While bad debt expenses have doubled, income growth has been strong and this has enabled them tohold the reduction in aggregate underlying cash earnings to just 2.4%25.
Key elements of their combined underlying cash earnings are:
This result for FY09 reflects the fact that the economic and financial environment in Australia has been less turbulent than expected at the start of the calendar year, with the Australian economy dodging recession, growth in unemployment slowing, and less volatility in overseas wholesale funding markets. Residential property prices have stabilised (and in some segments increased), while commercial property prices have continued to weaken but in an orderly and relatively benign manner. Equity investors, not least the domestic super annuation funds, have been willing supporters of equity raisings.
In this environment, the banks have been able to increase their aggregate net interest income by 19.8%25 in FY09. This was driven by margins improving for the third half-year in a row as the banks repriced their loans; plus the banks benefited from the ‘flight to safety’, which resulted in a 13.4%25 average increase in their deposits. Another highlight was the significant increase in financial markets revenue, although this tailed down in the second half.
Looking to the year ahead, we expect economic growth in Australia to be in the order of 2%25 to 2.5%25 in 2010, compared to 0.4%25 in 2009. In otherwords, we expect an ongoing economic recovery, but with the economy still growing below trend. While growth may yet again surprise on the upside, there are a number of uncertainties remaining for the international financial system and the international economy which add to the risks for the year ahead:
We also expect the ongoing improvement indomestic economic conditions to translate into only modest improvements in the demand for bank borrowing until well into 2010, as households and businesses continue to take a cautious approach, strengthening their balance sheets and being wary of the potential for higher interest rates.
On the regulatory front the change process still has a long way to go. It seems clear at the international level that the approach is one of significant refinement to the existing frameworks rather than root-and-branch reform. The timetable set out by the G20 in Pittsburgh is nonetheless ambitious, stretching out to at least 2013, and Australia has little option but to fall into line with that timetable. Inevitably the net effect of the changes will be to raise the cost of deposit raising and lending by banks which will, at least inpart, be passed on to customers.
The liquidity risk management proposals recently released by the Australian Prudential Regulation Authorities (APRA) illustrate this point.The proposals will translate into requirements for the banks to increase their ‘as normal’ holdings of low-yield liquid assets, in particular of the limited pool of Australian government bonds. Inevitably this will increase funding costs which will flow into higher lending rates and, at least potentially, lowerbank lending. We support the direction of these proposals but believe certain aspects, such as the definition of liquid assets, need review so as to ensure that the right balance is struck between system stability and efficiency needs.
Possible policy actions which fall into this category for banking include: reducing tax rates on domestic deposits, which we believe is a matter of priority; confirming future deposit insurance arrangements; abolishing interest withholding tax to encourage foreign banks to operate in Australia; and facilitating the growth of a much deeper corporate bond market in Australia. We would also like to see changes to policy to stimulate the securitisation market further, because more activity in this market will assist with both funding and competition more generally. However, we suspect that the international debate about securitisation still has a long way to run (especially ‘skin in the game’ requirements), which may make quick changes to domestic requirements difficult.
Beyond navigating 2010 and impending regulatory change, the challenge for banks will be to harness sufficient funds – both debt and equity – to meet the investment needs of the Australian economy in a post-GFC world. In the medium and long term, the potential for investment in the Australian economy may be unprecedented, driven by factors including export demand for resources, infrastructure requirements for rapid population growth, Australia’s enhanced reputation as an international investment destination, and responding to climate change.
In turn, this is why the retention by the Australian majors of their AA credit ratings has been so important. Assuming no major disruptions in international financial markets, we believe that the combination of international confidence in both the Australian major banks and in the Australian economy more generally will ensure that the Australian banks continue to be able to find willing overseas lenders to fund their operations.
Rather, over time, the issue may be more around the banks’ own willingness, from entirely justifiable risk management considerations, to expand their offshore borrowings relative to their domestic liabilities, bringing us back again to the critical importance of growth in domestic deposits. Given an outlook of only modest growth in demand for borrowing in the short term, we do note expect this to be a binding constraint, but it may emerge as an issue should demand for borrowing accelerate.
As we have previously argued, Australia has come through the GFC precisely because of the combination of a strong and profitable banking system in tandem with robust economic policy and industry supervision. The need for this balanced approach of strengths from all sides will be just as important to ensure that Australia takes maximum advantage of its current strong position.
The banks themselves focused on strengthening their balance sheets in FY09, with aggregate tier 1 capitalrising by 118bps. As a consequence,their combined average return on equity over the past year has been13.1%25, compared to an average of16.6%25 in FY08. The increased level of capital now held will likely lead to a re-evaluation of the longer-term returns that a highly regulated bank should achieve.
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