What next for Australia's banks?

Australian bank shares have been on a tear recently, with the average major bank share price up by more than 25% since November 2023.

In his latest Industry Pulse report, Morningstar’s banking analyst Nathan Zaia said there is no clear catalyst for the latest rally and that most of the sector looks overvalued.

Nonetheless, conditions in the industry look fairly positive.

Slower credit growth but margins look set to improve

Credit growth eased to an annualized 4% in the three months ended May 2024 as higher interest rates and inflation continued to reduce borrower capacity.

Zaia expects low-single-digit credit growth over the medium term, given modest economic growth. He also expects refinancing activity to continue to slow in 2024 now that most older loans having largely matured and been repriced at higher rates.

This market dynamic, where banks compete for a modest pool of new loans and fight to retain existing customers, fuels competition on rates. In the medium term, however, Zaia expects bank margins to improve modestly regardless of what the Reserve Bank of Australia does with interest rates.

If rates stay higher for longer, banks can continue to earn a larger margin on low-cost customer deposits and income from hedges. If rates fall, banks can offset headwinds by repricing loans and deposits to protect margins. In other words, they can reduce deposit rates by more than home loan rates.

Rising number of borrowers in arrears covered by reserves

Banks reported rising arrears in May 2024 due to materially higher mortgage repayments.

Current arrears are similar to long-term averages and will likely trend higher as savings run down and borrowers adjust to higher rates on recently matured low-rate loans. This hasn’t impacted profits, though, as the banks have large loan loss provisions set aside.

The impact has also been cushioned by the fact that struggling home loan borrowers have been able to sell into a strong housing market. Low unemployment, a tight rental market and large equity buffers have also kept loan losses low.

Bank balance sheets remain strong

All four of the major banks remain comfortably above the minimum capital levels set out by the Basel international banking framework.

The big four’s capital positions are also significantly above the target range set by their respective management teams. This surplus cash could potentially support further dividends and share buybacks going forward.

You can read more about the banks’ capital requirements and the outlook for dividends and potential capital returns here.

Sector looks overvalued

The outlook for Australian banks appears relatively benign. However, this is reflected in rich share prices in the sector compared to Morningstar’s estimate of Fair Value. This is especially true for the major banks, which trade at an average premium of over 20% to Morningstar’s Fair Value estimate.

Commonwealth Bank (ASX: CBA) looks particularly expensive at over 20 times forward earnings estimates and almost 3 times book value. Zaia believes these levels leave little room for disappointment and are at odds with his estimate for just 4% annual earnings growth.

Among the majors, Westpac (ASX: WBC) and ANZ (ASX: ANZ) look cheapest but are only a whisker below Zaia’s fair value estimate after the latest rally.

Zaia sees more value in non-major banks at the moment, with no moat Bank of Queensland (ASX: BOQ) and no moat MyState (ASX: MYS) among his top picks.

Although he sees a rise in bad debts at the Bank of Queensland as inevitable, he notes the bank’s efforts to diversify its loan book outside of Queensland while maintaining lending standards. He also expects Bank of Queensland to earn higher margins as competitive pressures ease and cost-saving measures pay off.

Further reading

You can see Nathan Zaia discuss ANZ's recently approved takeover of Suncorp Bank here.

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