Business banking: The next battleground

For most investors bank stocks are the key dividend yield providers based on mortgage profits ... but business banking is emerging as the next battlefield.

Summary: In an environment of lower earnings growth, the big banks are stepping up their efforts to win market share in the competitive small business lending sector. This area provides banks with similar returns on equity to new mortgages and is generally more defensive than larger corporate loans.
Key take-out: Among the major banks, ANZ appears to be best placed at this stage to win market share, which will be at the expense of market leader NAB.
Key beneficiaries: General investors. Category: Shares.

The Australian major banks are experiencing an environment of low credit growth and improving asset quality post the global financial crisis.

This has led to the banks becoming increasingly competitive with their lending practices in order to sustain their ability to consistently deliver strong earnings growth. The banks engaged in intense deposit price competition after the GFC in a bid to improve their proportion of deposit funding in order to meet regulatory changes. This was followed by very fierce competition in residential mortgages as banks fought to increase their lending balances, given the benign credit growth environment and improving asset quality.

The next battleground for supremacy will be in business banking (in particular small to medium enterprises) as banks continue to look for new areas to stimulate lending while earning high returns. My analysis suggests that lending to SMEs is particularly attractive from a return on equity perspective. In terms of market place positioning, ANZ is best placed to benefit from this at the expense of NAB.

A changing environment for SME lending

There is no consensus definition of what constitutes SME business and how to precisely distinguish it from corporate and institutional banking. While different banks set their own demarcations in this regard, I consider NAB’s definition of SME business as a good guide. NAB defines SME business as lending to business customers of up to $25 million. SME banking has tended to be an area dominated by the major banks, in part due to the requirements of many SMEs for a higher level of branch contact than many larger businesses. During the GFC, many of the specialist financiers servicing the sector found themselves in strife, leaving the major banks to selectively build on their exposures.

Since the crisis, banks have increased their lending rates relative to cash rates across all business loan categories as seen in Figure 3. Unlike mortgage lending however, banks are fairly active in differentially pricing businesses for risk. Part of this relates to the pricing structures available to them. This means banks have the capacity to charge a spread over a variable base rate (often the bank bill swap rate) in business lending rather than simply pricing an entire portfolio using a standard variable rate, as is the case in mortgages (albeit with some discretion on discounting depending on how much a customer is looking to borrow).

With the backdrop of rising wholesale funding costs, increased risk sensitivity with the adoption of Basel II in Australia from 2008, and a changed perception that the industry had been dramatically under-pricing their loan exposures for risk in the lead-up to the crisis – the banks began a process in 2008 to reprice business lending exposures.

Banks were able to use the flexibility built into business lending pricing structures to respond to the funding pressures, and arguably take advantage of the shortage of liquidity available to business customers at the time. Many of the banks introduced a mechanism known as a ‘liquidity premium’ into their pricing structures, which helped to boost margins and offset the decline in business lending volumes.

NAB and ANZ’s disclosures of business lending margins illustrate the level of repricing that took place. NAB’s Business Banking divisional margin increased from 2.25% to 2.66% from 2008 to 2011, while ANZ’s Commercial Australia divisional margin increased from 4.56% to 4.99% as seen in Figure 4 and Figure 5, respectively.

Why is SME lending attractive?

Most SMEs continue to use intermediated lending for the majority of their debt funding as it remains difficult and costly for them to raise funds directly from capital markets. This has remained essentially unchanged since prior to the crisis. At least in part as a result of this reliance, small business loans and business credit to unincorporated businesses (proxies for SME lending) have remained relatively resilient compared to large corporate and institutional lending, which experienced a period of contraction and de-leveraging in the early years after the crisis broke as seen in Figure 6 and Figure 7.

In contrast, corporates have tended to become relatively more reliant on internal funding sources as well as non-intermediated funding since the onset of the crisis. In a recent market update, Westpac (WBC) characterised the business lending environment as “improving although caution remains”. WBC made the observation that corporate customers were well positioned with balance sheets improving and strong cash flows coming in, but that large corporate customers remained cautious and were waiting for additional signals before committing to significant investment. This insight highlights the need to shift attention to SMEs within business banking.

Access to SME finance increased over the decade preceding the crisis, and since then most industries have experienced tighter but still reasonable access to funds, albeit at a higher cost (disproportionately for SMEs compared to large businesses) and with apparently more stringently applied terms and conditions. More recently, business surveys suggest that the availability of finance has improved and is not the most significant factor concerning small business at present. For example, according to the Sensis Business Index, the share of SMEs reporting that access to finance is relatively difficult has declined from circa 40% in late 2012 to 30% in late 2013.

It is my view that this is the result of increasing competition amongst the major banks in the SME segment, which has led to a recent decline in the rates being offered to SME customers. The renewed commitment of banks to the SME segment was seen as recently as last month, with ANZ announcing a target of $2 billion of SME lending over the next 12 months vs $1 billion in the previous year. HSBC Australia also released a statement in March 2014, targeting $250 million of loan facilities for SMEs looking to start or expand their business internationally.

Based on my calculations, a new SME loan generates an ROE of c33%, which I calculate to be the same as a new mortgage given the high level of competition in mortgages currently. In our calculations we have accounted for the differences in risk weightings between the two different assets. My calculations determine that an incremental corporate loan would generate an ROE of only c18%. As a result, I believe the competition in SME lending will intensify in the future as major banks attempt to capture the SME segment, given ROEs are better than corporate lending and equivalent to mortgages.

How have business banking market shares changed?

Based on the latest APRA statistics, ANZ grew its corporate loan book by 9.2% over the last 12 months while system growth for corporate loans was 3.8%. ANZ also outpaced all of its major bank peers. Concerningly, NAB’s corporate loan book declined by 2.6% over this same period. It should be pointed out that corporate lending as defined by APRA includes SME as well as larger corporate and institutional loans. However, I feel it is still a reliable data source for my purposes given the general lack of activity in the larger end of town.

As seen in Figure 9, NAB is currently the incumbent market share leader in corporate lending, followed by CBA, ANZ and then WBC. It is interesting to observe that the banks with the largest market shares are also the banks which have lost the most market share in the last 12 months. NAB lost 1.52%, CBA lost 0.42%, ANZ gained 0.86% and WBC gained 0.23%. On this basis, I feel that ANZ is already starting to take advantage of the opportunity in SME given its growing market share in overall business lending.


As the banks move into an environment of lower earnings growth, they face increasing pressure to compete more aggressively in new markets while still attempting to earn a high return on equity.

I am of the view that the major banks will become progressively more competitive in SME lending as it provides banks with similar ROEs to new mortgages and is generally more defensive than larger corporate loans. Any further improvement in asset quality makes this proposition even more attractive. I am of the view that ANZ is best placed to benefit from this at the expense of NAB.

This is an edited version of an article by Omkar Joshi, an investment analyst at Watermark Funds Management. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

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