22 Apr 2014
Is there a Bad Moon on the Rise for bank results?
The interim profit season looms for four of the five major Australian banks and some of the regionals, a time when investors will take stock of whether the strong run in bank shares – despite some jitters – can continue.
Different investors of course have different measures of value. For some it is the solid yields bank dividends provide and so they’re less attuned to profit taking. The predictability of bank earnings and dividends in volatile times is a big attraction. Others however may be looking for signals to switch out of banks – or even into international banks.
But underpinning those valuation assessments are bank fundamentals. It is almost counter-intuitive in this period of abnormally low volatility but the primary anxiety is that there may be some major shock.
Recent profit seasons have been dominated by concerns, near hysteria in some quarters, that bank net earnings have been driven primarily by lower than expected charges for bad and doubtful debts.
At one extreme some observers have argued it is akin to unnatural that earnings are reliant on such a factor - rather than say revenue or margins or lower costs. The hierarchy for many investors is that revenue growth is the best followed by cost control. Lower bad debt charges are valued much less.
More sanguine observers have merely noted lower than expected bad debt charges are not sustainable.
They’re right, they’re not. My chief executive here at ANZ, Mike Smith, made exactly this point during the latest round of suspicion about low charges. In a typical credit cycle, he noted, bad debts will be lower than expected maybe 70 to 80 per cent of the time.
It’s the crook years you have to watch out for.
But there’s a difference between the inevitability of the cycle turning and the latest trend of low charges being unsubstantial. There is a perspective issue here: bank earnings and bad debt charges are backward looking while it is impossible to ignore the slew of dispiriting economic news today.
But bad debts don’t come out of nowhere nor are they linked to lending made yesterday. Typically loans which go bad enough to be written off are written two to three years earlier. They are often written when conditions are frothy, companies are over-confident, risk assessment a bit too generous. Bad loans get written in good times.
Moreover, such loans require a trigger to go bad, an event or series of events which mean the borrower can’t repay. That’s often a rise in interest rates. A spike in unemployment is the most common cause of mortgage defaults. The downturn in mining investment stranded many mining services companies.
So the question is whether conditions are present which may puncture the lower-than-expected bad debt cycle.
Well consider conditions two to three years ago. Were they a little warm, were borrowers pitching for extra funding? The answer is no – have a look at the credit data since the financial crisis. Both the corporate and household sectors have been ultra-cautious, indeed savers rather than borrowers.
There is little to suggest there is a compendium of loans out there waiting to go bad. And if there were, what would be the trigger? Interest rates remain historically low, corporate balance sheets robust – and corporate leverage is a key indicator of a looming bad debt cycle. The household sector may be considered highly indebted in some quarters but there have been no external conditions which would be expected to trigger repayment issues over the last March half.
To the extent there may be surprises in this profit reporting season, they are unlikely to be on the bad and doubtful debt side.
Rather, and this is where the analysts have to earn their keep with complex models, the challenge will be in scrutinising all the intricate moving parts of a bank profit and loss sheet.
There’s been plenty of anecdotal evidence of tough competition in business banking, so how much pressure has that put on margins?
We know, from the credit data, that revenue growth is likely to be constrained unless it comes from winning market share – which again may come at a cost. But then New Zealand has been stronger than expected over the last half and all the banks have considerable businesses across the ditch.
The slightly eerie calm on global financial markets and the general narrowing of yields on debt suggests funding costs may have improved for the sector. But then all the banks have also been on the front foot about the critical importance of new technologies in banking – so have they been spending?
We have seen evidence of heightened competition in business and mortgage banking but again, if that has led to some poor loans, we won’t see them yet. We may see some margin compression.
I have no actual insight into what has been happening in the engine room of the lenders in Australia, not even here at ANZ, or the region. But history tells us jolts are never completely out of the blue – the best guide to historical earnings are historical economic conditions.
There will be surprises in this reporting season but an unexpected surge in bad debts seems unlikely to be one of them.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.