Why cash-filled Commonwealth is hedging its bets

In an environment where demand for credit has been weak and patchy, the Commonwealth Bank result is an extremely impressive one, reflecting a pay-off from the years of heavy investment in systems, productivity and customer satisfaction.

The bottom line, a 10 per cent increase in cash earnings to $7.8 billion, was a very solid result but it is the detail of the performance that is most notable, particularly the ability of the group to keep the growth in its costs well below its income growth. Expenses rose 4 per cent but income was up 7 per cent.

Commonwealth Bank was able to improve its cost-to-income ratio by a full percentage point, to 45 per cent, with the cost-to-income ratio within its core retail banking business improving by 160 basis points, to 38.5 per cent.

Part of the explanation for that is the big investment in technology that began under David Murray and continued under Ralph Norris and now Ian Narev. The bank invested about $1.2 billion in the latest financial year and continues to spend heavily to improve its efficiency and effectiveness and to protect itself from the prospective threat of new technology-based competitors.

That’s an enabler of what the group describes as its ‘productivity culture’, which was reflected in increases in customer service and sales and converted referrals transactions per employee as well as a truncation of the time to execute transactions and services.

In a low-growth environment, the 4 per cent increase in interest-earnings assets during the year, to $653.6 billion, was material and was driven by above-system growth in home loans, deposits and business lending that didn’t involve sacrificing margin. Commonwealth Bank’s net interest margin rose 7 bps between December and June, from 2.10 per cent to 2.17 per cent.

The growth in its Australian loan portfolio of $24 billion was match-funded by a $25 billion increase in average deposits. The bank is 63 per cent deposit funded and, with a common equity tier one capital adequacy ratio of 11 per cent and $137 billion of liquidity, is conservatively positioned.

Commonwealth Bank is predominantly a retail bank and it was its retail banking business that drove the result, lifting earnings 13 per cent to $3.95 billion. The contribution from its business and private banking unit was down 2 per cent. Wealth management (up 9 per cent) and its New Zealand business (up 17 per cent) also produced strong results.

The strength of its profitability and balance sheet had led to some expectation that Commonwealth Bank would pay a special dividend to trim its store of surplus capital. It didn’t, despite a slight reduction in its return on equity from 18.6 per cent to 18.4 per cent, although its annual dividend of $3.64 a share was 9 per cent higher than the previous year’s.

That would tend to signal some nervousness about the outlook even though the group’s loan impairment expenses were down 1 per cent for the year and the group said that, while some of its customers were facing “challenges”, this wasn’t translating into a deterioration of credit quality.

Commonwealth Bank did refer to the “uncertain” outlook for both the global and domestic economies in a reference to the strength of its balance sheet, supporting the view that it is concerned that conditions and credit quality could deteriorate.

It sees limited short-term upside for the domestic economy and says confidence (which recent surveys have indicated is lacking within both businesses and consumers) is the key to the outlook.

Conditions in China, the value of the Australian dollar and the stability of funding markets were other factors which would influence the outcome of the 2013-14 year but, as a predominantly Australasian retail bank, it is the domestic settings that will most influence its performance.

Ian Narev won’t be the only chief executive hoping for a clean outcome from the federal election and more consistent and predictable policy settings from the new parliament, although he did say that he expected conditions this financial year to be similar to those in the year just ended, suggesting he’s not that confident there will be an improvement in conditions once the election is out of the way.