A View on Banks

About the Author - David Walker

David has over 20 years experience in economics, equities research

and funds management. He joined Clime Asset Management in 2013
and is Clime’s Portfolio Manager for the ASX’s large companies:
the ASX 50 (including Australia’s largest banks). He also chairs
Clime’s Macro Committee, produces Clime’s economic forecasts and
co-manages the StocksInValue ASX Model Portfolio.

David’s articles and commentary can be found in The Australian,

Sydney Morning Herald, ABC Business, Money Magazine, ASX
website, SBS News, Livewire Markets among many other online and
print media.

1 | A View on Banks
We retain a cautious stance on ASX major banks, which sees us likely to rotate to other stocks with more earnings
and dividend growth as we identify them. In 2018 the only realistic role for banks in portfolios is steady fully franked
dividends, with the shares unlikely to rally given the many headwinds to earnings discussed in this report. Our
valuations at the time of writing are:

FY Earnings Per Price-Earnings Valuation Per Share

Share Forecast Multiple (PER) Range
ANZ $2.35 11.5-12.0x $27.03 - $28.20

CBA $5.50 12.0-12.5x $66.00 - $68.75

NAB $2.40 11.5-12.0x $27.60 - $28.80

WBC $2.44 12.0-12.5x $29.28 - $30.50

Figure 1. Major banks’ EPS and Valuations estimates - ANZ, CBA, NAB, WBC
Source. Clime and StocksInValue

Dividends - Key messages

Major bank dividends are largely safe as long as there is no surge in bad debts expense. We do not expect this
given surveyed business conditions are good, employment continues to grow, consumer confidence is gradually
improving in response, and Australian interest rates remain at historic lows with the Reserve Bank unlikely to raise
its cash rate until 2019.

The problem for investors is bank shares are unlikely to rally while earnings growth remains soft and slows further.
During this period, banks cannot be expected to contribute meaningful or consistent capital growth to portfolios,
which underlines our central point that their only realistic role in portfolios in 2018 is steady fully franked dividends.
ANZ has the sector’s strongest capital position and is likely to raise its dividend in 2019. Westpac should also
be able to lift its payout in 2019 but CBA’s dividend is more likely to be flat given regulatory capital constraints,
elevated regulatory and compliance costs, and some loss of operating momentum.

National Australia Bank remains the bank most likely to cut its dividend given its excessive dividend payout ratio
and diminished stock of surplus franking credits. Reintroducing a discount in the dividend reinvestment plan is
a more likely first move if NAB decides to accumulate more capital faster. Trading on a dividend yield nearly one
percentage point higher than the other three majors, NAB is priced for a dividend cut. Should this happen, the
stock would probably rally as the most identifiable risk comes out of it. Over recent years, ANZ and BHP Billiton
both rallied when they announced their dividend cuts.

The decline of banks as portfolio stalwarts

The major banks are at the end of a 25-year super cycle in mortgage lending and are derating in the sharemarket
as revenue growth slows, margins come under pressure from intensifying competition and regulatory costs mount.
Bad debts expense is no longer a source of upside earnings surprise. While banks have longer-term options to
support interest margins and reduce operating costs, and consensus earnings forecasts have already fallen a long
way, the risks to consensus earnings over 2018-20 are still moderately to the downside. Trading multiples in the
sharemarket are no longer expensive and have fallen to levels better suited to the more difficult and constrained
future than the post-GFC pro-growth era, when higher multiples were justified. Valuations which capitalise the
value of franking credits make banks look undervalued but the discounts to value are unlikely to close while
earnings growth is soft and weakening. In short the market is correctly pricing in extension of the existing long-
term downtrends in bank return on equity:

A View on Banks | 2
Figure 2. Long-term downtrend in bank returns on equity
Source. Macquarie Research

At some point banks will become oversold or fundamentals will stop deteriorating. Our base case is bank earnings
multiples stabilise around current levels but consensus earnings per share forecasts drift moderately lower.
Unrelated macro events could push multiples too low, where bank de-risking is not fairly priced in.

Acknowledgement
While the analysis in this note is our own, we make extensive use of the excellent graphs and charts produced by
Macquarie Research’s bank analyst team, to whom we are grateful.

Key value drivers

Twelve key matters affecting bank earnings, dividends and valuations in 2018 and 2019 are:

1. The end of the home lending boom

2. Interest margins set to fall
3. Subdued growth in business lending
4. Scrutiny of misconduct, pricing and competition
5. Oligopoly pricing power under pressure
6. Technology, its costs and opportunities
7. World economic and financial conditions (especially unemployment and interest rates)
8. Bottom-of-the-cycle loan losses and the rebuild of collective provisions
9. Flat dividends, elevated payout ratios and varying capital management opportunities
10. Low returns on equity in institutional lending
11. Should be priced for a slower-growth era
12. Longer-term options to reduce costs.

Below we discuss each matter in turn.

End of the home lending boom

Growth in home lending bottomed in the 1982 recession then trended higher, admittedly with impressive volatility
due to recessions and economic slowdowns, for 22 years until mid-2004. Since then home lending has slowed
substantially and the post-GFC average growth rate is slower than the average since data were first recorded in
this form in 1977:

3 | A View on Banks
Figure 3. Growth in home lending by banks, 12-month basis, per cent
Source. RBA

This is a powerful and confronting headwind to bank earnings growth given mortgages contribute up to two thirds
of total loans depending on the bank. If banks cannot grow their home lending assets as quickly as before then
growth in interest income – the largest component of a bank’s revenue - is inevitably slower and dividend growth
harder.

Figure 4. The increase in home loans as a percentage of total loans

Source. Macquarie Research

A View on Banks | 4
The home lending super cycle is over because household gearing has risen to now onerous record levels, which
constrain further rises while wages growth is historically slow; interest rates have bottomed and households know
it; the prudential regulator APRA has increased the amount of capital required to be held against mortgages
and constrained growth in investor and interest-only lending; lending standards have tightened; banks have less
tolerance for high loan-to-valuation ratios; banks are avoiding lending to owners in oversupplied postcodes; banks
are exercising more scrutiny of the expenses and other liabilities of mortgage applicants; and the house price
boom in Sydney and Melbourne is over, deterring speculative investment. Over 27+ years housing lending has
trended higher to an extraordinary ~90% of GDP, so this important revenue driver has far less growth potential
than before. We expect the household sector will now de-leverage for 5-10 years.

Figure 5. Stock of loans to GDP

Source. Macquarie Research

In mid-2018 mortgage lending by banks was growing at 6% pa on a 12-month basis but the banks themselves
forecast a further slowdown to 4%. APRA, other financial regulators and government do not want to stop growth
in the supply of credit to the economy but do want to limit the buildup of further household leverage, as today’s
record household gearing would force borrowers to cut spending heavily if an external shock were to hit the
economy. APRA is particularly keen to ensure banks hold sufficient capital against their riskier investor and interest-
only lending loans, so we expect further increases in the capital banks are required to hold against these loans.
This will dampen growth in these categories by increasing their capital cost.

Figure 6. Slowing home lending growth for each major bank

Source. Macquarie Research

5 | A View on Banks
APRA has said it will remove the 10% benchmark on investor loan growth for banks that have strengthened
their lending standards. However, it has retained its 30% cap on the proportion of interest-only loans in new
home lending, and now expects banks to develop internal portfolio limits on the proportion of new lending at
very high debt-to-income (DTI) levels and policy limits on maximum DTI levels for individual borrowers. It has
said “the environment remains one of heightened risk and there are still some practices that need to be further
strengthened”. The new DTI framework will incrementally reduce total mortgage lending.

We do not expect removal of the investor benchmark to spur faster growth in investor lending, as no bank should
be growing this category at 10%+ pa. That would be more than four times faster than system growth of 2-3%
pa, requiring excessive risk-taking.

Government policies to allow negative gearing and capital gains tax discounts on assets held longer than one
year supported the home lending boom. Federal Labor says it will repeal these policies in certain circumstances
if it wins the 2019 election.

Interest margins set to fall

Since the GFC, steady net interest margins and growth in home lending volumes have been a profitable duo
for banks. Now interest margins are narrowing as home lending slows. 1H18 earnings results and management
commentary confirmed margins have peaked given increasing price competition for new owner-occupier loans,
the only category with steady growth and the most attractive category to banks given the potential to build a long-
term relationship with the customer. Switching from interest-only home lending (higher interest rate, loan isn’t paid
off) to principal & interest (lower interest rate, borrower repays loan as fast as possible) is another margin headwind.

Wholesale funding costs are rising from cyclical lows as US and Australian bond yields gradually trend higher.
Political pressure, AMP’s public shaming and regulatory scrutiny of competition are making it less acceptable for
banks to re-price home loans in response to rising funding costs. We expect average falls in bank interest margins
of 4-5 basis points in 2H18 and FY19. As the worst political heat from the Royal Commission passes later this
year, banks might feel more confident about repricing mortgages if wholesale funding costs keep rising.

Trading and markets income will remain a volatile, low-value component of interest income.

Figure 7. Long-term downtrend in interest margins

Source. Macquarie Research

A View on Banks | 6
Subdued growth in business lending
Business lending, while volatile on a monthly basis, has not consistently accelerated to offset the slowdown in
home lending. Australian business conditions are at a 10-year high, business confidence is above average and
business gearing is low, creating expectations of an improvement in business loan growth. But business conditions
have been favourable for several years without translating into a material acceleration in credit growth. Bank
lending to businesses has recovered to only GDP-style rates of growth since the GFC and remains way below
historical averages:

Figure 8. Growth in business lending by banks, 12-month basis, per cent

Source. RBA

After a small recovery from the GFC, disillusionment with political dysfunction in Canberra caused the 2013
slowdown then there was another recovery, then lending faded again as consumer confidence and spending
remained restrained in response to record slow wages growth, record household leverage, the rising cost of
essentials, cooling residential property markets and memories of the GFC. Also the general appetite for debt has
declined since the financial crisis. We expect growth in business lending in 2019 of around 5%. Faster growth than
this is not in consensus forecasts and could trigger a partial re-rating of banks.

Figure 9. Weak revenue growth for banks in 1H18

Source. Macquarie Research

7 | A View on Banks
Scrutiny of misconduct, pricing and competition
Banks have always been unpopular in Australia and there seems to have been as much bank bashing in the
popular media of the 1890s as today. The strong contemporary public distrust of the sector began with the mass
closure of bank branches, to drive cost savings, in the 1990s then worsened as banks started to move mortgage
rates independently of the RBA cash rate. Today the combination of political and regulatory scrutiny as the Royal
Commission reveals customer mistreatment is demonstrably influencing management decision making. We think
the current uncertainty weighing on share prices will continue until final recommendations are released by the
Royal Commission, the Productivity Commission enquiry into competition in the financial sector, and the ACCC’s
investigation of mortgage pricing.

We expect these inquiries to result in more responsible lending, slower loan growth, less interest income, more
pressure on fees, customer refunds, higher compliance and regulatory costs, structural change in mortgage
and wealth management advice and revisions to management objectives and incentives. The implications for
competition and the majors’ retail pricing power are harder to predict, while material fines and/or loan forgiveness
are tail risks that are difficult to estimate. Consensus estimates have captured most of the downside risks to
earnings and growth prospects but have another round of downgrades to go as the recommendations from the
enquiries emerge.

The Royal Commission’s recommendations will add to existing trends for banks to be increasingly cautious about
how much they lend to mortgage borrowers. Sales cycles, both in bank proprietary channels and mortgage
brokers, are already lengthening. It will be harder to get a home loan and the amounts lent will be smaller. This will
weigh on house prices and further reduce home lending growth and bank earnings.
It is however important to appreciate how much lending standards have already improved. Before APRA in 2015
mandated the use of a 7.25% interest rate in mortgage serviceability calculations, major banks were already using
7.00% to reduce their risks as booming house prices peaked. Today standard variable mortgage rates are still only
4-5%. More recently, the household expenses and additional liabilities of loan applicants have received increased
scrutiny and this trend has further to run. Banks have also reduced their tolerance for high loan-to-value ratios and
cut lending to riskier postcodes. Debt to income is the latest theme promoted by APRA and is already influencing
credit decisions.

Also most of the behaviour exposed at the Royal Commission is historical and the banks have programs underway
to remediate it.

Government and regulatory responses to the enquiries are very unlikely to be too aggressive. It is not in Australia’s
interest for its policy-makers and legislators to cause such a slowdown in credit that house prices fall precipitously,
households are unable to de-leverage gradually and household spending contracts. Also, the intention of bank
managements remains to supply sufficient credit to the economy. Regulators will be further concerned not to steer
too many borrowers into the lightly regulated non-bank sector, where lending standards are lower and interest
rates higher. For all the failings of the major banks, at least they are regulated, intensely scrutinised, increasingly
transparent and more cautious than before.

Penalties, levies, fines and other mechanisms to exploit the national loathing of banks to augment government
coffers are probable and would detract from consensus earnings. The bank levy launched in the 2017 Federal
Budget is currently reducing bank interest margins by ~3 basis points.

Oligopoly pricing power under pressure

The major banks have had strong market positions since the deregulation of the Australian banking system in the
1980s, then the ‘Four Pillars’ official policy of the early 1990s entrenched this. Along the way, the industry became
more of an oligopoly with progressively stronger pricing power as the State Bank of NSW, Bank of Melbourne,
Advance Bank, St George and BankWest all became owned by the majors, which emerged from the GFC in their
strongest position ever with 90%+ market share of new mortgage lending. This is one main reason why 2009-15
was a golden era for bank shareholders. The remaining independent regional banks had less access to wholesale
funding markets during the crisis and have laboured under tougher capital standards since.

A View on Banks | 8
Over the last 10 years the majors have used their oligopoly pricing power to raise rates on owner-occupier and
investor loans relative to the cash rate by averages of ~190bp and ~240bp respectively, according to broker
estimates. The increase in wholesale funding costs in 2018 perhaps justifies another round of repricing but is
harder this time given public and political scrutiny, AMP’s scandals and the potential for adverse outcomes from
the Royal Commission, the Productivity Commission and the ACCC. Later in 2018, the banks might be able to
get away with re-pricing if 2H18 margin decline is worse than expected and political and regulatory pressure has
abated.

Technology - its costs and opportunities

Today’s retail and business bank customers expect instant and seamless transactional banking across all their
devices, the ability to apply for banking products online and while mobile, and fast approval of applications. Banks
that do not provide as much functionality as peers will lose market share. The pace of change is rapid and costs
per bank run into the billions but there are also new revenue opportunities from reaching customers through new
digital channels and there are cost savings from the automation of manual processes.

Banks also need to reduce revenue share losses to fintech disrupters. To date banks and their brokers have largely
had the loan value chain to themselves but technology majors are going to take part of that margin off banks.
Banks can respond but this will be an extra defensive cost and extra returns will come only with a lag.

The questions are the rate of return (extra profit) on technology investments and the period over which this is
measured, or how long it takes for payback, remembering banks capitalise some of their technology investment
rather than expensing all of it in the year incurred. We think that while technological innovation, upgrades and
automation are necessary, most of the gains will be competed away by rival banks achieving the same standards
and functionality. We also think the timeframes for returns will be longer rather than shorter given banks will need to
lift near-term investment before they can pursue staff reductions. The current example here is NAB, which plans to
deliver annual expense savings of $1bn by 2020 by automating 6,000 positions at an upfront cost of $500-800m
in redundancies and technological investment.

Capitalising technology costs inflates earnings in the year the costs are incurred, then the capitalised costs are
amortised over periods specified in accounting policies. Given the large size of the capitalised balances, there is
the risk of negative earnings surprises from writeoffs if technology programs are suddenly rendered obsolete or
unsuccessful by mistakes or rapid technological change/disruption.

Figure 10. Bank capitalised software balances

Source. Macquarie Research

Software amortisation expense has risen faster than total earnings, highlighting the increasing drag on bank
earnings of staying competitive in technological functionality and the upfront costs of digitisation and automation:

9 | A View on Banks
Figure 11. Bank software amortisation expense
Source. Macquarie Research

World economic and financial conditions

Despite investors’ experience since the 1990s, banks are not perpetual motion machines which necessarily
churn out flat or higher dividends most years. Instead banks are leveraged plays on the host economy because
their loan impairment expense is sensitive to household and business cashflows and because borrowing is also
cyclical. Owning bank shares implies a positive view on economic growth, employment, household debt-servicing
capability, business confidence and conditions, and credit quality. Devoting a large proportion of the portfolio to
banks implies a stronger positive view.

Our outlook for the economy regarding banks over the year ahead is for:
• GDP growth to accelerate to 2.75% pa but fall short of the RBA’s 3%+ forecasts as households de-leverage
and rebuild savings. Private consumption will grow but disappoint
• The unemployment rate to fall to 5.3% - still too high to drive widespread wages acceleration
• Credit quality to remain historically strong but deteriorate marginally as some mortgaged households fall into
arrears and bank hardship programs
• Business lending to accelerate modestly but home lending to slow from 6% pa to 4%pa.

At their half-yearly presentations the banks were largely positive about economic conditions:

A View on Banks | 10
Figure 12. CBA’s economic forecasts
Source. CBA 1H18 result presentation

Figure 13. Good business conditions but falling house prices to weigh on home lending
Source. NAB 1H18 result presentation

11 | A View on Banks
Figure 14. Generally positive economic conditions but consumers are constrained and lending is set to slow
Source. Westpac 1H18 result presentation

Bank share prices will remain sensitive to offshore financial and economic news, especially the overnight lead from
Wall Street. We expect no material increase in interest in the sector from foreign investors and not much more
interest from local fund managers other than by those investing for income on behalf of clients. The marginal buyer
of banks is and probably will remain the retail/SMSF investor seeking franked dividends.

Bottom-of-the-cycle loan losses and rebuild of collective provisions

The major banks’ impairment charge for bad and doubtful debts was ~14 basis points (0.14%) of loans in
1H18, in line with the cyclical low of ~14bp in 2H17. Credit quality is sound but home loan arrears and stressed
exposures are increasing gradually from a low base as inflation in the cost of essentials exceeds wage growth
for many households. Loan impairment expense could reach ~16bp in FY19 and ~20bp in FY20 as provision
writebacks cease and collective provision coverage starts to increase for the first time since 2010. In the case of
Commonwealth Bank in particular, the proportion of arrears attributable to Western Australia is 18%, well above
the state’s 10% population share. This reflects the economic pressures on households from job shedding in the
mining industry since commodity prices and capital expenditure peaked in 2011-12.

A View on Banks | 12
Figure 15. Home loan arrears (90 days past due) continue to deteriorate gradually
Source. Macquarie Research

Given stable unemployment and low interest rates, bad debts expense could stay lower for longer. Lending
standards have improved, average buffers in bank mortgage loan books are wide, riskier investor and interest-
only lending have fallen in proportion, customer switching back to principal & interest will see principal paid back
sooner, employment growth continues and the RBA is unlikely to tighten monetary policy any time soon. The
point is there are unlikely to be any more positive earnings surprises from reported bad debts expense less than
market expectations, which removes a reason for banks to rally. The sell-off in CBA shares after the 3Q18 trading
update is an example. While credit quality was mostly stable, declining bad debts expense no longer offset soft
revenue and higher operating expenses. Further, the sector’s imminent adoption of IFRS9 accounting standards
will increase collective provisioning for impaired loans as banks conservatively factor various economic scenarios
into their modelling.

Figure 16. Loan impairment expense, as a percentage of total loans, has already fallen far
Source. Macquarie Research

13 | A View on Banks
Figure 17. Collective provisions, as a percentage of loans, have already fallen very far and can no longer create positive
earnings surprises
Source. Macquarie Research

Flat dividends, elevated payout ratios and varying capital management opportunities
The 1H18 bank reporting season saw a marked divergence in the majors’ CET1 ratios, which measure the ratio
of common equity tier 1 capital, the highest-quality type of bank capital, to loans. ANZ finished its first half with a
proforma CET1 ratio of 11.0%, already above APRA’s 10.5% target for January 2020. Westpac was on-target at
10.5%, NAB was at 10.2% and CBA’s ratio on 31 March was just 9.8% after APRA’s imposition of an extra $1bn
capital charge for operating risk.

While NAB and CBA should reach the target before the 2020 deadline, capital generation is currently slow for NAB
given its excessive dividend payout ratio, which was 100% of statutory earnings in FY17, will be 92% for FY18
and will still be 80% in FY19. In contrast ANZ is at a comfortable 67% in FY18 with CBA at 78% and WBC 76%.

CBA, NAB and WBC are unlikely to have meaningful excess capital without further asset sales, which leaves
ANZ the only major with sizeable capital management options in FY18 and FY19, when we forecast buybacks of
$4.5bn. Likely increases in regulatory mortgage risk weightings will increase the capital intensity of retail banking
while uncertainty about the earnings and capital consequences of the Royal Commission’s recommendations will
encourage boards to take a more conservative approach to capital management. Small special dividends by CBA
and WBC are possible for FY19 but unlikely. Instead these banks will likely pay flat or incrementally higher ordinary
dividends.

Assuming stable economic conditions NAB should be able to hold its ordinary dividend flat until the end of FY20,
when the dividend payout ratio should be down to a more acceptable 78%. NAB’s currently high payout ratio
leaves it the bank most likely to cut the ordinary dividend if earnings deteriorate suddenly, which would be in
response to an economic shock from outside Australia and a surge in bad debts. CBA and WBC are also unlikely
to cut their dividends in the absence of an upturn in bad debts but elevated payout ratios limit the prospects for
dividend growth. Despite a more modest outlook for asset growth, which means less capital is needed to back
loans and more is available for dividends, the decline in earnings growth rates means payout ratios need to fall
at CBA, NAB and WBC before dividend growth faster than low single digit can resume. Having previously cut its
dividend, only ANZ has clear headroom to grow its FY19 dividend at mid-single digit.

A View on Banks | 14
Figure 18. Elevated dividend payout ratios at CBA, NAB and WBC
Source. Macquarie Research

For CBA, NAB and WBC, special dividends and buybacks are more likely in FY20 or FY21 after APRA’s capital
target has been met and increased risk weights for mortgages have been digested. As yet there is no timetable
for the regulator to lift its $1bn operating risk charge from CBA, which will first have to satisfactorily address all 35
demands in APRA’s prudential inquiry report.

Low returns on equity in institutional lending

Returns on equity in retail mortgages, where the major banks have large market shares, economies of scale and
reasonable pricing power, can be as high as 30% but are generally less than 10% in institutional (large corporate)
lending. In this segment foreign banks easily import cheaply sourced foreign capital to Australia and drive prices
down to marginally profitable levels. Currently foreign banks are chasing institutional customers in the booming
infrastructure sector, where ASX major banks would also like their fair share. The UK’s Barclays, Dutch lender
ABN AMRO and Italy’s Intesa Sanpaolo all plan returns to the Australian market, adding to Asian banks already
competing and sharpening prices here.

ANZ is increasing its profitability by de-risking and shrinking its institutional loan book, and we expect CBA to head
in the same direction. In our view the four major banks do not have a sufficient case to grow their low-returning
institutional banking businesses when this would dilute group returns on equity, and it is unlikely they will develop
sufficient competitive advantage to justify growth strategies.

Should be priced for a slower-growth era

Since 2000, when banks benefited from rising household leverage and oligopoly pricing power, the major banks
have traded at an average price-earnings ratio (PER) of ~12.5 times. The slower growth and profitability pressures
of the future now justify a sector derating to a multiple more like 12.0 times with downside to 11.0-11.5 times
if fundamentals deteriorate further, for example due to an economic downturn, adverse regulatory outcomes,
reduced pricing power or disruption to an important revenue stream. For example, the chart below compares
CBA’s PER since 1999 (grey line) with its average since 2014 (black line). From here the multiple should not be
as low as during the 2008-09 GFC and 2010-12 Eurozone debt crisis, when banks were priced at 10-11.5 times
for frozen or sharply more expensive funding markets, but should settle around 12.0-12.5 times. With an FY19
earnings per share forecast of $5.50, this gives a valuation of $66.00-$68.75.

15 | A View on Banks
Figure 19. CBA price-earnings ratio, 1999-2018 (grey line), and its 2014-18 average (black line)
Source. Credit Suisse

Longer-term options to reduce costs

In the new era of slowing revenue growth, heightened price competition in mortgages, bottoming loan impairment
expense, disruption in payments, diminished oligopoly pricing power, rising technology costs and elevated
legal, regulatory and compliance costs, banks will have to look to operating costs, especially the automation
and digitisation of manual handling and processing, to sustain earnings and dividend momentum. NAB has
acknowledged this reality with its major staff cuts announced with the FY17 result, but the 5-8% increase in NAB’s
costs in FY18 is the start of a new trend we expect: banks will have to lift near-term investment before they can
pursue material staff reductions and close legacy systems. This applies to ANZ should it seek a new round of cost
savings and it certainly applies to CBA and Westpac, which have not yet embarked on large-scale staff reductions.

While ANZ has now reduced operating costs for the fourth consecutive half, the 1H18 bank reporting season
largely left us less confident about cost control at the other majors. The scale of NAB’s program is matched by
a similar risk of delays and disappointment, while Westpac is limiting itself to incremental productivity gains and
CBA is no longer able to deliver positive ‘jaws’ (revenue growth faster than costs growth) every half. Other than at
NAB we see little prospect of material reductions in cost-to-income ratios or step changes in total costs over the
next three years. Banks have already achieved impressive gains in cost efficiency but now seem unable to drive
further gains:

Figure 20. Major banks cost-to-income ratio

Source. Macquarie Research

A View on Banks | 16
Longer-term sources of earnings upside centre on new approaches to cutting costs. Australian banks have over
30% more branches per capita than foreign peers despite Australia’s highly urbanised population, so closing
branches could become an option as more transactions and approvals migrate online and the use of cash
declines. Australian deposit rates are also far higher relative to the central bank’s cash rate than in other countries;
ASX banks could be forced into managing these deposit margins better, especially if they need less funding for
slow loan growth.

Given staff expenses are 50-60% of costs, ultimately this will have to be the source of further material gains in
cost efficiency. Over the next 5-10 years we expect to see a substantial reductions in positions doing manual
handling, processing and low value-add activities, partly offset by growth in IT positions which oversee investment
in automation, predictive/artificial intelligence and potentially robotics.

ASX Major Banks - Investment Cases

A cautious stance that reflects banks’ diminished role in portfolios
Given we expect little capital growth from banks over the year ahead, the (at the time of writing) 13% allocation
to the sector in our model portfolio reflects our appetite for dividend income from this source, and some value
support now banks have derated. We rate the sector a funding source for stocks with more earnings and dividend
growth potential.

ANZ - Investment Case

• The sector’s strongest capital position and most sustainable dividend payout ratio. This allows ANZ to support
its share price by buying back shares in the market and gives it the most scope to raise dividends in FY19.
ANZ is also best-positioned to sustain its dividend if earnings suddenly deteriorate.
• Best record and momentum on costs. ANZ has reduced the absolute level of costs for four consecutive halves,
a stronger outcome than merely achieving positive ‘jaws’ (revenue growth faster than costs growth), but still
has the highest cost-to-income ratio of the four majors. This leaves room for ANZ to reduce expenses further.
• Improving risk profile in business banking as the institutional book is de-risked and non-core businesses
without scale and competitive advantages are sold.
• But still the riskiest loan book of the majors. ANZ has the sector’s highest exposure to institutional (large
corporate) lending. The smaller number of large clients makes loan impairment expense lumpy and strong
competition in this category makes group interest margin management harder. For these reasons we see value
for ANZ in the lowest PER range of the four: 11.0-11.5 times.
• Questionable growth strategy in mortgages. As ANZ withdraws from its failed Asian expansion strategy it
seeks to increase share in Australian mortgages. The price discounting and lending standards required to
achieve this require scrutiny.
• Differentiated approach gives ANZ the most ROE upside. ANZ’s New Zealand institutional banking business
is the jewel in its crown because a higher weighting to large corporate services like cash management,
as opposed to balance sheet lending, increases return on equity. Should ANZ achieve a similar mix in the
rest of its institutional business, shareholders would see material improvements in ROE. As ANZ shrinks its
institutional loan book and rotates to Australian mortgages, ROE will improve.
• Revenue and margin pressure in 2H18 and FY19 as mortgage lending slows and banks compete on price
over what remains.
• Somewhat less exposed to conduct and competition enquiries given lower weighting to retail and SME
banking.

17 | A View on Banks
CBA - Investment Case
• Declining ROE with downside risk to interest margins: Return on equity was ~18% in FY15 but is set to fall
below 15% in FY19, where its premium to peers is lower, due to increasing competition in mortgages and
slower home lending volume growth through the cost structure. Interest margins will keep trending lower.
Potential downside to revenues, volumes and margins from the Productivity Commission and ACCC inquiries
is not reflected in consensus estimates.
• Conservatism on capital management: The organisation’s capital and risk management culture is conservative.
CBA is unlikely to pay a special dividend until it has more certainty on when it will be able to persuade APRA
to lift all of the $1bn capital impost for operating risk after the regulator’s prudential inquiry found multiple
deficiencies in governance, culture and accountability. Capital generation is healthy: CBA accumulated 37bp
of tier 1 capital in the March quarter alone.
• Slower housing loan growth: CBA’s weighting to mortgages and strong retail franchise made it a major
beneficiary of the mortgage super cycle but this period is over and CBA’s loan growth will slow further.
• Little scope to surprise positively on loan losses: Loss rates are near historic lows of ~15bp of loans and
collective provision coverage is now set to rise.
• Flat dividend given full payout ratio and asset sales: CBA’s sale of its life insurance business and upcoming
IPO of Global Asset Management bolster regulatory capital but reduce earnings. Combined with a full dividend
payout ratio of 78% in FY18, this spells flat dividends.
• Consequences of misconduct: We see potential for adjustments to sales and growth strategies, incremental
share loss from brand damage, ongoing process and remediation costs, more intrusive scrutiny by APRA, and
adverse consequences from the Royal Commission, APRA prudential inquiry, PC and ACCC inquiries.
• CBA no longer deserves much of a valuation premium to peers. Our earnings multiple range for valuation is
12.0-12.5 times, the same as peer mortgage-heavy bank WBC. Although the latter has a better record of
managing operating risk, we think time will demonstrate the resilience of CBA’s retail and SME franchises.

NAB - Investment Case

• NAB back to its best: After a wasteful, draining and distracting 20-year misadventure into foreign banking and
wealth management, NAB is finally back as Australia’s best-positioned business bank. Today, revenue growth
demonstrably flows from management initiatives to win and retain more business customers. NAB is also now
lower-risk and less complex. However the turnaround is now done and has no more upside for consensus
estimates.
• Lower earnings and ROE in FY18, uncertainty for FY19-20: NAB’s acceleration of technology spend and
redundancies will cut EPS and ROE in FY18. We see risk NAB will fall short of its FY20 cost savings targets,
and/or cause operational problems along the way, given the ambitious scale of the program. Because NAB is
catching up after years of underinvestment in technology, due to management distraction exiting foreign banks
acquired in the 1990s, it might have to increase digital spend further than currently planned.

A View on Banks | 18
• Questionable potential for faster business lending: The fundamentals here have been supportive for some
years but business lending is yet to sustainably accelerate and remains volatile month to month. Admittedly
NAB has clean leverage to any improvement. Meanwhile home loan growth is slowing and retail bank margins
have peaked. Revenue growth will be low single-digit in coming years.
• Solid credit quality and assessment: NAB’s group loan losses were less than 15bp and in line with peers
despite its higher weighting to riskier business loans. This signals strong credit quality in the economy and also
means NAB is managing its risks in business lending.
• Flat dividends for at least three years: The FY18 payout ratio of 92% of statutory earnings is too high for a
leveraged business like a bank, especially the one with the leading share in risky small business lending. To
reduce the payout ratio to a more comfortable 78% NAB will have to hold its annual dividend flat at $1.98 until
at least FY20, with the constant risk of a cut.
• In our view NAB’s advantages and disadvantages equate to a 11.5-12.0 times earnings multiple, the same
as ANZ.

WBC - Investment Case

• Margin compression in mortgages: WBC has the sector’s highest weighting to mortgages at 68% of the
loan book. Home loan repricing boosted interest margins in 2H17 but margins will peak in 1H18 given price
competition for new loans, switching from interest-only to principal & interest, and reduced scope for further
repricing given political pressure on the sector. There is more downside risk to margin and revenue growth
forecasts than upside.
• More exposed to conduct and competition enquiries given greater weighting to retail and SME banking.
More responsibility in lending will dampen housing loan growth. Remediation costs and fines from the Royal
Commission findings could be higher. Oligopoly pricing is at some risk from the Productivity Commission and
ACCC inquiries.
• Retail bank profitability is in trend decline unless cost and productivity gains can be found to offset.
• Increased capital intensity of retail banking: WBC’s overweight to mortgages, especially interest-only, makes it
the bank most exposed to APRA’s new capital proposals, reducing its future capital generation.
• A settled strategy with the sector’s lowest execution risk. Unlike the three other majors WBC does not face
upheaval, forced change, major restructuring or divestments. Its management team and strategy are delivering
consistent results in a tough environment. This appeals.
• Low risk of a dividend cut or further equity raisings: WBC has reached APRA’s ~10.5% capital target without
having to sell assets to release capital sales, and the dividend payout ratio is not excessive. However the bank
does not have surplus capital to return to shareholders.
• Barriers to a re-rating: political and regulatory scrutiny, higher capital intensity and the end of a 25-year
mortgage super cycle.
• Weighing all these considerations we think WBC deserves a PER range of 12.0-12.5 times.

19 | A View on Banks
If you wish to further your knowledge in investing, Clime offers an extensive program of educational events
throughout the year. These are run by various members of the Clime Investment and Advisory Team, covering
topics such as:
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• SMSF administration and Estate Planning
• Macro economic outlook and forecasting
• Alternate asset classes
• Investing outside the ASX 200
• Valuing banks and other large-cap stocks

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1300 788 568

A View on Banks | 20
Clime Asset Management Pty Ltd
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Published June 2018