been under way for some time. Every bank is engaged in some form of restructuring but with timing of benefits varied. Some have already made fundamental choices about business architecture and realised significant reductions in operating costs, while others are making substantial upfront investments in digitisation and productivity with the promise of substantial savings down the track. The extent to which this has been successful remains to be seen and opportunities for cost reduction continue to emerge through automation, data and AI.

Price, reflected in both interest and non-interest margins, is a more complex discussion. To protect their ability to generate attractive margins and dull the kind of ‘commodity-trap’ price competition we described in our September 2016 report: Escaping the Commodity Trap: the future of banking in Australia, banks must introduce new, differentiated and tailored services to become more deeply connected to their customers. That report described a number of organisational, operational and strategic choices banks could make.

However, there is an opportunity to improve what already exists today. Increased transparency and more nuanced, risk-based pricing can more closely align offer to customer needs while improving price realisation in existing products and services - even those that are commodities. At the same time, it can also achieve a number of other social objectives including increased economic efficiency, enhanced financial stability as well as fairness. We describe this opportunity in the attached Hot Topic: “The Price is Right - What should we pay?”

Future outlook

Significant investments in digitisation and automation balanced by increased requirements on compliance, oversight and control.?

Likely but as-yet unquantifiable additional expenses to respond to conduct and other operational risks.

Asset quality has been very benign for many years.

Potential mortgage tightening may have second-order consequences.

Bad debt expense

Credit provisions4.

Ass

et q

ualit

y

?Increased scrutiny on pricing and competition including impact of open banking.

Possible scope for more risk-based pricing.

Ongoing pressures augmented by Royal Commission transparency and sensitivity.2.

Rev

enue

Net interest margin

Non-interest income

Major moves on capital largely complete.

Further divestments may even provide future flexibility.

Clear regulatory intent to constrain mortgage growth over the medium term.

Potential for accelerated business lending still unclear.

Common equity

tier 1 ratio

Credit growth

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Itemised charges

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© 2018 PricewaterhouseCoopers. All rights reserved. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. Liability limited by a scheme approved under Professional Standards Legislation.127063390

AcknowledgementWe would like to thank the following PwC team members who have made a significant contribution to the development of this publication:

• Mathew Kassar• Will Dunn• Abe Alvarez• Lauren Lopatko

• Nat Bauman • Brooke Cashman

Jim ChristodouleasBanking and Capital Markets Director

Tel: +61 448 431 121jim.christodouleas@pwc.com

Hugh Harley Banking and Capital Markets Partner

Tel: +61 2 8266 5746 hugh.harley@pwc.com

Contact usColin HeathBanking and Capital Markets Leader

Tel: +61 3 8603 0137colin.heath@pwc.com

Sam GarlandBanking and Capital Markets Partner

Tel: +61 2 8266 3029sam.garland@pwc.com

Julie CoatesFinancial Services Industry Leader, Australia

Tel: +61 2 8266 2006julie.coates@pwc.com