Australian banks & rising rates: Some notes

Australian banks & rising rates: Some notes

In the last few years I’ve started looking more and more for possible setups. A “setup” is where there are five or six identifiable moving parts that may or may not align but have the potential to create significant value if they do. I’ve written before about setups at CD Projekt Red and and at Metro Bank.

Australian banking is another setup. We are in the middle of a regime change. Until recently the last interest rate rise was eleven years ago. Anyone that started investing (or lending) in the last ten years has never seen rates go up. There are going to be significant disconnects.

The background

We might be headed for a recession as central banks hike rates to reduce demand and curb inflation. It is possible but not guaranteed that we are looking at the top of the credit cycle as it turns. The last two years were definitely a blow-off top in Australian housing caused partly by loose money but also by fundamental shifts in the value of living space. If you think that return to office will be the trend for most, that blow-off top certainly retraces causing a ~10-15% decline in house prices prior to the impact of rising rates.

New mortgage rates are up more than 2 percentage points on where they were 18 months ago. There is conceivably another 10-20% to come out of housing prices before the impact of normalising immigration, rising wages (inflation) and any rate cuts or unemployment in recession. Whether house prices go up or down I have no view (& don’t much care), this is simply to highlight that there are many moving parts.

One plausible scenario sees rising bad loans as an overstretched consumer (note the explosion in home values & lending last two years) gets bitten by rising loan rates. Depending on provisioning behaviour over the next 6-12 months, a few percent of the loan book going bad would put most banks into stress.

It’s easy to get hung up on interest rates and house prices and credit losses and blah blah because this is what’s in the media. I think this is wrong; the signal is the strength of the core banking franchise. This is my current thinking about Australian banks:

The setup:

• We are heading from a loosening environment into a tightening environment
  • There may well be a recession which would likely entail significant pain for banks
  • It is possible but not a given that there will be significant reductions in bank valuation – lower income, higher bad loans, lower P/B ratios
• Lending volumes may be flat to down and cost of funding is up; bad loans are likely to rise
• Lenders without a deposit base will find it harder to competing on price & will experience NIM compression
• Subscale or unprofitable lenders like neobanks will find the environment significantly more difficult for the same reason
• Sharply rising interest rates, as we are seeing now, will provoke significant switching behaviour (this is playing out already)
  • Australian consumers don’t switch banks anywhere near as much as they should. This has been a key part of any bank thesis for at least 10 years.
  • AFR: Big banks net $4.5 billion a year through ‘loyalty tax’ costing borrowers $70,000 (afr.com)
• The real question is whether switching behaviour leads to NIM compression and higher cost of acquisition
  • I.e. does this regime change lead to a sustained and measurable change in business environment for Big 4 lenders
• If it does the banks are probably not a buy. They likely have a lean decade ahead.
• The signal in this setup is not interest rates, bad loans (except in financial cataclysm scenario) or house prices. The signal is the strength and direction of bank moats. I.e. the ability to acquire loyal customers at a 2% NIM on a predominantly low-cost deposit base of funding.

The crucial question is “does the industry structure change from a cooperative oligopoly to a fragmented and highly price competitive one?”

Bottom line:

At the moment, my money is on “no”. I struggle to see the Big 4 competitive position worsening given the range of foreseeable outcomes. Nonbank lenders and neobanks/second tier lenders likely suffer worse than the big banks in recession/credit cycle scenario. They’re less well capitalised, have more expensive funding, and it is harder to find customers. However – this is an open question.

If there is a real washout in Big 4 bank valuations I am looking to be a buyer. That is the setup. But there are many moving pieces to watch in the interim.

I have no financial interest in any Australian bank, except perhaps through my superannuation fund. The scenario I have outlined here is hypothetical and only one of a fairly wide range of possibilities. I am currently considering purchasing put options on Australian banks. This is a disclosure and not a recommendation.

Sean O'Neill

Sean lives in Sydney, and writes this blog in his spare time.

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