Investment Matters

The banks

The big-4 banks are making press headlines this week - on multiple fronts (including bad debts as mentioned above).  This week Investment Matters considers their share price performance year to date, as well as two key drivers of this performance - the Basel reforms and bad debt provisioning.

Newsworthy banks

The big-4 banks are making press headlines this week - on multiple fronts (including bad debts as mentioned above).  This week Investment Matters considers their share price performance year to date, as well as two key drivers of this performance - the Basel reforms and bad debt provisioning.

Performance YTD

A graphs sum it up quite nicely:

Big 4 1

Westpac has performed relatively well (perhaps it learnt the lessons of the 1992 [1], and its capital position and overall lending exposure is considered in a more favourable light than its counterparts (well, until this week anyway)).  As depicted in the graph, ANZ and NAB have underperformed the market considerably.

Bad debt provisioning

Banks must put aside a pool of money, providing for loans that will not be repaid in full.  The size of this pool will vary, depending on, for instance, the arrears rates that are being experienced, and projections for unemployment rate and the like.  Changes in the size of the pool go directly to increase or decrease the bottom line profit of the bank.

Since the GFC, the banks' profit has been greatly enhanced by decreased provisioning.  Provisioning is actually at very low levels - measured by the provisioning pool size relative to the total size of the loan books (and it remains so, even after the recent announcements by ANZ and Westpac).  ANZ's bad debt provision is now ~0.32% (Deutsche Bank estimate, still quite low), vs just 0.11% to 0.17% for its competitors.  Significantly, even small increases in the provisioning pool size have a large impact on the profit result in a given period.

Concern now exists about whether current provisioning is adequate - with mining related exposures likely to increase in the short-term.  Additionally, there is concern that a more systemic issue exists, related to general economic conditions - provisioning levels on a more widespread basis need to be increased (from corporate / commercial, into house and personal lending).

Basel reforms

Basel reforms, a worldwide initiative which have been brought in in phases since the GFC, have already resulted in an increase in the capital requirements for Australia's big-4 banks.  The initiates are complex and impact banks in different ways.

Note: simplistically, bank equity is the difference between a banks assets (loans / credit outstanding, cash on hand etc) and its liabilities (e.g cash deposits and bond debt).  Capital is this equity, plus any loss absorbing hybrids and bonds.   It is actually way more complex than this, with risk adjustment (see below), different capital levels etc.   The higher the capital level of a bank, in effect the lower the gearing.  Also, the better the risk profile, and the lower the returns for shareholders.

There are two Basel reforms currently muted that could have very significant impact on the big-4 banks. 

1. Basel 3 - liquidity reforms, in particular the Net Stable Funding Ratio (NSFR)

Under these reforms the big-4 banks will need to more closely match the terms of the loans they provide with the duration of their funding sources (cash deposits, overseas wholesale loans etc).  They will need to have more long-dated term deposits (rather than cash savings accounts), and longer-duration wholesale funding.  This will increase the cost of funding for the banks, and thus reduce their profit margins.  Some offset to this may be available if the banks increase their loan interest rates, but competition and customer's ability to pay are likely to cap the extent of the offset.

2. Basel 4 - use of internal risk models

It is really early days on this one.  Therefore the potential impact really hasn't been able to be quantified.  However, because the big-4 extensively use internal risk models, the impact on them could be significant.

The big-4 have been using internal models to do risk assessment on their loans.  These complex internal models have resulted in lowering the capital requirement for a given credit risk.  This Basel reform will bring in a "standardised approach", including hard minimums or capital floors, and a greater emphasis on a loan's LVR (value of the loan in relation to the value of the underlying asset).  The big-4 will not be able to use their own risk assessments to reduce their capital requirement.  It is likely that their capital will need to be increased (via capital raising or quasi-capital raising aka a DRP).

Smaller Australian banks will be the relative beneficiaries - in the past, APRA, Australia's banking regulator, hasn't permitted them to use internal risk models to the same degree as the big-4.  Thus their capital requirements are likely to be less impacted.

Please note that there are many other provisions and potential impacts of the Basel reforms on the Australian big-4 banks.  Today's Investment Matters has focused on just two; two that we understand could have a large impact.

Although the Basel reforms will go to improving the long-term financial stability of the banking system in Australia and globally (a good thing), there is, however, a downside - they dampen lending activity, and thus economic growth - at a time when growth is happening, but it is not as strong and potentially resilient as some would like.  In effect, in the short-term we need to give back a bit of the over-borrowing undertaken over the last two decades.