ANZ Archives - the patient investor

November 14, 2019

Australia: Major banks

Summary

Our review of APRA’s June 2019 quarterly report on the four major banks — Commonwealth, Westpac, ANZ and NAB — concludes that they are collectively priced at a 16.5% premium over fair value.

Technically, the ASX 300 Banks Index ($XBAK) is experiencing secondary selling pressure and a correction is likely.

A correction would reduce the premium over fair value and may present buy opportunities.

Valuation

We project:

long-term asset growth at 3.0% p.a. (down from 4.0%);
net interest margins at 1.65% of average total assets (down from 1.70%);
non-interest operating income of 0.5%;
operating expenses at 1.05% (previously 1.10%);
provisions for bad/doubtful debts averaging 0.2%;
additional equity capital required of $12 billion; and
a 30% tax rate.

That delivers a forward PE of 16.9 based on a market cap of $399 billion.

We estimate that the major banks are priced at a 16.5% premium over fair value, based on a 12-year payback period*.

*Note to readers: we have simplified our model by removing the margin of safety and use a lower payback period instead.

Technical Analysis

The ASX 300 Banks index retreated below its rising trendline, warning of a correction. Follow-through below support at 7600 would strengthen the signal, with a target of primary support at 6750.

ASX 300 Banks Index

Book Growth

Total assets are the primary engine of bank revenue. Heady growth of the last two decades ended in 2015, when the ratio of total assets to nominal GDP (right-hand scale) started to decline. Nominal GDP also slowed (5.4% p.a. in June 2019) and is likely to restrict future book growth.

Majors: Total Assets Annual Growth and compared to Nominal GDP

Household debt near saturation level, at close to 200% of disposable income, is another headwind to future book growth.

Australia: Household Debt to Disposable Income

Total asset growth of the major four banks slowed to 1.4% for the twelve months ended June 2019 and we have reduced our long-term projection to 3.0% per year.

Margins

RBA rate cuts are squeezing net interest margins, currently 1.73%, and we expect a long-term average of 1.65% of total assets.

Majors: Income & Expenses

Expenses declined to 1.09% of total assets but non-interest income, at 0.56%, is falling even faster.

Non-Interest Income

Fees and commissions — the major component of non-interest income — have suffered the largest falls. Transaction-based fees are the worst performer, while declining credit growth has reduced lending-based fees. The sharp drop in other fees, to 0.19%, is likely to be permanent as banks shed their wealth management operations.

Majors: Fees

We project non-interest income to average 0.50% of total assets in the long-term.

Expenses

Operating expenses declined to 1.09% of total assets, as the majors attempt to cut costs in line with income, but personnel costs have proven sticky and are falling at a slower rate.

Majors: Operating Expenses

Non-Performing & Past Due Assets

Charges for bad and doubtful debts remain low at 0.09% of total assets but we expect a long-term average of 0.20%.

Majors: Charges for Bad & Doubtful Debts

Impaired loans are falling as a percentage of total loans and advances but past due loans have climbed to 0.6%, reflecting mortgage stress.

Majors: Impaired Assets

Provisions for impaired loans, however, are reasonable at 95.8% of impaired facilities including security held.

Majors: Provisions for Impaired Assets

Capital

Common equity Tier 1 capital (CET1) remains low, with a CET1 capital ratio of 10.8% in June 2019, based on risk-weighted assets. CET1 as a percentage of total assets is a low 4.96%.

The Reserve Bank of New Zealand has called for “more skin in the game“, asking the big four Australian banks to increase their capital holdings in New Zealand subsidiaries by $12 billion:

The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”.

A similar move by APRA is unlikely but RBNZ presents a problem for the big four banks as they will have to raise additional equity to capitalize their NZ subsidiaries. One alternative is to raise equity through a separate listing of their NZ subsidiaries but this is still likely to dilute returns on equity.

Return on Equity

Declining return on assets and increased capital requirements are both exerting downward pressure on return on equity (ROE), from a peak of 20.5% in 2007 to 9.7% in March 2019.

Majors: Return on Total Assets & Return on Equity

Management & Culture

Australian regulator APRA is suffering from regulatory capture. A 146-page capability review, stemming from David Murray’s Financial System Inquiry found APRA “slow, opaque, inefficient, and in urgent need of a culture and leadership overhaul.”

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above companies.

August 1, 2019August 14, 2019

Australian banks: Still overpriced

Summary

We have just completed a review of Australia’s four major banks — Commonwealth, Westpac, ANZ and NAB — and conclude that they are collectively overpriced by 23.5 percent. Our review is based on APRA’s quarterly reports, where the four banks can be viewed as a collective unit.

The ASX 300 Banks Index ($XBAK) is in a primary down-trend and we expect it to re-test support at 7000.

We estimate forward PE at 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we calculate a combined fair value of $310.7 billion, compared to current market cap of $406.1 bn, based on a 13-year payback period.

Our conclusion is to wait for $XBAK to re-test support at 7000.

Future Growth

Total assets are the base which generates most bank revenue. Heady growth of the last two decades is unlikely to continue. Growth in total assets has lagged GDP since 2015. Private credit growth for Australia slowed to 4.4% in FY18 and 3.3% in FY19.

Majors: Total Assets to Nominal GDP

Private borrowers are near saturation point, with household debt at an eye-watering 190% of disposable income.

Australia: Household Debt to Disposable Income

David Ellis at Morningstar writes:

Many investors are concerned about a potential sharp downturn or crash in the Australian housing market. While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons despite recent weakness in house prices. Tight underwriting standards, lender’s mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending. Average house prices in Australia are falling, with the national average declining 5% during the 12 months to end December 2018 based on CoreLogic data. But investors who readily compare the Australian residential real estate market to that of the U.S. and other markets are ignoring fundamental differences.

The counter-argument is that loose lending policies exposed by the Royal Commission, vulnerable mortgage insurers with concentrated exposure in a single sector and low bank capital ratios have created a banking sector “more likely to act as an accelerant in a down-turn rather than a shock absorber” in the words of FSI Chair David Murray.

Nominal GDP is growing at an annual rate of 5.0% (March 2019) and we expect this to act as a constraint on book growth. We project long-term book growth of 4.0%.

Margins

Net interest margins declined to 1.73% for Q1 2019 and we expect a long-term average of 1.70%.

Majors: Income & Expenses

Expenses declined to 1.10% of average total assets but non-interest income has fallen a lot faster, to 0.60%. The decline in non-interest income is expected to continue and we project a long-term average of 0.50%.

Fees & Commissions

Fees and commissions — the major component of non-interest income — have suffered the largest falls, with transaction-based fees the worst performer. Lending-based fees are likely to be impacted by declining credit growth.

Majors: Fees & Commissions

Expenses

Operating expenses have also fallen but sticky personnel costs are declining at a slower rate.

Majors: Expenses

Non-Performing Assets

Charges for bad and doubtful debts remain low but we expect an up-tick in the next few years and project a long-term average of 0.20%.

Majors: Provisions for Bad & Doubtful Debts

Capital

Common equity Tier 1 capital (CET1) remains low, with a CET1 capital ratio of 10.7% in March 2019, based on risk-weighted assets. If we calculate CET1 as a percentage of total assets, the ratio falls to 4.9%. Leverage ratios, which calculate CET1 against total credit exposure, are even lower because of off-balance sheet exposure.

The Reserve Bank of New Zealand has asked the big four Australian banks for “more skin in the game” and to increase their capital holdings in New Zealand subsidiaries by $12 billion:

The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”.

The move by RBNZ has exposed ineffectual supervision of major banks in Australia. A new chairman at APRA could see increased pressure on Australian banks to improve their capital ratios.

Management & Culture

Australian regulator APRA is suffering from regulatory capture. There have been calls in Parliament and the media for APRA chairman, Wayne Byers, to resign after the Royal Commission revealed numerous shortcomings in bank culture and supervision.

A 146-page capability review, stemming from David Murray’s Financial System Inquiry found APRA “slow, opaque, inefficient, and in urgent need of a culture and leadership overhaul.”

Clancy Yeates at SMH weighs in:

A rare public intervention from banking royal commissioner Kenneth Hayne could be aimed at ensuring his recommendations are not watered down by financial sector lobbying, former watchdog Allan Fels says….

“It’s very unusual for a royal commissioner, especially a former High Court judge, to speak after a report, but probably he is concerned about weak implementation of his report due to enormous pressure from the financial institutions, an enormously powerful lobby.”

There have been several recent changes at major banks whose poor conduct was exposed by the Royal Commission. NAB CEO Andrew Thorburn and Chair Ken Henry resigned in the wake of the findings. Earlier, in 2018 Ian Narev resigned as CEO of Commonwealth after an APRA investigation into money-laundering found there was “a complacent culture, dismissive of regulators, [and] an ineffective board that lacked zeal and failed to provide oversight.”

A change at the head of APRA could have even more long-lasting consequences for the banks.

Valuation

We project:

long-term asset growth at 4.0% p.a.;
net interest margins at 1.7% of average total assets;
non-interest operating income of 0.5%;
operating expenses at 1.1%;
provisions for bad/doubtful debts averaging 0.2%; and
a 30% tax rate.

That delivers a forward PE of 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we arrive at a combined fair value of $310.7 billion (current market cap is $406.1 bn) based on a 13-year payback period.

Technical Analysis

The ASX 300 Banks index, dominated by the big four, reflects a primary down-trend. The recent rally is currently testing resistance at the descending trendline. Reversal below 7000 would warn of another decline. The previous false break below 7000 suggests strong support.

ASX 300 Banks Index

Conclusion

Expect another test of support at 7000. Respect of support would provide an entry point at close to fair value.

Valuations are sensitive to assumptions: LT book growth of 5% and a 0.1% increase in net profit (% of average total assets) would increase intrinsic value to $387.4 bn (4.6% below current prices). At present we favor a conservative fair value of $310.7 billion, 23.5% below current market capitalization.

We currently have no exposure to the four major banks in our Australian Growth portfolio.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above companies.

December 18, 2015

CBA: big four to raise another $32 billion of equity | afr.com

From Chris Joye at AFR:

On the question of whether the majors are done and dusted on capital raising, investors need go no further than CBA’s chief credit strategist, Scott Rundell, and CBA’s head of fixed-income strategy, Adam Donaldson, who on Thursday published a report arguing the big four are short $32 billion of CET1 capital.

“Capitalisation [is] likely to be a source of credit strength for banks as they build toward meeting APRA’s expected ‘unquestionably strong’ capital requirements,” Rundell and Donaldson said. The authors reiterated previous analysis that suggested the majors’ target CET1 ratios will settle at “around 10 per cent to 10.5 per cent”, which “would put the majors at the bottom of the top quartile” of global competitors.

July 16, 2014

Australia: UBS eyes $23b capital hit to big banks

Chris Joye at AFR reports on a recent study by UBS banking analysts Jonathon Mott and Adam Lee. The two believe that David Murray’s financial system inquiry is likely to recommend an increase of 2 to 3% in major banks tier 1 capital ratios.

Based on an extra 3 per cent capital buffer for too-big-to-fail banks, UBS finds that the major banks would have to “increase common equity tier one capital by circa $23 billion above current forecasts by the 2016 financial year end”.

…This automatically lowers the major banks’ average return on equity at the end of the 2016 financial year from 15.4 per cent to 14.3 per cent, or by about 116 basis points across the sector. Commonwealth Bank and Westpac come off best according to the analysis, with ANZ and National Australia Bank hit much harder.

Readers should bear in mind that capital ratios are calculated on risk-weighted assets and not all banks employ the same risk-weightings, with CBA more highly leveraged than ANZ. As I pointed out earlier this week, regulators need to monitor both risk-weighted capital ratios and un-weighted leverage ratios to prevent abuse of the system.

Bear in mind, also, that a fall in return on equity does not necessarily mean shareholders will be worse off. Strengthening bank balance sheets will lower their relative risk, improve their cost of funding, and enhance valuations.

July 16, 2014

Banks try scare tactics to avoid calls for more capital

ANZ chief executive Mike Smith is the latest banker to warn that the push to increase bank capital ratios will reduce access to bank finance. The AFR reports Smith as saying:

It is not just about banks, it is about the real economy – about corporations, business and individuals… It is one thing for a bank to complain about regulation but it is another thing for a corporation to say we are not getting finance because of this regulation that is being imposed on the banks.

Methinks bank resistance to increased capital requirements is more about protecting bonuses than about protecting shareholders or the broad economy. Shareholders would benefit from lower funding costs and improved stock ratings associated with a stronger balance sheet, while Bank of England’s Andrew Bailey had this to say about the impact of stronger capital ratios on bank lending:

I do however accept that there remains a perception in some quarters that higher capital standards are bad for lending and thus for a sustained economic recovery…… Looking at the broader picture, the post-crisis adjustment of the capital adequacy standard is a welcome and necessary correction of the excessively lax underwriting and pricing of risk which caused the build up of fragility in the banking system and led to the crisis. I do not however accept the view that raising capital standards damages lending. There are few, if any, banks that have been weakened as a result of raising capital.

Analysis by the Bank for International Settlements indicates that in the post crisis period banks with higher capital ratios have experienced higher asset and loan growth. Other work by the BIS also shows a positive relationship between bank capitalisation and lending growth, and that the impact of higher capital levels on lending may be especially significant during a stress period. IMF analysis indicates that banks with stronger core capital are less likely to reduce certain types of lending when impacted by an adverse funding shock. And our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements. These banks are less likely to cut lending aggressively in response to a shock. These empirical results are intuitive and accord with our supervisory experience, namely that a weakly capitalised bank is not in a position to expand its lending. Higher quality capital and larger capital buffers are critical to bank resilience – delivering a more stable system both through lower sensitivity of lending behaviour to shocks and reducing the probability of failure and with it the risk of dramatic shifts in lending behaviour.

The BOE and BIS tell us that higher capital ratios will improve bank lending, yet Mr Smith is trying to scare regulators with threats that it will have the opposite effect.

And at ANZ CEO Mike Smith Rebuffs Murray Inquiry Call For More Bank Capital | Business Insider.

July 9, 2012

Basel takes aim at Mega Bank | | MacroBusiness

Deep T: As the research previously posted here on MB shows, Mega Bank [the big four Australian banks: NAB, CBA, WBC and ANZ] carries a level of capital against residential mortgages that is less than 2% even with mortgage insurance. Mega Bank uses internal risk based models to determine the amount of capital which are primarily based on the historical default rate of Australian mortgages relative to loan to value ratios. The period over which Mega Bank assesses the historical default rate is primarily over a period of rising house prices fueled by the expansion of mortgage credit by Mega Bank. Thereby masking probable default levels over a more benign period…..

via Basel takes aim at Mega Bank | | MacroBusiness.