Watershed moment in funding of record bank profits

Westpac rounded out the Australian bank profit reporting season on Monday for those banks with a September year (Commonwealth Bank, with a June year, has a trading update this week) and one set of figures stood out: total loans grew 8 per cent over the year to $580.3 billion while total customer deposits grew 7 per cent to $409.2 billion.

That and greater use of market funding meant customer deposits made up 60 per cent of the bank’s stable funding ratio – down from 61 per cent a year earlier.

"Since the crisis the story has been retail deposit funding, sticky, secure, is good; wholesale capital market funding, flighty and prone to market conniptions, bad."

One percentage point is not a meaningful change and Westpac is still very stably funded however the interesting thing was it confirmed a trend across the sector: Australian banks are no longer matching their new lending with the same amount or more domestic deposits as they have done, essentially since the financial crisis hit and new regulations started to come into force favouring deposits.

Since the crisis the story has been retail deposit funding, sticky, secure - good; wholesale capital market funding, flighty and prone to market conniptions - bad.

According to PwC’s review of the profit season, including CBA’s June year, “in percentage terms, bank loans (7 per cent) and bank deposits (7.1 per cent) have grown at almost exactly the same rate over the past year but because total bank loans substantially exceed bank deposits, the banks are no longer funding all new growth in loans out of deposits”.

“Benign market conditions in credit markets have assisted the banks’ requirement for increased wholesale funding, with credit spreads paid by the markets approaching those prevailing before the GFC.”

This trend reversal raises two questions. Is it the start of something more enduring? And does it matter?

There are two schools of thought. Westpac’s Phil Coffey, in a speech when he was chief financial officer, articulated the concern that one possibility as economies recover and demand for bank lending increases is banks will run into funding pressure.

That’s because new loans need to be funded but as economies improve and risk appetite increases, deposits – a safe haven for investors – tend to run down. So just as banks need more funding, deposits drop off. In the past banks would simply go to wholesale markets for that funding but under post-crisis regulation, wholesale funding is not so attractive.

Another view though, articulated by amongst others Professor Rod Maddock of Monash University here in BlueNotes, is that structural changes since the crisis mean Australia can be self funding. Offshore funding won’t be needed to fill a gap, only for diversification.

The first question though is whether this past 12 months on the funding front will continue. The decline in deposit funding doesn’t so much reflect new risk appetite as a recognition by the banks they have built up sufficient deposit bases. Overall, measuring deposits against total loans outstanding, the trend to more deposit continues, emphasising the flip in new deposits to loans is not yet deeply embedded.

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Source: KPMG.

However, the flip does reflect banks are not paying the high prices for deposits they have in recent years and indeed the latest results show an improvement in margins on deposits, partially offsetting margin compression in lending where there is tighter competition.

According to PwC, business deposit growth over the past year was steady at 3.6 per cent while deposits from households – many of which experienced slowing wages growth – were also steady at 8.1 per cent on last year but down from the 9.3 per cent growth in the year to March.

So part of this story is opportunistic. Offshore capital markets, because of the low volatility and excess liquidity courtesy of central bank money printing, have been open and good value for banks. Regulators have also relaxed their view on the stability of corporate deposits and given corporate balances sheets still have lots of cash being hoarded rather than invested, banks have held on to this money.

Regulators, notably the Reserve Bank’s Guy Debelle have also made it known there was a certain irrationality in paying high margins for domestic deposits when long term wholesale funding was just as “sticky”. Indeed, often more so.

The latest data from the Australian Prudential Regulation Authority showed solid system deposit growth in September with both household and business deposits up on the previous month. But lending is starting to build greater momentum.

Household lending over 12 months grew 6.5 per cent, business lending 7.5 per cent (compared with 12 month growth of 6.6 per cent a month earlier). Total household deposit growth was up 9.1 per cent for the September year but business deposit growth was down to 4.4 per cent.

It is likely then that this particular watershed in funding represents more opportunistic factors. Absolute loan growth levels are still relatively low but banks have all grown deposits substantially over recent years.

Most banks are probably at or close to capacity given the need to have certain weightings in the funding book between deposits and short and long term wholesale funding. Meanwhile costs for wholesale have dropped significantly and the market has been pretty consistent, even with the impact of the US Federal Reserve’s decision to stop buying debt and creating liquidity through quantitative easing (QE). And Australian savings rates remain high but are now off a very high base and so absolute growth can't be as strong.

Nevertheless, the likely outlook over the mid term is for improving economies, more risk appetite and tighter funding markets as investors chance their arm for more return (and hence banks must pay more for their debt to compete with the higher returns investors are prepared to chase).

This wasn’t evident in the latest profit season. Indeed, one of the main themes was lower margins in lending as banks tried to win market share with tighter pricing in a low growth market. So the lower demand for deposits was an offsetting factor.

According to PwC, margins in the sector fell 2 basis points to 2.06 per cent in the second half amid strong competition for new lending – the lowest since the all-time low of 2.05 per cent in the first half of 2008.

The two dynamics at play in this watershed moment will continue into the future. Demand for safe assets like deposits will rise with anxiety and lending could be expected to ease in such times. And the opposite will occur in better times. Meanwhile banks will be opportunistic in choosing funding sources and influence markets with their pricing of loans and deposits. They actively manage the trade off between margin and volume.

Will then this current trend of lending exceeding deposits, if it continues, ultimately hit funding constraints? Coffey warned it could, particularly because bank boards won’t want too much wholesale market risk in their funding.

Many note domestic economies are in effect “closed” – that is deposits stay onshore but they go into different asset classes. Coffey says this is true but ultimately makes them more expensive in risk-on times. Superannuation already holds around 18 per cent of deposits.

But other bankers argue banks have enough choice to fund through alternative means if deposits are too expensive – via securitisation of loans for example. Maddock believes we’re entering a period when Australia will actually export rather than import capital.

That’s perhaps the most adventurous scenario. For most of its history Australia has imported capital to fund the investment of a growing economy for which there are not enough domestic savings. Hence Australia has a structural current account deficit which the banks historically have filled by borrowing offshore and on-lending the funds raised.

If the September results are a watershed, we are about to find out how the Australian economy will fund itself under new global bank regulation and more risk averse bank boards.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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