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Banks’ engine rooms face a tougher grind

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For the last two decades, the four major banks have been among the biggest corporate winners from an almighty debt splurge by Australian households.

The massive lift in borrowing for housing – and the fact we’ve avoided a deep recession – have been been critical in propelling the majors’ combined profits to some $30 billion a year.

Two thirds of bank loans are mortgages, leaving lenders exposed if regulators dampen the property market. Two thirds of bank loans are mortgages, leaving lenders exposed if regulators dampen the property market. Photo: Rob Homer

Yet as house prices reach eye-popping levels, and regulators fret over how much debt is too much, can this great tailwind for the banks keep on blowing?

Several leading bank-watchers have their doubts.

As the market awaits coming profit reports from ANZ, National Australia Bank and Westpac, top analysts are questioning just how banks will be able to maintain the growth in their home loan books, which underpin their mammoth profits and fat dividends.

You won’t see much slowing reflected in this round of results, to be sure, as Sydney and Melbourne’s roaring housing market has kept credit growth strong in the past six months, and loan losses appear well contained.

But over the longer term – the next year or two – banks will probably struggle to expand their mortgage books at the pace of recent years. When residential mortgages make up two thirds of all bank loans, that matters for future profits.

To see why loan growth is likely to get tougher, it’s worth recapping how big the debt splurge has been.

Since the early 1990s, the amount of housing debt Australian households carry relative to their incomes has steadily climbed from about 40 per cent to a whopping 133.8 per cent, a record. In the last few months, we overtook the Danes to become the second most indebted households in the world behind the Swiss, according to Deloitte Access Economics.

This binge didn’t just happen out of the blue – it occurred because we’ve been able to afford to borrow much more.

The size of an average mortgage has swelled because of a deep-seated (structural) fall in interest rates, more competition between banks, and the fact banks allowed people to borrow much larger multiples of their incomes.

Interlinked with this is the housing market – the extra borrowing power was used to bid up the price of houses. 

As a result, all of the big four, but especially Commonwealth Bank and Westpac, have become more and more powered by the mortgage market.

However, leading analysts think the Australian Prudential Regulation Authority’s latest moves to dampen loan growth should put the brakes on in some important ways.

For one, APRA is capping the share of new lending that can be done on an interest-only basis at 30 per cent – compared with about 40 per cent currently. UBS analyst Jonathan Mott says this will have a “more pronounced impact than many anticipate”.

Morgan Stanley’s Richard Wiles estimates the big four will need to cut their new interest-only lending by about $36 billion a year, or almost a third, to meet the target.

To fill this hole, banks have to convince more customers to take out loans where they pay back principal, as well as interest.

And that’s a significant change, because loans with principal included can cost significantly more in monthly mortgage payments in the first few years.

Wiles reckons principal and interest lending will need to jump by 15 per cent to a record $205 billion just to keep loan approvals at 2015-16 levels. By jacking up the price of interest-only loans, the banks are also encouraging customers to pay down debt, which also makes it harder to grow their overall loan portfolios.

There are also limits to how much banks can make up for the slower growth by simply raising their interest rates.

Macquarie analyst Victor German crunched the numbers on just how sensitive the most indebted households are to a rise in interest rates, and found a significant minority who would be hit hard by even fairly small hikes.

Most borrowers wouldn’t feel much pain if interest rates rose by 1 percentage point or so. But German says the most indebted 10th of the population would see their disposable income slide by between 12 and 31 per cent, just as inflation is also eroding spending power.

While only a hypothetical exercise, it illustrates how the household debt binge that has put so much into bank profits could also act as a headwind.

For shareholders in the big four, that raises the question of where growth will come from?

It’s hard to see corporate lending picking up the slack: business credit growth slowed to just 3.4 per cent in the year to March, the lowest in more than two years. Credit card and personal debt is also on the nose, and banks have been deliberately shrinking their institutional loan books because the returns are too skinny. 

For as long as the housing market continues to fire, the question of future growth will probably be a second order concern for many investors.

But it is worth remembering the phrase RBA assistant governor Michele Bullock used in March to describe APRA’s previous interventions in the housing market: “sand in the gears”.

No doubt this is what the overheated housing market needs, but it would be naive to think the banks can sail through unaffected.

Ross Gittins is on leave.

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