Lewis Jackson: US Federal Reserve raised interest rates for the first time since 2018 last week, and many economists expect the Reserve Bank to follow later this year. Rising interest rates have put a spotlight on banks, and I'm joined today by Morningstar's Nathan Zaia to talk about the local banking sector.

Nathan, thanks for being here.

Nathan Zaia: Pleasure, Lewis.

Jackson: So, what's going on? The banking sector is up 10%, 12% since early March, more than double the wider index. Why are investors flocking to banks right now?

Zaia: Yeah, I think there's a couple of things. The first one is, in a higher cash rate environment, they tend to do better. They've more opportunity to make a larger net interest margin, so more profits. I think we've seen low unemployment and strong house prices. So, that, sort of, reduces fees about a rise in bad debts. I think the third one is, they have been undervalued like relatively to a lot of other sectors. So, I think there's a bit of a rotation out of some of those growth and sexier companies and something solid like a bank.

Jackson: Okay. So, margins, a strong economy and undervalued. On that point about margins, so investors always say rising interest rate, it's good for banks. Why? What's the logic? What's the mechanism where the RBA raising the cash rate improves bank performance?

Zaia: Yeah. So, basically, a bank is charging an interest rate on a loan, and they have to fund that loan. So, customer deposits, wholesale debt, or bonds and there's also shareholders equity in that mix. So, typically, when that rate that they're lending at goes up, they don't necessarily have the same increase on their funding costs. And the customer deposits is the key one there. So, that's 60% to 70% of their funding. And that is broken up between savings, term deposits and just money, having your transaction account, and the transaction accounts is really that Holy Grail. So, for the major banks, that's 40-odd percent of their customer deposits, and they basically pay nothing for that. So, if you think about rates going up, that cost of funding stays at basically zero, and they're just charging more and more for their loans. So, obviously, they do have a more diverse funding pool than just that. But that definitely does help them make more.

Jackson: Okay. Well, households paying for someone else's mortgage.

Zaia: Yeah. I guess, the other thing to probably call out, during COVID and during very low interest rate environments, term rate deposits have been very low. So, most people – not most – but a lot of people have just thought why lock up my money; I'll just leave it in my transaction account. So, as rates do rise, we expect that we will see some of that money flow back into term deposits. But I mean the tailwinds will be far greater than those sort of small more negatives that will probably unfold over time as well.

Jackson: The reporting season wrapped up around a month ago. Looking ahead now, what's your outlook for the Australian banking sector? Is it all just good news, rising interest rates? Are there anything that investors should be worried about?

Zaia: Well, I think rising interest rates is the good news story for the banks, but it probably won't show up in the next half year result, even the next full year. We might see some benefit in the second half for them.

Jackson: Could be 12, 18 months away?

Zaia: Yeah. And we need the rate increases to start, then they pass on the increased lending rates. But don't forget, a lot of their book has become fixed now, too. So, it's going to take time to work through those. So, there's going to be, sort of, a transition from where we're at now to what sort of margins they make in five years' time. And there's going to be timing issues around that. But I mean, we try not to get caught up with what the NIM will be next quarter or the quarter after that. It's more about the trajectory that matters most, I think.

Impairments and credit growth in a rising rate environment, that's obviously something to be aware of, but…

Jackson: And it's about bad loans, the loans going sour.

Zaia: Yeah, exactly. So, as the rate increases happen, it can get more costly for people that have loans to be able to service those loans. And it should reduce the availability of credit as well or how much people can borrow. So, how fast the total loan pool grows as well is another potential headwind.

Jackson: But do you expect that the extra margin from rising rates is going to outweigh the credit losses on the one hand and the sort of slower loan growth in general?

Zaia: Yeah, definitely. I mean, our forecast across the major banks from if we take FY '21's profit number, somewhere like 25%, 30% higher in five years' time. So, yeah, quite a big increase. But in the short term, I think we still have a little bit more downside to go. And in the last results, we did see that margin compression, but the market sort of took it in its stride, because we are starting to look a bit more forward now.

Jackson: Okay. And with the recent share price rally, around 10% in the last month, it's left only Westpac undervalued for the big four banks under coverage. Walk us through your case. What do you see that the market doesn't when it comes to Westpac?

Zaia: Yeah. I think there's probably two things. It's not that the market doesn't see them. I think we're just probably taking a slightly different approach to them or have a different view on them. The first one is on home loans. Westpac has lost a of couple percent share in the last two years. So, their market share is about 22% now. And we think it's issues that can be resolved really. Like, their approval times have been what's let them down. And Westpac, they had those AUSTRAC proceedings, they had issues with serviceability tests where they had to make changes and their systems were a lot more manual, so disrupted things. They had offshore processing, so during COVID that got shut down. And at the same time, this massive rise in applications to refinance loans. So, you got to do all this work just to hold onto a loan essentially. So, that sort of all happened at once and just compounded the problems for Westpac. But they are getting on top of things. Their approval times are improving. And we expect them to probably lag the market in the short term, and they might have to price a little bit more aggressively than some peers as well. So, that might have a bit of a margin squeeze on them. But over time, we think they should be able to digitize and automate more and more of their credit decisioning and at least be competitive with the market. They're the second largest lender. They've got a lot of resources to throw at this. Over time, we think they'll get there. So, I think that's the first one.

And the second one is – it's a bit of a cost out story at the moment, and there's some that probably just don't believe Westpac will get there.

Jackson: 8 billion is the target.

Zaia: Yeah. So, it's 8 billion excluding any one-offs or notable items which tend to always be there for these major banks. So, we don't think they get quite there. But if you look at where their cost base is now, they've spent a lot on risk and compliance and customer remediation, and a lot of those were subcontractors as well. So, they have a good line of sight like who is working to set up these projects. So, once they're finished their cost out, they can pretty quickly and easily take out. So, we think they should be able to get a decent saving there. And the second point is, over the last three years, this has become a totally different organization. They've got rid of general insurance, mortgage insurance, wealth management. They want to get rid of superannuation. So, the cost base to support the new more bank-focused group, I think, is likely to get reshaped. So, we do think they can take out a fair bit of from costs. And our cost to income ratio in five years' time is at about 45%, which is still a lot higher than what we think CBA will get to, and CBA is overvalued, in our view. So, I think the market is taking a totally different view on both.

Jackson: Well, on the point – I mean, CBA is a great example. The market loves CBA. It's outperformed for months, for years now. We do think it's overvalued. What are people getting too excited about? Why is the market being too bullish in our view?

Zaia: This is a hard one to answer. I think it's just especially retail investors just flocking to what they perceive as the safest bank, which bank has been performing the best. CBA has been growing ahead of market. And given how much of the market it already has, it's quite a feat. But they're facing the same challenges with margin pressure. I think the one good thing for CBA during all this period – they haven't had to worry about what are we going to do about costs because they are still growing. So, it does give them a little bit more of opportunity to make investments that set them up for the future and to keep leading the market in terms of offering to customers the loan approval times and the rest of it. Adding things like crypto and NBN deals and all that sort of stuff same banks – or companies in general, I should say, try to cross-sell things in the past and increase stickiness. I don't think it's going to be a material thing in this case. But yeah, I think the history of strong earnings, strong dividend payments, I think that's probably what people have flocked to. But valuation-wise, it is…

Jackson: Expensive.

Zaia: Yeah, especially compared to its other peers which are still wide moat rated banks.

Jackson: Okay, fantastic. Nathan, thank you so much for your time.

Zaia: Thanks, Lewis.