After reasonably uneventful earnings updates, it is hard to pinpoint a single specific driver for the turnaround in bank sentiment. Still, we think part of it is that a likely lower cash rate eases housing fears and provides banks an opportunity to reprice loans and deposits to protect margins.

Major bank share prices increased 23% since November 2023, outperforming the 16% increase in the Morningstar Australia Index over the same period. The major banks' weighted average price/fair value estimate is 1.14, up from 1.05 in the last quarter. Nonmajor banks trade at a price/fair value of 0.85.

Australian banks face low credit growth, softer net interest margins, and an increase in loan losses in the short term. Industry returns on equity will be suppressed in fiscal 2024; hence, we expect the banks to change loan and deposit pricing in the medium term to lift margins to a level that allows the wide-moat-rated major banks to generate returns above their cost of equity.

Net interest margins are softening due to competition in loan and customer deposit rates. Repayment of cheap Reserve Bank of Australia funding and above-average refinancing activity are elevating competition.

When banks had a large loan book on higher rates, cheaper loans to new customers could be made while the bank still achieved strong returns overall. However, excess returns are now modest, making it unlikely this trend will continue. We expect banks will pull back from aggressive competition on new loans and deposit rates.

Low unemployment, a tight rental market, and rising house prices support low loan losses despite materially higher mortgage repayments. Current arrears are below 2019 levels, borrowers have larger equity buffers, and banks hold extra bad debt provisions. Expired low-rate fixed-rate loans were a cause for concern but are performing in line with other loans.

Sector landscape

While we believe Australian banks are modestly overvalued on average there are differences in individual names.

Westpac (ASX: WBC) and ANZ Group (ASX: ANZ) are modestly undervalued. Both have addressed market concerns around weak growth. The next catalyst is improving operating efficiency.

Commonwealth Bank (ASX: CBA) is expense. On a forward P/E of almost 20 times and a fully franked dividend yield of just 4% valuation metrics leave little room for disappointment.
The divergence in valuation between Commonwealth Bank and peers Westpac and ANZ is stark, and in our view, unjustified. Price / book discounts are likely to unwind as Westpac and ANZ hold market share and deliver similar earnings growth.

Price to book

MyState (ASX: MYS) and Bank of Queensland (ASX: BOQ) are the cheapest banking shares in our coverage universe. Both banks represent higher risk propositions given relatively weaker funding positions, but industrywide loan and deposit repricing supports growth.

Across the sector dividends yields look attractive despite higher deposit rates. After resetting payout ratios, dividends can now grow in line with earnings. Share price weakness in most nonmajor banks sees yields at attractive levels. Nonmajors have more costly funding, but the margin downside risk is more than reflected in stock prices.

Forward dividend yields

Top picks for investors

Westpac

As the second-largest lender in Australia, we are confident the funding cost advantages wide-moat rated Westpac Banking enjoys will likely see a return to strong profits and returns on equity over time. Customer remediation, uplifting risk management and digital investment, and divesting nonbank businesses were costly and distracting. Not only did operating expenses rise as revenue was under pressure, but loan approval times were slow. Loan approval times, and loan growth, have already improved, but a cost rebasing takes time. We think Westpac can maintain a dividend payout ratio of 70%, which underpins an attractive fully franked dividend yield. The balance sheet is sound.

ANZ Group

ANZ Bank has lost material home loan market share, and having less funding sourced from low-cost household customer deposits has incurred material margin pressure across the bank. Process investments should make the wide-moat bank more competitive in home lending. While this comes with added costs, it should help drive earnings growth and returns on equity. We expect Suncorp Bank to improve bank efficiency modestly, but the drawn-out integration and associated costs make it unlikely to be materially valueaccretive. Some acquisitions in the past failed to extract cost savings and contributed to customer service issues, which are risks for ANZ Bank.

MyState

MyState commands a tiny 0.3% share of the Australian home loan market, but with investment in its digital offerings and expanded sales team, has demonstrated an ability to profitably grow loans. We expect market share gains to be more difficult, with cost inflation and rising wholesale funding costs affecting smaller banks more than major banks. While MyState margins will likely fall more than major banks due to rising customer deposit funding, due to a greater reliance on term deposits, it is still better placed relative to nonbank lenders. MyState focuses on lower-risk owner-occupier borrowers with a loan/value ratio below 80%.

Bank of Queensland

We expect Bank of Queensland's medium-term earnings recovery to be driven by net interest margin improvement as industry competitive pressures ease and the bank extracts cost savings from consolidating banking platforms and digitizing more processes. Bad debts are almost certain to rise, but we take comfort that recent loan growth is not from compromising on lending standards. Increased exposure to home loans outside of Queensland is also helping to diversify risk. Our long-term bad debt/loans forecast of 12.5 basis points is below the 10-year average of 16.0 basis points, driven by changes in the mix of loans.