banking Agenda: Changing Times - Ey€¦ · Banking Agenda: Changing times Australian major...

Banking Agenda: Changing times Australian major banks’ full year results 2015November 2015

Overview | Market volatility | Capital — how much is enough? | Asset quality | Net interest margin (NIM) | Cost to income | Technology transformation | Wealth — selective divestments | Risk management | Contacts

1 EY Banking Agenda: Full year results 2015

The banks1 have continued to perform well in 2015, but profit growth is slowing. Key challenges facing the sector include financial markets volatility, increasing regulatory capital requirements, and margin compression from low interest rates and intense competition.Cybersecurity is rising up the agenda in line with the ever increasing focus on digital enablement. Emerging fintech competitors are yet to make significant inroads on the banks’ business, but pose both a potential disruptive threat and an opportunity for banks to collaborate to get ahead in the technology innovation race.As regulatory requirements continue to play out, capital management remains at the forefront of the banks’ agendas. Although APRA acknowledges that the banks are well capitalised, it wants more done to make the sector’s capital ratios ‘unquestionably strong’ and in the top quartile of banks globally. This is likely to require an increase in capital ratios of 200bps from June 2014 levels. Mortgage risk weights are also in the spotlight, with APRA introducing a risk weighting floor of 25% for banks using the IRB model. It requires only a simple adjustment to correlation factors used in IRB models to achieve average RWA on residential mortgages of 25%. But the floor is an interim measure only. It could be increased depending on the outcomes of BIS studies and Basel IV, still some time away.

Implementation of the Financial System Inquiry (FSI) recommendations will reshape the banking sector landscape. The Government has largely accepted the recommendations, including the call for stronger capital ratios and reforms to mortgage risk weights. The proposed increased focus on innovation will force individual banks to accelerate their own innovation to maintain competitive differentiation — especially given the recommendations’ aims to facilitate new business models and new market players.Given these headwinds, slowing growth and declining returns have confirmed the end of the banks’ ‘golden era’. As the banks transform their businesses for the new era, the majority of the four banks are transitioning, or have transitioned to new CEOs. Strategic priorities are shifting as these new leaders realign geographies, invest differentially in technology and rationalise portfolios.To survive, let alone thrive in the new environment, banks must refocus on core businesses, redefine their structure and reshape their business through technology – these are the transformation imperatives. The banks are underway on this transformation, underpinned by their investment in technology and the digital agenda. However, they are at very different points in the journey, with very different approaches to technology investment.

Overview — capital, competition and change

Bad debt expenseIncrease of

10.67%

Net interest margin

decrease of 5 basis points

Average return on equity

15.01%decrease of

52 basis points

2.02%

Underlying cash earnings

$30bn

5.3%Increase of

Total

Figures throughout this report are calculated on the prior corresponding period unless otherwise stated.

1 Unless otherwise specified, references to the banks in this publication refer to the ‘big four’ Australian banks: ANZ, CBA, NAB and Westpac

(total of all four banks)



Market volatility — bank share prices take a hitIn recent months, the banks have experienced significant volatility, with the market showing high sensitivity to strategic announcements. The banks’ share prices and market capitalisations have fallen by more than 20%. Share prices are under pressure from uncertainty over capital requirements, pending US interest rate rises and heightened concerns about China’s slowdown – and the knock-on effect on regional and global economies. Although volatility has eased, markets remain unsettled as the global economy recovers more slowly than anticipated.

At a domestic level, Australia has been struggling with the transition to a broader-based economy after a prolonged period of heightened reliance on the resources sector. Business confidence and consumer sentiment have been subdued for a longer than anticipated period post GFC. Select industries, most notably the mining sector, continue to be under pressure with dampened exchange rates and appetite for leverage.

However, Australian banks remain among the largest in the world, ranking in the top 30 by market capitalisation. They also continue to outperform European and US peers in ROE.

100

105

110

115

125

130

120

135

140

Dec 12

Sep 12

Mar 13

Jun 13

Sep 13

Dec 13

Mar 14

Jun 14

Sep 14

Dec 14

Mar 15

Jun 15

Sep 15

85

90

95

100

110

105

115

Dec 12

Sep 12

Mar 13

Jun 13

Sep 13

Dec 13

Mar 14

Jun 14

Sep 14

Dec 14

Mar 15

Jun 15

Sep 15

Business Confidence Consumer Sentiment

Source: Roy Morgan Business Confidence Source: Melbourne Institute



Industry trends on ROE are heading downwards as the banks’ larger capital buffers erode returns from lending. The banks are seeking to offset the impact of higher capital requirements by lifting mortgage rates, but ROE is likely to remain under pressure. Payout ratios may need to be reduced given increased capital needs, the challenge to generate ROE in a low margin/high competition environment and the impact of investment in technology on the banks’ ability to reduce operating costs.

Capital accumulation will continue to be a key focus for the banks, in light of the Government response to the FSI and upcoming Basel IV. There has been much commentary in recent weeks about the costs of regulation and in particular, the costs of maintaining an ‘unquestionably strong’ banking system, driven by the major banks raising interest rates out of cycle with the Reserve Bank of Australia.

Capital — how much is enough?Anticipating higher capital requirements, the banks have undertaken more than $20 billion in capital raisings since May. More may follow, with further potential changes under the global framework and APRA yet to finally determine what constitutes ‘unquestionably strong’ banks. All four banks are also subject to the D-SIB capital buffer from 1 January 2016.

Optimising capital to fund growth remains an imperative. But moves by APRA to strengthen the resilience of the banking sector have raised concerns of excessive constraints on future growth and profitability. In addition to increasing capital and mortgage risk weights, the regulator also wants the banks to strengthen leverage ratios and funding structures. It is calling on banks to shift deposit bases from at call to term deposits and further lengthen bank debt maturity profiles. The Australian banking sector’s reliance on short-term wholesale funding has long been regarded as a vulnerability. Now, lengthening profiles means more expensive funding and more pressure on margins.

As part of the drive to optimise capital, banks are rationalising portfolios. Each of the banks has divested, or is divesting, selected operations that are either not core business or failing to generate an acceptable level of return. This includes stakes in Asian banks, particularly given the Basel III capital treatment of minority stakes. Portfolio rationalisation will not only free up capital for growth, but also deliver improved operational efficiency, cost savings and compliance benefits.

2012 FY 2013 FY 2014 FY 2015 FY

20%

0%

5%

10%

15%

ANZ CBA NAB WBC Average

2012 FY 2013 FY 2014 FY 2015 FY


9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

Return on Equity (Cash Basis) Tier 1 Capital



Asset quality — pockets of pressure emergingAgainst all expectations, the banks have maintained strong asset quality, supporting their full year results. However, as we noted in the half year results, this is not sustainable given economic cycles. The likely cooling of property markets in Sydney and Melbourne, the challenges of Australia’s economic transition and the impact of China’s slowdown suggest bad and doubtful debts will rise from their current low levels.

Pockets of pressure are emerging. In the resources-exposed states of Western Australia and Queensland the banks are experiencing higher levels of stressed retail loans and a slight uptick in mortgage arrears. Deterioration in some commercial property markets is emerging, particularly in apartment sales. Exposure to agribusiness is a further area of rising risk, with environmental impacts continuing to impact the north east Australia regions.

The banks continue to closely monitor potential areas of risk and tighten lending standards in response to the current market environment and regulator areas of focus. In future, the forward looking approach to credit loss provisions under IFRS may also influence the way the banks monitor exposures, given the expectation that more fulsome provisions will be recognised earlier under this standard.

0

500

1,000

1,500

2,000

2,500

2012 FY 2013 FY 2014 FY 2015 FY


0

1,000

2,000

3,000

4,000

2012 FY 2013 FY 2014 FY 2015 FY


5,000

10,000

15,000

20,000 35%

20%

25%

30%

02012 FY 2013 FY 2014 FY 2015 FY

Impairment Total Provisions Impairment %

0

500

1,000

1,500

2,000

2,500

3,000

2012 FY 2013 FY 2014 FY 2015 FY


Specific Provisions ($m)

Collective Provisions ($m)

Aggregate Impairment vs Total Provisions ($m)

Impairment Charges (Statutory) ($m)



Responding to rising housing portfolio riskAustralian banks have a high exposure to the housing market compared with other countries. Housing lending accounts for around 40% of banking industry assets and nearly two-thirds of the aggregate loan portfolio.2 Combined with market concerns over housing prices in Sydney and Melbourne, record-low interest rates and high household debt levels, regulators are understandably wary of the downside risks in the housing market.

APRA and ASIC have increased their scrutiny of loan serviceability and responsible lending for investor lending and interest only loans. In response, the banks have tightened serviceability tests on investor loans and increased minimum deposits. They have also increased interest rates, on both front books and back books, to improve margins and offset the impact of higher capital requirements.

Given the intense competitive pressures and increased housing portfolio risk, regulators remain focused on ensuring the banks maintain appropriate lending standards. APRA has acknowledged that it is slowly ‘turning up the dial’ in its supervisory intensity. The regulator has not resorted to prudential controls so far, but it may be forced to do so if it believes current measures are not sufficiently effective. In addition to its focus on lending standards, the prudential regulator is also scrutinising banks’ data quality, most notably in the area of mortgage lending.

20%

25%

30%

35%

40%

2000 2003 2006 2009 2012 2015

0%

10%

20%

30%

50%

40%

60%

20112010 2012 2013

Owner occupier Investor

2014 2015

Investor Housing Credit — Share of Total Housing Credit

Growth in Investor vs Owner Occupier Housing Credit

Source: Reserve Bank of Australia, EY analysis

Source: Reserve Bank of Australia, EY analysis

2.APRA, Speech: Banking on housing (Wayne Byres), 26 August 2015

Asset quality — pockets of pressure emerging (continued)


Net Interest Margin (Cash Basis)


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

2012 FY 2013 FY 2014 FY 2015 FY


Despite reduced pressure on funding costs, competition, lower rates and regulatory capital requirements are constraining interest margins.

Competition has been particularly fierce in housing lending between both the majors and challenger banks. With the regulatory brakes applied to investor loans, banks are stepping up competition for owner occupier loans.

But the higher regulatory capital requirements are putting pressure on the banks to reprice owner-occupier loans as well as investor loans. All the banks have recently raised variable home loan interest rates for owner occupier and residential investor loans, reported to be the first owner occupier rate increases in more than three years. Further mortgage repricing is anticipated as banks seek to pass on the cost of higher capital to customers and improve margins.

As well as the competition for home loans, banks have noted intense competition from foreign banks in institutional lending. Asian regional banks are looking to Australia as they seek to expand their footprint and grow their market. Banks are also seeing increasing competition in business lending. At the same time, credit demand remains subdued. Margin compression remains a challenge, despite volumes increasing.

Competition from fintech players offering lower-cost services may further compress margins. The technology-driven business models of these players have several advantages over banks, including competitive interest rate offerings, faster processing and lower overheads. In addition, market place lenders, and other shadow bank players who are not subject to the banks’ regulatory compliance requirements, have opportunities for regulatory arbitrage.

Net interest margin (NIM) — competition and lower rates putting the squeeze on margins

The banks will also have to tackle the controversial matter of Interchange Fees and Customer Surcharging. In its response to the FSI, the Government has agreed to improve interchange fee and surcharging arrangements to achieve a more efficient system and fairer outcomes for consumers, merchants and system providers. Increased regulation in this space is likely to place additional pressure on interest free days, card fraud protection and rewards programs, which all provide significant benefit to consumers. Legislation is likely to be phased in banning surcharges that exceed reasonable costs faced by merchants. We expect the banks will more critically evaluate the costs of product features attached to cards such as insurance, concierge services and loyalty points, in preparation for the reduction in fees.



Cost to income — costs of transformation outweighing benefits realisationCost to income (CTI) ratios continue to trend downwards, although achieving a CTI ratio of 40% or less remains elusive. Slowing growth coupled with the costs of growing granularity in regulatory compliance has ensured an ongoing focus on cost discipline and commitment to efficiency.

The major challenge for the banks is to balance the costs of transformation and compliance so the benefits of these programs outweigh the cost of change and deployment. This presents a genuine challenge for the banks to drive down CTI ratios. To date, the banks have started to digitise and automate processes, leading to efficiency and productivity gains at an individual process level, but this is yet to translate to improvements in CTI ratios at the wider bank level.

Robotic Process Automation technology is likely to play an increasing role in driving efficiency. Not only does the technology provide lower-cost process automation, it ensures organisational knowledge is retained locally rather than moved to a captive offshore operation or to an external BPO vendor. This will become increasingly important as the digital-driven pace of change requires banks to continually adjust their processes and operating model to respond to fast moving customer expectations and new disruptive market entrants.

In the longer term, continued investment in IT capability, digital banking channels and branch network restructures will drive operational efficiency and help drive down CTI ratios. But for now, jaws remain narrowed under pressure from the ongoing costs of transformation.

Branch network transformationThe banks are undertaking selective branch reduction and transformation as customers increasingly turn to digital banking. The past decade has seen technology used innovatively to reimagine branches to provide customer self-service for many transactions and free up staff to specialise in more complex, higher value financial needs of customers.

With branch networks accounting for a significant proportion of the cost base, banks are likely to continue to target branches in cost cutting initiatives as the move to digital continues. Although investing in digital channels is an imperative for banks to meet customer needs and minimise costs, this cannot be at the expense of personal interaction. Customers still want the availability of the ‘human touch’ as part of their omni-channel experience, particularly for more complex products and services. For branch staff, moving into higher value, sales focused roles requires a new mindset, skills, behaviours and performance expectations. Banks need to ensure that their branch staff are fully and holistically supported in their new roles if the branches of the future are to deliver on their promise of banking’s new revenue generation assets.

38%

40%

42%

44%

46%

48%

50%

52%

2012 FY 2013 FY 2014 FY 2015 FY


-4.0%

1.0%

6.0%

11.0%

2012 FY 2013 FY 2014 FY 2015 FY


Cost to Income (Statutory)3

Jaws (Statutory)3

3 The NAB cost to income ratio and JAWS calculation has been adjusted for specific items as per results announcement on October 28 2015



Technology transformation — restructuring for the digital ageOur Global bank outlook identified digital business as one of the four global mega trends shaping the market. Banks that fail to offer a high quality digital experience – and importantly, one that is continually improving in line with consumer expectations

– run the risk of losing customers. Digital also plays a key role in reducing costs and improving efficiencies.

Australian banks have made significant headway in embracing digital business. A high proportion of customer interactions have moved online, reducing cost and improving customer service and convenience by removing some of the friction points that can occur with offline channels. Real-time payments are drawing closer as the banks join forces under the New Payments Platform.

As the banks seek ways to harness the power of new technology to differentiate themselves and drive efficiency, they are increasingly partnering with players in the emerging fintech sector. This includes funding and distribution agreements with startups and partnering with fintech hubs and incubators to identify new digital opportunities. One area attracting strong interest is block chain technology, which offers a more efficient way to transfer funds via distributed ledgers. The banks are exploring future commercial applications to determine where this technology may add value to payments. Initial investigation has focused on intra-bank transfers. It remains to be seen if this technology will become systemically important.

The right level of investment by the banks is critical. However, balancing the need for increased technology investment with a low growth environment is a challenge. Although banks are investing significantly in digital, opinion leaders surveyed by EY described a lack of investment as a major concern.4 Critically, such investment must be applied to innovating the customer experience in a planned and coherent way, avoiding a ‘me too’ approach.

Success in integrating fintech into traditional banking models will be central to the banks’ ability to respond to the pressures of today’s macro environment, as well as compete with new, agile, technology-driven competitors.

4 EY Digital Australia: State of the Nation 2014. Digital opinion leaders survey

5 In an average four week period

Mobile-only banking

in three yearstripled

Digital banking channels

1/3of Australians use only digital banking channels5

The number of Australians using mobile-only banking has

Source: Roy Morgan Single Source, Jan 2012–Jun 2015


Wealth Operating Earnings ($m) Annualised Insurance Premiums ($m)

0

1,000

2,000

3,000

2012 FY 2013 FY 2014 FY 2015 FY


Funds Under Management ($m)

0

50,000

100,000

150,000

200,000

250,000

300,000

2012 FY 2013 FY 2014 FY 2015 FY


0

1,000

2,000

3,000

4,000

2012 FY 2013 FY 2014 FY 2015 FY



The banks’ wealth businesses benefitted from a strong performance in investment markets for most of the year and a lower Australian dollar. Insurance premiums increased due to repricing but this was offset in part by higher general insurance claims due to severe weather events.

The wealth businesses of the banks have been the subject of conduct issues related to the provision of financial advice. Customer remediation costs have been minimal however; the major cost to the banks has been reputation. It is therefore no surprise that the Government’s response to the FSI endorsed the recommendations regarding financial advice.

Generating acceptable ROE remains a challenge due to the capital intensive nature of wealth operations.

Expensive life insurance underwriting and manufacturing operations are likely to come under review as banks look for ways to free up capital and improve returns. Divestments and strategic partnerships will enable the banks to focus on more profitable product distribution.

Banks are also looking to implement more cost effective technology-enabled sales and advice in their wealth operations. With the rise of robo-advice, a digital financial advice revolution is underway that will help bridge the gap between what regular households are willing to pay for advice and what advisers are willing to charge for advice, and increase the consistency of advice.

Wealth — selective divestments coming up?



Risk management — conduct and cyber security increasing in priorityA consistent theme in our global 2015 risk management survey5 is the degree to which firms are rethinking their approach to managing non-financial risks and risk accountability.

Conduct and compliance failures have resulted in financial and reputational costs to the industry globally, with nearly two-thirds of survey participants agreeing that lapses in internal oversight and controls are the main reasons for these losses. Given the heightened regulatory, public and board attention to misconduct in the industry, conduct risk management is a high priority for banks. The importance of assigning and monitoring accountability has emerged over the past year as a key factor in non-financial risk management. Banks are also introducing new processes to manage conduct risk, including early detection and prevention of misconduct. In our view, the key to mitigating conduct risk is a strong focus on the end-to-end product life cycle.

Cybersecurity is another growing priority on the CRO agenda. Cybersecurity risk ranked equally with conduct risk in this year’s survey, more than doubling in importance compared with our 2014 survey. The banks face a range of challenges in managing the growing number of cyber threats effectively. One is balancing the competing demands of offering an exceptional customer experience with ensuring the security of customer data. Another is lack of appropriate levels of resourcing and of cybersecurity skills. As part of addressing these challenges, banks must determine where cybersecurity fits in the business: does it require a technology solution or a risk solution? In our view, cybersecurity needs to move from being purely a technology issue to a technology and risk issue

– and elevated from an IT responsibility to a board issue.

5 EY, Rethinking risk management: Banks focus on non-financial risks and accountability



Contacts

Tim DringPartner, Financial ServicesEYTel: +61 3 9288 [email protected]

Andrew PricePartner, Financial ServicesEYTel: +61 2 9248 [email protected]

James RobertsPartner, Financial ServicesEYTel: +61 2 9248 [email protected]

EY | Assurance | Tax | Transactions | Advisory

About EY

EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organisation and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organisation, please visit ey.com.

© 2015 Ernst & Young, Australia. All Rights Reserved.

APAC No. AUNZ00000573 ED None S1528552

This communication provides general information which is current at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Ernst & Young disclaims all responsibility and liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk. Liability limited by a scheme approved under Professional Standards Legislation.

ey.com/au

Rowan MacdonaldManaging Partner, Financial Services — OceaniaEYTel: +61 2 9248 [email protected]

Gerard DalboscoPartner, Financial ServicesEYTel: +61 3 9288 [email protected]

Stephen JackPartner, Financial ServicesEYTel: +61 2 8295 [email protected]


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