Banks: RBA Says It Won’t Be a Bonanza/Watch Macquarie

Buried in last Friday's Stability Review from the Reserve Bank was yet another warning to banks and their investors not to be too optimistic about the outlook.

The warning was brief, just a paragraph or two, and it's a reminder that many investors, and even bank executives seem out of touch about the prospects for growth for the sector in the next couple of years.

It came a week before three of the country's biggest banks, The NAB, Westpac and ANZ; rule off their 2010-11 financial years tonight. They are due to report late next month or early November.

While the RBA gave the banking sector a clean bill of health, the warning was a repeat of previous comments from senior officials on how the outlook for bank business and earnings growth will be constrained.

According to figures given previously, credit growth in Australia was around 13% in the years 2000-2007 (known as the Good Old Days). At the moment it's running at just under 3% (annual rate). And will grow modestly for the next year.

RBA credit data shows that housing finance growth is running at around 7% at the moment, which is close to the lowest level for decades, business finance is expanding at less than 2% and other finance is seeing either negative of flat growth.

With economic growth slow (except in resources, where the banks are not big players), continuing high savings by consumers, modest growth in consumer credit and weak housing finance growth, the banks can forget a return to the pre 2007 days of double digit rises each year in credit and profits.

The RBA has been making this point now for almost a year and the comments in the Stability Review underline the point.

"The scope for banks' domestic balance sheets to expand is likely to be more limited than in the years preceding the crisis, given the more cautious approach of the household and business sectors towards leverage," The RBA said.

"Banks and their shareholders may therefore need to adjust their return expectations to be consistent with an environment of slower credit growth."

Now that has nothing to do with the current offshore financial pressures, more the constraints caused by the rise in consumer saving and the changes in spending patterns.

And on top of their high current levels of saving, a majority of Australian bank customers, especially mortgagees, are repaying more than they have to.

It's a trend that emerged during the GFC and has remained a feature of the Australian financial scene since. It is actually an additional bit of saving, on top of the 10.5% rate seen in the June quarter.

"The household sector in Australia is continuing to exhibit a more cautious approach to its spending and borrowing behaviour than prior to the crisis.

"The household saving rate increased further over the past year and debt has continued to grow at a rate broadly in line with income growth.

"Around half of mortgage borrowers are continuing to make substantial excess principal repayments, which is improving their resilience to any change in financial conditions."

Broadly, the RBA said, "The Australian banking system remains in a relatively strong condition compared with some overseas.

"The recent global market turbulence has contributed to falls in Australian banks' share prices and some tightening in wholesale funding conditions, but the overall effect has been modest compared with the experience in 2008-09 or with some other countries currently.

"The Australian banking system is considerably better placed to cope with periods of market strain than it was before the crisis, having substantially strengthened its liquidity, funding and capital positions in recent years.

"Growth in bank deposits is continuing to outpace growth in credit, and the major banks are ahead of schedule on their term wholesale funding plans.

"Profitability for the major banks has continued to increase to around pre-crisis levels, mainly due to further declines in charges for bad and doubtful debts."

But the RBA cautioned that Australian household debts were still high, which would further impact business growth for the banks.

"Even so, household indebtedness remains quite high, as does the aggregate debt-servicing ratio, though both are below their recent peaks.

"While the mortgage arrears rate drifted up over the first half of the year, it nonetheless remains at a low level by international standards and in absolute terms.

"The rise has mainly related to loans taken out prior to 2009, when banks' lending standards were weaker; newer loans are performing well despite the increase in interest rates over the past couple of years.

"The business sector is also experiencing mixed conditions: mining and related sectors continue to benefit from the resources boom, while other sectors, including retail, are facing pressures from subdued domestic household spending and the high exchange rate.

"Sectoral measures of profits and business confidence have therefore diverged.

"Having deleveraged considerably, the business sector is in a stronger financial position overall than it was several years ago.

"Businesses' demand for external funding remains weak.

"This is partly because the business sector has been able to finance a larger share of its investment through internal funding in recent years, as much of that investment has been concentrated in sectors such as mining, where profitability has increased the most," the RBA said.

The comments on mortgage arrears contradict assertions this week from Moody's and many media commentators that more and more Australians are feeling mortgage stress.

If half those with mortgages are repaying them faster than they should, how can more people be feeling mortgage stress.

The Moody's comments were based on analysis by the group of securitised mortgages that Moody's have rated: they equate to around 10% of all mortgages in the country, a very small sample.

As the RBA noted, most of the rise in mortgage arrears has been in deals done before 2009 and involve low doc or no doc loans which had lower lending standards.

But that's not to say the banks and Australia aren't without problems. We still have high levels of domestic debt which are only falling slowly, housing affordability remains high and there are some people struggling with their debt levels (as there are with some companies).

A recent peer review of the Australian financial system by the Financial Stability Board (which is part of the G-20 group of major economies) found that

"Australian banks have made good progress in reducing their dependence on wholesale (particularly external) funding, and they should continue to work towards managing this funding risk".

It warned that "the size and nature of activities of the four big domestic banks could pose systemic and moral hazard risks in Australia.

"The authorities have a framework in place to address those risks through a graduated supervisory response... while a concentrated system by itself is not necessarily less competitive, it is important to proactively promote competition and contestability, as currently proposed in various government reforms".

The review said another possible problem for the banks was the way they were exposed to the resources boom (i.e. the boom is the single biggest economic factor in the Australian economy at the moment).

Bank shareholders and others should be aware that that the big four in particular will come under increasing pressure from big investors, bank analysts and brokers wanting to know how managements are going to offset the slow growth in business and earnings over the next few years.

So watch for more talk about cost cutting staff cuts, outsourcing of jobs and other moves, such as cutting front end staff and branch numbers to save money.

But perhaps the biggest comfort for Australian banks, regulators, shareholders and customers is that they are not based in Europe, Japan or the US and facing high debts, no growth, instability, rising losses and high unemployment, among a host of negatives.

That's why the most important comment for the banks and the Australian economy in the past week was Standard & Poor's reaffirming of Australia's long-term AAA credit rating.

S&P said that it was reaffirming Australia's rating because of the country's economic resilience, public policy stability and sound financial sector.

The ratings agency also affirmed the country's short-term A-1+ rating and stable outlook, in a statement on Friday.

"The ratings on Australia reflect Standard & Poor's view of the country's ample fiscal and monetary policy flexibility, economic resilience, public policy stability and its sound financial sector," credit analyst Kyran Curry said in a statement.

"These factors demonstrate Australia's strong ability to absorb large economic and financial shocks, such as the global recession in 2009."

He said possible worries were Australia's reliance on external savings and commodity income to fund growth, its high household debt and emerging fiscal pressures associated with an aging population.

"Australia has what we consider to be strains on its financial sector, compared to other highly rated sovereigns, reflecting its heavy external borrowings to partly fund investment in its mining sector.

"The high debt burden will constrain growth in domestic consumption over the next three years."

But S&P said the economy had favourable prospects for sustained growth, while there remained strong demand for commodities from emerging Asia, particularly China. Australia was likely to return to trend growth of 3.5% annually by 2013, S&P said.

That means so long as the banks remain well-managed and supervised and lend prudentially, there won't be any problems.

And one bank to keep an eye on is Macquarie Group, the country's biggest investment bank.

It has already warned that first half profits and rules off that six month period (and second quarter) tonight.

And many of its major investment banking competitors such as Goldman Sachs, JPMorgan, Morgan Stanley and Deutsche, rule off their third quarters tonight as well.

Because of the instability in August and September, many could be reporting very weak figures and Macquarie's might be worse than previously thought if commentary from Barclays in the UK, issued last week, is any guide.

Barclays reckons Goldman Sachs could lose money in the third quarter and that many of its peers are currently struggling (and is Barclays' very large investment banking business feeling the same pain?).

According to a quote in the Financial Times late last week Barclays said it was struggling "to find any broker-dealer businesses reporting positively trending results".

"Nearly every line is being marked down from our prior forecasts, which were not particularly optimistic to begin with having been at or near Street lows when we updated estimates in July after 2Q earnings.

"Some revenue lines are being reduced by more than half and due to the equity and debt market decline we are now incorporating large principal investment losses, particularly for GS who we now forecast to report the second loss in its history, with the first in 4Q08.

"We are lowering our 3Q11 GAAP EPS estimate for GS to a loss of $0.35 (core: -$0.44) from $2.40 and for MS to $0.12 (core: -$0.23) from $0.43.

"The primary drivers of our downward revisions include principal markdowns, lower trading, weaker investment banking, and in the case of MS a much higher compensation ratio as the low revenue outcome presses against minimum fixed compensation. As we noted then, weak equity markets are GS's primary "Achilles' Heel"."

You could mount a similar case for Macquarie, despite the profit warning already in the market place.