Over the past week ANZ, NAB , WBC and Macquarie have all reported their half year results and CBA provided a quarterly update. The theme is consistent across issuers with cash earnings remaining strong (although below inflated expectations), asset quality remained relatively stable (with the exception of a couple of outliers) but the key theme has been an increase in capital held (or plans to hold) in response to FSI recommendations and APRA intentions to get the job done quickly. The equity market has responded in kind and we witnessed very sharp falls in the their share prices. This is primarily as a result of a higher cost of capital  which will result in a lower return on equity. However, from a debt and hybrid investors perspective this is positive and will further improve the robustness of the capital positions in a “worst case” scenario. Volatility in the banks share prices is likley to have some impact on the valuation for hybrids (primarily because the equity volatility impacts the convertibility premium) but from a fundamental perspective we see this as a good buying opportunity and will be adjusting our recommendations accordingly.

Our overall position with the banks remains unchanged. However, in hindsight the changes being made by APRA (and global regulators) have been improving the outlook for the banks over the past few years and with default and arrears rates low (and falling) the majors should have been on positive outlook. The situation today is slightly different where the economic environment does not seem to match the provisioning strategy of the banks. This is partially mitigated by the new capital requirements set out under APRA’s D-SIB buffer and the position on a new floor for residential mortgage RWA requirements.

Below is a summary of the results for each issuer:

Australia and New Zealand Banking Group Limited (Half Year Results) – Remain on Stable Outlook 

ANZ has reported strong results for the first half of FY2015 , better (in a relative sense) than some of its its peers. The reported statutory net profit of A$3.5 bn (cash earnings of A$3,676m) was up 3% on the year  primarily driven by loan growth from retail and commercial operations (ANZ has been investing to grow its relatively underweight share of the New South Wales market and has hired 600 staff to achieve this target). The key points of interest were the net interest margin dropping 0.08% to 2.04 (driven by competition), trading and wealth management income bucked the market trend and  legacy IT upgrades and increased staff numbers weighed on the bottom line.


Although capital was not the focus of the earnings announcement, ANZ has made clear its intention of assets sales (i.e Esanda, minority stakes in Indonesia’s Panin Bank, Malaysia’s AMMB, and China’s Shanghai Rural and Commercial Bank and Bank of Tianjin) in previous weeks. ANZ’s capital ratios are adequate based on current regulatory requirements. The common equity tier 1 ratio (CET1) crept lower over the half to 8.72% (down from 8.79%). This was a result of an increase in risk weighted assets (and movements in currency) rather than any lack of organic capital generation.

ANZ CEO (Mike Smith) has suggested that any increases in capital requirements made by APRA are unnecessary and could impact the supply of credit to the economy. Even though he believes the current capital ratios are high enough and  he has also accepted that APRA is likely to raise them further. He has also suggested that ANZ will not make any preemptive moves as he expects to have time to respond to any further changes required by APRA. In our opinion they are already moving towards a higher CET1 ratio through asset sales (which are a drag on earnings and return on equity), earnings retention and adjustments to the dividend reinvestment plan (currently assumed that 20% will be reinvested). If ANZ does not make active capital decisions to increase this ratio then they are likely to fall below other major banks. We note that ANZ generates slightly lower returns than the other banks and has a slightly higher capital intensity given its Asian growth strategy and therefore the payout ratio is slightly lower (65-70% range). Overall, capital is sufficient at present but is likely to lag peers in terms of growth over the next 12 months.

Asset Quality

The credit quality of ANZ remains strong with gross impaired assets falling ~25% in the half to A$2,708 mln (0.48% of gross loans). Provision coverage was strong at 149% by total provisions and 41% by individual provisions. New impaired loans ($1.2 billion) were just 0.4% of gross loans on an annualised basis. This improvement can be partially attributed to the gross loan growth 8% in Australia, 11% in New Zealand and 15% in asia pacific. The delinquency ratio for Australian residential mortgages (0.57%)  and credit cards (1.08%) were slightly higher on the half but still very low relative to long term averages. The biggest risks in the loan book remain in the Resources Portfolio ($19.5 billion)  and its commercial real estate (CRE) portfolio ($51 billion). The demand for CRE lending has been evident across the sector and is something we are watching closely as historically this has been the largest driver of non-performing loans.

Funding and Liquidity

ANZ has significantly increased its holdings of high quality liquid assets (HQLA) over the half and this is evident in the liquidity coverage ratio (LCR) at 119% (111% at September 2014). As with the other banks this is the new normal and with contingent liquidity available from the Reserve Banks’s committed liquidity fund (CLF) we see no reason why liquidity will become an issue over the coming year. The funding composition remained fairly stable over the period with the exception of a 3% swing away from deposits to term funding. During the six months $11 billion of term funding was issued which represents between 40-60% of the full year target depending on loan growth and funding composition.


We expect the next six months will be a less favorable period for ANZ as operating conditions are currently optimised for the banks and we expect regulatory changes (on capital and loan growth limits), increased costs and a deteriorating economic environment to impact performance. However, the change will be subtle and provided the regulatory changes can be implemented without major disruption we believe the credit profile will benefit in the long term. Asset quality will remain benign as low interest rates and an appreciating US Dollar support borrowers. The biggest risk to ANZ remains its Asian exposure during a period of capital outflows and economic volatility. ANZ has committed to its long term super regional strategy and we would expect that they will closely monitor any deteriorating performance.

Westpac Banking Corporation (Half Year Results) – Remain on Stable Outlook

WBC has reported an unexpected set of results for the first half of FY2015. The reported statutory net profit of A$3.609 bn (cash earnings of A$3,778m) was down 8% on the half (but unchanged on the year). The market reacted poorly as expectations for earnings growth was moderate but new accounting treatments to fair value derivative assets had a significant impact on profit. WBC also struggled to maintain market share as net mortgage lending growth was limited to 3% (below system growth). The net interest margin dropped slightly to 2.01% (down 0.01%) and costs were well controlled. This result was not the best ever produced by WBC, but the underlying performance of operating divisions was solid. It’s our view that WBC is in a period of reflection in terms of market strategy and will not chase loan growth at the expense of quality. Although this is not good for equity investors this is a strong attribute for debt and hybrid investors.


The core equity tier 1 (CET1) ratio fell 0.20% on the half from 9.0% to 8.8% . This drop was was primarily attributed to changes in the groups internal risk models for residential mortgages which increased the default probability for residential mortgage loans, and hence the average risk weight from 14% to 16%. In our opinion this is the first stage of a larger program (as the final outcome is still not clear) which will see the default probabilities increase further to meet the APRA / Financial System Inquiry recommendations (the new risk weights could be as high as 25-30% ). WBC has a current Common Equity Tier 1 (CET1) target of 8.75%-9.25% but because of uncertainties with regard to future capital settings, it will review its capital levels every six months. As part of the half year results WBC announced it would be underwriting its dividend reinvestment program to the value of $2.0 billion which means the pro-forma CET1 ratio will rise to ~9.3%. Although this is at the high end of their target range, it is our opinion that the staged process of increasing their risk weights on residential mortgages will negatively impact this level over the course of the next year. WBC has also indicated that APRA could potentially increase its capital requirements if residential property investor lending (currently ~45% of total  residential mortgage loans) exceeds the 10% growth threshold (currently 11.5%). Therefore, although the pro-forma capital ratios look good on a reported basis (and relative to some peers) they are likley to drop slightly over the next year.

Asset Quality

The asset quality of WBC remains strong with gross impairment charges flat over the 6 months period on a nominal basis (0.11% of average gross loans) and impaired assets reducing to 0.35% of gross loans.  Specific provision coverage increased to 48% but this was offset by a small nominal release in overall provisions. The delinquency ratio for Australian residential mortgages was 0.47%  and even lower on investment properties (~0.35%). Similar to its peers, WBC did report a small increase in delinquency rates on credit cards up 0.26% to 1.08%. From a balance sheet perspective, the biggest risks in the loan book remain in the commercial real estate (CRE) portfolio (~$50 billion) and the investment property portfolio. The reality is WBC has a market leading position in terms of asset quality and all things remaining equal we do not expect this to change. The new lending criteria for residential mortgages could cause some issues going forward but given its historical performance we do not think this will be an issue.

Funding and Liquidity

Liquidity and funding conditions have improved significantly since the introduction of the Liquidity Coverage Ratio (LCR)  implemented on 1 January 2015. WBC has reported an LCR of 114% based liquid assets of A$123 billion (we note that WBC has ~50% of its liquid assets derived from the RBA’s committed liquidity facility). From a funding perspective customer deposits increased by 3% on the half (8% on the year) which meant the deposit to loan ratio decreased to 69.5%, however the reported Stable Funding Ratio (internal ratio) was maintained at 83.2%. During the six months ~$16 billion of term funding was issued which represents between 40-60% of the full year target depending on loan growth and funding composition.


The current operating conditions for WBC are strong with wholesale debt markets open and asset quality remaining  strong. However, we expect over the next six months WBC will be focused on changes to regulation around its residential mortgage book (both owner occupier and investor) as the potential new requirements will constrain loan growth while  increasing minimum capital requirements. WBC’s larger market share in the residential mortgage market means it is sensitive to macroeconomic changes (i.e unemployment) and we will carefully monitor arrears rates on unsecured lending for signs of deterioration. However, given the low interest rate environment and quality of the loan book we do not expect a significant deterioration in the asset quality over the next 6 months.

National Australia Bank (Half Year Results) – Remain on Stable Outlook

NAB’s half year result was overshadowed by the large capital raising and announcement of the divestment of UK banking subsidiary Clydesdale Bank plc. To complete the strategic move NAB are raising ~A$6bn of capital (ie ~A$5.5bn accelerated rights issue + ~A$500m MLC re-insurance agreement) but almost half of it ($3.2 billion) will be held as protection against future potential legacy claims. This was a precondition to the exit as required by the UK banking regulators. Clydesdale is to be spun off under a holding company currently referred to as “Listco”. The new entity will be ~75% owned by NAB’s own shareholders and the remainder ( 20-30%) sold to institutional shareholders through an initial public offering. NAB will realise a loss from the sale of the UK operations as proceeds will be less than the carry value.

From a debt and hybrid investors perspective, this move is a clear signal from the board  they want to be proactive in managing the business back to a domestic focus. The raising will result in a sharp increase in common equity tier 1 (CET1) capital and asset quality will benefit from the transition away from the UK bank. This is a positive outcome for debt and hybrid investors and should alleviate any concerns that NAB might be considered the outliers in terms of balance sheet risk of the major banks.

The transaction will significantly change the balance sheet and there is no doubt there will be significant changes in asset composition across multiple business units. However, the proposed actions (which as of writing look completed) should increase NAB’s proforma CET1 ratio from 8.87% to ~10.0%. This is a full percent above their current CET1 target of 8.75%-9.25%. This headline figure is very strong on a relative reported basis, but in reality the bank is positioning itself ahead of upcoming regulatory headwinds in the form of the proposed conglomerates regulation (and changes to risk weighted assets in residential mortgages) which on an adjusted basis means they will be only modestly above the other banks. NAB has the ability to claw back some of the provisions held against Clydesdale Bank as the amount represents a severe conduct stress scenario, but for for reporting purposes this will be deducted from their CET1 position.

From an earnings perspective, the half year cash profit was up 5% to A$3,320 million (statutory basis $3,460 million) driven by above average loan growth in housing (particularly investor mortgages). The group net interest margin was down slightly on the year to 1.92% but costs were well contained increasing by only 2.3%. Impairment charges ($455 million) were low at 0.16% of gross loans and the funding composition remained stable.

Commonwealth Bank of Australia (March Quarter 2015 Trading Update – Remain on Stable Outlook)

CBA’s cash earnings and statutory result came in at $2.2bn for the period as a result of home loans growing below average and business lending only in mid-single digits. Net Interest Margins were flat as a result of competitive pressures. Overall,the result was flat on the prior period and below the 3Q14 statutory profit of $2.3bn and also below market expectations which is why the share price has fallen (down ~15% from its peak). As we have flagged before, the increasing regulatory and compliance landscape is starting to take its toll on costs and volumes in retail and wealth channels. The average retail/wealth result is probably part of the reason why CBA chose to pass on only 0.20% of the 0.25% RBA cut to its mortgage customers (standard variable rates now sit at ANZ 5.38%, CBA 5.45%, NAB 5.43% and WBC 5.48%).

Asset quality was in line with expectation and ‘sound’ in the word of the Bank . Loans in arrears were broadly flat but the Bank did reveal a quarterly impairment charge of $256 million (small on relative scale). Common equity tier 1 capital was up 0.20% to 8.7%, but unlike the other banks CBA appears comfortable with this level for now (but we will likely see action in the second half). Liquidity remained strong with the Bank reporting that is liquidity coverage ratio stood at 122%.

On a more interesting note the Bank lifted some deposit rates which may indicate they are cautious of wholesale funding markets given the Greek situation, some uncertainty of  Australia’s AAA credit rating and the rapidly steepening yield curve.

Macquarie Group (Full Year Results) – Remain on Stable Outlook

MQG reported strong results for the full year 2015 with net income of $1,604m (up 17% on the year) and $926m (up 37%) for the half year. This is a strong result and well above expectations. The international diversification and focus on annuity style business units has proven successful  as income ex-Australia approaches 70% of total revenue. The result was driven by an increase in loan growth, better trading outcomes, a 24% increase in fees and commission and higher advisory fees from mergers and acquisitions ( we note it was also helped by a weaker Aussie dollar). This was partially offset by a 12% increase in operating expenses as technology and compliance spending increased significantly. MQG’s operating model (annuity income and less transaction based) is a proven model which arguably supports its credit profile more now than the past but there will always be a large degree of earnings sensitivity to MQG’s business (perhaps less so than the past). Market volatility presents trading opportunities for MQG and they should capitalise on a continuation of these conditions.


Macquarie Group is unique in the Australian landscape as an APRA regulated entity, but the only group regulated using its own internal Economic Capital Adequacy Model (ECAM). They are required to hold adequate regulatory capital to cover risks for the whole Macquarie Group, including the non-bank Group. This is where transparency becomes an issue as there is limited information available about the group outside the banking entity. We maintain our view that Macquarie Bank is adequately capitalised and regulated to APRA standards which makes risk reasonably identifiable. However, investors outside the banking entity are not given the same transparency. The Group has historically held a solid capital buffer over and above its minimum requirements (both Bank and Non-Bank Group capital requirement) but this does not necessarily make it less riskier than its peers. However MQG still has easy access to capital markets and in March 2015 they raised $500 million in equity capital to help  fund an aircraft leasing portfolio.

Macquarie Bank reported a small increase in its common equity tier 1 capital to 9.70% (from 9.6% in 2014) but the volatility in its is asset book is significant (23% increase in risk weighted assets over the half). This volatility in capital in unlikely to change anytime soon as changes in risk weighted assets for residential mortgages and the conglomerate regulation is likely to impact the group. Under the proposed regulation, fund managers part of a banking conglomerate , will be subject to more stringent capital requirements relative to global fund managers and domestic non bank owned managers. Factors such as a capital charge based on funds under advice to cover operational risks, 100% core equity capital for acquired goodwill and intangible assets (i.e. US funds management business) will all drag on excess capital of the group. Although the group is well capitalised, it is still facing some uphill challenges with new regulations.

Funding and Liquidity

The funding composition of the group changed significantly over the past year as liabilities did not match the multi currency and high asset growth profile of the balance sheet. Retail deposits increased 12% over the year but as a proportion of funded assets they decreased to 33% (from 36%). MQG issued $12.8bn of term funding in the year and confirmed that it is meeting the liquidity coverage ratio requirements.

Asset Quality

The huge growth in assets also came with a large increase (93%) in impairments and provisions to $467 million. This can be partially attributed to a higher collective provisions policy . The significant commodites price decline over the past year caused a visible increase in provisions for the commodity and financial markets unit. It is unclear exactly the reason for this but the group reports the under performance of specific issuers.


The group outlook for MQG is always difficult due to their aggressive growth in balance sheet and history of acquisitions. The earnings from the annuity style business will continue but the poor impairment results from commodities exposure could get worse (albeit commodity prices appear to have stabilised). Overall, we remain positive on MQG’s operating model but we caution investors that the impact of the conglomerate regulation could alter the capital management strategy going forward.