Why I love the banks

Australian banks are proxies for the economy and, on balance, should trade at close to the market multiple. This view is supported by the pace of evolution in the banking sector over the past decade as a result of the following critical events:

• Regulation/supervision that increases sector transparency and efficiency.
• Risk management that reduces interest rate and other operating risks.
• Retirement opportunity '” the supercharged superannuation segment that is set to further reduce banks' reliance on net interest earnings.
• Return on economic capital discipline, which leads to capital efficiency.

On balance, the Australian banks remain in good shape and should continue to provide good value. The Commonwealth St George banks remain my preferred bank exposures.

Source: Company data and Southern Cross Equities estimates

Banks are not what they used to be

On average, the Australian banks continue to trade at a discount to the market. I feel this is hardly justified because they are proxies for the economy and should trade at close to the market multiple. Bank valuation is traditionally penalised by the probability of loan losses. The market discounts the banks because of the likelihood of loan default '” the unexpected.

But times have changed. I believe banks have evolved over the past decade in terms of their robustness, risk management, revenue diversification and focus on economic return. This should ensure their continued relevance and competitiveness. I am, therefore, not surprised to learn that the banks have outperformed the other sectors in recent times, as shown in the next chart. This leads me to believe that the structure of Australian banking changed enough to warrant a new, positive perspective on relative valuation. I discuss in the following sections the key reasons why banks in general should continue to outperform the market.

More transparent, more efficient

Prudential supervision imposes a cost on banks but I believe there are also benefits from having a disciplined and structured approach to bank risk management. I believe the banks' relative outperformance can be traced back to the deregulation of the Australian financial system in 1983 and the establishment of the Financial System Inquiry (FSI) in 1996. Both of these are designed to achieve a more transparent, competitive and efficient financial system.

The banks' competitiveness has improved significantly since these events and the establishment of the Australian Prudential Regulation Authority (APRA) in 1998. The disciplines imposed mean the local banks are now more transparent, efficient and more adept in risk management than their overseas counterparts. This has allowed the local banks to cope with competitive pressure from overseas banks such as HBOS and ING.

Source: Bloomberg and SCE

Less sensitive to interest rates

Most Australian banks remain liability sensitive; that is, their liabilities reprice earlier than assets. They tend to fare better (through lower funding costs) when short-term rates decline, and tend to be worse off when short-term rates increase. I believe the banks have improved their interest rate risk management capabilities over recent years. This has resulted in a much lower inverse correlation between bank performance and interest rates since 1999.

Source: Bloomberg and SCE estimates

One way to evaluate this capability is to assess the banks' duration gap, measured in years. The lower the gap, the smaller the impact of interest rate changes to margins. Excluding Bank of Queensland and Bendigo Bank, this relationship is illustrated in Figure 4 with a correlation of 0.9. There appears to be scope for NAB, St George Bank and Commonwealth Bank to further manage their duration gap to reduce margin decline.

The emphasis towards fee income has also reduced the banks' susceptibility to interest rate movements. St George, Commonwealth Bank and Bendigo Bank in particular stand out in having reduced their reliance on margin income (Figure 5).

Source: Company data and SCE estimates

Retirement opportunities

Changes to superannuation have benefited the banks with significant wealth management businesses. Superannuation is a direct substitute for bank savings and this explains the ability of retail banks to cross-sell in this segment. Figure 6 supports our view that banks are becoming less reliant on net interest earnings. I expect Commonwealth Bank to continue to be the market leader in this space with its above-average net fund inflows, followed by Westpac and St George Bank (Figure 7). As the laggard in this segment, I believe ANZ would have to acquire either the share of the INGA JV it does not already own, or wealth managers such as IFL and AMP for scale effect.

Source: Company data and SCE estimates

The Superannuation Guarantee Charge was mandated in July 1992, but it took another four or five years before the funds started to flow in (Figure 8). I believe it will take a similar time period for additional funds to start flowing following the introduction of superannuation tax reforms mooted in this year’s budget. I expect a significant boost to wealth management earnings for the above-mentioned banks in the medium term.

Source: Bloomberg and SCE estimates

Return on economic capital

In addition to better risk management and revenue diversification, I believe banks have outperformed in recent times because of their ability to manage capital efficiently. I prefer banks to grow profitably rather than grow for growth's sake. This is a discipline that ensures any return from incremental business should cover the bank's cost of equity. A further upside is that by choosing not to grow in an unprofitable segment, the capital that would have been set aside to fund the growth would more likely be returned through higher dividends.

Banks do not manage their business on an individual product/segment basis. Instead, they do so using a portfolio approach that seeks to optimise capital allocation and maximise economic return (Figure 9). This approach also allows the banks to operate in micro-economies that have significant local growth opportunities, such as Western Australia and Queensland.

Source: SCE estimates

Banks have been progressively paying higher dividends since 1999 (Figure 10). I believe this is primarily due to efficiencies in capital management as described above. It also explains to a large extent the banks' recent market outperformance '” the dividend factor (Figure 11).

Source: Bloomberg

Banks have paid $72 billion dividends in the past 10 years. Of this, 92% is attributable to the major banks alone.

I provide an update of the banks' capital generation and usage rates in Figures 12 and 13. I have excluded Suncorp-Metway from this analysis due to the pending Promina Group acquisition. The banks that generate the highest economic return (Figure 1) also tend to have high capital generation rates and high payout ratios. On balance, the charts below support Commonwealth Bank as my preferred major bank exposure ($54 price target: Buy), and St George as my preferred regional bank exposure ($36.00 price target: Buy).

Source: Bloomberg and SCE estimates

The main point of this note is to encourage investors to consider whether the Australian Banking sector deserves a permanently higher price/earnings (P/E) multiple to reflect lower asset risk and higher diversity of income streams. The pure debt ratings agencies have been upgrading major and regional bank debt ratings for the past decade. If lending to the banks is now lower risk, as measured by debt ratings, why then shouldn't we be also be experiencing P/E expansion to reflect that lower asset risk situation?

Southern Cross Equities bank analyst, TS Lim, is not looking to history for his guide to Australian bank sector pricing. Too many of our competitors simply look at current P/Es versus historic P/Es and come to the same conclusion that my Labrador could: that "banks are expensive". It’s not comparing apples with apples, and it will cost you performance if you continue to view the banking sector in that way.

Betting against Australian banks hasn't worked for a decade, and with the value of fully franked dividend streams rising under a falling personal income tax regime and rising compulsory superannuation contribution regime, I maintain that betting against Australian banks this decade, particularly those with a high percentage of wealth management earnings, will remain a flawed strategy. Look forwards, not backwards.