Have banks misjudged the credit cycle?

Credit quality, unsurprisingly, was the major focus of investors and analysts with the Australian bank interim results and trading updates.

" What was evident in the questioning of the banks after their results… was a body of opinion which believed they either didn’t understand the quality of the loan books or had underprovided."
Andrew Cornell, BlueNotes managing editor

With revenue in the major markets of Australia and New Zealand difficult to come by, margins stable and growth in regulatory capital an ongoing obligation, the most direct impact on bank earnings (and ultimately dividends) is going to be costs – credit and operational.

According to EY’s wrap of the season, bad debt expenses increased by 52 per cent from the 2015 half year results to $A2.5 billion, confirming the commentary both before and during the week the credit cycle had “turned”.

“This has been marked by home and personal loan losses in the resources states of Queensland and Western Australia, as well as in a number of individual corporate exposures,” noted EY’s banking partner Tim Dring.

“Softening demand for apartments and flat rents for commercial property in select markets and exposure to the dairy industry in New Zealand are also adding to the pressure.”

Commentary from the banks themselves was that the turning of the cycle was episodic rather than universal. The big names involved – companies like Arrium, Peabody, Dick Smith, Slater & Gordon – reflected particular companies from stressed environments or more idiosyncratic situations.

Meanwhile sectoral stresses, whether in mining services or resource-dependent locations in Australia or dairy in New Zealand, have been evident for some time. In such cases, the ways these stresses appear in P&L charges has evolved from non-specific general provisions to actual charges. Overlays in expectation of deterioration decrease as the expectations are realised.

But the tone of the questioning around the cycle was in the opposite direction: why haven’t banks taken more general provisions for much broader sector wide deterioration rather than the piecemeal approach evident in the interim reports?

This is a critical question. It reflects both the specific intent of accounting rules and a wider philosophical question.


There are actually two questions here. The first is whether the banks understand what is happening in their loan books. That is, looking at measures such as missed payments, is there a specific reason to categorise a loan as impaired with the view some or all of the money might not be repaid?  And hence make a specific provision.

Moreover, are there enough of these loans, in concert or across specific industries, to overlay on those potentially bad loans - for which there is clear evidence - a further charge for similar ones which may emerge?

Technically, under current accounting rules, a material event must have occurred. It cannot be just expected to occur when viewed through some management crystal ball (although, under proposed new accounting rules, management will be able to provide for what they believe will happen, not what has already actually happened).

What was evident in the questioning of the banks after their results – Westpac Banking Corp, ANZ Banking Group, National Australia Bank and Macquarie Group – was a body of opinion which believed the banks either didn’t understand the quality of their loan books and had underprovided. Or they did understand their loan books but still hadn’t overlaid a more general provision.

The answer is these decisions, while they appear to reflect management discretion, actually don’t.

That’s because of the very specific accounting and regulatory prescriptions about how and when bad loans are charged to the profit and loss account.

And that touches on the wider philosophical issue: who should pay for prudence in provisioning? Current or future shareholders?

In the 90s, in the wake of the last Australian recession when two of the major banks nearly failed, the banks and regulators looked closely at why credit loss provisioning had become a water melon – all green on the surface, all red inside.

The answer, particularly pushed by Westpac which had been hardest hit, was “dynamic provisioning”. Loan portfolios would be provided for in advance of going bad. Obviously no bank would extend a loan if management knew it would go bad. However, some loans always do go bad. Dynamic provisioning, a sort of expected loss provisioning, modelled this in.

However, when banks moved to new accounting standards in 2006, there was a shift to pro-cyclical “incurred loss” model s.  This incurred loss model was conservatively applied in Australia but less so in the UK and elsewhere.

So when the GFC hit the incurred loss model couldn’t keep up with the pace of deterioration.  That led the standard setters to introduce a newer standard, which moves back to a more expected loss basis.

But expected losses, while rational can also be seen as a kind of profit smoothing – which may be desirable from a systemic perspective but in practice means today’s shareholders are paying for losses which will occur in the future and which arguably should be paid for by later shareholders.

That however is a policy decision, not a management one anymore.


The loudest calls for extra specific provisioning was around housing portfolios where there is debate about the existence and location of asset bubbles and in Macquarie Group’s corporate and asset finance division, particularly where it intentionally invests in higher risk, higher return loans.

Macquarie reported nearly $A10 billion of such loans with 90 per cent sub-investment grade. Critically though, Macquarie said 97 per cent of the loans were secured and 81 per cent are senior debt, the highest ranked debt.

The bank said each asset was assessed and purchased “name by name”, was stressed tested and subject to concentration analysis. So Macquarie has gone through all the assessment banks need to undertake around any loan portfolio before deciding on specific and general provisions, critically, judging the likelihood of loss.

NAB CEO Andrew Thorburn made the same point about the bank’s New Zealand dairy exposure as did Shayne Elliott about ANZ’s business in Asia.

Andrew Cornell is managing editor at BlueNotes

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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