Are banks a bad bet in 2014?

Fitch Ratings has painted a quite lacklustre picture of the outlook for Australian banks this year. While a subdued year might have some political benefits for them, it wouldn’t help support the major banks’ stretched sharemarket ratings.

The Fitch thesis is that there will be a ‘’modest’’ weakening in the environment within which the banks operate. That will lead to some ‘’manageable’’ asset quality deterioration and place pressure on revenue growth. Fitch also believes strong competition to lend will impose pressure on net interest margins.

The biggest risk to the outlook, it says, would be a sudden and severe downturn in China (which isn’t its base case), or weakening credit standards if banks attempt to increase market share in a low credit growth environment, or a prolonged and severe dislocation in funding markets.

A year of modest earnings growth might help the banks defuse some of the criticism that crops up bi-annually when they release their earnings numbers, which might not be a bad thing in the year of Joe Hockey’s financial system inquiry.

It wouldn’t, however, support share prices that have been inflated by investors’ search for yield (albeit they have come off their November peaks), nor would it generate the new capital the banks need to create through their profitability to ensure they can absorb the pressure of the tiers of new capital requirements they face over the next few years while still meeting shareholder expectations.

Last year the Australian Prudential Regulation Authority announced it would impose a capital surcharge of one per cent on the majors, having determined that they are domestic systemically important banks.

The majors had a quite solid 2012-13 despite weak demand for credit from consumers and, in particular, business.

It was, however, notable that the improvement in their earnings came from reductions in already historically-low impairment charges and big reductions in their costs.

The maths say it will be increasingly difficult to generate further meaningful reductions in impairments (if Fitch is right they will begin rising), although there may still be some momentum left from the intense focus on costs.

It was also notable that there was a slowdown in the majors’ earnings – and a crimping of their net interest margins – as last year progressed. That may have had something to do with the impact of the federal election on business and consumer confidence but, with the resources investment boom fading rapidly, it could also have reflected the slowdown in the underlying economy.

There have been some encouraging signs through the Christmas period of an improvement in consumer and business confidence and in their demand for credit which, if sustained, might help the banks’ top line. The overall outlook for the economy, however, is for a relatively weak year. If Hockey brings down a horror budget in May, of course, the outlook could deteriorate.

It is unlikely that the majors would engage in destructive competition to win market share. Post-crisis, the focus on the liabilities side of their balance sheets has generally seen them restrain their lending growth to their ability to generate growth in deposits, which has slowed. Having lost, on average, four basis points of net interest margin last year they would be wary about sacrificing margin for top-line growth.

They’d also be conscious of the significant job losses and weakening of activity flowing through the resources and manufacturing sectors and the potential for that to impact on their home loan and personal loan books, although it would probably take a very large surge in unemployment and a big crack in the housing market for their retail lending books to be a material source of loan losses.

Traditionally, spikes in impairments have come out of their business loan books and lending against commercial property in particular.

Fitch makes the point that the banks’ starting points of solid profitability, solid provisioning and conservative capital positions should mean they can easily withstand any deterioration in their loan books and also notes that their funding and capital positions will continue to strength through 2014 as the banks prepare for the raft of new capital and liquidity requirements.

For bank shareholders, of course, the reassurances that the banks can survive deteriorations in the economy and the quality of their loan books aren’t particularly comforting. They need the banks to grow their earnings and dividends and (APRA willing) have excess capital they can return to shareholders to justify today’s share prices, let alone tomorrow’s.