Odinian Beta

In recent times the big banks – CBA (ASX: CBA), NAB (ASX: NAB), Westpac (ASX: WBC) and ANZ (ASX: ANZ) – have tried to offset lower net interest margins (NIM) caused by low interest rates and slow credit growth through cost cutting.

The major ways they have tried to cut costs is via closing branches and laying off staff.

Unfortunately for them, however, ever-increasing regulation as a result of the Financial Services Royal Commission along with rising competition from smaller banks and fintechs are forcing the banks to invest significant sums in new people and on technology in response.

As far as the Royal Commission goes, the banks only have themselves to blame for treating so many of their customers with such disdain, whether acting immorally, unethically or in many cases, allegedly illegally.

So it’s no surprise that even a Liberal government has forced more regulation on the big banks in an attempt to get them to mend their ways.

However, the speed of technological change is only increasing, and the banks can’t do much about that other than try to respond in kind. However, like many large organisations, they are slow and cumbersome, and as difficult to turn around as a fully-laden container ship.

Technology is allowing smaller, more nimbler companies to target the more profitable parts of the banks, helped by the government encouraging competition to offset the market dominance of the big four banks and Macquarie (ASX: MQG).

Even after taking into account “one-off” costs such as customer remediation and the like, this is why the banks’ costs are increasing. For example, Westpac just reported that it brought on 3,294 more people during 2021 to help the company enhance its risk management and compliance programmes, as well as to support higher mortgage volumes.

This contributed to expenses rising by 5%, from $12.7bn to $13.3bn, in 2021, pushing the bank’s cost-to-income ratio up 1.57%, to 63.1%.

This is an even bigger problem when low interest rates and low credit growth are making it harder to grow the top line, with Westpac’s NIM falling 8 basis points during 2021. As a result, net interest income fell 2%, to $16.7bn.

With interest rates essentially at zero, the banks are finding it harder to lower funding costs – the majority of all the big banks’ funding comes from deposits rather than wholesale investors – to compensate for lower interest rates being charged on mortgages, corporate and personal loans.

Shareholder salvation?

Happily for bank shareholders, salvation appears at hand via two means.

Firstly, all the big banks booked large provisions for bad debts at the start of the pandemic because they understandably thought the economic downturn caused by COVID would lead to many of their customers struggling to repay their loans.

I note that recent changes to accounting rules also meant the banks had to look forward rather than backward when booking provisions (that is, act proactively rather than reactively), resulting in much larger provisions being booked than under the previous accounting rules.

With the Australian economy doing fairly well despite various lockdowns, helped by government stimulus these provisions have proven to be too conservative and so the banks have started to release them, pumping up their cash earnings.

Another way in which higher costs can potentially be offset is through credit growth and in particular, higher interest rates, as the RBA normalises its very easy monetary policy as inflation rises and Australian economic growth improves. Rising interest rates should lead to improving NIM, particularly as the majority of the banks’ loans are variable rate loans and so can quickly rise along with increasing interest rates.

However, trying to predict interest rates is difficult but if inflation continues to rise – due to increasing prices of raw materials, strained supply chains and rising energy prices – then sooner or later the RBA will have to act, benefitting the big banks. Hopefully this and increased credit growth will offset rising costs.