Recent chatter in the markets has focused on the idea that Australia's banks may be victims of rising short-term benchmark lending or wholesale funding rates at home or abroad, while being beneficiaries of rising central bank lending rates over the medium term.
Australia's benchmark lending rate the Bank Bill Swap Rate (BBSW) has reportedly climbed above 2% in recent months and the idea that a rising Bank Bill Swap Rate is a negative for the local banks is based on the age-old banking mantra of 'lend long, borrow short'.
This is because banks borrow from each other largely via 'paper bank bills' or short term debt offerings (over 1 to 6 month periods) and lend long to home buyers (over 25 to 30-year periods) with the lending securitised against the equity in the homes.
The spread on the difference between the short-term borrowing and long-term lending rates being the bank's net interest (profit) margin.
Therefore if the short-term interbank lending rate climbs it might hurt the net interest margin to the detriment of profit.
This is true to an extent, but remember banks' balance sheets all have BBSW-linked products as assets that benefit from a rising BBSW, with floating rate mortgage products commonly priced a fixed margin above interbank-lending rates for example.
In other markets collateralised debt obligations such as mortgage backed securities are also priced with reference to BBSW and usually a fixed margin above it, therefore the theoretical returns to investors would be greater as BBSW rises.
As such a rising BBSW is a double aged-sword and not an unambiguous negative as some have claimed.
In fact the main driver of the local banks' profits is their ability to write new profitable business not variable interbank lending or central bank rates that are commonly speculated upon by the business media. This is because markets are interconnected and banks' balance sheets have exposure to different interest rates on the long and short side of assets or liabilities.
However, the lend long, borrow short, business model does create risk around maturity transformation, liquidity, and the potential for the value of the assets on banks' balance sheets to fall.
For example, Australian banks are heavily focused on residential mortgage lending and trade on price-to-book ratios much higher then their European or U.S. peers as their asset books (home loans) are considered safer than the asset mix contained on the balance sheets of more exotic international banks that have long track records of problems created via financial alchemy.
Dismissing the likes of CBA as too expensive on a price-to-book ratio ratio relative to international peers is probably a mistake therefore, but remember it will have further to fall if falling asset prices lead to a price-to-book multiple de-rating.
Regulatory headwinds
Another big risk to bank profits is the Hayne Royal Commission via coming requirements that lending practices are tightened up as credit (lending) growth to borrowers is restricted.
Likely commission recommendations will include tighter checks to prevent 'liar loans' where applicants exaggerate income and hide costs, while forcing the banks to reform their relationships with fee-earning mortgage brokers who oil the wheels of home loan lending markets as key distribution channels.
There's also now more potential that investor lending restrictions imposed by the prudential regulator APRA will not be loosened to soften the impact of the bottoming of the central bank's base rate lending cycle.
Currently, banks cannot exceed 10% loan growth to property investors in any 12-month period, although it's been anticipated that this rule would be relaxed to support property prices that will come under pressure if home loan lending rates rise in 2019.
Finally, the banks are still facing regulatory pressure to lift their reserves of liquid capital as a percentage of risk weighted assets on their balance sheet. The more idle capital banks are forced to hold in reserve on their balance sheets the lower their returns on equity, as idle capital cannot be lent out at the most profitable returns.
Outlook
As such I expect the shares of Westpac (ASX: WBC) and its peers are unlikely to deliver investors much growth over a 2 to 3 year time horizon.
The banks do have some growth levers to pull in terms of cutting costs and asset sales though, which means dividends and share prices should at least track on a flat trajectory over the period ahead.
I'm not a buyer of bank shares, but if I were a conservative income focused investor I would probably be inclined to hold on for now.
