Westpac rattles the sabre
Westpac shares have staged a strong recovery since their lows in March last year, and we believe the ascent has been justified by the bank’s strong rise in the December quarter cash profits and other factors. Westpac, like its peers, is benefiting from the economic recovery playing out in Australia and much ‘better-than-feared’ outcomes. Litigation risk has also receded, and the bank has been seeking to simplify its structure. We do feel though the announcement that it could exit the New Zealand market has an element of ‘sabre rattling’ about it.
In mid-March, Westpac’s latest effort in its ‘fix, simplify, perform’ strategy was announced, with the bank saying it was selling Westpac Lenders Mortgage Insurance (WLMI) to Arch Capital Group (Arch) and entering into a 10-year exclusive supply agreement for Arch to provide lenders mortgage insurance to the Group.
The sales price will be at book value, which will be determined at completion. The transaction also includes “small, fixed annual payments to Westpac over the next 10 years.” Westpac said it expects to record a loss on sale in FY21 from separation and transaction costs, along with the $84 million write down in goodwill that was announced in its 1Q21 update. The transaction is expected to add approximately 7 basis points to Westpac’s Common Equity Tier 1 (CET1) capital ratio.
The announcement followed on the heels of the decision to merge its consumer and business divisions into a new Consumer & Business Banking division. Westpac CEO Peter King said, “The combined division will drive simplification of banking and help to reduce cost, including by consolidating support functions. The change will enable more efficient utilisation of common assets such as branches and call centres, and better capitalise on the work underway to improve our capabilities, particularly in service, digital and data.”
Westpac too has already placed a number of businesses into a Specialist Businesses Division, to seek an ultimate exit. This is alongside announcing a consolidation of its international operations in Asia.
On 24 March, Westpac though announced it was reviewing the Westpac New Zealand business, in response to changing capital requirements in New Zealand and the Reserve Bank of New Zealand (RBNZ) requirement to structurally separate Westpac NZ business operations from its operations in Australia.
It also comes alongside the RBNZ seeking independent reviews into the bank’s liquidity and risk culture after a series of mishaps over the years. Deputy governor of the RBNZ, Geoff Bascand noted that “We have experienced ongoing compliance issues with Westpac NZ over recent years, most recently involving material failures to report liquidity correctly….The bank has continued to operate outside of its own risk settings for a number of years.” Westpac’s NZ unit will therefore be required to hold “additional liquid assets” until the central bank is satisfied its efforts to meet the policy guidelines are met.
The RBNZ has instructed Westpac New Zealand (WNZL) to commission two independent reports concerning its risk governance and liquidity risk management. A Westpac response said, “WNZL has taken a number of steps to improve risk governance but recognises more work is required, and supports the additional oversight that the independent reports will provide. The reviews apply only to WNZL and not the governance processes of Westpac Banking Corporation in Australia or its New Zealand branch.”
We note that the Westpac announcement its NZ business was under review also coincided with the New Zealand government announcing measures to cool its rampant housing market. The initiatives include doubling the bright-line test (the time that investors need to hold onto a property to avoid paying tax on selling) to 10 years, while negative gearing has been banned and investors will no longer be able to offset interest on loans against rental income.
However, we don’t view the environment as reason enough for Westpac to necessarily demerge the NZ unit. Westpac itself noted that it was “in the very early stage of this assessment and no decisions have been made.” The AFR reported that Macquarie has been appointed to help Westpac with its review.
While the changes in New Zealand will reduce the attractiveness of the NZ unit for Westpac and the other big Australian banks operating in the country that have about 85% market share, these businesses have long been strong contributors for Westpac and its peers.
Westpac New Zealand contributed A$612 million of cash earnings in the fiscal year ended 30 September 2020, representing a little more than 23% of the group’s total cash earnings of A$2.61 billion. Westpac New Zealand serves approximately 1.3 million customers and reportedly has a 19% market share in the consumer lending market and an 18% share in deposits.
Capital efficiency going forward, along with regulatory scrutiny will likely be key factors in Westpac’s review. The RBNZ requires systematically important banks like Westpac NZ to lift tier 1 capital ratios to 16%, the toughest requirements in the world. This will require an extra NZ$20 billion for the big banks, although the RBNZ has provided some concessions in the type of capital that will qualify and delaying the deadline for the capital accumulation to seven years, rather than an earlier five years.
Westpac has previously said this will require an additional NZ$1.6 billion to NZ$2.2 billion of tier 1 capital to meet the requirements, which will come into full effect in 2028.
Higher capital requirements will reduce the return on assets that Westpac NZ can generate and as the Australian business recovers, Westpac will be assessing whether that return would drag on the group. Previously, the NZ units have been favourable contributors and in 2020 the ROE was a strong 8.9%. A potential price tag will be a key factor as well and the best price tag would likely come from the sale to another financial entity that can extract cost savings. The pool will be limited on that front though as the big Australian rivals are facing the same environment with their NZ units and would face competition concerns.
It would be a massive swing for Kiwibank (a local player) and we doubt they could pull together the funding. An international bank may want to snap up the assets, though we are not too sure how the New Zealand government would view a potential buyer. A partial listing on the New Zealand market would be well-received and allow the Australian banks to retain control at the same time they raised capital to meet requirements. A full exit via an IPO is an option and would also likely be well-received.
Summary
Ultimately, we continue to view the prospects for Westpac favourably. Westpac’s quarterly cash earnings bounced back strongly in the December quarter, driven by improved margins, lower expenses and an impairment benefit. The banks are benefiting from the economic recovery playing out in Australia and much ‘better-than-feared’ outcomes. A steepening yield curve is a boon.
With the litigation risk having faded and provisions seemingly more than adequate to cope with the fallout from the pandemic, we expect the focus to return to other areas, and that is what we are seeing. These include a simplification of the business, trimming costs, updating aged legacy systems and addressing a weak performance on market share in Australian mortgages.
The sabre rattling about Westpac NZ may very well prove to be just that. Yes, return on capital from the NZ unit will decline due to the higher capital requirements, but it is from a very profitable level. We have seen a wide range of values attributed to Westpac NZ between NZ$10 billion to NZ$15 billion, although we would take the top of the range with a grain of salt. Nonetheless, Westpac would come out well in front. We suspect a partial listing in NZ that allowed Westpac to retain control and raise capital to meet requirements may very well end up being the outcome, rather than a full exit and it could also be that Westpac retains the business entirely.
We recommend Westpac (ASX:WBC) shares as a buy to Members without exposure.
Disclosure: Interests associated with Fat Prophets hold shares in Westpac (ASX:WBC).
