Interest rate hikes, a cooling economy and technology disruption are all set to hit the Australian banks this year. While the major players have all just reported positive results, the challenges keep growing so are the big 4 banks worthy of consideration?

Interest rate hikes are back in the news. Often a downer for investors, there’s one sector where this can be positive news as higher rates create a greater lending margin and thus stronger profit growth for Australian banks.

All four major banks - the Commonwealth Bank of Australia (ASX:CBA), the Australia and New Zealand Banking Group (ASX:ANZ), the National Australia Bank (ASX:NAB) and the Westpac Banking Corp (ASX:WBC) - were quick to pass on the recent hike in interest rates by the Reserve Bank of Australia (RBA) to their customers without changing deposit rates that much.

Australian banks are estimated to generate around 80% of their total revenue from net interest income, and therefore are highly dependent on this to drive returns.

But while the rising interest rate environment should support growth, the outlook is tempered by the impact of those rate rises. This includes a slowing economy as rate rises bite, growing mortgage impairments and rising cost pressures on individuals and businesses. There is also the ongoing technological disruption threatening their core operations. It all adds up to another tough year ahead for the big four, which are among the most popular shares on the ASX.

Solid start to 2022

A KPMG review of the recent half-year reporting season by the big four found profits after tax had risen by 5.1% to $14.4 billion and this was before the Reserve Bank of Australia had started hiking interest rates. The report also noted that return on equity was up 0.21 percentage points to 10.6% and the average dividend payout ratio had increased to 66%.

Australian bank shares are often bought by investors due to their very generous dividends, lofty franking credits and competitive stability.

During this latest six-month reporting period to the end of December 2021, the value of mortgage loans issued by the major banks, which is the core of their profitability, had risen 2.5% over the second half 2021 to $1.812 trillion. At the same time, business lending grew 4.8% to$1.077 trillion.

KPMG found the underlying drivers of the Australian major banks’ operating income growth have been the continued strong volumes in both mortgage and business lending. As Australia powered ahead in the first half of the 2021/22 fiscal year both areas saw continued high demand.

Momentum needs to be maintained

Steve Jackson, KPMG Australia’s Head of Banking and Capital Markets commented, “The major banks have successfully used the recovery of the Australian economy and the strong housing market performance to deliver improved financial results”.

“With returns on equity in the sector now again restored to double digits but with uncertainty ahead, it will be interesting to see how they maintain their current momentum,” he said.

Looking ahead, KPMG’s banking strategy lead Hessel Verbeek added: “We expect to see the dual impacts of both net interest margin relief and higher levels of mortgage book stress, as RBA interest rates are expected to increase several times. However, these impacts will take their time to pull through as both margins and book quality have built up their momentum over a long period of low rates.”

Rival accounting firm PWC, in its own review of the big four banks’ recent results, said the forthcoming economic environment of inflation and rate rises will have an immediate impact on bank costs, investment choices and productivity.

“The cost of living for banks is under pressure and they’ll have to work hard to contain it,” its analysts concluded.

Changes on the horizon

But PWC said it felt new opportunities for banks were closer than ever. “The decarbonisation of the world will redefine Australia’s economy and the banks are transforming to play their critical role. Technology is also disrupting existing processes and customer experiences, creating opportunities for the banks while potentially redefining how and by whom financial services are provided.”

PWC’s banking experts pointed out five factors which will determine what this industry will look like over the coming years:

1. Investment, execution and delivery: in the immediate term the banks will have to focus on operational throughput and digitisation, completing transformation programs, remediation and change. In the medium term, the pressure will be on costs with an increasing need to invest in future technology and opportunities and requiring a delicate balancing act on investment choices and prioritisation.
2. Adaptability and growth: the degree to which banks can innovate and evolve to keep pace with the changing ways people store, transmit and exchange credit and value.
3. Workforce and productivity: a key driver of performance which will become more crucial if system lending growth were to fade in the new economic environment.
4. Trust: the area in which the industry has arguably made the most progress recently. Elevated focus in areas including cyber-security, sanctions, money-laundering and financial crime and now the climate transition will create more domains in which trust will be tested and earned.
5.  Societal leadership: The opportunity banks have given their social capital to provide genuine leadership on climate, housing, equality, and our collective prosperity.

Speed and ambition needed

Notwithstanding the amount of work still to be done, PwC believes Australia’s major banks are indisputably better at the core functions of a bank: lending and deposit taking, technology, payments, managing risk and helping to keep customer’s assets safe.

 The question for investors is whether these banks are thinking big enough, moving fast enough and executing well enough to respond and capitalise on the opportunities available, and which banks are best placed to do so.

Following the recent round of results, the major brokers following the banks were all marginally positive on the banking sector, especially for investors focused on dividend payouts which are expected to remain strong.

Within the sector, the bank that stood out for many was ANZ Bank. According to financial commentator Paul Rickard major brokers are marginally positive on the banking sector. His analysis found:

• Citi, Credit Suisse and Morgan Stanley prefer ANZ Bank. UBS likes all banks but prefers Westpac.  Macquarie and Ord Minnett prefer ANZ and NAB;

• On earnings and multiples, the brokers forecast the most improvement in earnings between FY22 and FY23 for Westpac. Looking at FY23 multiples, NAB is marginally more expensive than Westpac and ANZ; and
• Dividends are forecast to yield about 5%. ANZ has the highest forecast dividend yield.

In a world of rising inflation and rates, slowing economic activity and rapid rises in automation, the big four banks are in an advantageous position to ensure further growth but the question remains, will they?