CBA confirms bank sector blues

The Commonwealth Bank's March quarter update is just another confirmation, if one were needed, that the banking system is stagnating within the stagnant non-resource sectors of the economy.

All the majors, faced with weak demand for credit, funding cost pressures, increasing regulatory costs and the elevated risks emanating from Europe, have retreated to a level of conservatism last seen in the early 1990s.

CBA, like its peers, is restricting lending growth to its ability to fund new loans with deposits while maintaining historically high levels of tier one capital and stocking up on liquidity as insurance against the risks of another financial system meltdown, a risk that has risen dramatically now that Greece is on the verge of a financial implosion.

The European Central Bank's withdrawal of funding for some Greek banks, and the accelerating exodus of depositors from those banks as Greek individuals and companies pull their funds out of the country in fear of a forced departure from the eurozone that would decimate their savings, makes it more likely than not that the eurozone, and global financial system, is about to experience another extreme "event".

In the circumstances, it isn't surprising that the Australian banks and their customers have adopted highly defensive postures that are likely to be maintained for the foreseeable future.

The challenge for the banks is that while demand for credit has dried up, denying them volume growth, their efforts to reduce their exposures to volatile wholesale funding markets by raising more deposit funding and the risk premia being demanded on their residual wholesale requirements are imposing continuing pressure on their net interest margins.

CBA said today higher funding costs had a negative impact on group net interest margins and that the net interest margin of its retail bank had declined during the quarter. The only response within the banks' control if they want to maintain earnings is to cut costs, hence the torrent of job losses occurring within the sector.

CBA, more reluctant than its peers to axe staff because of the investment it has made in recent years in improving customers' satisfaction – and employee satisfaction is a major driver of that – said continued focus on process efficiency and cost management had produced a good expense outcome within its core retail business.

Despite further improvement in asset quality, some growth in business lending (where it is easier and less politically sensitive to reprice lending to protect margins), strong growth in institutional and markets income and a continuing recovery in the New Zealand economy and banking environment, CBA, as with its peers, could only nudge up its earnings, from $1.7 billion to $1.75 million.

The banks aren't the only institutions trying to de-risk. Today IAG made an announcement that it probably should have made several years ago. It is undertaking a strategic review of its UK business.

IAG's ill-fated expansion into the UK motor insurance market last decade has cost the group more than $500 million. IAG chief executive, Mike Wilkins, could have – and probably should have – cut that business loose from the group when he became chief executive in 2008. He chose not to and has focused instead on fixing a business which has been plagued by the over-capacity in the UK motor insurance sector, sub-economic pricing, extraordinary levels of claims inflation and a culture of compensation and fraud.

His team have made considerable progress. In the half to December 31 the UK business, which had lost $121 million in the December half of 2010, reduced its losses to only $5 million. Wilkins said today that with the business's ‘'remediation'' program continuing, and early signs of government action on industry reform, IAG was now assessing its options.

National Australia Bank recently concluded a similar review of its UK business and considered, as IAG will, the obvious options of holding, holding and restructuring and selling all or part of the business. In the end the poor state of the UK banking market and economy meant the only realistic option for NAB was to hold onto the traditional core of its UK banking operations while putting its troubled commercial property loan portfolio into run-off.
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IAG may well come to a similar conclusion. The recessed state of the UK economy, which is experiencing a double-dip recession, makes it difficult to sell financial service businesses at sensible prices, although it is possible that one of IAG's competitors in the UK might see an opportunity to rationalise capacity in the sector.

A more likely outcome is that IAG further refines its UK strategy and narrows its presence to an even more specialised offering. With the business nearing break-even, the option of hunkering down and waiting for better times to emerge is more viable than it was when the business was haemorrhaging badly.

Wilkins, like the bank chief executives, has been very focused on the detail of IAG's operations and, in the Australian business at least, has been very successful in improving IAG's insurance margin. While the insurance sector was buffeted badly last year by the spate of large natural disasters the general insurance sector is heavily consolidated and has pricing power which, unlike the banks which are under intense political scrutiny, it can deploy. There is a solid and conservative core to IAG.

The improvement in the UK business in such a difficult environment has provided Wilkins with some options for removing it as a major source of risk and concern for management and shareholders in an environment where any exposure to Europe and the UK by Australian financial institutions, whether banks or insurers, generates uneasiness.