Aus banking plays the waiting game

It’s been an extraordinary year for the Australian banking sector. The banks have had their hands full supporting customers through natural disasters at the beginning of the year, followed soon after by the COVID-19 global pandemic-driven economic crisis.

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Profits and shareholder returns have of course been negatively impacted by these external factors but overall the major banks’ financial position has remained sound due to strong capital and liquidity levels – with resilience further supported by the policy measures put in place to address COVID-19 stresses.

"Rather than V-shaped, it’s becoming increasingly likely we will see a prolonged global economic recovery period.”

So far, the big banks have withstood the pandemic crisis well. Strong capital adequacy has enabled banks to continue to lend and support their customers through additional liquidity facilities and loan repayment deferrals. Now though, it’s a waiting game as they brace for the full effects of the economic downturn on asset quality yet to play out.

Rather than V-shaped, it’s becoming increasingly likely we will see a prolonged global economic recovery period, particularly with the resurgence of further waves of the virus currently impacting the US and European economies. Either way, there are significant challenges ahead and, while Australian banks are already taking measures to prepare for portfolio distress, the true scale of the impact won’t be revealed until temporary deferral programs and government income support measures draw to a planned close in the first quarter of the 2021 calendar year.

The headlines

EY’s analysis of the Australian major banks’ 2020 full year results found combined cash earnings decreased to $A17.38 billion – down 36.5 per cent from the same time last year – with this dip largely due to increased collective provisioning as the banks prepared for anticipated credit losses as a result of the downturn.

Total impairment charges across the big four banks rose to $A11.9 billion before tax, up 201.6 per cent from the 2019 full year. Earnings were also impacted by revenue pressures associated with muted credit demand, record low interest rates and heightened mortgage competition.

The banks also saw average net interest margins decrease 5 basis points from the prior comparative period – to 1.89 per cent. On the upside, strong household and business deposit flows combined with the Reserve Bank of Australia’s (RBA) Term Funding Facility (TFF) have given the banks access to low cost funding.

However, margins do remain under pressure from a range of factors including ultra-low interest rates, the banks holding more liquid assets and increasing competition for home loans. The RBA’s most recent cut to the cash rate and announcement of quantitative easing suggests Australia is in for a ‘lower for longer’ environment. Differential pricing is also leading to wider margin spreads for higher risk lending, such as loans with a high loan to value ratio.

Digital approach

While these are extraordinary times, RBA Governor Philip Lowe continues to think a negative official cash rate in Australia is “extraordinarily unlikely”. The RBA sees limited benefit in a negative official cash rate, although this view may need to be reassessed if other major central banks, notably the US Federal Reserve, adopt such a policy.

That said, the setting of the interest rate on exchange settlement balances at zero at the November RBA meeting means wholesale rates could fall below zero on high liquidity days. This will be a challenge to manage, both for the banking sector as well as broader corporate Australia.

Further, Australian financial institutions operating in New Zealand may well have to tackle a negative official cash rate, with the Reserve Bank of New Zealand (RBNZ) expected by some to adopt such a policy in 2021.

In this lower for longer environment, tackling costs remains one of the great challenges for the major banks. Cost bases across the banks remain elevated - reflecting ongoing remediation, compliance, continued investment in technology programs and higher personnel costs - as banks mobilised additional resourcing to help their customers through the initial stages of the pandemic. These profitability constraints saw average return on equity (ROE) decline to 6.7 per cent.

The good news is the banks are continuing to invest in areas such as technology, process automation, digitisation and process simplification, with the COVID-19 pandemic accelerating the pace of digital transformation programs.

The pandemic has changed consumer behaviour, increasing the use of digital banking products and services. The EY Future Consumer Index found 62 per cent of respondents intended to use less cash in the future and 59 per cent expected to use more contactless payments.

The Australian banks have an opportunity to reduce costs by accelerating product simplification and digitisation. Using their increased interaction with customers, they can move customers off legacy products to simpler, more cost-effective digital offerings. With bank margins under pressure, digital tools can help unlock cost savings in both front and back office operations and, if well executed, it will be these investments that should help them reduce their cost base.

Compassionate approach

The expected increase in customers entering financial difficulty as temporary pandemic support measures come to an end will create a significant challenge for the Australian banking sector in the near term.

Large numbers of customers are likely to need customised payment strategies and solutions, and this is forcing banks to rethink their collections model and scale their capabilities.

Banks will need to replace their traditional transactions-based approach to collections with a more customer-focused model to create a better and more personalised experience for vulnerable consumers. This will require a much more nuanced approach to measuring and monitoring credit risk.

Predictive and high-frequency analytics will be essential to understanding an individual customer’s probability of default. In this way, banks can incentivise at-risk customers to proactively reach out for a more tailored and effective service – at the same time building loyalty and improving recovery return rates.

The way forward

The Australian banking sector remains resilient but risks are clearly elevated in the challenging operating environment brought about by the pandemic. The economic downturn, dampened credit demand and significant asset quality risks are all weighing on the banks’ future revenues, profits and returns.

However, as a transition takes place into the recovery phase, banks can still position themselves for future growth. To help rebuild profitability in the wake of the COVID-19 crisis, EY expects to see banks focused on improving efficiencies and developing the customer experience. Strategies are likely to include:

  • Reshaping the cost base through cost transformation and fast-tracking digital transformation strategies
  • Optimising branch footprints
  • Implementing a more flexible operating model with a dispersed workforce
  • Introducing new digital products and services to address changing customer behaviours and needs, underpinned by an enhanced data analytics capability.

With improved digital capabilities and more agile operating models, Australian banks will be able to deliver an even better customer experience and create capacity to invest in further transformation for the future.

Tim Dring is the EY Oceania Banking and Capital Markets Leader

The views expressed in this article are the views of the author, not Ernst & Young. The article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Liability limited by a scheme approved under Professional Standards Legislation.

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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