New Zealand’s banks hold steady despite rising challenges in the marketplace

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Banking perspectives / Major banks analysis / April 2015 PwC analysis of the major banks’ results for the second half of their 2014 financial years

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Introduction

New Zealand’s five major banks reported core earnings of $3,281 million in the second half of their 2014 financial years (2H14), up from $3,083 million for the previous six months (1H14). This was driven by increases in net interest income (up by $130 million) and other operating income (up by $178 million), while bad debt expenses increased (up by $113 million) and operating expenses increased (up by $110 million). Overall, profit before tax was up 3 per cent, or $85 million, to $3,154 million (1H14: $3,069 million) and profit after tax was up 2 per cent or $54 million to $2,280 million.

3New Zealand’s banks hold steady despite rising challenges in the marketplace

Looking at the results of the major banks for the second half of 2014, it is clear there has been a further step up on the results reported six months earlier. However, when you look at the script that underpins the results, there are some specific drivers behind this increase.

The increase in net interest income of $130 million is on the back of lending growth to the corporate and residential markets, with total lending up by $7 billion to $315 billion at the end of the major banks’ 2014 financial years, but also a supporting role provided by the net interest margin which has also lifted when comparing 1H14 to 2H14. The lending growth exemplifies the economic forces and conditions that were in effect, with the New Zealand economy playing a leading role in determining the end performance of our major banks.

The positive lift in other operating income isn’t a quality income story, but more reflective of gains being recognised or the reversal of previous losses recognised on financial instruments held at fair value. As we have previously reported, this is effectively a zero-sum game from period to period and the swings in the fair value of financial instruments have contributed to the earnings volatility of our major banks.

The costs associated with producing the banks returns were also up, with some of this due to one-off non-cash items.

Impaired asset charges, or bad debt expenses increased significantly from 1H14 to 2H14. Examining this in isolation, you would have thought that, albeit not back to those dark days at the onset of the Global Financial Crisis, the credit environment had made a turn for the worse. However, the reality was, the banks reported a fairly non-existent impaired asset charge for the first half of 2014, something that hasn’t been seen, and some would argue, never been contemplated for a number of years.

This publication focuses on the major banks’ (ANZ New Zealand, ASB Bank, Bank of New Zealand, Kiwibank and Westpac) performance for the second half of their 2014 financial years with reference to the previous six months.

$130 million increase in net interest income.

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Overlaying the performance of our major banks has been the continued focus of the Auckland property market which continues to increase and set new records with relative ease. This has been reflected in continued household lending growth. A lot has been said of the underlying drivers for this property price growth and the measures undertaken to slow it down, including Reserve Bank of New Zealand (RBNZ) speed limits on mortgage lending to customers with loan-to-value ratios (LVRs) in excess of 80 per cent. While commentators have concluded that these restrictions have softened property price growth, the clarity of RBNZ speed limits, LVR limits and choices to either fix or float has become household conversation pieces around the kitchen table and the sports’ field side-lines. This is something that wouldn’t have been considered a few years ago.

What highlights a positive signal for the New Zealand economy, however, is the sixth consecutive period of growth in corporate lending. This is further illustration that many New Zealand businesses are showing a degree of confidence in the future of the New Zealand economy. PwC’s recent 18th Annual Global CEO Survey showed that 94 per cent of New Zealand CEOs are confident about their company’s revenue growth prospects over the next three years (88 per cent for the year ahead). This growth will need to be fuelled to some part, through leverage. Continued low interest rates would alleviate some of the pressures associated with increased debt servicing.

From a global perspective, banking and capital markets CEOs equally have a renewed sense of optimism about growth, while recognising that the challenges are large, the risk of disruption very real, and the pace of change increasing. This year’s Global CEO Survey also revealed that 79 per cent of banking and capital markets (BCM) CEOs consider cyber risk to be the top potential threat to business growth, followed by speed of technological change (68%) and the shift in consumer spending behaviour (63%). These challenges are correspondingly as large here in New Zealand.

Digital technology is a game changer to the global banking sector. Technology is rapidly evolving, and impacting all areas of banking – the way banks understand and engage their customers, the way they enhance their operations, and the way they manage risk. Are banks able to keep up the pace of change, and keep up with more nimble competitors? More than 50 per cent of BCM chief executives worldwide view new market entrants as potential threats to growth, up significantly from 32 per cent in 2014.

Further, customer expectations are rising, often shaped by their experiences with other industries. They expect seamless, on-demand, and relevant interactions – challenging banks to move beyond thinking in silos of products and channels. To deliver this requires diversity of talent and thought – people who can think and work in highly different and innovative ways, to partner successfully with customers and meet their needs.

Overlaying these challenges is also the perception that over-regulation is a major threat to growth, mirroring its return to number one in our Banking Banana Skins 2014 Survey. In addition, 53 per cent of BCM CEOs believe regulatory change will have a very disruptive impact over the next five years.

Regulatory demands continue to rise and compliance is both expensive and operationally challenging – significant costs are at stake. These demands also have the potential to divert the investment and management focus needed to address the transformation trends in the industry. Banks are evolving business models based upon regulatory demands and the new economics.

These challenges will need to be addressed to ensure the financial results can be maintained in the long term. By harnessing digital transformation, fostering innovative collaborations, leveraging diversity, and being proactive in regulatory compliance, our banks can succeed in this new and ever-evolving world. Comparing the script of today to that which will be written in five years’ time will be very interesting – very interesting indeed.

The sixth consecutive period of growth in corporate lending highlights a positive signal for the New Zealand economy.

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Five major banks’ combined performanceAnnual resultsBoth statutory profit and profit before tax showed continued growth from FY13 to FY14, with an increase of 21 per cent to $4,506 million and 21 per cent to $6,223 million, respectively. This growth follows previous increases in statutory profits of 10 per cent in FY13 and 12 per cent in FY12. The growth in FY14, as in previous years, has been driven by a decline in bad debt expenses of 63 per cent ($242 million) coupled with increases in net interest income ($351 million) and other operating income ($559 million).

Interest rates have started to rise during FY14 and gross interest income has risen 5 per cent from FY13 to FY14, while net interest income has continued to increase rising to $7,848 million in FY14 . Other operating income increased by 24 per cent to $2,898 million in FY14 on the back of positive fair value movements on financial instruments and a $91 million one-off insurance settlement being recognised in FY14 by one of the major banks.

Operating expenses have remained stable year on year increasing by 2 per cent (or $93 million) to $4,382 million. Tax expenses increased from $1,423 million in FY13 to $1,699 million in FY14, broadly in line with the increase in profit before tax.

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Figure 1: Banks' change in profit after tax

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Table 1: Annual income statement comparisons (NZ$ millions)

FY14 FY13 FY14 v FY13

Interest income 19,363 18,435 5%

Interest expense (11,515) (10,938) 5%

Net interest income 7,848 7,497 5%

Other operating income 2,898 2,339 24%

Operating expenses (4,382) (4,289) 2%

Core earnings 6,364 5,547 15%

Bad debt expenses (141) (383) (63%)

Profit before tax 6,223 5,164 21%

Tax expenses (1,699) (1,423) 19%

Outside equity interest (18) (17) 6%

Statutory profits 4,506 3,724 21%

7New Zealand’s banks hold steady despite rising challenges in the marketplace

Semi-annual resultsComparing 2H14 with 1H14 we see a 2 per cent increase in statutory profit from $2,226 million in 1H14 to $2,280 million in 2H14. Profit before tax increased by 3 per cent to $3,154 million in the same time period.

The main driver for this growth in profit is the 13 per cent ($178 million) growth in other operating income. Other operating income comprises of fees and commissions on banking transactions, trading income and gains and losses on the fair value of financial instruments. The fees and commissions continue to remain stable with

the key growth in other operating income being driven by the fair value movements on financial instruments being a loss of $127 million in 1H14 moving to a gain of $74 million in 2H14.

The semi-annual results show that the bad debt expense has increased half on half, from a low point in 1H14 of $14 million, which was predominantly due to low write-offs for the period and also credit provision releases to $127 million in 2H14.

Operating expenses and tax expenses remained largely consistent when comparing the two periods, although several one-off charges impacted the operating expenses recorded in 2H14.

Table 2: Six monthly income statement comparisons (NZ$ millions)

2H14 1H14 2H13 1H13 2H14 v 1H14 2H14 v 2H13

Interest income 10,030 9,333 9,225 9,210 7% 9%

Interest expense (6,041) (5,474) (5,434) (5,504) 10% 11%

Net interest income 3,989 3,859 3,791 3,706 3% 5%

Other operating income 1,538 1,360 1,233 1,106 13% 25%

Operating expenses (2,246) (2,136) (2,142) (2,147) 5% 5%

Core earnings 3,281 3,083 2,882 2,665 6% 14%

Bad debt expenses (127) (14) (178) (205) 807% (29%)

Profit before tax 3,154 3,069 2,704 2,460 3% 17%

Tax expenses (864) (835) (753) (670) 3% 15%

Outside equity interest (10) (8) (8) (9) 25% 25%

Statutory profits 2,280 2,226 1,943 1,781 2% 17%

The main driver for the growth in profit is the 13%, or $178 million, increase in other operating income.

Net interest incomeNet interest income is up 3 per cent from $3,859 million in 1H14 to $3,989 million in 2H14.

In breaking down this figure, we observe that interest income is up $697 million to $10,030 million for 2H14 and interest expense has increased by $567 million to $6,041 million. As seen in Figure 3, this growth in net interest income tracks the growth in loans and advances to customers which increased by $7,414 million during the banks’ 2H14.

The growth in net interest income is due to the sustained lending growth that has continued over recent times and the continuation of low funding costs.

Figure 3: Net interest in relation to customer loans and advances

Breaking down the numbers

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9New Zealand’s banks hold steady despite rising challenges in the marketplace

Figure 4: Net interest margins are sitting above 2.25%

Source: Reserve Bank of New Zealand

Net interest marginThe banks’ net interest margins have continued to operate around the 2.25 per cent to 2.35 per cent range shown since September 2011 in Figure 4. This continues to be a function of close interest rate management for retail deposits and lower wholesale funding costs partially offset by a continued reduction in lending spreads. These are due to customer preferences for lower margin fixed rate mortgages at a time of rising interest rates and intense pricing competition for new lending.

The net interest margin (NIM) for Australian banks has continued to drop since September 2011 and sits at 2.06 per cent at 2H14. The fall in the major Australian banks NIMs is mainly due to heavy discounting in business and mortgage lending and the need to hold more liquid assets under the implementation of the liquid coverage ratio (LCR) requirements.

The 2015 environment will be interesting with interest rates tipped by economic commentators to remain low and the increased competition by the banks for market share and volume which may slightly suppress net interest margins.

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Net interest margin (NIM) (%)

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2.00%

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LendingGross lending increased 2.4 per cent in 2H14 to more than $315 billion. The corporate lending market has recorded its sixth consecutive period of growth (2.6 per cent between 1H14 and 2H14). Figure 5 shows corporate lending continues to go up indicating increasing business confidence, while household lending shows growth of between 2 per cent and 3 per cent each half year since 2H12, reaching $200 billion in 2H14.

Corporate lending growth of 2.6 per cent in 2H14 was the highest since the GFC. This is reflective of an improving New Zealand economy, business confidence and other positive economic indicators. These growth rates are still low compared to pre-GFC but, given the sustained period of lending growth, are a strong sign of business and economic confidence. What will be interesting is whether this growth can continue with the Chinese economy slowdown, fluctuating commodity prices and the entry of new foreign banks (including three of the four major Chinese banks) actively competing for corporate lending. Offsetting this, a decreasing New Zealand dollar against the US dollar will be a relief to exporters as well as the continued low interest rate environment indicated for 2015.

Household lending growth has slowed, albeit only slightly during 2H14, indicating the RBNZ’s speed limits on high LVR lending (80%+) has started to show some impact with growth in mortgage lending slowing to 2.3 per cent in 2H14, compared to between 2.7 per cent to 2.8 per cent growth for the previous three periods. Household lending growth in 2H14 is $4,518 million which is the lowest growth period since 2H12.

Figure 5: Corporate and household lending

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The proportion of household lending with LVR above 80 per cent has decreased to 15.9 per cent in 2H14 from 18.1 per cent in 1H14, further showing the RBNZ’s speed limits have had an impact. Previously the ratio was between 18 per cent to 21 per cent for all periods from 1H11 to 1H14. It will be interesting to see what the RBNZ will do going forward with these LVR restrictions and the continued thriving property market. This has been somewhat addressed with the recent announcement that the RBNZ is considering banks to hold further capital against residential investment property.

With the expected low interest rate environment in 2015, this will provide additional fuel to the heated property market, reinforcing the positions the RBNZ has undertaken and currently considering.

11New Zealand’s banks hold steady despite rising challenges in the marketplace

Figure 6: The shift from floating to fixed mortgages continued in 2014

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As seen in Figure 6, the shift from floating rates to fixed mortgage agreements have continued in 2014 with more customers choosing to fix for longer terms. At September 2013, 7.1 per cent of the household lending portfolio was fixed rates over two years, and this has increased to 14.8 per cent at September 2014. Conversely, the level of floating rate mortgages has decreased from 44.6 per cent at September 2013 to 29 per cent in September 2014.

We would expect to see more people fixing their mortgages to longer terms with the current economic indicators of low inflation and the decrease in interest rates in Australia in 2015. With interest rates already dropping in 2015, competition for mortgages has intensified to a potential mortgage war. This has caused slashed interest rates across various fixing periods to assist the banks to maintain – and hopefully – maximise market share.

Floating rate mortgages have decreased from 44.6% at September 2013 to 29% in September 2014.

Source: Reserve Bank of New Zealand

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FundingFunding has increased slightly from $323,491 million in 1H14 to $333,021 million in 2H14. Customers’ deposits increased by 3 per cent to $228,063 million in 2H14, while wholesale funding increased by 3 per cent to $104,958 million in 2H14.

Figure 7 shows that deposit growth in 2H14 has slowed compared to 1H14. Retail deposit growth is unlikely to be strong going forward because of low interest rates, the competition for deposits from a buoyant local equity market, and alternative investment opportunities.

In 2H13 we observed the first time since 2010 a net cash outflow (representing more being lent to customers than deposited with the major New Zealand banks). This reversed during 1H14 where deposit growth exceeded loan growth. However, in 2H14 we observed a net cash outflow which may include a seasonal swing, but nevertheless, the net cash outflow is still not at the levels we witnessed pre-GFC.

The banks’ retail deposit-to-loan ratio have increased from 70.56 per cent in 2H13 to 72.35 per cent in 2H14. If the pace of new lending continues to outpace new retail deposit funding, the banks will need to rely on alternative sources of funding, including further offshore wholesale funding.

Figure 8: More money was lent to customers than deposited in 2H14

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Figure 7: Deposits and wholesale funding continue growth

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13New Zealand’s banks hold steady despite rising challenges in the marketplace

Other operating income has increased by 13 per cent from $1,360 million in 1H14 to $1,538 million in 2H14.

This has largely been driven by a significant increase in gains on financial instruments held at fair value.

• Trading income increased 12 per cent from $258 million in 1H14 to $289 million in 2H14.

• Fee income increased slightly, up 3 per cent from $1,074 million in 1H14 to $1,101 million in 2H14.

• Financial instruments held at fair value have moved from a loss of $127 million in 1H14 to a gain of $74 million in 2H14.

• Other income decreased from $155 million in 1H14 to $74 million in 2H14 due to a $91 million one-off insurance settlement being recognised in 1H14 for one of the major banks.

Figure 9: Other operating income increased 13%, from 1H14 to 2H14

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FV movements on FI Other income

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Operating expenses have largely remained flat at $2,246 million in 2H14 (1H14: $2,136 million). Tax expenses have increased by 3 per cent to $864 million in 2H14 ($835 million in 1H14), due to both an increase in profit before tax and in the effective tax rate from 27.2 per cent in 1H14 to 27.4 per cent in 2H14.

Cost control continues to be a key area. Increased costs relating to higher salaries and wages, regulation and compliance requirements, and the depreciation associated with capital expenditure projects (in particular, with IT and software costs) have been offset by productivity gains realised, cost cutting and the closure of bank branches.

As a result, the cost-to-income ratio for the New Zealand majors declined by 1 per cent to 40.6 per cent, compared to a 1 per cent increase in the Australian majors’ to 45.6 per cent. Looking at Australia’s cost-to-income ratio, it is relatively stable when compared to the major New Zealand banks’ ratio reflecting their larger proportional size and diversity and the greater impact on New Zealand results of movements in the financial markets. When you exclude the volatility of gains/losses on financial instruments recognised at fair value, the cost-to-income ratio for New Zealand is approximately 44 per cent at 2H14 and relatively consistent with Australia.

Cost control will continue to be a major focus for banks in the drive for profit growth. It is unlikely that costs will decrease much going forward other than efficiency driven from new technology and the repositioning of bank branches.

Expenses

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Cost control will continue to be a major focus for banks in the drive for profit growth.

15New Zealand’s banks hold steady despite rising challenges in the marketplace

Figure 10: Comparison of bad debt expense

Overall, bad debt expenses have increased from $14 million in 1H14 to $127 million in 2H14. Non-household bad debt expenses have increased to $49 million in 2H14 from a recovery of $61 million in 1H14. Household bad debt expenses have remained stable at $78 million in 2H14 (1H14: $75 million). However, bad debt expenses fell from $383 million in FY13 to $141 million in FY14.

The increase in non-household bad debt expenses over the six-month period is due to large individually impaired provisions being raised on stressed assets in 2H14 which offset credit provision releases in 1H14.

The performance of household lending has remained steady and is dependent on the impact of interest rates. In 2H14 interest rates increased, however in FY15 we have seen the upward pressure on interest rates soften due to New Zealand’s low inflation outlook, banks’ competition for market share and global economic pressures.

Figure 11 shows that bad debt expenses, impaired assets and 90 day past due assets (all as a percentage of gross loans and advances to customers) have all been trending downward since 1H12 and at the lowest point in 1H14. In addition, Figure 12 shows that the impairment provisions held on the balance sheet as a function of the overall lending have also reduced for both household and non-household lending.

The major banks’ provisioning levels have decreased in the current period with household provisions decreasing from $714 million at the end of 1H14 to $674 million at the end of 2H14. Non-household provisioning has remained significantly higher than household provisioning which stood at $1,150 million at the end of 2H14, a decrease of $36 million from the end of 1H14.

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Figure 11: Bad debt expenses, impaired assets and 90 day past due assets are trending downward

Figure 12: Basis point loan loss provisions

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The improvement in provisioning levels has also been replicated in other asset quality indicators. For example, figures reported by the major banks in 2H14 stated that 90 day past due assets have dropped from 24bps of gross lending at the end of 1H14 to 18bps at the end of this reporting period. Similarly, impaired assets figure continues to improve, falling from 61bps of gross lending in 1H14 to 52bps at the end of 2H14.

We would expect to see key indicators to remain steady or start to trend back up in the short term due to New Zealand economy being very dependent on China whose growth is slowing down and the decreased dairy commodity prices which puts pressure not only on dairy exposures but also all other industry that support the dairy industry. With the growth in corporate lending, it will be interesting to see if the push for growth and market share will come at the expense of modest deterioration in credit quality.

Household provisions decreased from $714 million at the end of 1H14 to $674 million at the end of 2H14.

17New Zealand’s banks hold steady despite rising challenges in the marketplace

Figure 13 shows New Zealand’s major banks continue to be well capitalised. The total capital ratio increased from 12.1 per cent in 1H14 to 12.4 per cent in 2H14, remaining well above regulatory requirements.

With the recent announcement that the RBNZ is contemplating higher capital requirements for mortgages to residential property investors – and assuming this is introduced without any further changes – the major banks will either need to hold further capital to retain their current capital ratios or, alternatively, the current excess above capital minimums will be slightly eroded.

Return on equity New Zealand’s major banks average return on equity has slightly decreased from 16.6 per cent in 1H14 to 16.4 per cent in 2H14. However, this is consistent with pre-GFC levels of 16 per cent and compares favourably with what we see in Australia of 15.5 per cent.

Figure 13: Total capital ratio increased to 12.4% in 2H14

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The average return on equity has slightly decreased from 16.6% in 1H14 to 16.4% in 2H14.

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Sam ShuttleworthPartnerFinancial ServicesT: +64 9 355 8119M: +64 21 976 949 E: sam.shuttleworth@nz.pwc.com

Karl DeutschlePartnerT: +64 9 355 8067M: +64 21 352 383E: karl.p.deutschle@nz.pwc.com

Wayne LeungSenior ManagerT: +64 9 355 8743M: +64 21 820 298E: wayne.y.leung@nz.pwc.com

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