Life is a very straightforward process: something is conceived, it’s then born, grows, matures, plateaus, then eventually deteriorates until it dies. Of course that’s a ‘healthy’ life-cycle. Some lifecycles are unfortunately cut short and others are extended beyond what would be defined as natural. Companies or businesses have a life cycle too. Yes some companies may be around for decades, or even centuries, but eventually they will die, or at the very least evolve into something different. Banking corporations are no different. That’s why there is so much pressure on banks to get bigger (or grow). Our economic system simply doesn’t take kindly to entities that are happy to just ‘be’. Last week we saw three of Australia’s big four banks post billions of dollars in profits. How did they do that? Can those sorts of profits be maintained? And are they playing fair?
Let’s look at some of the hard facts.
The National Australia Bank kicked things off early last week with its $1.4 billion June quarter earnings result. Not bad – especially when the bank said that figure now puts it on track to achieve a record full year profit of around $5.5 billion. The Commonwealth Bank was up next. It came shining through with a record full year profit of $7.1 billion. A fattened dividend distribution was the icing on the cake this time around though - analysts were surprised when the figure came in at the top end of their estimates. In fact retirees with a fair chunk of their super in the CBA would have also been laughing all the way to the bank. Then, as if that wasn’t enough, the ANZ played its hand delivering a 9 month profit of $4.5 billion, up 5.5 per cent on the previous period. One thing is certainly for sure, when you look at all these numbers, none of the big four banks can cry poor.
So why is there a sense of anxiety about the earnings potential of big four banks? They look in pretty good shape don’t they? The answer lies at the very heart of finance. So what is finance? It involves two words: debt and equity. Put simply, it’s how you pay for stuff when you don’t have the cash up front. Banks exist because consumers finance their purchases through debt. That’s all pretty straight forward – the bank has money and you don’t… you want to buy something you can’t pay for right now… so you ask the bank for money and it gives it to you, as long as you provide some sort of security like a car or a house. Most commonly consumers will interact with a bank to buy a house (a mortgage). So what about the equity? Well that where it starts to become interesting. Do banks need equity? Of course not, they can just take in deposits (liabilities), lend out loans to borrowers (assets), and make a profit on the difference in cost between the two (the margin). Ah, but that’s not enough, they also need to grow and expand! It’s the business life cycle: if you’re not growing, you’re dying, aren’t you?! Enter equity. Money from the owners of the company (shareholders) who will materially benefit from any growth the bank enjoys. It’s the alchemy of finance, shareholders put money into the organism, watch it grow, and receive more money back (capital gains and dividends). Shareholders are the key to any bank’s growth plans and therefore have to be very well looked after (the CBA’s move to substantially increase its dividend this time around was a smart move). Any anxiety the banks express at any given time can usually be tied back to how well their shareholder base is being looked after. The shareholders are the water that help feed the bank’s branches.
For now, the banks are looking quite robust and healthy. If you look at the financial statements of the big four banks, it’s easy to spot the similarities. They’ve also got very similar business models. Importantly though, each is distinctly different, and in that difference hope to achieve the most positive attention from shareholders.
For the National Australia Bank its point of difference is two-fold: penetration into the business banking space, and its UK operations. It’s competing with the ANZ Bank which also has ambitions to take a share of the nation’s demand for business loans, and has growth plans in Asia. This round of profit results was very telling for both banks. The ANZ managed to dazzle investors with its Asian performance (which now comprises more than 20 per cent of the bank’s earnings). The NAB on the other hand, fell short of expectations after revealing it was scaling back its operations in the UK. The ANZ bet on China and won. The Commonwealth Bank and Westpac are different stories. The Westpac Bank has decided not to give quarterly trading updates anymore but its business model is similar to the CBA. They’re both very domestically focused banks. Both have therefore benefited from the consumer rush to plough money into bank deposit accounts rather than spend it or stay in the share market. Yes the competition for deposits has meant margins have been squeezed, but, importantly, it’s also reduced their reliance on wholesale money markets in Europe to fund their loan books.
All four big banks have focused heavily on cutting costs. For the NAB it’s meant slashing its activities in the UK and sacking staff, for the ANZ it’s meant things like salary freezes and staff cuts, and for the Commonwealth Bank it’s all about having the best technology out there.
With Australia’s unemployment rate among the best in the developed world, relatively high interest rates, improving business confidence and a slight pick-up in the housing market, you can see that, as costs come down the banks are able to squeeze out a slightly bigger profit than last time. When you add in the extra benefits of successful business strategies like the ANZ’s push into Asia, you can see why investors haven’t given up on the banks just yet.
What about next year? Can they do it again? Basing my judgements purely on the reaction of investors on the days of each of the banks’ announcements it would appear that shareholders are looking for evidence that the banks are able to move beyond their core models of personal loans. In the short term investors are looking for banks to become lean and mean. Only the essential back-office staff and equipment, and the most streamline processes they can find (major technological advancements). In the long term they will have to either take a bigger share of the business banking market, or pursue growth opportunities overseas – preferably not in Britain or Europe where economic growth has turned negative. In short, I’d say low single-digit growth looks possible, anything more than that would be quite a big ask.
What do consumers get out of all of this? Well if you’re invested in the banks through a superannuation fund, then you too are also interested in the banks growing further. If, on the other hand, you have a home loan and are struggling to pay off the mortgage, or you’re sick of paying exorbitant bank fees, the future’s not looking so comfortable. There is more attention being paid to unfair bank charges in the courts at present but that’ll be an on-going battle with the banks. As far as interest rates are concerned, well some of the banks are now even starting to talk about actually raising interest rates again sometime next year – the National Australia Bank in particular. The chief economist there, Alan Oster, seems to think as the economy grows further, the RBA will have to start focusing on inflation again. As inflation swells on the back of above-trend economic growth, the bank may be forced to tighten policy in the first move of what would be a new interest rate cycle.
So are the banks playing it fair? It depends on who you are. The bank has many different stakeholders, and, unlike some companies, those stakeholders have competing interests. The bank though will always choose the path that leads to the most growth, regardless of who loses in that scenario. It’s a matter of survival – no matter how healthy the bank is looking at any given time.