Tougher times for Australia's banks

Water-side view of the Sydney Opera House at duskAustralia’s banks, and their shareholders, have been enjoying an easy ride. Since the Reserve Bank of Australia (RBA) began slashing interest rates in 2011 there have been bumper profits and returns for shareholders have been close to 100 per cent.

But things have shifted in the last month or so. Shares in Australia’s big four banks - NAB, Westpac, ANZ and Commonwealth Bank - have all fallen more than 10 per cent from April’s peaks despite their combined cash profits after tax rising 10.7 per cent to $15.4bn.

So what's changed to make investors nervous? Several factors are at play. Australia’s banks face three key challenges; tighter margins, rising operating expenses and higher capital costs.

Diminishing returns

Another interest rate cut by the RBA in May had little effect for banks and investors. The fact is rates are already at all-time lows and there are bigger challenges facing the economy that cannot be solved by cheaper credit.

Low rates are not the boon in another sense; net interest margins are contracting, squeezing profits. Some banks have not fully passed on the recent lending rate cut to customers, such is the crunch. At 6.2 per cent, credit growth is slow and banks are competing more for what’s out there.

Banks are also having to increase their holdings of liquid assets due to compliance with new regulatory liquidity requirements under Basel III.

Costs

Costs are also rising. Average cost to income ratios for the big four increased to 43.7 per cent, according to KPMG.

Commonwealth Bank, which suffered its worst day since the global financial crisis after posting soft profits, said: “Expense growth was higher in the quarter, impacted by growing regulatory, compliance and remediation costs.”

NAB is also facing costs from the fallout of Britain’s PPI mis-selling scandal. Around $3bn is being put aside for "legacy conduct costs" in the UK, with the Australian bank looking to offload its Clydesdale Bank subsidiary by the end of the year.

Operating costs are also an issue. IT investment hit $1.3bn in the first half of the year, as the major banks invested heavily in projects designed to drive strategic change. This is likely to increase further as banks seek to remain competitive and reduce costs in the longer term. Rising personnel costs and a weak Aussie dollar added to overall operating expenses.

Capital

The completion of the Financial Systems Inquiry (FSI) in December last year is also weighing, as there is still uncertainty over future capital requirements.

Australian Prudential Regulation Authority chairman Wayne Byres says he will act "sooner rather than later" to implement the FSI’s call for the big four to hold higher capital against mortgages. NAB has announced a $5.5bn rights issue, while the others are preparing to also boost capital.

The booming property market, which is being fuelled by ultra-low rates, is seen as a source of systemic risk. The FSI wants the big four and Macquarie to raise average risk weighting on their mortgage books from 18 per cent to 25-30 per cent.

A tough economic picture and tighter capital requirements are making it hard to maintain returns on equity. This will only worsen as capital levels increase in response to FSI and BCBS.

“We face some headwinds, including modest demand, the continuing impacts of global quantitative easing, and ongoing regulatory uncertainty," Westpac CEO Brian Hartzer told Fairfax Media.

After four years of relatively calm waters, Australia's banks have a rougher ride ahead.