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Banking and Capital Markets

The JournalMajor banks analysis: How do you knowwhen you have turned a corner?

December 2009

PwC Journal Nov 09:Major banks analysis 21/12/2009 13:49

While bad debt expenses havedoubled, income growth has beenstrong and this has enabled them tohold the reduction in aggregateunderlying cash earnings to just 2.4%.

Key elements of their combinedunderlying cash earnings are:

• Very strong net interest incomegrowth driven by margin expansionas well as volume growth in somesegments.

• Reduced wealth managementearnings following equity marketdeclines.

• Significant increases in financialmarkets revenue.

• Continued focus on costmanagement.

• A near doubling in bad debtsexpense compared to 2008.

• Overall only a modest reductionin underlying cash earnings forthe year.

In ‘big picture’ terms, the banks haveearned combined cash profits of $18bnin FY07, $17.5b in FY08 and $17.1bn inFY09. During this period, the bad debtexpense has climbed from $2.4bn inFY07 to $6.7bn in FY08 and to $13.1bnin FY09. Clearly, if the bad debtexpense returns to more ‘normal’ levelsin the future, the banks appear wellpositioned to improve their earnings.

Michael CodlingPricewaterhouseCoopers(Australia) +61 (2) 8266 [email protected]

Hugh HarleyPricewaterhouseCoopers(Australia) +61 (2) 8266 [email protected]

2 PricewaterhouseCoopers The JournalMajor banks analysis: How do you know when you have turned a corner?

The four major banks in Australia have now reported their full-yearearnings for 2009 and in doing so show that they have navigatedthe most challenging period in international banking marketsin over 60 years with considerable success. Michael Codlingand Hugh Harley outline some of the key findings followingPricewaterhouseCoopers’ analysis of the Australian major banksannual results for 2009.

Four major banks combined performance – $A million – underlying cash earnings

Source: PricewaterhouseCoopers analysis of the major banks’ results for 2009

FY09 FY08 09 vs 08

43,789 36,556 19.8%

22,268 21,307 4.5%

66,057 57,863 14.2%

29,097 27,091 7.4%

36,960 30,782 20.1%

13,211 6,714 96.8%

6,577 6,464 1.7%

103 112 (8.0%)

17,069 17,492 (2.4%)

13,701Statutory results

Underlying cash earnings after tax before significant items

Outside equity interests

Tax expense

Bad debt expense

Core earnings

Operating expense

Total income

Other operating income

Net interest income

16,505 (17.0%)


This result for FY09 reflects the factthat the economic and financialenvironment in Australia has been lessturbulent than expected at the start ofthe calendar year, with the Australianeconomy dodging recession, growth inunemployment slowing, and lessvolatility in overseas wholesale fundingmarkets. Residential property priceshave stabilised (and in some segmentsincreased), while commercial propertyprices have continued to weaken butin an orderly and relatively benignmanner. Equity investors, not least thedomestic superannuation funds, havebeen willing supporters of equityraisings.

In this environment, the banks havebeen able to increase their aggregatenet interest income by 19.8% in FY09.This was driven by margins improvingfor the third half-year in a row as thebanks repriced their loans; plus thebanks benefited from the ‘flight tosafety’, which resulted in a 13.4%average increase in their deposits.Another highlight was the significantincrease in financial markets revenue,although this tailed down in thesecond half.

Looking to the year ahead, we expecteconomic growth in Australia to be inthe order of 2% to 2.5% in 2010,compared to 0.4% in 2009. In otherwords, we expect an ongoingeconomic recovery, but with theeconomy still growing below trend.While growth may yet again surprise onthe upside, there are a number ofuncertainties remaining for theinternational financial system and theinternational economy which add to therisks for the year ahead:

• Many financial institutions in thenorthern hemisphere are stillcarrying substantial portfolios oftoxic assets.

• The underlying trade and capitalimbalances between the majoreconomies remain.

• The dramatic growth in publicsector debt in many westerneconomies may create fundingchallenges for wholesale markets.

• Stimulatory packages are beingphased down in many economies.

• Interest rates cannot remain athistoric lows indefinitely.

Taken together these considerationssuggest that the operating environmentfor the domestic banks is on animproving trend, but with a risk ofperiods of volatility in financial marketsdriven by offshore events. We alsoexpect the ongoing improvement indomestic economic conditions totranslate into only modestimprovements in the demand for bankborrowing until well into 2010, ashouseholds and businesses continueto take a cautious approach,strengthening their balance sheets andbeing wary of the potential for higherinterest rates.

On the regulatory front the changeprocess still has a long way to go.It seems clear at the international levelthat the approach is one of significantrefinement to the existing frameworksrather than root-and-branch reform.The timetable set out by the G20 inPittsburgh is nonetheless ambitious,stretching out to at least 2013, andAustralia has little option but to fall intoline with that timetable. Inevitably thenet effect of the changes will be toraise the cost of deposit raising andlending by banks which will, at least inpart, be passed on to customers.

The liquidity risk managementproposals recently released by theAustralian Prudential RegulationAuthorities (APRA) illustrate this point.The proposals will translate into

PricewaterhouseCoopers The Journal 3Major banks analysis: How do you know when you have turned a corner?



requirements for the banks to increasetheir ‘as normal’ holdings of low-yieldliquid assets, in particular of the limitedpool of Australian government bonds.Inevitably this will increase fundingcosts which will flow into higher lendingrates and, at least potentially, lowerbank lending. We support the directionof these proposals but believe certainaspects, such as the definition of liquidassets, need review so as to ensurethat the right balance is struck betweensystem stability and efficiency needs.

We do not support calls for a majorreview of the Australian financialsystem. The system has shown itsability to withstand extraordinaryexternal pressure, albeit with somegovernment underwriting. It may bethat a major review is warranted in afew years’ time when we really can beconfident that all the disruption of thiscrisis is behind us and we can lookback dispassionately. By then we willalso understand the full extent ofchanges to the international regulatoryenvironment. In the meantime, what isrequired at present is a focus onspecific, actionable changes in policywhich can help the economy adjust toa post-global financial crisis (GFC)world and return to trend growth assoon as possible.

Possible policy actions which fall intothis category for banking include:reducing tax rates on domesticdeposits, which we believe is a matterof priority; confirming future depositinsurance arrangements; abolishinginterest withholding tax to encourageforeign banks to operate in Australia;and facilitating the growth of a muchdeeper corporate bond market inAustralia. We would also like to seechanges to policy to stimulate thesecuritisation market further, becausemore activity in this market will assistwith both funding and competitionmore generally. However, we suspect

that the international debate aboutsecuritisation still has a long way torun (especially ‘skin in the game’requirements), which may makequick changes to domesticrequirements difficult.

Beyond navigating 2010 andimpending regulatory change, thechallenge for banks will be to harnesssufficient funds – both debt and equity– to meet the investment needs of theAustralian economy in a post-GFCworld. In the medium and long term,the potential for investment in theAustralian economy may beunprecedented, driven by factorsincluding export demand for resources,infrastructure requirements for rapidpopulation growth, Australia’senhanced reputation as an internationalinvestment destination, and respondingto climate change.

In one way the funding challenge forthe major banks has been disguised bythe GFC, because while there has beena much greater emphasis on depositsfor funding, the deposit market itselfhas been growing quickly at 20%-plus.Now that the deposit market isreturning closer to trend growth, thisbegs the question of the banks’ abilityto grow funding sufficiently quicklyto meet the lending needs of theeconomy. Hence our emphasis aboveon reducing tax rates on bankdeposits.

Inevitably though, a return to thoselower trend rates of deposit growth at atime of stronger economic growth willrequire the banks to review carefullytheir use of wholesale funds and, inparticular, offshore funds. Indeed thebanks play a key role as a conduit offoreign borrowing into Australia, havingborrowed a total of $115 billion fromoverseas in the past year.


In turn, this is why the retention bythe Australian majors of their AAcredit ratings has been so important.Assuming no major disruptions ininternational financial markets, webelieve that the combination ofinternational confidence in both theAustralian major banks and in theAustralian economy more generallywill ensure that the Australian bankscontinue to be able to find willingoverseas lenders to fund theiroperations.

Rather, over time, the issue may bemore around the banks’ ownwillingness, from entirely justifiable riskmanagement considerations, toexpand their offshore borrowingsrelative to their domestic liabilities,bringing us back again to the criticalimportance of growth in domesticdeposits. Given an outlook of onlymodest growth in demand forborrowing in the short term, we do notexpect this to be a binding constraint,but it may emerge as an issue shoulddemand for borrowing accelerate.

As we have previously argued,Australia has come through the GFCprecisely because of the combinationof a strong and profitable bankingsystem in tandem with robusteconomic policy and industrysupervision. The need for this balancedapproach of strengths from all sideswill be just as important to ensure thatAustralia takes maximum advantage ofits current strong position.

The banks themselves focused onstrengthening their balance sheets inFY09, with aggregate tier 1 capitalrising by 118bps. As a consequence,their combined average return onequity over the past year has been13.1%, compared to an average of16.6% in FY08. The increased level ofcapital now held will likely lead to are-evaluation of the longer-termreturns that a highly regulated bankshould achieve.

The banks’ competitive position in themarket hasn’t been so strong for manyyears, and we expect that margins willcontinue to increase in FY10 and baddebt expenses will moderate. However,system credit growth will take sometime to recover, and fee income willremain under pressure, particularly inlight of recent initiatives to reduce oreliminate certain fees.

So where does this leave us? After twoconsecutive years of negative growth inunderlying cash earnings – 2.4% inFY09 and 3.0% in FY08 – we believethe corner may have been turned.At the half-year stage, the PwCbanking gauge predicted that thebanks’ underlying cash earnings forFY09 would finish relatively flat onFY08, as they did. We would becautiously optimistic about FY10, withexpectations of good earnings growthin FY11. The PricewaterhouseCoopersbanking gauge is more bullish,predicting that the banks’ underlyingcash earnings will increase by 13.9%in FY10.

PricewaterhouseCoopers The Journal 5Major banks analysis: How do you know when you have turned a corner?


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