Simplicity raises focus on future – PwC Major Banks Analysis

  • Cash earnings of $14.4b, up $1.4b on half, driven by reduced notables, low credit costs and good lending growth, which offset a continued fall in net interest margin (NIM). Return on equity of 10.6%
  • ‘Notable’ charges negligible and significantly lower than prior half and $13b since 2008
  • Lending growth of 6.7% (half-on-half growth annualised) continues to be strong, if uneven across banks, in both mortgage and business lending
  • NIM down 9bps in half to 1.75%, a historical low with the majors overall losing mortgage share
  • Credit costs represented a $0.2b benefit to the half, lower than the $0.7b in prior half but below the typical $1.5b-$1.8b per half of history
  • As with NIM, non-interest income at $7.5b also continued multi-year structural decline, overall, it is now lower than at any time since the global financial crisis
  • Expense-to-income (ex. notables) down 70 bps half-on-half from its highest level in decades, however remains close to 50% at 48.5%
  • Substantial reduction in remediation from levels seen in FY19, 20 and 21 ($3.3b, $4.4b and $1b respectively), now comparable to levels seen before the Royal Commission in 2018
  • Common equity Tier 1 (CET1) declined to 11.8% on the back of meaningful dividends and share buy backs

Australia’s major banks delivered a strong, if uneven result, earning more than $14 billion in the first half year 2022, up more than 10% half-on-half and 5% on the prior comparative period. The results give the clearest view of progress, challenges and future choices facing the banks and appear to put the pandemic behind us.

It was the cleanest result in years, with a general absence of notable charges relating to restructures and remediation which were previously a discernible feature (cumulatively over $13 billion since 2008). This is due to years of the banks becoming simpler and ‘smaller’ – remediations, portfolio restructuring, free of material ‘non-core’ businesses and operations, either overseas or in Australia. The drivers of the financials were much more normal – the basic fundamentals of banking: margin, balance sheet, fees, productivity and asset quality.

Sam Garland, Banking and Capital Markets Leader at PwC Australia, said, “This was a strong and clean result, if a little uneven, that points to the progress the banks have made in recent years but also the challenges and choices they face as market change continues and we enter an inflationary environment. The banks are much simpler and have fixed many issues over the past five years, in addition to responding to Covid, and the result had more to do with lending market share, operational processes, margins, cost profiles and credit performance as a result. This is key in the context of the outlook as the banks determine where growth will come from.

“We’ve been noting for some time that the traditional core of growth for the banks is increasingly competitive and the base of earnings has narrowed as a result of the ‘simplification’ over the past decade. Lending growth has been unevenly shared among the major banks, particularly in mortgages, in which three non-majors have taken material share, with the resultant pressure on margins. And while rising cash rates should provide some benefit, the banks have been careful to manage expectations given the competitive landscape and funding cost implications.

“We’re entering an economic environment of inflation and rate rises that a generation of customers and bankers has never experienced. While concerns for credit quality from rates appear low so far, the immediate impact for banks is on execution- operational processes, costs, investment choices. The ‘cost of living’ for banks is under pressure and the banks will have to work extremely hard and make investment choices to contain it. At the same time we are seeing real momentum as technology and ESG are driving significant change in the market. This presents other imperatives for our simple and strong banks – making choices about their business model in light of these changes so that they adapt fast enough and maintain their reputational strength in the process. The decarbonisation of the world is the most prominent example of this – it will redefine Australia’s economy and the banks are in the early stages of transforming to play a critical role in guiding and supporting this change for their customers – with huge opportunities as a result.”

Strong, if uneven, result that was cleanest in years

Bank earnings exceeded $14 billion for the first time since 1H19, driven by dramatically reduced notables, expenses (both credit and operating), and continued lending growth. As a result, they returned close to $14 billion to shareholders: $9.5 billion in dividends and $4.5 billion in buybacks. It was the cleanest result in years, free from large notable items, capital changes, major disposals or distractions from activities which are not ‘core.’

There were minimal notable charges: gains and losses on disposals largely cancelled out remediation expenses. The impact of ‘Covid provisions’ was also muted relative to prior halves, albeit still a large benefit to the half. The drivers of the financials were therefore more about the critical fundamentals of banking: margin, balance sheet, fees, productivity and asset quality.

Mr Garland said, “The banks, on the whole, have had a strong half. However, this performance was not only uneven, for now it rests on a narrow base. Five years since the Royal Commission and with the Covid years behind us, this reflects the substantial work to remediate consumers, redress regulatory breaches and put in place the controls necessary to ensure these issues don’t happen again. It also reflects a wave of work required to restructure banks around simpler lines of business, core banking services, and contemporary, cloud-based information systems. For now, most of this work simplifying and remediating appears to either be done, significantly underway or at least already provided for, especially for restructuring given the number of divestments which are now complete.”

Clarity highlights progress, as well as future challenges and choices

As a result of the simplification over the past decade, the traditional core of growth for the banks is increasingly competitive and the base of earnings has narrowed. Expenses remain on a steady and potentially-upward trajectory, NIMs remain low and non-interest income continues to fall. In the landscape of ‘new’ opportunities, technology will be increasingly contested by both traditional banks, and non-banks, from all over the world.

Mr Garland said the major banks have a great platform to respond to this, but it comes at a time of sentiments shifting around the macroeconomic environment and intense competition. “The future foundation of earnings growth – dependent on more than lending growth – comes into stark relief in this environment. There is no question the banks are better at (and still improving) the core functions of a bank – lending and deposits, relationships, payments, managing risk and helping to keep customers safe – than at any time in recent memory. Significant investment is continuing on many of these opportunities and there is clear growth opportunity in the core, but it is highly contested.”

Despite market share just over 6% in 2019, the ‘Next Three’ accounted for more than 20% of total loan growth since then, more than any major bank bar one. When it comes to the services part of financial services, the banks have been shrinking for years, partly as a direct consequence of the simpler, smaller franchises they have chosen to become.

Non-interest income, which includes banking fees, is significantly reduced following business divestments and fee removals after the Royal Commission, as banks continue to search for new services for which customers are willing to pay. In comparison, Canadian banks earn three times the revenue (per dollar asset) from non-interest income as Australian banks do, and while that is a different banking system, operating model and environment, it highlights the extreme concentration of banking income in Australia today.

In the short and medium term, however, the more acute imperative is to arrest the growth in operating costs and to balance investment decisions as a result. Expense-to-income for the majors continues to sit close to 50% excluding notable items, a level not seen in Australia since the early noughties. In announcing the half, each bank made it clear that they were not immune from inflationary pressures and some released themselves from their absolute cost targets. Mr Garland pointed out that it was not that long ago when banks were talking about an aspirational expense-to-income ratio in the 30s.

What will Australia’s banks choose to be?

Mr Garland said, “Twelve months ago we said that Australia’s banks are in their best shape in a generation, and believe it still today. There’s enormous pent-up demand to be satisfied, liquidity and capital to invest and spend, and enormous challenges and opportunities requiring innovation, funding and advice. Most importantly, there was a unique confluence of factors suggesting a new resolve to address long-standing social issues. It was what we called a ‘window of opportunity.’”

“While there’s still work to be done, Australia’s major banks are indisputably better at the core functions of a bank and are investing to adapt to the future. In a world of rising inflation and rates and potentially falling asset values, will lending growth continue to deliver? More importantly, in a world where economic and financial activity is moving into increasingly virtual domains, where it can can be disaggregated, automated and reintegrated in totally novel ways, the banks know that while they need to get better and better at doing those ‘core’ things, they need to return to taking more risks on innovation and change. What will Australia’s banks choose to be?

“There is no question the banks are alive and investing to answer this and their simplicity gives them the platform to do so. The question is therefore whether they are thinking big enough, moving fast enough and executing well enough to respond and capitalise on the opportunity,” concluded Mr Garland.