Comm Bank: Boom ends quietly, for now

Commonwealth Bank’s customer surveys suggest Australians are an unhappy lot. With unemployment at just 5%—a figure my Economics lecturer of 15 years ago claimed was impossible—what is there to worry about?

Behavioural finance offers an explanation: We don’t compare ourselves with rioting Greeks or foreclosed Americans. Instead, we look closer to home—to the lopsided distribution of benefits from the mining boom; the higher costs of living; and the (in)adequacy of retirement incomes.

The remarkable figures in the latest round of bank profit results only compound the feeling that someone, somewhere, is doing better than us. That sense of envy, however, may soon be replaced with one of pity. Although you wouldn’t see it in the Commonwealth’s latest result, banks are beginning to struggle.

Compared to the same period in 2010, Commonwealth’s interim cash earnings increased 7% to $3.6bn while cash earnings per share rose 6% to $2.27. As a result a fully franked interim dividend of $1.37 cents was declared (ex date 20 Feb), up from $1.32.

Result highlights

Highlights included the retail banking division, which represents 40% of the bank’s total profit, delivering a profit up 3% to $1.4bn. Even the company’s net interest margin (the difference between what a bank charges on loans and pays on deposits and debts) increased slightly to 2.15%, helping keep return on equity steady at pre-GFC levels of 19.2%.

The good news continued with bad debts falling 25% to $545m. Even BankWest managed to increase profit by 20% to $268m, revealing how the $2.1bn purchase price was a real steal.

Where, then, is the struggle? Whilst the numbers look good, things are about to get worse—potentially much worse.

There are three reasons for that. The first is readily dealt with: Investors don’t like erratic, falling sharemarkets, which is why Commonwealth’s wealth management business, led by Colonial, experienced a 24% drop in profits to $272m. This, one might hope, is a cyclical decline that will eventually recover.

The increase in Australia’s savings rate, from 2.1% in 2006 to 10.4% in 2011, is not so easily explained away. Australian household debt levels have increased from around 40% of disposable income in the 1980s to 155% currently. That’s higher than in the US, where a housing market-led economic collapse ensued.

Clearly, household debt levels can’t stay that high forever but whether this is a cyclical trough or not is hard to say. Commonwealth’s own forecasts suggest 2012 will be the low point for credit growth but it also signifies the end of Australia’s greatest ever credit boom, ending with a whimper rather than a bang.

Mean reversion

The upshot is that banking profit growth may well be reverting to the mean. Indeed, retail banking profits actually fell 1% compared to the six months ended 30 June 2011. This is good for the sustainability of future banking profits and economic growth but it means the future probably won’t look like the past: bank shareholders shouldn’t expect much in the way of capital gains from here.

The third component poses the biggest immediate threat to bank profitability. Chart 1, reproduced from slide seven of Commonwealth’s results presentation, shows how wholesale funding costs have increased.

Since 2009 the bank has tempted savers and managed to increase its proportion of deposit funding from 56% in 2009 to 62%. But a reliance on overseas funding remains its Achilles heel.

We’re about to learn that extremely high banking profits aren’t down to good management and regulation but rather the world’s largest credit boom, financed locally with the help of foreign money. Now we’re finding out what banks do when that ends and money becomes more expensive.

The spate of income security offers is but one indicator. Why pay expensive overseas lenders, they tell themselves, when you can borrow at home from nervous investors for a much lower rate? We’re going to see many more of these offers over coming weeks.

Increasing margin spreads is another tactic. Banks don’t want to pay the higher costs of offshore funding so they’re going to pass as much as they can on to you, the borrower.

It’s already clear that the relationship between the Reserve Bank’s cash rate and average mortgage rates is breaking down. Banks have said as much. Mortgage holders might get crunched as banks will do everything in their power to pass on higher funding costs.

In truth, without sacrificing their profitability, they don’t have much choice. The strategies of the past are no longer available. With bad debt levels back around pre-GFC levels, more stable bad debt expenses will no longer boost profits. And lower debt provisioning also reduces protection against falling home prices.

Decision points

Consolidation doesn’t offer much scope either. The insurance, funds management, retirement planning and institutional banking industries have already been colonised by the big four. And the low hanging fruit of moving back office tasks overseas, closing branches and using new technology to produce large efficiency gains has already been picked.

Perhaps Commonwealth will be tempted by a distressed overseas acquisition but given the experience of National Australia Bank in the UK, we hope they don’t follow ANZ’s path.

No, in the end it all comes down to the essentials of the industry: how much does a bank pay to borrow money and what can it charge to lend it out? Banks will be trying to borrow for less and charge more—simple as that.

Where does that leave Commonwealth shareholders?

If China experiences a hard landing and/or Australian home prices keep falling, you might consider holding some cash for future capital raisings. But our main injunction is to portfolio limits: Including bank-issued income securities, keep your exposure to the banking sector to 10% overall and for Commonwealth, 5% in particular.

Despite their larger exposure to the Australian housing market, we still prefer Commonwealth and Westpac over ANZ and National Australia but all banks are entering potentially troubling times.

With Commonwealth’s share price up 3% since the update on 17 Nov 11 (Hold – $48.64) we’re sticking with HOLD but please, pay attention to those portfolio limits.

Note: Next week we’ll be publishing a feature explaining the impact of wholesale funding costs on the banking sector and the threats it poses to investors.