The Commonwealth Bank (CBA) was the only bank to report its full year results in the August earning season. However, the trading updates for National Australia Bank (NAB) and Westpac (WBC) still gave a good glimpse into their respective businesses particularly on the margin front and it seems their margins have come under pressure.

NAB's trading update missed market expectations but so too its net interest margins, or NIM, failed to surprise to the upside.  Operating expense guidance was also increased and in line with Morningstar's 3.5% expense growth forecast for the bank. The bank also increased its cost forecast for 2022 by 1%.

Westpac’s third-quarter trading update was scant on its costs and profit numbers, however, the bank provided details on its credit quality with home loan arrears trending lower in the quarter with 70% of their borrowers ahead on mortgage repayments.

And while CBA reported no benefit to the recent rate increase on its margins - NIM fell 18 basis points to 1.9% for the year off the back of stiff price competition - Morningstar bank analyst Nathan Zaia expects the lender along with the other banks to pass on the expected future cash rate rises to borrowers but not to savers.

According to Zaia the June half was the bottom for bank margins.

“Despite ongoing competition on loans and deposits, recent cash rate increases which have been passed on in full to borrowers is expected to see bank margins increase. The major banks in particular, which get the benefit of having more transaction savings attracting little to no interest, should benefit the most,’ Zaia says.

A robust outlook

This positive leverage to rising rates will not only help bank margins, but the growth outlook remains relatively robust for the big four.

Underpinned by growth in its home and business lending a well as a rise in deposits, cash profit for NAB rose 6% over the quarter.  Zaia forecasts the benefits of customer deposit funding and returns on deposit and equity portfolios will see NIM rise for the bank to 1.8% by fiscal 2024.

CBA also reported a boost in growth and even took market share in both retail and business deposits. In the last 12 months, the bank grew loans by 8%, and customer deposits by 12%. “The bank is not doing it with price either, benefiting from investment in digital offerings to differentiate and headcount to ensure a positive customer experience,” Zaia says. On his numbers, CBA’s margin is expected to grow 2.1% by fiscal 2025

In comparison, Westpac lagged on deposit and loan growth. In the June quarter, Westpac’s household deposits grew 0.3%, compared with 1.1% across all the banks. “We suspect Westpac has simply not competed as aggressively as some smaller lenders for term deposits to help protect margins,” Zaia says.

Going forward, he believes its margins will improve off the back of improving loan approval times and expects the bank to get back to loan growth in line with market, 3%-4% per year. The bank also remains on Morningstar’s Best Stock Ideas list

“With leverage to rising cash rates, cost out opportunities, good credit quality and a sound capital position, we think the market is too pessimistic on Westpac’s earnings growth,” Zaia says.

He acknowledges that it has taken longer than expected for Westpac to improve its home loan approval process, however, he believes the bank will get there soon and be able to grow in line with market. “We think the margin story has become much more important than growing volumes as system credit growth slows,” however, he warns that the bank needs to have its house in order to handle an expected rise in refinancing activity.

Early days for bad debts

A shadow over the banks is of course the quality of their borrowers and lending book. However again the August earnings season highlighted that bad loans to date do not pose a risk for the banks.

Zaia notes that arrears trended down again in the recent results with loan to value ratios in the mid 40% range for the major banks. The banks also reported large repayment buffers while loans written in 2021 and 2022 had serviceability buffers of 2.5% to 3%.

“We don’t expect bad debts to rise beyond long-term averages,” Zaia says, however, he cautioned that it is still early days to gauge the impact of the central banks raft of cash hikes with more to come.

“Rising interest rates and inflationary pressures are expected to put pressure on home and small business owners. It probably takes a few months to see signs of borrowers falling behind.”

On the dividend front, Zaia is also relatively positive.

“The dividend outlook is reasonably good, the banks have reset payout ratios to more durable levels, and there have been some headwinds to strong capital positions which will unwind.”