Business and home loan discounts won't dent banks' appeal

A split between the margins Westpac is getting on its high-end institutional banking business and the ones it is getting on business and home lending suggests that pressure on banks to cut mortgage and business rates will rise.

A split between the margins Westpac is getting on its high-end institutional banking business and the ones it is getting on business and home lending suggests that pressure on banks to cut mortgage and business rates will rise.

The profit numbers banks are now reporting generally underpin their share prices. Top-line revenue growth is mediocre, but the banks are boosting their bottom line by extracting costs, and their bad debts are falling.

They lead the world for cost efficiency, and Westpac is top of the local class, with a cost-to-income ratio of 40.6 per cent compared with 41.1 per cent a year ago. The bank's fully-performing loans have risen from 97.52 per cent of its loan book to 98.06 per cent in the past two years.

Rising dividends are also keeping a yield play alive for investors despite a 53 per cent share price increase for the banks in the S&P/ASX 200 index since the beginning of last year. ANZ lifted its first-half dividend by 11 per cent on Tuesday, and on Friday Westpac raised its interim dividend by 2¢ and declared a special dividend of 10¢ a share, taking the total interim payout up by 14.3 per cent.

Bank shares have set a blistering pace this year, however. They are up 27 per cent compared with a 12 per cent gain by the ASX 200 index, and have risen by almost 10 per cent since the end of March, far above the 2 per cent gain logged by the ASX 200.

The question is not so much whether they are absurdly overvalued - they are still yielding almost 5 per cent before imputation credits - but whether they can continue to rise aggressively. There are two answers, one long-term, and one short-term.

The long-term answer is that Australia's banks are golden: buy them, put them in the bottom drawer, and go to the beach.

They pay big dividends, and have rock solid balance sheets. Westpac for example is paying its special 10¢ a share dividend because its tier 1 core common equity ratio is stronger than it needs to be.

It has risen from 7.7 per cent of assets to 8.7 per cent of assets in a year, leaving it above the bank's preferred range of between 8 per cent and 8.5 per cent.

Bad debts are falling even though the the banks are exposed to a domestic economy that is weak in pockets being affected by the strong Australian dollar, and they are becoming more profitable, pound for pound. Westpac's return on equity, for example, rose by a full percentage point in the year to March, to 16.1 per cent.

All this is being achieved while borrowers are in a coma. Home loans were expanding at an annual rate of 22 per cent in 2004, but were running at 4.4 per cent in February.

Business lending growth peaked at an annual rate of 24 per cent at the end of 2007, but in February the rate was just 3.9 per cent. Loan growth will not accelerate significantly this year, but it will, eventually, and when it does, the banks' earnings growth will accelerate too.

The short-term answer is that bank shares could take a breather if the big four decide to steer more of their profits to retail and business borrowers.

Westpac's overall net interest margin was up by only one basis point to 2.19 per cent in the March half compared with the September half.

The bank's wholesale borrowing costs are trending down, but are a smaller part of the funding pie after the global financial crisis. Deposit costs are still high, but should decline as wholesale borrowing costs ease. In the lending market, meanwhile, there is now a clear split between institutional banking, and retail and business banking, where mortgages and business loans are written.

The institutional business is facing intense competition as the liquidity wave unleashed by the central bank stimulus looks for a home. Top-rated corporate borrowers are raising money at very low rates, and the net interest margin in Westpac's institutional division has contracted from 2.59 per cent to 2.3 per cent in a year. In its retail and business banking division, however, the net interest margin has grown by six basis points in six months, and by 10 points in a year.

Chief executive Gail Kelly sees no signs of the competitive pressure in the institutional lending market easing, and says that if pushed, she would predict the bank's overall net interest margin will be one or two basis points tighter in the September half year.

One of the ways the banks have been propping up their margins on retail and business lending is by not passing on Reserve Bank cash rate cuts completely. The RBA has cut its cash rate by 1.75 percentage points to 3 per cent since October 2011, and the average variable home loan rate has fallen over the same period by about 1.3 percentage points.

As profits and dividends continue to rise strongly, the banks have less political room to justify withholding part of any future RBA rate cuts (the odds are about 50-50 that the next cash rate cut will come on Tuesday, when the central bank's board meets), and a growing temptation to announce a tactical variable home loan rate cut.

A unilateral variable rate cut would not be a straightforward bonus for borrowers because it would make the Reserve less likely to cut rates in future. It's an emerging tactical option as the global liquidity wash continues to put pressure on interest rates, however, and if one of the big banks breaks cover, the others will follow.

A mini-variable loan rate war would not dent the long-term appeal of the banks in share portfolios, and in my opinion would not prompt an investor exodus. But it would trim interest margins in the short-term and perhaps suck some of the heat that has built up in bank shares this year.

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