It seems nine months into the COVID pandemic there have been three major effects on all ADIs in Australia, but these have been most pronounced within the smaller mutual sector based on Amicus’ interpretation of data from the recent KPMG annual mutuals survey.
Firstly, revenue was static for mutuals as a group due to falls in interest rates which have affected net interest margins (NIM) (the difference between the average rate at which ADIs lend money to their customers and the average rate at which they can source those funds). NIM fell 13bps to 1.79% in the year to 30 June 2020 for the mutual sector as a whole. This may sound relatively small, but 13bps on a starting value of 1.92% represents a 7% decline. There will also almost certainly be a further a decline in the 2021 financial year because interest rates have fallen further since June 2020 and a full year of the lower market interest rates will be captured within the 2021 figures. The issue for all ADIs is it is difficult to charge customers for holding their money so a fall in interest rates nearly always causes a fall in NIM because part of every ADI’s funding base is a proportion zero (or low) interest chequing or transactional accounts. For mutuals, NIM is their largest source of income representing over 80% of income. Across the mutual sector in 2020, fee income fell 3.65% to $421 million while NIM income rose to $2.475 billion mainly because there was deposit growth of 7% offsetting the fall in margin. However while deposits grew by 7%, loan growth was only 2.9% as the surplus deposits went into increased liquidity. It is unlikely this deposit growth will be repeated in 2021 because it was a one off reaction of consumers to the onset of the pandemic to give themselves increased financial flexibility and ready access to funds; it is in fact more likely to reverse in 2021.
The second effect was a major change in consumer behaviour towards digital and online banking and away from branch visits due to the COVID pandemic. This was already a trend which was simply accelerated by the pandemic and is unlikely to reverse. Across the mutual sector, this resulted in increased IT and personnel expenditures. It is highly likely ongoing substantive investment in systems and technology will be necessary while there will be short-term costs associated with branch closures.
The third effect was impairment charges for likely loan losses were also an increased cost rising by 8bps to 12bps due to the bushfires and loan deferrals because of the pandemic. Total loans within the mutual sector on deferral at 30 June 2020 were $5.65 billion (or 5.5% of total loans and advances). It is questionable whether these provisions will be sufficient as S&P has forecast (probably conservatively) that major banks will experience 0.85 bps of loan losses in 2021. While losses in the mutual sector are expected to be less due to more conservative lending and a lower proportion of lending to corporates, it would appear as if the risk is to the downside in terms of loan loss provisions for the mutual sector. However as per Amicus’ other article this month, losses on residential mortgages are very closely tied to house prices and with house prices now rising there is scope for earlier provisions and forecasts to be too pessimistic.
The early effects of these three factors combined to reduce 2020 profitability within the sector which fell 19% to $494 million, primarily as a result of Cost to Income ratios rising to 79.7% from 77.7% the prior year while revenue largely remained static. Cost to Income ratios were close to 72% in 2016 and this is a point of weakness for mutuals compared with the major banks whose Cost to Income ratios are far more competitive at an average of 53%. Return on Equity (ROE) for the mutual sector fell to 3.7% from 4.7% in 2019. This measure has fallen every year since 2016 when it was close to 6.0% and is far below average ROEs for commercial enterprises that historically have averaged in the high teens across the business cycle. A sign of increasing stress within the mutual sector was the number of mergers that increased to five in 2020 from two for the previous year causing a 7% reduction in the total number of mutual ADIs left in Australia.
The statistics above are for the mutual group as a collective and situations for individual mutuals will vary due to differing circumstances, starting points and specific responses to the challenges ahead. However, there is an overall crisis of profitability looming in the sector due to increased costs and reduced revenues (primarily NIM) as outlined above. The risk of any mutual defaulting is currently low as capital adequacy across the sector is high as is liquidity due to the Term Funding Facility and support from the RBA. Further, those mutuals who recognise their future outlook is precarious will likely seek a merger and Amicus expects more mergers to occur in 2021 and 2022.
The medium term risk for an investor in the debt of a mutual is if the mutual does not have a strategic plan or does not execute that plan effectively to respond to the changed market environment. In this case, the mutual can rapidly find itself in a loss making situation without the funds to invest to reduce its cost base. For some mutuals in poor circumstances, the only strategic option will be a merger and if a merger is not possible then there is a possibility of default, although Amicus believes APRA will likely act pre-emptively to try encourage a struggling mutual to merge with a stronger competitor.
In summary, the mutual sector is likely to be entering an increasingly dynamic situation where the risks to some individual mutuals may be high depending on the competence of their management teams and the quality of their planned responses. Investor transparency is relatively poor within the mutual sector, especially for the smaller mutuals that are not assessed by the rating agencies. It is likely to be these smaller mutuals who are most vulnerable rather than the top ten, most of whom are rated and further as a general rule the skill sets and experience within the Boards and Management teams at smaller mutuals is likely to be less than at larger ones.