What is going on with the Australian Banks profits, and the negative reaction of the market?

Had the conversation several times in the past few days (Nov 2023), so I thought I’d drop a note here for those interested.?

The Australian Big 4 banks have just reported $31.99bn profit for Financial Year 2023. If you count 25 million people in Australia, That’s basically $1,279 for every person living in this country. A profit pool literally the equivalent of 1.3% of Australia's GDP. For just 4 businesses. And up +8.2% from last financial year. Not insignificant; and you would think the markets would see it as good news.

Yet, the share market reacted negatively. For example, ANZ share price got smashed on the ASX. Why?

(?? ??... hint, it's the "NIM". Not Trent Reznor's band, the other one)

A key point is that unlike Tech stocks for example, for which the market tolerates more risk and variations in their results because what matters for them are "future innovation potentials", banks are under significant pressure to perform according to market consensus. Their business model is pretty much set in stone. Like Swiss trains, they need to deliver like clockwork on their key indicators. Otherwise, analysts and investors immediately react, as we are seeing today, despite the impressive profits at face value.

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STARTING WITH THE MAIN REVENUE SOURCE FOR THE BIG 4 BANKS, THE MORTGAGE MARKET:

Long story short, retail banks make money by taking money and lending it out. The difference between the rate they pay to take money in deposits or from financial markets, and the rate at which they lend, is the spread where they make their profit. And the mortgage the average person gets to buy a home is the biggest loan they will ever get. That's where retail banks make a large part of their profit. At the basic level.

In the past years, the Australian mortgage market has been intensely competitive, and essentially the banks have been losing money in writing new mortgages.

They have been giving cash backs, etc, to gain market share. And their profit margin in mortgages - the famous “Net Interest Margin”, the NIM - which is their key metric in this core part of their business, has been declining.

CBA for example, have just shrunk their loan book for the first time in decades. Over the latest quarter, lending fell 0.75%, or an annualised rate of 3%. And they're the biggest player in the game: that tells us that this part of their business is under massive margin pressure.

THEN YOU LOOK AT "THE COST TO FUND":

During COVID the RBA dropped the cash rate, ran a Government Bond Purchase Program, and importantly created a “Term Funding Facility “, and made something like half a trillion dollar available, at around 0.15%. It was a very low funding cost, to make sure the system would survive.

Good idea at the time, and it worked.

But that money is being repaid currently, and has to be repaid in full by mid 2024.

So the banks must now switch funding costs from around 0.15% to new market rates. For example, both Westpac and CBA recently just had a bond issuance at around 6.5% or 7%. So in other words, the funding cost for that part of the book has gone from almost nothing to 6% or 7%, which means that their profit margins are being hit.

Therefore, they're reviewing all their lending projects, and the new capital costs, and realise that a lot of their lending will not be profitable.

> This is what the analysts are looking at: yes the Big 4 banks just published increased Profits (+8.2 %) and NIM (up 11 basis points) for the full Financial Year 2023... BUT… that NIM declined in the 2nd half of the year. Which is what the market is picking on, and not happy about. Because it means it’s likely to get worst (before it eventually bounces back).?

See that AFR piece: https://www.afr.com/companies/financial-services/anz-posts-improved-7-4b-full-year-cash-profit-20231113-p5ejfm#:~:text=In%20signs%20the%20bank's%20much,its%20commercial%20and%20institutional%20divisions

"ANZ’s share price fell by 3 per cent on Monday to $24.70, as the sharp deterioration in retail banking margins spooked investors. Over the second half, the net interest margin in the retail bank fell by 33 basis points, after ANZ prioritised loan growth over pricing to win more share.

The second-half group NIM squeeze was the same as Westpac, which contracted by 10 basis points in the second half, and more than National Australia Bank, which reported a 6 basis point decline in second half NIM last week."

?

THEN YOU LOOK AT WHAT HAS BEEN ERODING THEIR BUSINESS MODELS OVER THE YEARS:

For the last 10-15 years, FinTechs have been eroding some of their higher margin business.

Like the credit card business with BNPL (Afterpay, Zip etc). The foreign exchange business: they used to make large margins of FOREX. Now people use OFX or Wise, because it’s cheaper and offers better rates.

So all the high margin things that used to bring extra easy cash are slowly being eroded.

The punchline is that the banks have some trouble adjusting their cost base. And the view from the market analysts is that it will take time. They will come back to lending. But first, valuations have to correct, which they have begun to do.

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COMMERCIAL REAL ESTATE IS A GOOD EXAMPLE OF THAT:

From the RBA bulletin in September 2023: ?"Leasing demand for commercial property, particularly in the large office segment, has declined with COVID. A shift towards working from home has reduced office attendance rates globally, to around 60–70% below pre-pandemic levels in some major cities. In the retail segment, the shift to online shopping has also had consequences on bricks and mortar shops."

So there’s a lack of new money coming into the sector as investors look at the relatively high returns on offer from bonds and term deposits. They are rethinking the risk of investing in commercial real estate.

Consequently, the big banks are getting cautious about commercial property for fear of lending to non-viable projects.

?

CONCLUSION:

Following the GFC, and to some extent COVID, the regulators have turned their major banks into effectively building societies. They don’t want the banks to fail. So they have imposed more restrictions on capital, and as a result banks are really well capitalised. They are definitely seen as healthy businesses by analysts, but they need to digest those changes.

It will take time to adjust. How long? Hard to tell. Rising interest rates are a very insidious force. They work the system slowly, and it's always more complex than we think.

?

A final interesting one to illustrate that point of weird complexity - the current housing freeze in the US:

The US have 30-year mortgages. People who got a mortgage in the past years would be on 3%. But today, the financing rate for 30 years is 8%. So people who have a mortgage at 3% are not selling their houses because they cannot afford to get a new one at 8%. So the housing market has become frozen: there is now a shortage of housing because nobody can afford to buy at 8%.

This freeze is an example of such an unusual situation, and it will take time to resolve.