The Reserve Bank has delivered a tough warning to the big banks not to go looking for risky ways to boost earnings and returns at a time when building capital buffers is paramount.
In its first Financial Stability Review of the year, the central bank said that banks at the moment were facing falling returns on equity (ROE) – a key measure of profitability – because of pressure to build their capital reserves and buffers by regulators, so as to improve their ability to withstand a downturn.
But those ROE’s as they are known, are also expressions of the overly fat profits the banks are making in Australia and NZ at the moment where they dominate completely with 80% of each market.
Westpac has a ROE target of 15%. Its latest figure was 15.8%, The ANZ last year abandoned its target when it was clear that it would not be met because of rising capital demands by regulators.
Westpac’s latest figure was 14%. The CBA (17.2% and the highest in the sector) and NAB (12%) don’t have targets
"While banks face heightened risks in some areas, their resilience to adverse shocks has increased significantly via a strengthening of their capital and liquidity positions since the previous Review," the RBA said on Friday.
"In particular, the major banks’ capital positions have moved further above their minimum regulatory requirements. This has largely been in anticipation of higher future capital requirements as the Australian Prudential Regulation Authority (APRA) finalises the level required to ensure that the capital positions of authorised deposit-taking institutions (ADIs) are ‘unquestionably strong’ by international standards.
"As a result, banks’ return on equity (ROE) has declined a little, despite strong profitability, as more capital has been raised.
"It is important that banks and investors recognise that this decline has been associated with an increase in resilience and do not seek to offset it by increasing the overall level of risk-taking or by weakening risk controls and culture; the latter, in particular, can have both financial and reputational ramifications,” the RBA warned
"Banks have recorded strong profit growth in recent years as revenues have increased and loan performance has improved. While headline profit in the latest half was 7 per cent lower than a year earlier, at $16 billion, the decline largely reflected the effect of extraordinary items (including writedowns of capitalised software).
"Net interest income increased over the period due to moderate asset growth, but net interest margins narrowed slightly as the boost to margins from mortgage repricing was offset by strong competition in business lending markets.
"Charges for bad and doubtful debts were steady as a share of total assets and remained at a low level relative to their history . Some major banks indicated that credit quality had deteriorated in their resource-related portfolios, but highlighted that these exposures represent only a small proportion of total credit exposures.
"The banking sector’s aggregate ROE declined in the most recent half because of lower headline of major banks, but it remains within the range seen in recent years and high by international standards. The increase in capital is expected to have a persistent effect on ROE; equity market analysts expect the major banks’ ROE to decline by around 1 percentage point in the current financial year.
"Investors may accept that a lower ROE is offset to some extent by a reduction in risk associated with stronger capital positions, but if investors’ expectations are not adjusted it could push banks to take more risk to maintain returns.
“Indeed, banks that publish explicit ROE targets have set these at levels that exceed both current returns and analysts’ expectations and are at least as high as those achieved over recent years.
If these targets are maintained, it will be important that banks also maintain appropriate risk management practices and operational capabilities.
“So far the major banks appear to be focusing on divesting low-return and capital-intensive businesses, both internationally and domestically, as well as repricing their loan books to support profitability.
"For example, NAB announced the sale of 80 per cent of its life insurance business to Nippon Life in 2015 and finalised the demerger of its UK Clydesdale subsidiary in February this year.
"Banks’ share prices are more than 15 per cent lower than mid last year, and have been volatile over recent months. These developments largely reflected the deterioration in sentiment towards banks globally.
"Recent announcements of increased charges for bad and doubtful debts have also contributed, as have analysts’ expectations that the major banks may need to lower their dividend payout ratios to meet anticipated higher capital requirements if profit growth slows.
"These expectations for lower profit growth reflect a variety of factors, including an anticipated end to declining charges for bad and doubtful debts, possibly lower net interest margins, and the potential for growth in mortgage lending to slow as the housing market cools and lending standards tighten. “(I)t is important to continue to monitor whether there is any significant switch of lending to non-ADIs in response to tighter housing lending practices at ADIs, given that non-ADI mortgage originators fall outside the prudential regulatory perimeter and tend to have riskier loan pools than banks.”
