Why the banks are set for a profit squeeze

Fitch's prediction of a softening outlook for banks is hardly surprising, but a spike in bad debt charges is unlikely to have a material impact on slower earnings growth.

Fitch Ratings’ assessment of a softening outlook for major bank earnings this year is uncontroversial, although its concerns about higher bad debt charges might be misplaced. There should be other, more material, issues for them to deal with.

The major banks have to some degree defied gravity in recent years, posting solid earnings growth despite modest levels of credit growth.

While the boom in lending for housing under-pinned by historically low interest rates has been a factor, the two big drivers of their performance have been improved productivity/lower costs and a continuing decline in their bad and doubtful debt charges to levels that are extremely low by historical standards.

Last year impairment charges represented only about 0.15 per cent of the banks’ interest-earning assets, which compares with their most recent peak of around 65 basis points during the financial crisis in 2008-09.

It is obvious that, at 15 basis points, there’s not much tailwind left in further reductions in impairment charges. Fitch, however, appears to be concerned that weaker economic conditions and losses with their business loan portfolios could see impairments rise.

If they did -- and it’s not inevitable that they will -- it is improbable at this point that the rise would be material. That’s because the banks actually haven’t been doing much lending to business.

While there was a gradual (albeit modest) increase in business credit growth through 2014, it is still at quite weak levels, running at an annualised rate of less than 5 per cent. Pre-crisis, business credit was growing at rates north of 20 per cent.

If there isn’t much new lending occurring, the likelihood of a spike in bad debts is small.

In fact it wouldn’t necessarily be a bad thing if impairments did rise relative to the banks’ loan portfolios. Don Argus, chief executive of National Australia Bank in the 1990s, used to say that a bank wasn’t taking sufficient risk if it wasn’t incurring impairment charges of around 50 basis points.

The problem, however, hasn’t been the banks’ willingness to lend and accept risk but the reluctance of their business customers to borrow. There has been a significant amount of risk aversion and deleveraging occurring within the business sector and the household sector.

Rather than impairments, it is the relatively low levels of volume growth that may temper the banks’ earnings growth rates. Even demand for home loans appears to be weakening.

That should mean intense, margin-squeezing competition for the demand that is available from business and households. The likely safety valve for the banks is an increase in the already-intense focus on costs and productivity and, perhaps, efforts to further reduce the costs of deposits in order to offset the competitive pressures on lending rates.

The slightly longer-term focus, although one that might start to show up in their 2014-15 numbers towards the end of the financial year, will be the Murray inquiry into the financial system and its probable impact on their capital requirements.

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