ANZ's underlying strength

The ANZ result sets the scene for the major banks' reporting season. Its underlying earnings are surging as the tide of impaired corporate loans ebbs rapidly and its margins, driven by the re-pricing of its commercial loan book, continue to swell.

The 20 per cent growth in first half underlying earnings understates what was actually happening within ANZ during the half. Excluding exchange rate movements the result was actually nearly 30 per cent better than the first half last year.

That's quite impressive, given that the bank's balance sheet essentially hasn't grown over the past 12 months – total assets were, at $506.7 billion, only one per cent or just under $4 billion higher than at end-March last year.

As always there are a lot of moving parts within a bank result, but the obvious drivers of the result were the improvement in impairment experience, some changes in assets and funding mixes and improved net interest margins.

Impairments charges appear to have peaked in the September half of last year. At just over $1 billion in the latest half, the charges were $291 million lower than for the March half of last year and $550 million below the September half's as the impact of the initial bout of corporate distress created by the financial crisis has receded.

The 11 per cent fall in risk-weighted assets from March last year points to a significant shift in mix, with corporate lending falling and commercial lending, excluding acquisitions, essentially flat-lining over the past 12 months. The modest net growth in total assets was driven by above-system growth in mortgage lending.

That reflects the general preoccupation of the majors, except National Australia Bank, with pulling back their exposures to the corporate and commercial sectors while aggressively pursuing share in less risky and capital-intensive mortgage lending. Last year while NAB grew its business loan book by $5 billion, its peers collectively shrank their's by $28 billion.

The politically sensitive aspect of this round of bank results will be the continuing, albeit gradual, increase in net interest margins and returns on equity.

ANZ's overall net interest margin rose by 6 basis points to 2.43 per cent but its Australian business, excluding global markets activity, grew its margin by 40 basis points to 2.87 per cent. Its return on equity, 10.4 per cent a year ago, is now at 12.2 per cent.

Some of the improvement in margin reflects the re-pricing of corporate and commercial loans for the obvious crisis-driven increase in risk as well as the decline in lower-margin corporate lending. With the majors all having raised a lot of equity the increased capital also has a positive impact.

The positive influences more than offset the five basis point impact of higher term funding costs and a similar increase in the cost of deposits as the majors competed for domestic funding and will provide ammunition for those bank critics who argue that the majors are over-stating the implications of the continuing rise in wholesale funding costs and profiting from the decline in the competitive intensity of the sector.

What the ANZ result does reinforce is the conservatism of the Australian banks.

ANZ is carrying a Tier 1 capital adequacy ratio of 10.4 per cent, which would be equivalent to 15.4 per cent if the UK Financial Service Authority's approach to calculating capital adequacy were used. It has already raised about 70 per cent of its 2010 wholesale funding requirement and is holding prime liquid assets of more than $63 billion.

The banks are as well prepared as they could be for another global credit market shock, which is, given events in Europe, highly possible, or the introduction of tougher capital and liquidity requirements that are working their way slowly through the global regulatory pipeline.