The calm between two storms: strongest result in years suggests pandemic has passed, but uncertainties ahead - PwC Major Banks Analysis Full Year November 2022

• Cash earnings rose to $28.5b (from $26.8b), return on equity was 10.6% (FY21 9.9%)
• Net interest margin (NIM) was 1.77%, down 9bps for the year, a record low NIM for a year though the banks exited FY23 with NIMs benefitting from rate rises
• Non-interest income again fell by $1b to $15b compared to the prior year, now sitting at close to its lowest level since the global financial crisis
• Expense to income (excluding notable expenses) fell to 47.7%, with net interest income increases exceeding flat operating expenses
• Credit impairment remained accretive to earnings, at a positive write back of $133m, once again exceptionally low relative to the long-term, however second half shows a return to impairment charges as provisions grew
• Notable expenses came to $1.8b, a reduction of $1.5b and the lowest since banks started separately reporting these items in 2018
• Lending growth was a healthy 7.0%, and deposits grew faster still (8.5%), though both were less than system
  The Common Equity Tier 1 (CET1) ratio was 104 bps lower at 11.6% following the large capital returns at the beginning of the year

Australian banks have made it through the COVID crisis, delivering the best result since FY18 and emerging strong towards a FY23 that is going to feel like a very different economic paradigm around the world. Cash earnings were $28.5 billion up from $26.8b, driven by falling notable expenses, lending growth that offset falling margins for the year, and a credit environment that is as benign as it has ever been. However, the results also highlight a number of slow-moving yet challenging trends, including structurally-lower net interest margin (which was again down over the year, notwithstanding a strong pickup in the final quarter), ongoing reductions in non-interest income, inflationary and operational pressures on expenses, and reducing overall market share in lending.

Sam Garland, Banking and Capital Markets Leader at PwC Australia said, "With a cash earnings result that would have been respectable in the years before COVID, it seems the banks have made it through to the other side of the pandemic and are emerging strong into uncertainty. The improved result was driven by falling notables and rising lending, which together more than compensated for falling net-interest margin for the year and reduced non-interest income.

"The results were also underpinned by the remarkably low level of credit losses and limited signs of any distress currently being experienced, as well as cost-discipline given the inflationary environment.

"Understandably there is focus on the outlook for all these metrics given rising rates, economic uncertainty and stubborn inflation, in addition to broader significant transitions that are taking place in the world economy. That's why we are wondering whether FY22 could be looked back on as 'the calm between two storms, but there is no reason this has to be negative for the Australian banks.

"As the banks exited FY22, many performance measures were strong or improving, net interest margins were rising (with more to come), costs were showing only a limited uptick and there was very limited sign of any distress as a result of rates. However the speed of adjustment means it is likely that lag effects will be present, particularly for borrowers, but also lending growth and inflation.

"We're coming off a period of unprecedented low rates and a very benign credit loss environment. There are borrowers who have never experienced any rate hike in Australia,and probably very few who remember the last time rates rose this quickly, which was 1994.

"It's inevitable that rising repayments will cause stress for some customers, so it's really a question of how strong are the buffers that people have in place and their ability to adjust.

"However, banks as a whole are arguably in a stronger position to manage this and support customers than in past crises. Whilst this is in part due to stronger lending standards they have been required to apply and their experience managing changes in customer credit, this is also due to how different the banks are now compared to what they were then; stronger capital, higher provisions, simplified businesses, and increased reputational capital and trust."

Critical transitions underway for 2023 and beyond

While the virus still lingers and its presence still felt, particularly in China and among vulnerable populations, FY22's solid financial result, coupled with the strong economy and benign credit environment, indicates that the pandemic, for now, is behind us. However, the disruption it has caused is not.

"In the coming year we will face a number of challenges related to the aftermath of the crisis that's passed. These include falling asset values (and housing), reduced demand for loans, lingering supply constraints, especially labour, food and energy. It's likely that, as the global economy pivots in the face of these challenges, that it (but not necessarily Australia) moves into recession, with the consequences that implies. Although we're still a long way from anything extreme globally, the range of plausible scenarios for FY23 is extraordinarily broad," said Mr Garland.

Looking beyond twelve months, the rate rises that began in May which have lifted the cash rate 275 basis points in just six months, represents the end of the long-term secular decline in interest rates from its peak of 17.5% in January, 1990. Banking, investing and doing business of any kind in an age of rising rates will be fundamentally different than it has been in the age which has passed. For banks, the implications will be both strategic - including where and how value is created, sources of advantage and opportunities for growth - as well as tactical.

No-regrets priorities for 2023: focus and flexibility

"In the face of so much change and risk, we see several immediate priorities, which we can think of as reflecting a balance between the imperative for focus and the need for flexibility," Mr Garland continued.

"Banks and their leaders must maintain focus on commercial discipline, particularly as lending growth slows and cost pressures increase, delivering on their transformation agenda (cost, technology, operations, operating models) and their long-term strategic goals such as supporting the energy transition.

However, they must also remain flexible to the need to change and react quickly, and remain humble to the reality of great uncertainty.

"Practically speaking, this requires recognition of how little we can know about what the future holds, along with investing in preparation and capacity to react as events transpire. It calls for thoughtful and careful deliberation about the road ahead, lessons learned from past crises, and markets around the world, which, despite the supposed 'de-globalisation' of banking and economies over the past decade, are facing a surprisingly common set of challenges today."

'Shock absorbers' for Australia once again

For the second time in two years, Australia's banks are preparing for a year ahead full of uncertainty, and with the spread of risks seemingly skewed to the downside. Then, as now, they took confidence in the balance sheet, financial, strategic, operational and cultural resilience built up steadily over many years. Australia's banks acted proactively to protect their franchises, credit portfolios and customers from the turbulence they believed was to come.

They were then galvanised by a clear vision for how banks, along with governments, regulators, and other agencies, could act together to cushion the shocks and help the nation make it through the crisis ahead. Whilst the 'crisis' faced is different in nature, and therefore the resulting issues and roles differ across these agencies, it is clear that once again there is a uniquely-important role for the banking industry to play.

"Two years ago Australians were asked to come together to respond to a crisis with governments, citizens, businesses and banks working to adapt and absorb the shock of COVID. Banks, for their part, helped to absorb the financial shock and in doing so rebuilt trust to levels exceeding those before the global financial crisis.

"In the years ahead, the shock of inflation, fiscal tightening, energy transition, global instability and a possible recession may remind us once again how, across society and around the world, common challenges require common solutions, that we really are 'in this together'.

"If we are to get through the next phase, whatever it looks like, as we did the last one, banks will have a critical role to play," concluded Mr Garland.

To view the Banking Matters - Major Banks Analysis Full Year November 2022, click here.

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