Under the Microscope
Australia’s Big Four banks are under the microscope again this week, with the second round of the Royal Commission underway. This time the focus is on financial planning and it is already generating a lot of press, with likely plenty more to come. This increased scrutiny, along with the raft of new regulations has seen the big banks de-rate over the past year, lagging the broader market. Amid this gloomy sentiment though, Westpac (ASX:WBC) and its peers though have shored up capital and are advancing down the automation path.
The Royal Commission is almost certainly going to uncover more skeletons and short fallings of the banks, with this week’s review highlighting clients being charged fees for financial advice they did not receive an example. Ultimately though, we believe the impact of the Royal Commission on local banks, including Westpac is likely to be overshadowed by our expectation of rising bond yields over the next year or two. This should lift the sector globally.
1Q18 Capital, Funding and Asset Quality update
In its brief capital, funding and asset quality update for the three months to 31 December 2017, Westpac (ASX:WBC) numbers revealed the shift from interest-only mortgages to principal and interest continued in the first quarter of fiscal 2018.
Some $8.6 billion of mortgages switched from interest-only to principal and interest, and while that was not as much as the $11.3 billion in mortgages that made the switch in the September 2017 quarter, it was well above levels prior to June 2017. Since June 2017 some $27.3 billion in mortgages at Westpac have made the switch. This has been a blend of mortgages reaching the end of the interest-only (I/O) period and switches initiated by the customer. The following chart shows the mix, with most of the switched mortgages over the past three quarters initiated by the customer.
Source: Westpac (ASX:WBC)
This follows direction from the Australian Prudential Regulation Authority (APRA), which last year told banks to limit interest-only lending to 30% of business. Regulators worry that investors encouraged to hold Interest-only loans due to tax incentives pose a bigger risk to the financial system, due to the large proportion of these loans due to expire over the next 4-5 years. Accordingly, the big banks are intentionally shifting their mix away from interest-only home borrowers.
We note the Reserve Bank of Australia’s April 2018 Financial Stability Review refers to how the stipulated regulatory measures have collectively reduced risk in Australia’s household mortgage debt system. In the December 2017 quarter, new interest-only loans were 16% of approvals, marking the lowest share in over 10 years and far below the peak of 44% in late 2014. Lending at high loan-to-value ratios is also at low levels by recent standards.
Source: April 2018 Financial Stability Review, RBA, APRA
We have previously discussed in our commentary on the banking sector how the heated housing market in some areas is a risk, but Westpac (ASX:WBC) is strong financially and well placed to withstand a measured correction. We certainly do not anticipate a GFC-style crash with the general structure of lending not as perilous (thanks to APRA’s strict oversight), and domestic interest rates not set to escalate dramatically overnight.
To prompt the progress in reducing interest-only mortgages as part of the overall mix, Westpac has made several key changes to interest-only (I/O) mortgage settings. The bank reports this includes a repricing, changes to the loan-to-value ratio (LVR) requirements, waiving the fee to switch since June 2017 and no longer accepting external refinances from other financial institutions for owner-occupied interest-only mortgages. Looking at the first two changes in a little more detail and differential pricing is applied to investor property lending, interest-only and SMSF lending.
Source: Westpac (ASX:WBC)
There is an 80% maximum LVR for all new interest only loans, including limit increases, interest-only term extensions and switches, with only limited exceptions. Only 22% of new home loans in 1Q18 were for interest-only, which is less than half the 46% figure a year earlier and well below the 30% limit applied by APRA.
Source: Westpac (ASX:WBC)
Westpac’s mortgage lending to investors using APRA’s definition grew 5.1%, which was also well below the 10% cap imposed by APRA. It also represents a dramatic easing in pace from a year earlier as can be seen in the below chart. Owner-occupied mortgage lending growth stood at 4.8%, which is moderately higher year-on-year.
Source: Westpac (ASX:WBC)
Credit quality remains sound in Westpac’s mortgage business, with 90-day plus delinquencies flat with a year earlier at 0.67%. There was a notable difference in where these delinquencies stem from, with Western Australia hard hit by its relative economic downturn.
Source: Westpac (ASX:WBC)
Overall asset quality across Westpac remains strong, with key metrics “near cyclical lows.” Impaired assets were stable, with no large individual impaired loads over $10 million in the quarter. At 1.03% stressed exposures to TCE (total committed exposure) were 2 basis points lower than at the end of September 2017.
Turning to the capital position and in the absence of any major shocks, Westpac should comfortably meet APRA’s 10.5% “unquestionably strong” capital requirement by the 2020 deadline.
To recap, APRA last year told the banks to raise their CET1 ratios to 10.5% by 2020 to act as a buffer against financial shocks.
Source: Westpac (ASX:WBC)
Westpac’s common equity tier 1 (CET1) ratio was 10.1% at the end of 2017. That was down from 10.6% at the end of the September 2017 quarter, with this was due to 2H17 dividend. Excluding the dividend, the CET1 ratio increased by 20 basis points from September 2017.
Summary
Shares of Westpac (ASX:WBC) have lagged the broader market over the past year as the sector faced a flurry of headwinds. The government’s decision to plug the budget deficit with a ‘big bank’ levy set the ball rolling and the announced Royal Commission (RC) into the banking, superannuation and financial services industry has dampened sentiment lately. We expect the banks, including ANZ, to ultimately pass most of the costs of these onto customers. We also expect the RC to be overshadowed by rising bond yields globally.
Westpac (ASX:WBC) shares currently trade on 11.8 times forecast FY18 earnings, falling to 11.5 times the following year. The projected yield over the same time frame is 6.6%, edging up to 6.8%.
Westpac (ASX:WBC) will remain held in the Fat Prophets portfolio.
Disclosure: Westpac (ASX:WBC) is held in the Fat Prophets Australian Share Income model.
