As bank profits come under pressure in the next year, don’t expect them to be able to resort to an old trick and cost cut their way back to normal profitability.
Buried in the second Financial Stability Review of the year from the Reserve Bank this week was a very prescient warning for investors in Australian banks, especially the big four.
Having spent the best part of the past 20 years cutting costs and lowering their cost to income ratios to near world’s best, there’s very little scope left in bank costs to offset an expected slowing in revenues and profits over the next one to two years, as the housing boom slows and the economy continues to grow sluggishly.
And if the Reserve bank is right then its quite possible the banks current high levels of dividends will come under increasing pressure is they can match cost cuts with slowing revenues.
Bank shares are already weakening (Westpac shares are down 9% or more from their most recent high, while ANZ shares are down more than 10%) and could go lower as the RBA and other regulators look at ways of putting a choke hold on bank home lending, especially to investors in the hot Sydney and Melbourne markets.
And there are additional costs for capital and liquidity support from the RBA and other regulators that the banks will have to factor into the cost sides of their balance sheets.
On top of that, the major driver of the record profits and dividends in the past two years – falling bad debt provisions, is about exhausted, as the latest results from a couple of the major banks (the Commonwealth and the NAB) would indicate with small rises in provisioning.
Smart investors had better be aware that the RBA sees little room for the banks to cut costs to lower their cost to income ratios (CI ratio) at a time when the income side of the relationship will come under growing pressure.
The RBA points out that the big Australian banks have spent most of the past 20 years cutting their cost to income ratios to where they are now among the lowest in the world.
Those cuts have gone some way to helping offset the narrowing of the bank’s key net interest margins (most are now just over 2%).
“The major banks’ aggregate CI ratio has fallen by just under 20 percentage points since the mid 1990s, to be 44 per cent in the 2013 financial year.
"The Australian major banks’ CI ratios have been at the bottom end of the range of their peers internationally in recent years, contributing to their relatively higher profitability.
"Over recent years, the Australian major banks’ returns on equity have been well above those recorded by large banks in many other advanced economy banking systems. This partly reflects the relatively stronger asset performance of the Australian major banks.
"Another factor is their lower cost-to-income ratios than large banks in Europe and the United States, with the disparity having increased since the onset of the financial crisis. The reduction in the major banks’ aggregate cost-to- income ratio has been an offset to the decline in their net interest margin over the past couple of decades,” the RBA said.
But the question now is whether the banks can continue putting downward pressure on their costs to help offset the expected slowing in revenue growth (and rising capital and borrowing costs because of regulatory changes).
"However, given the relatively low level of this measure of operational efficiency, there is a question as to how much the major banks’costs can be further contained in future without their risk management capabilities or controls being affected,” the RBA wondered.
"The improvement in banks’ overall asset performance has been an important contributor to their profit growth over recent years, and this trend continued in the most recent period (March 31 and June 30).
"The major banks’ aggregate charge for bad and doubtful debts fell by 17 per cent in their latest half-yearly results and, for the 2014 financial year as a whole, it is expected to decline to a historically low level as a share of assets.
"Aggregate profit of the major banks was a little over $14 billion in their latest half-yearly results, an increase of around 13 per cent on the corresponding period a year earlier.
"In addition to lower bad and doubtful debt charges, profit growth was supported by higher net interest income: stronger growth in interest-earning assets more than offset a small decline in the aggregate net interest margin arising from strong competition in lending markets.
"After declining in 2013, operating expenses increased over the year to the latest half, reflecting higher staff and investment-related costs.
"The major banks’ annual return on equity is expected to be 15 per cent in their 2014 financial year, similar to the average return they recorded over the 2010–13 period,” the RBA said Meeting that target in the next couple of years will become tougher, and force the banks to look deeper at their costs, including staff.
The RBA said the banks cut their CI ratios by adopting new technologies, which have allowed them to provide more streamlined banking services to customers and improve back-office processes such as loan approvals, and information processing and management.
"Additionally, a focus on reducing high-cost, low-value operations resulted in the closure of a large number of branches during the 1990s. The major Australian banks have renewed their focus on costs in the past few years to help counteract the effect of more moderate balance sheet growth on their profitability.
"Specifically, they have undertaken a range of initiatives including restructuring operations, upgrading their core banking systems, and outsourcing back-office processing and support operations to lower cost locations offshore.
"In addition, the major banks have moved towards branch operating models that focus on product sales and cross-selling, as opposed to traditional transactional banking activities that are being done increasingly through internet and mobile facilities.
"The Australian major banks’ focus on commercial banking – that is, lending to households and businesses – appears to be a contributor to their relatively low CI ratio. In 2013, those large banks that earned a greater share of their income from net interest income (a proxy for a bank’s focus on lending activities) tended to have lower CI ratios than ‘universal’ banks, which earned a larger share of their income through non-interest sources such as investment banking or wealth management,“ the RBA said.
