Investors willing to take the long view and look past this week’s modest trading updates from ANZ Bank and Westpac could be rewarded as the two cheaper banks cut costs and resolve the execution issues hampering performance, according to Morningstar senior equity analyst Nathan Zaia.

Net interest margins, the difference between what a bank pays to borrow and what it charges lenders, are down across all four major lenders. But where NAB (ASX: NAB) and CBA (ASX: CBA) offset the hit with more mortgages and business loans, slower approval times and other operational issues left ANZ (ASX: ANZ) and Westpac (ASX: WBC) lagging the market in loan growth and exposed to the downward drift in margins.

Short-term bumps aside, Zaia backs ANZ and Westpac to cut costs, lift services levels and improve loan processing time, giving long-term investors cheaper entry points into the banking majors.

“We expect both banks to be able to process a loan as quick and as consistently as their peers,” he says.

“We’re not talking about tiny corner stores. These are still very large banks and their ongoing investments in digital offerings to speed up processes. Eventually, they catch up.”

Zaia points to Westpac reiterating guidance for lower costs over the full year and an organisational restructure that should contribute to lower head office costs and better accountability. Recent investments in the loan approval process should have the ANZ loan book growing in line with the market from FY 2023.

Fair values and long-term earnings forecasts are unchanged across the four banks. Westpac is trading at a 22% discount to fair value. NAB closed Friday at $29.84, just above the fair value of $28 while ANZ closed $27.82 compared to a fair value of $30. Commonwealth Bank closed Friday at a 21% premium to fair value.

Mortgage hikes could rock boat in election year

Bank margins will improve as the cash rate rises over the next year or two, but how much upside the big four see will depend on the politics of passing on rate hikes to mortgage customers in an election year, says Joseph Koh, a portfolio manager in the Schroder Australian Equity Long Short Fund.

“In an election year when rates are going up that squeezes household budgets. There will be a lot more focus on whether banks raise rates by the full amount, or will the press say 'you guys didn’t pass on all the reductions on the way down, why are you passing on all the rate increases now?'”

Derivative markets are pricing in a cash rate of 1.175% by December. Economists at Commonwealth Bank forecast three rate hikes to 0.75% this year. In comments last month, Governor Philip Lowe said a cash rate rise this year was “plausible” while maintaining market pricing was aggressive.

Westpac, Commonwealth Bank and NAB are signalling margin weakness to continue into next year. Interest rates are already rising in New Zealand, so ANZ could start to see some improvement this year, says Koh. The bank earnt roughly a quarter of its cash profit in New Zealand in FY2021.

Banks diverge amid margin pressure

Intense competition, low rates and regulatory shifts are driving down margins across the big four.

In a bid to wrest market share, banks turned to low margin fixed rate lending, with many households refinancing on the cheap. Regulators now require banks to hold more low yielding liquid assets. Above all is the cash rate locked at 0.1%, keeping a lid on how much banks can charge lenders.

Margins fell between 5 and 17 basis points, or one hundredth of a percent, across the lenders. Commonwealth Bank fell furthest, down to 1.92%. NAB was down 5 basis points to 1.65%.

Strong operational performance helped both banks deliver above system loan growth and partially offset the margin hit. CBA grew its mortgage book $40.4 billion, or 1.2 times the market. Home lending at NAB was up 2.6% for the quarter, compared to 1.5% for the market. Mortgage and business loan growth at ANZ and Westpac lagged the market.

“The big differentiator between Westpac and ANZ, and NAB and CBA, was the latter two growing their loan books, offsetting a lot of that pain on the margin. Having a good offering and service levels, especially in the broker channel has been very important there,” says Zaia.

“Westpac has still grown, but it’s how they got the growth. NAB got the growth without having to give up a lot of margin. Westpac got it by pushing hard on the lower margin fixed rate loans.”

Zaia points to how Westpac took a 10 basis point hit to net interest margins from competitive pressure and housing lending versus 2 for NAB.

Commonwealth Bank reported a first half FY 2022 profit of $4.75 billion, up 23% on 1H21. Profit at Westpac was up 1% to $1.58 billion in quarter one 2022, excluding notable items. NAB notched a solid $1.8 billion cash profit for the first quarter. ANZ's quarterly update did not report on earnings.

Dividends to grow modestly to pre-pandemic levels

Banks are still handing back capital as part of buybacks announced in 2021 but investors may need to wait until FY 2024 before dividends reach pre-pandemic levels as banks work to reset market expectations lower, says Zaia.

A trend of overly generous pay-outs before the pandemic left some banks cash strapped when covid hit, forcing them into expensive equity raises at market lows.

“A lot of the banks have been guilty of paying out dividends and increasing the payout ratio too rapidly and then when something goes wrong, they need to raise equity at the worst time,” he says.

“So, I think at the moment the mindset is to try and try to avoid that and have a more sustainable dividend payout ratio.”

Commonwealth Bank announced a half year dividend of $1.75, up 25 cents versus 1H21. Zaia expects a larger second half dividend.

Australia’s biggest bank also unveiled a $2 billion on-market buyback, coming on top of its $6 buyback announced in October. Previously announced buybacks at NAB, Westpac and ANZ are set to continue, with ANZ signalling it may increase the size of its currently underway $1.5 billion buyback.