When the COVID-19 pandemic first started to bite in Australia, we said the banking sector would hold up in relative terms, certainly better than it did during the Global Financial Crisis. I’m pleased to say, those projections are holding true.
Seven months on since the COVID-19 pandemic started impacting the global economy, Australian major banks have fared well despite weaker earnings, reflecting our early view that this recession would hurt income statements but not balance sheets.
Large fiscal stimulus and changes to the regulator’s forbearance, which are the requirements of banks classifying deferred loans as arrears and needing to hold additional capital for those assets, are the main reasons for the relatively good performance of the banks. The crucial test for the banks’ balance sheets will occur once fiscal stimulus eventually subsides, and regulators start unwinding current forbearance measures. Once the banks need to declare deferred loans as arrears, they will also need to hold more capital against these loans, which ultimately impacts their capital ratios and the banks’ asset growth prospects.
We believe that we should have greater clarity on the health of the banks’ loan portfolios by mid-2021. In the meantime, we continue to assess the banks’ deferred loans. A large portion of these loans have been taken out by customers that were unsure about the impact of COVID-19 on their personal income. We have run several sensitivity analyses assuming banks’ reduced pre-provision profits and assessed how the banks would be able to cope with the potential provisioning if we assumed 20% to 50% of the deferred loans at its peak would become impaired. Even under the worst-case scenario, we believe the Australian major banks should be able to cope with the impact over a two-year horizon.
However, since mid-2020 we have noticed that the balances and accounts of deferred loans have declined. We believe that even our previously most benign scenario is likely to prove overly cautious given borrowers have resumed repayments, allowing the banks to perform significantly better than anticipated. We remain cautious as the duration of the pandemic and regulatory forbearance time frame is likely to impact the viability of businesses, which in turn impact the major banks’ asset quality.
We believe COVID-19 will have a longer-lasting impact on the banks’ earnings profile as interest rates are likely to stay low for at least the next three years, hurting revenue generation even if credit growth were to pick up again. The Reserve Bank of Australia’s (RBA) Term Funding Facility (TFF) provides some cushion as the banks can refinance their upcoming wholesale funding maturities with this cheaper alternative. We believe that this facility is likely to stay in place unless the RBA starts raising interest rates, allowing banks to generate more attractive asset spreads on loans which would offset larger funding costs if the TFF was withdrawn.
In other words, we believe the RBA needs to be confident enough that marginally higher interest rates will not restrict credit growth – a time which is likely to coincide with the RBA gaining confidence in the timing of its next hiking cycle.
Hence, we believe major banks’ senior note supply may be disappointing. We estimate that the Australian major banks – which used to be penalised for being highly reliant on wholesale markets – may not need to issue new senior unsecured notes for at least the next 12 months. The risk is that unless the RBA is willing to see loan rates increase – most likely driven by an increase in the cash rate – the TFF is likely here to stay.
Any issuance will be opportunistic and may likely occur in the offshore markets so that the banks maintain their relevance in global markets. We foresee Australian major banks to remain active issuers in subordinated notes (Tier-2), in line with their regulatory capital requirements, but any other capital market funding will be minimal. In 2018, the Australian Prudential Regulator Authority introduced the total loss-absorbing capacity (TLAC) requirements to ensure banks had sufficient assets to absorb losses and recapitalise in the unlikely event off failure. The conditions allowed banks to meet these new capital requirements by increasing their Tier-2 capital. This led to a boost in Tier-2 issuance volumes which many considered to be significant, even scary to some.
In 2020, these estimates would be considered miniscule and any issuance is likely to be absorbed comfortably across several markets. Hence, we believe that the current pricing of outstanding Tier-2 notes are attractive even considering our expectation of weaker credit profiles over the next 12 months. In fact, even a prolonged recession and a slower recovery, which will impact banks’ credit strengths, should not have a meaningful impact on credit spread widening for Tier-2 as central banks are likely to remain supportive.
At AMP Capital, we have identified a number of these trends early and our credit funds hold a sizeable portion of these instruments which have positively contributed to the funds’ returns.
Author: Andrea Jaehne, Senior Credit Analyst – Global Fixed Income
Source: AMP Capital 16 Nov 2020
Reproduced with the permission of the AMP Capital. This article was originally published at AMP Capital
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