Banking and the jaws of death

Shark swimming through a reef

The "Jaws of Death" is how accountants affectionately describe declining revenue and increasing costs. You would never guess that this is the reality facing our banks. Why is this of interest? Ultimately I think the lending market will get more competitive and that has to be great for Kiwis. Secondly, but less exciting, higher mortgage margins are here to stay for the foreseeable future. Banks will look to squeeze extra margin out of their lending books to pay for their investment in branch networks and payments systems, and the higher cost of raising retail deposits.

The upper jaw: increasing costs

Retail banks have been investing in their brands and heavily into their branches and relationship management models. Much of the emphasis has been around mortgages and debt products like Personal Loans and Credit Cards. In more recent times the emphasis has swung more towards KiwiSaver and insurances. The easy way to gauge this? Walk into a branch and see what the tellers try to cr0ss-sell to you! Over the past five or six years our banks have added layers of cost without removing existing cost structures. This was manageable when revenue was increasing at 10% per year. As revenue growth drops off and possibly declines, banks will have to come back to focusing on costs and figuring out what makes sense and what doesn't. I think some form of direct banking will make a comeback. I have always been surprised that Bank Direct faded away. In my mind it doesn't make sense to force customers into a branch to do mortgage rollovers when it can be done perfectly well over the phone or email. Sooner or later the focus will be on making your life easier rather than trying to cross-sell products to you every time you walk into a branch store.

The lower jaw: decreasing revenue

Sustainable revenue growth comes from balance sheet growth. Given that debt growth has stalled, banks do not have natural revenue momentum in their businesses. Currently revenue growth is coming from one-off adjustments related to the recession:

  • Write-back of bad debt provisions. Banks intentionally took a conservative approach to provisioning
  • Financial market windfalls – banks make money from customer risk-aversion
  • Profits on the banks’ own interest-rate bets
  • Margin expansion on their lending books

Lending margins

Gross lending margins have increased from 0.60% in 2007 to 1.50% now. That is nearly a 250% increase in net margin in the space of two years. If you run that over a household lending market of $180 billion, it equates to a one-off increase in industry profits mortgage margins of $1.62 billion. Wow! The risk for banks is that high profits on mortgages create opportunities for new entrants, which is not lost on Marac and the notion of a Heartland Bank. But it’s not all upside, overall revenue is actually on the decline. The real challenge is on how to raise deposits cost-effectively.

Deposit margins

The overall interest margins that banks earn on their balance sheets has dropped from around 1.98% to 1.93% in the past 12 months. This is a combination of higher wholesale funding costs and lower deposit margins, mostly due to a low interest rate environment (see graph below.) 

By my estimates mortgages have gone from representing 25% of bank profits to representing over 50%. In saying that, we should recognize that the banking system is hugely inter-dependent. You cannot have lending without deposits. If you like, deposits have become a loss-leader and the key constraint on potential growth.  It feels like old-school banking.

Fee income

Banks have only recently unwound a lot of their fee income sources. They have reduced honour and dishonour Fees, credit card late payment fees and transaction fees. This is more evidence of the importance placed on deposits and the shift in where banks make their money. Given the move away from fees (and competition from the likes of Kiwibank) it would be difficult to put these fees back in again. Yet in the absence of continued mortgage margin expansion or mortgage volume growth, I struggle to see where sufficient revenue growth can come from. I wonder sometimes if banking is like telecommunications and we'll see the same sort of revenue trends - flat to declining - plus increasing competition. Is banking a mature industry?

My view? The current model is broken

Over the past decade bank profits went from 0.90% of GDP in 1997 to 2.0% of GDP in 2007. We always hear about how mortgage lending went from $53 billion to $153 billion over that same decade. Bank profits increased on average by 15% per year over the entire decade whilst NZ Inc profits (GDP) increased by 5%. A simple observation is that, like the property market, it is impossible for an industry to keep growing faster than the economy that supports it! Fundamentally that means (1) bank profits cannot keep increasing and (2) personal view - bank share prices are way too high relative to future growth. (Let's just say I'm not bullish on bank shares!) Depending on your view of the world, eventually the property market would stall or fall, and we are seeing the early stages of that now. As a result, bank lending growth has also dried up, almost to a complete standstill. So, if profit growth has historically come from debt growth where is the next lot of profit growth going to come from? In short – my view is that it isn’t. The jaws of death might not have swallowed the industry, but it doesn’t look as though the pressure those jaws are exerting will be easing up anytime.

Implications

Our banks are inherently conservative, which is probably a good thing! The credit crisis created enough distraction that profitability came second to survival and credit risk management. Over time however, fund managers (“investors”) will push harder for underlying profit growth. Banks are going to continue to use mortgage margins to compensate for lower earnings in other part of their business. Even over the past six months, mortgage margins have increased from around 2.40% above wholesale to 2.80% above wholesale.

By implication I do not think we’ll see long-term mortgage rates get any lower than they are now. However banking is a fragile oligopoly. (Maybe that's a bit harsh.) It isn't that often that one bank steps out of line, but sometimes it does happen and it is definitely a competitive market around the fringes. Anyway, as lending margins have expanded there has been a discernible increase in discounting of mortgages, at least relative to the past few years when it felt like many lenders were closed for business. There are a number of below-the-counter packages and discounts emerging for various professional groups and associations. Whilst we cannot publish all the packages or discounts are available (as they tend to be fairly low-key and to be honest we don't necessarily know the full extent of what is out there), we will always help clients into the best solution we can.

Reality is, if your household income is over $130,000 then chances are you will be entitled to some sort of package or discount whether you hunt for it yourself or we do the legwork! I think we will also see a definitive move to risk-based pricing - which is overdue. (Banks do not want to grow at all costs.) That means a mortgage at 50% loan-to-value ratio will get better pricing than one at 80%, and an owner-occupied house will get better pricing than an equivalent investment property. It would also make sense to recognise the lower risk of homeowners who have income or mortgage protection insurance in place. Risk-adjusted and value-based pricing tends to increase in mature markets as new entrants and competitors look to cherry-pick parts of the market. An example of this might be HSBC Premier pricing which has a one-year mortgage rate at 5.99%.

Prying the banks free from the jaws In the absence of meaningful revenue growth, a lot of focus will go back onto cost efficiency. Banks have already trimmed costs a lot (without reinventing cost structures), so in my mind the next five years is going to force a rethink. The conundrum for banks is the high cost of creating branch traffic versus the opportunity to “cross-sell” other products if they can lure you into the branch.  Branches will remain critical for deposits (at least to internal management) as two-thirds are controlled by people over the age of 55, but my view is that the banking world is changing rapidly. I've been surprised by ongoing branch expansion so maybe I'm missing something here! It will be really interesting to see how retail banks respond to the pressures facing the industry. It is not an easy time to be a retail bank and there are some big challenges ahead.