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FIIG Credit Research

Banking On A Slowdown

Andrew Mayes

10 minute read

Bank bonds – an opportunity to increase IG exposure

We believe credit fundamentals for Australia’s banking sector provide a strong starting point as parallels are being increasingly drawn between COVID-19 and the Global Financial Crisis (GFC) (among other periods of significant stress).

Funding profiles for both major and regional banks have improved considerably since the GFC, with a reliance on short-term wholesale down noticeably; customer deposits, the most stable source of funding, is correspondingly stronger.
Capitalisation has similarly strengthened during this period, with major and regional banks above ‘unquestionably strong’ benchmarks. We expect local banks to prioritise capital preservation. Although not our base case, we also note a temporary freeze on dividends could also materialise, given regulators in Europe, England, and New Zealand have either encouraged or indeed mandated such actions.
Given the local major banks rely in-part on dividends from their New Zealand subsidiaries to pay their own distributions to shareholders, we believe a reduction in their respective payout ratios is a high probability. Ultimately, any attempt to preserve capital will be supportive for bank funding higher up the capital structure, including hybrids (and particularly) Tier 2 debt.
Arrears and credit losses across Australia’s banking sector have benefited from nearly a decade of benign operating conditions. Both will rise in the near-term given the widespread loss of employment--temporary or otherwise--although the starting point is very low. Recent announcements from the government will help with headline unemployment rates, although underemployment is likely to remain a very large and real problem.
Nevertheless, if we assume (not predicting) loss rates comparable to those witnessed during the GFC were to be applied today, both major and regional banks would have the capacity to absorb those without significantly deteriorating their creditworthiness. Capital ratios would be impacted by both a decline in the numerator--lower earnings--and an increase in the denominator--higher risk weighted assets, as performing assets would be reclassified to non-performing, which attract a higher risk weight.
Broadly, from a credit perspective, we see little to differentiate amongst the four major banks. There are likely to be very few, if any, sectors that are not in some way adversely impacted by COVID-19. Those with a greater exposure to residential mortgages--Commonwealth Bank and Westpac--may be more impacted this time around. However, we remain comfortable with the credit profiles of all four major banks.
Regional banks have less financial flexibility, but typically have a relatively lower exposure to larger, idiosyncratic risks. We prefer the credit profile of Bendigo over Bank of Queensland, although both should withstand the invariable increase in arrears and credit losses.

The growing risk of a health (and economic) crisis morphing into a credit crisis is unfolding in front of us, with individuals housebound (and either underemployed or unemployed) for an undefined period of time. Consumer and business confidence have sunk precipitously. The Australian private sector (business and consumer) accounts for around three-quarter of gross domestic product (GDP). Except for some essential goods (think food, medicine, and... jigsaw puzzles), this will present a significant shock to demand, to say nothing of the impact to individual wellbeing.

Interbank funding markets have settled as central banks around the world, including the Reserve Bank of Australia (RBA), cut rates to the bone (and committed to maintaining them at low levels for as long as necessary), and re-opened liquidity facilities to support credit markets (see here). With borrowing costs set to remain very low for an extended period, focus has since shifted to the fiscal response--serviceability of debt only works if one has the income (to service it). To date, an unprecedented level of fiscal measures have been announced locally, equivalent to around 16.5% of GDP (or more than three-times as much as in the Global Financial Crisis [GFC])

To be clear, these measures are not stimulatory--yet. Inflation will likely come, but not for a while. The aim for now is to keep individuals employed and preferably housebound (to stem the transmission of the virus). The latest announcement--an AUD130bn ‘JobKeeper Payment’, which falls short of the equivalent of a universal basic income for qualifying employees, but is arguably the most effective announcement to-date--should keep unemployment from reaching the stratosphere, although underemployment and hours work will remain a significant problem--as was the case long before we had heard of COVID-19.

In this note, we take a look at the health of the corporate and household sectors in Australia and how the banking sector is positioned to absorb the invariable rise in credit costs as businesses shutter and unemployment rises.

Bank credit fundamentals provide a strong starting point as parallels are drawn with the GFC

Widening of bank spreads--more than a function of credit worthiness

Spreads on bank debt widened recently (bond prices fell) as volatility surged in financial markets on mounting concerns over the economic impact of the virus (see Figure 1 and 2). While the widening in spreads undoubtedly stemmed in-part from the financial impact to banks, we believe it also reflected other non-credit factors, including a rush for US dollar-denominated liquidity (also see here) (for example, the sell-off in US-denominated debt was greater than the impact on locally-denominated debt). As such, the recent performance of bank debt has probably overstated somewhat the risk to local bank creditworthiness, in our view.

Figure 1: BBSW/OIS Spread (bps)

Source: Bloomberg

Figure 2: CBOE Volatility Index (VIX)

Source: FRED, Federal Reserve Bank of St. Louis. Data as at 31 March 2020

Funding and capital levels have improved significantly since the GFC

Funding profiles for both major and regional banks have improved considerably since the GFC, with a reliance on short-term wholesale down noticeably; customer deposits, the most stable source of funding, is correspondingly stronger, for the most part (see Figure 3). As we learnt during the global financial crisis, increasing tension amongst interbank funding markets can make it challenging for banks to rollover term debt, most notably short-term wholesale, but also long-term--the latter was on display recently when both NAB and Macquarie Bank withdrew proposed long-term wholesale (hybrid) issues, citing market volatility but also likely driven by a rapidly moving situation that would have exposed them from a disclosure perspective.

Figure 3: Funding Mix Evolution

Source: FRED, Federal Reserve Bank of St. Louis. Data as at 31 March 2020

Figure 4: FY20 Major Bank Funding Task (AUDbn)

Source: Bloomberg. Includes long and short-term wholesale debt FY20 for CBA: 30 June 2020. FY20 for ANZ, NAB and WBC = 30 Sept 2020 Percentage of FY20 refinancing completed in parentheses

Another factor working in favour of local banks is an anaemic level of credit growth currently (around 2.5%, compared with more than 15% in the years leading into the global financial crisis), which effectively reduces the funding task to refinancing maturing liabilities (see Figure 4). The four major banks have made good progress against their FY20 funding task and the remaining refinance task has been made somewhat easier following central bank intervention.

Capitalisation has similarly strengthened during this period (see Figure 5). For major banks locally, common equity headroom above the Capital Conversation Buffer (CCB) is equivalent to around two-times normalised earnings (see Figure 5). Typically, if the Common Equity Tier 1 Capital (CET1) Ratio falls below the CCB, earnings available to distribute to shareholders is reduced for the bank in question. Although we believe it’s unlikely local banks will breach their CCB in the near term--see below for our rationale--we believe local banks, both major and regional, will suspend distributions (as Bank of Queensland did) to shareholders in the near term to reinforce capital levels, given the high degree of uncertainty about the depth, breadth and length of the current downturn (see immediately below for further rationale). This includes ANZ and CBA who nevertheless may be better-placed given greater headroom above regulatory minimums following divestment of non-core assets. For comparison, dividend payout ratios declined to around 50% on average across the four major banks during the GFC.

We note the European Central Bank, Bank of England, and more recently, the Reserve Bank of New Zealand, have either recommended or indeed ordered banks under their jurisdiction to freeze dividend payments and share buybacks (recall that Eurozone banks, including those in the UK, required considerable government support, and as such, are still somewhat sensitive to repatriation of capital to shareholders). In New Zealand, repatriation of capital to Australia is similarly a sensitive theme.

While we do not foresee local regulators taking a similar approach, we believe capital preservation will be a priority for our domestic banks. Given the local major banks rely on dividends from their New Zealand subsidiaries to pay their own distributions to shareholders, we believe a reduction in their respective payout ratios is a high probability. Ultimately, any attempt to preserve capital will be supportive for bank funding higher up the capital structure, including Tier 2 debt.

Figure 5: Capitalisation (% of Risk Weighted Assets)

Source: Company data

Arrears and credit losses will rise, but from a very low base

We enter this period of considerable uncertainty with a corporate leverage down, household leverage up, but prepayments elevated. Corporate leverage is approximately a third of what it was leading up to the GFC (see Figure 6). On the other hand, household indebtedness is very high--and amongst the highest in the world (see Figure 7 and 8) (on a side note, this is why it is unlikely in our view that you will see the rollout of a ‘mortgage holiday’ similar to that introduced in Italy, where household debt is around a third of that in Australia).

Figure 6: Non-Financial Corporate Gearing (Debt/Equity)

Source: Australian Bureau of Statistics (ABS)

Figure 7: Global Household Debt

Source: Bank of International Settlements

In recent years, Australian households have largely responded to falling interest rates by prioritising (p-)repayment of debt (see Figure 9), although low savings rates amongst households suggest these buffers are likely to shrink rather rapidly.

Figure 8: Australian Household Indebtedness

Source: Bank of International Settlements

Figure 9: Mortgage Prepayments (No. of Months)

Source: Reserve Bank of Australia

Around 90% of businesses recently surveyed by the ABS expected to be adversely impacted as a result of the virus. Accommodation and food services, and retail and wholesale trade, as well as recreation and entertainment services, have been particularly impacted, although we expect further adverse impacts to be felt more broadly, including commercial property, construction and manufacturing. Invariably, arrears and credit losses will rise, including impacted individuals with mortgages (see Figure 10 for bank exposure currently and during the GFC, including performance).

Close to a decade of benign operating conditions--including accommodative interest rates, stable employment and reasonably strong economic growth--has provided a backdrop for low arrears and credit losses across Australia’s banking sector (see Figure 11). At the height of the GFC, credit losses rose to around 80 bps across Australia’s banking sector (see Figure 11). Comparisons with the GFC are not straightforward--larger banks have dramatically shifted the composition of their balance sheets since then, while unemployment (and particularly underemployment) is likely to be much higher this time around. There are other factors, including the forementioned lower levels of corporate leverage presently. Nevertheless, if we assume (but not predict) a similar increase this time around, credit losses would amount to an average of ~AUD5.3bn per major bank--a substantial loss, but one that would be absorbed (see Figure 5). For the smaller regionals, closer to AUD430m--equivalent to a year worth of earnings, but again, one that can be absorbed.

Figure 10: Non-Performing Loans (Sectors of Interest)

Source: Major Bank Pillar 3 reports. *Excludes CBA. ^Includes mortgages and personal loans. Sector share of total consolidated exposures in parentheses

Figure 11: Australian Bank Credit Performance

Figure 11: Australian Household Indebtedness

Source: Australian Prudential Regulation Authority

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