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Date : 20/10/2020

The Banking Sector

The Infamous Big 4!

The banking sector in Australia is in decline and the trend started prior to the pandemic. The big 4 – CBA, WBC, NAB, and ANZ are all in the midst of a cyclical decline. Declining cash flows and growth rates have been the norm for the last few years in the sector. The Royal Commission Hearings added an extra element of risk – mounting more pain for the sector and its investors. While we would love to talk about how the Royal Commission defamed our banks, it would be out of scope for this report. But we would like to say that the hearings made it clear that banks and most players in the financial services industry cannot be trusted and hence, a major overhaul is required. The noticeable change since the hearings among the banks is the sell off of the financial advisory segments.

Any financial crisis adds immense pressure to the banking sector. Banks lend money – not just to consumers like you and I, but also to businesses. Home loans, business loans, and consumer credit are the three largest service segments of not just the banking sector, but the entire finance sector of Australia. All three aforementioned segments will see additional degrees of risk added to them due to the uncertainty a crisis will bring along with it. Timely repayment of loans become less predictable, and the lenders suffer from borrowers defaulting from their debt obligations. This is exactly the reason why bad debts have a provision on every balance sheet. However, the reserve is just not enough during most crises.

Covid19 magnified these risks and put the banks under a microscope. Business loans were the most impacted as several industries suffered at the hands of the pandemic. Broken global supply chains, travel restrictions, etc. impacted every business that did not conduct its operations digitally. As a result, defaults on business loans increased. Unemployment surged and consumers with debt obligations defaulted on loan payments – be it home loans or car loans. Prior to all of these events, the Australian economy was suffering from low growth rates and in order to try and spring the economy back to life, the Reserve of Bank of Australia had been cutting interest rates. The interest rates cuts mean consumers pay lower interest on their loans or lines of credit. This results in lower earnings for banks, and also lower margins.

Ultimately, the picture we are trying to paint here is the cyclical decline of the banking industry – already under pressure from low interest rates and the rise of fintech. Covid19 has just amplified this problem the banks face. As an investor, since the past few years, the only reason to hold on to stocks from the banking sector has been for its dividend and not for the expectation of growth. However, the pressure this crisis has resulted in banks cutting down its dividend payouts.

The Budget to ease the pain?

The first quantitative easing announced by the government in response to the pandemic-stricken economy put money into the pockets of the people of Australia. They helped businesses retain employees and also increased weekly and fortnightly payments to ones who were left jobless.

The recent and newest budget is aimed at growth. The government has announced tax cuts for individuals and wage subsidies to decrease unemployment. In addition to this, the new budget also supports various industries. Infrastructure and manufacturing industries will see support with increased spending. The real estate market is forecasted to rebound as home loans are set to benefit from increased responsible lending – thereby benefiting banks with increased activity.

Ultimately, the new budget will look to drive private-sector growth to add life into the economy. Interest rates are set to remain low for the next three years. However, we forecast further easing to come in the future – resulting in lowering of interest rates and increased deficits.

Due to the nature of the budget, banks look like one of the winners – at least in the short-term. The potential of increased activity and business coming their way has resulted in all the banking stocks going up since the announcement of the budget.


The above chart shows the rebound the banks have made since the crisis and also the recent surge in October 2020 – induced by the budget. Macquarie Group Limited has been the best performer, better than the big 4, while Commonwealth Bank of Australia is the best performer among the big 4.

While the budget induced share price rebounds are seen in all banks, how much they will benefit in the long-term is yet to be seen. The fundamentals around the bank have not changed and they continue to be in structural decline.

The share price performance can be seen from the above picture – clearly showing how miserable the past year performance has been for the banks. Macquarie stands apart from the rest given how different they are in terms of the business model.

Considering everything we mentioned so far, it thus becomes extremely important for investors to know if they should hold bank stocks in their portfolio, and if so, which one?

The state of “lending”?

Declining interest rates has led to lower revenues in the past few years. Issuance of home loans, business loans and personal credit make up the majority of operations for the banks. Lending volumes saw growth in the first half of the financial year. However, it has declined since the pandemic started affecting consumers and businesses. The exposure to bad debts and deferred loan repayments will be a persistent concern during a crisis. The extent of bad debts, however, will not be clear as the firm’s balance sheet is big enough to assist its customers by deferring repayments.

CBA has recently said that deferred loan repayments have declined by 26% in September compared to the previous month. The total loan deferrals sit at 129,000 that accounts for about $42 billion. The bank added further that it expects the deferrals to further reduce in October.

The deferrals have been reducing since the peak of the pandemic in March and April. While that is positive news, how long the trend will last continue to be uncertain. The job market’s rebound will be essential for home loan and personal loan repayments to be made on time. These early numbers may be inflated due to the government’s quantitative easing program putting money in the hands of Australians.

Source: Commonwealth Bank of Australia

The new rules surrounding lending means that banks will be able to lend more money. As lending increases, it may just amplify the problem for lenders in the long-term. At this point in time, the economy will surely require another boost in 2021, and an almost certain interest rate cut. As the lending may increase, the decrease in interest rates may further reduce revenues for banks if the volumes do not match up. Another risk that may arise out of the increased lending is higher financial stress among Australian households. This may become a hindrance if the assumption of the worst of Covid19 already being behind us turns out to be wrong. The risk levels of the new loans that will be granted will play into how the bank will emerge out of the financial crisis.

Loan impairment expense and provisions have been increased to mitigate some of the risks posed by the current state of the economy. Even with a positive response to the budget over the course of the next few months under the assumption that everything goes according to plan, the performance forecasts for the bank are grim. The firm will continue to decline in revenues and earnings.

While the budget is set to increase lending volume, it remains to be seen just by how much. Even with a good real-estate market and the economy bouncing back from Covid19, we cannot see how the industry can post growth in revenues as interest rates are only forecasted to go lower.

Return on Assets

The only reason the banks are able to sustain the deferred loans, bad debts, and all the other risks that are accompanied by the pandemic is due to the strength of its assets on the balance sheet. Banks lend money and hold deposits – Business banking and consumer banking are the two biggest segments that account for the revenues generated by the big 4.

The performance of these assets has been questioned for a few years now. Traditional banking is in decline, but it is still essential to the economy. The gradual decline since 2015 can be seen in the below graph. Return on Assets tracks how well a firm’s asset performs to generate revenue. Non-performing assets have increased over the years.

Out of all 4 banks, ANZ holds the highest assets on its balance sheet, followed by CBA. However, the returns generated on assets paints a different picture for ANZ. The above graph makes it the worst performing of its peers relative to the size of its assets on the balance sheet.

In an industry that is not characterised by high capital intensity, it becomes vital for firms to generate high returns on its assets. The declining trend is a major cause for concern for investors.

Return on Equity

Return on equity measures how well shareholders’ equity has been managed by a firm to generate income. The metric is a benchmark to measure the earnings performances. A declining return on equity for all 4 banks questions how equipped these firms are at managing their capital and generating returns. Yes, a structural decline of an industry means a declining trend for returns on equity, however, the constant decline since the past 6 years also mean that the big 4 banks have slacked off in adding a degree of innovation to their business models.

The recent underperformance seems to have been amplified by the effect Covid19 has had on the economy. However, with that being said, we do not expect to see any turnaround in the coming years due to the reduced earnings forecasts.

Net Interest Margin

Net interest margin is arguably the single most important metric that is used to analyse the profitability of a bank. The metric measures the income a bank generates from its loans with the interest that it pays out on consumers depositing money into their accounts.

The margins will decrease if an increase in savings deposits is the theme, and it will increase if lending volumes have increased. Given the low interest rate set by the RBA in order to boost the economy, this metric should give investors an idea as to how well the measures to boost economic activity have worked so far.

From the chart below, it is safe to say that CommBank and Westpac have been the most consistent performers among the big 4. The metric also gives an idea as to how deferred payments have affected the firms. ANZ and NAB’s substantial drop-offs this year may mean that their borrowers are more affected by the pandemic than ones from CommBank and Westpac.

Another conclusion we can draw from is the fact that all 4 banks’ performance here has not reflected what the RBA planned to achieve by reducing interest rates. A declining trend since 2018 means that interest earned from loans are constantly decreasing compared to the interest it pays its account holders – a concerning fact that goes to show that economic policy may not always deliver results that were desired.

Is Macquarie Different?

The big 4 banks generate close to 90% of its revenues from Australian operations, and the remaining from New Zealand. The biggest segments as we mentioned earlier are business lending and consumer lending. Macquarie on the other hand is an investment banking institution. While Australian operations generate the most revenue, the firm is well diversified with operations in the USA and APAC and EMEA regions.

Banking and financial services make up just 17% of its revenues, while other investment banking activities make up the rest. The below chart shows how different Macquarie is to the big 4 bank stocks.

The investment banking industry is a mature industry as well. However, it is still forecasted to grow at 1.6%. Goldman Sachs have already reported an increase in M&A transactions this year – mainly led by tech firms. Increased M&A mean opportunities for investment banks. MQG seeks growth opportunities in Asia as the demand for asset management is expected to be high as the emerging markets are forecasted to grow and eventually over-take the OECD this decade.

The return Macquarie has generated on its assets and equity show just how resilient it has been with a diversified business compared to the big 4 banks.

The Bottom Line

The big 4 are heavily reliant to increased lending in the coming months. While increased lending may increase volumes, the risks associated with deferrals and bad debts will only increase. CommBank has been the best performer amongst the big 4, however still not good enough – the metrics reveal a firm and industry is in steady decline. Customer remediation costs, alleged breaches of money laundering laws, etc. have plagued the industry and the profitability of the banks are estimated to continue to decline. The big 4 banks may thus never see the highs that it was trading at prior to the pandemic.

Macquarie on the other hand is not exposed to low interest rates and lending as much as the big 4. MQG generates most of its revenues from investment banking activities. The performance of the firm during the crisis is pretty strong as it has recovered close to all of the losses incurred in share price. Our report on Macquarie analyses the firm in detail and gives investors an idea as to how they have performed historically as well.

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