Brighter picture for big four banks

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Lex Hall: Trading updates and results from Australia's major banks have underlined improving economic conditions. I'm joined today by Morningstar's senior banking analyst, Nathan Zaia. We're going to discuss the outlook for the banks, the outlook for dividends and of course, that move by the Bank of Queensland to acquire ME Bank and what it means, if anything, for Australia's banking landscape.

Nathan, welcome again. It's been a while since I've spoken to you.

Nathan Zaia: It's good to be back, Lex.

Hall: Now, what did you make of these updates and results? What stood out? Were there any surprises?

Zaia: Yeah, I think, overall, there were two key themes that were better than what we were expecting, and they were on the net interest margin and on the loan losses or the provisions for loan losses. So, on the net interest margins, we know low cash rates and the new lending rates are much lower than their back books. So, that's an ongoing headwind to the banks' margins. But we didn't expect how much of it they could offset from the transition to more of their funding coming from deposits. And we're seeing customers, the savings ratio now above 20 per cent. So, a little more people putting their money in the bank. We can't spend it like we usually do. And that's allowing the banks to be less competitive when it comes to pricing term deposits. And there's been a lot of savers who have said term deposit rates are so low, I might as well just put my money in a transaction account and have that flexibility. So, that's been a driver that we didn't expect to be so positive, that net interest margin management.

And the second one on the loan losses. So, we were thinking the banks put quite a bit aside for the losses we think will be coming and we expected that to fall this year and next, but still be relatively high as the losses started to come through and they kept a decent provision balance. But like you said, the economic conditions have improved materially, and loan deferrals are less than 1 per cent of their loan book now. They're seeing less signs of stress on their SME books. So, that's definitely giving a better picture when it comes to the outlook for loan losses. So, those two have driven a much brighter picture if you look at the earnings rebound.

And for Westpac, last year's loan impairments payments above $3 billion. This year, we're assuming it will be around $700 million. So, that's a big difference that flows through to the bottom line. So, we're expecting a big recovery in earnings now.

Hall: Okay. One of the big stories last year was obviously around dividends. They were slashed. What's the outlook for the banks now? It's more positive?

Zaia: Yeah, definitely. Late last year we increased our payout ratios to 65 per cent, 75 per cent across the banks. And that was when APRA came out and said, you know, there's no longer this 50 per cent cut. They still want the banks to be conservative. But if you look at the earnings recovery, the capital position the banks are in, the provisioning balances, we think it's very likely that we see a return to more normal dividend payout ratios and the excess capital they have as well now. So, most of the banks sitting on $5 billion to $6 billion in excess capital—CBA is more like 10 billion. So, that's $1.50 to $2 a share. So, we're not sure about timing-wise. There still is a fair bit of uncertainty in the outlook. But gradually, as things get better and we've got more comfort that the loan losses aren't going to be materially greater than they are provisioned for, I think, yeah, things will start to go from do the banks have enough capital to how much can they return to shareholders.

Hall: Okay. Now, you moved around—on the back of these results you moved your fair value estimates a little bit. All four big banks are now at 3 stars, or fairly valued, I think. Are they still worth investing in, do you think?

Zaia: Yeah, they're trading close to our fair values now. I mean, 12 months ago, it was very different. A little bit less than 12 months ago, I think, no one wanted to touch the big banks, right? There was just—everything seemed like it was the end of the world and their earnings would never recover. But we thought that that was the time to buy. They looked cheap back then. I mean, everyone was pricing in the downside for a long time where we thought, you know, we will get through this. They've got massive loan books. They'll generate strong profits and returns again. Not sure when it would happen. I think it's going to happen a lot sooner than we expected. But it just shows taking that long-time view can present opportunities.

So, if we do fast forward to today, still not expensive. I mean, the average dividend yield is about 4.5 per cent, and there's potential upside to earnings in the short-term if those loan losses are even lower than we're assuming. So, I definitely think there's positive momentum in the earnings. But I mean, if those earnings short-term are a lot better than we're currently budgeting for, I mean it's a great thing for shareholders. Dividends would be higher, more capital to return. But I don't think it will be material to our fair values.

Hall: Okay. Now, in other news, Bank of Queensland this week acquired ME Bank, which was formerly Members Equity. You argue that this is a good deal for the Bank of Queensland but not a big deal for the Australian banking landscape in general. Can you sort of expand on the advantages for Bank of Queensland?

Zaia: Yeah. So, for Bank of Queensland, I think, I can probably boil it down to three advantages. The first one—they've pretty much doubled their home loan book and that's—home loans in Australia are pretty profitable, good returns given the low risk weights that the banks—the amount of capital they have to hold against each loan. So, that's a positive, increasing their presence in the home loan market. They have always been overweight Queensland given their history. So, this will definitely help diversify their geographical exposure, which I think is a good thing. And the third one is the cost synergies that we think they'll be able to get out of this deal. So, they're going to have the BOQ brand, Virgin Money and ME Bank, all on the one banking platform. So, they should be able to lower their ongoing maintenance and innovation spend on the technology. So, that's definitely a good thing. And then, there's also the other costs like managerial, back office, credit decisioning, all those support, sort of, costs that they can share across all three brands. So, there's definitely opportunities for Bank of Queensland to lower their cost base and get some synergies there, and that should be a positive for shareholders. And we did increase our fair value on the back of that.

There still are risks definitely. When you're integrating these brands, you don't want to disrupt the ongoing operations of the bank as well. So, if it causes delays in your approval times, you will get dissatisfied customers. Then it sort of undoes all the good work that management has been doing in reversing their fortunes in the home loan market recently. So, there's still risks. And ME Bank, as well, coming out of ownership of industry funds, there's probably some of their customers that joined ME Bank because it was not part of a large ASX-listed bank. So, that's an area we will be watching as well—how good a job BOQ can do at retaining its customers and growing that.

An argument that it doesn't really change the or shake up the Australian banking landscape, we don't really think under BOQ's ownership ME Bank's growth trajectory really changes all that much. I mean, we think BOQ can keep the cost savings, but in terms of growing more aggressively, taking more share from the majors, we don't really see that happening. It's pretty—it's a little bit bigger than Bendigo now, pretty much on par with Macquarie. So, there's already been competitors of that size. So, that's why we don't really think it changes the outlook for the majors or even its competitors all that much. In fact, if some of those integration challenges do emerge, I think some of its competitors will be looking to pounce and take some share off BOQ's. So, it could go either way.

Hall: Okay. Nathan, thanks very much for your insights today.

Zaia: No problem. Thanks, Lex.

Hall: I'm Lex Hall from Morningstar. Thanks for watching.

This report appeared on 2022 Morningstar Australasia Pty Limited

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