It’s been a wild couple months for the economy with the highly publicised collapse of a number of prominent banks, such as Silicon Valley Bank, Signature Bank and Silvergate Bank, spurring fears that we may be on the brink of another global financial crisis.
But are things really as bad as it seems? Is it time to pull cash from the banks and store it under the mattress, or is there an opportunity to take advantage of the situation and pick up some banking stocks that are trading at a discount…
Since we can’t provide any financial advice, we’ll have to leave this question up to you to decide.
But with so much focus on banks in the media, at Mates Rates Capital we decided it would be a good opportunity to spend some time diving deeper into the Banking Sector.
To get the ball rolling, we decided to take a look at Westpac (ASX: WBC).
Quick Summary
Westpac Banking Corporation (WBC) is one of the “Big Four” Australian banks, along with Commonwealth Bank, National Australia Bank, and ANZ. WBC is headquartered in Sydney and has operations throughout Australia, New Zealand, Asia, and the Pacific.
Profitability
Westpac’s revenue decreased by 11.1% from $AUS 21.8 billion to $AUS 19.2 billion between 2021 and 2022, which certainly raised a few eyebrows at first glance. Upon closer inspection, this reduction in revenue can be largely attributed to Westpac’s simplification strategy, in which they have been sharpening their focus on their banking operations by selling off a large number of non-core businesses, such as their Australian and New Zealand life insurance businesses, along with their auto finance and novated leasing businesses.
Simplifying operations by selling off non-core businesses appears to already be having a positive impact for Westpac across different areas, contributing to lower asset write downs, reduced reliance on third parties and lower staff expenses.
Overall, from a profitability standpoint, things seem to be looking good for Westpac. Operating expenses were $AUS 11.1 billion, down 19% from 2021. Plus, net profit attributable to owners of Westpac Banking Corporation for 2022 was $AUS 5.6 billion, an increase of $AUS 236 million or 4% compared to 2021.
And these earnings come with further good news for investors, which is that Westpac pay a pretty juicy dividend of 5.74%. To make things even better, Westpac’s dividend payments are well covered by earnings, with earnings per share of $AUS 1.62 being well above the dividend per share of $AUS 1.25.
But while these dividends sound all well and good, what if Westpac is the next domino to fall in the line of failing banks?
Financial Health
At the end of the day, it can be challenging as an investor to predict with absolute certainty whether a company will be around in a year, 5 years or 10 years time. But fortunately for the banking sector, a number of measures have been put in place since the Global Financial Crisis in 2008 (GFC) that make it a little easier to get a gauge on how things are going at most banks.
These measures of a bank’s financial health focus on a number of key capital ratios. Some of the main ones include; the quality of a banks capital reserves (capital adequacy ratios), the availability of a banks capital (capital liquidity ratios), and the state of the bank’s lending (credit ratios).
Before diving into these ratios, we’ll do a bit of background on why they’re important.
Liquidity is incredibly important for ensuring that banks have enough available cash to meet customer withdrawal requests at all times.
This is because banks lend from customer deposits. This means that when you put money in the bank, chances are that the bank won’t actually have this money on hand. Instead, the banks would have likely lent some of your money out to other people. But because this money you put in the bank is your money, you expect to be able withdraw this money. Therefore, the bank needs a way to free up cash to make up for the money they’ve lent from customer withdrawals.
Fortunately, banks will often have a steady stream of liquid cash coming in from repayments on loan they have issued to customers, which can be used to pay back the money they have lent from customer deposits when customer’s wish to withdraw their money from the bank.
However, at times when there are large amounts of customers wanting to take money out of the bank, the liquid cash that banks receive from loan repayments won’t be enough to fulfil all these withdrawal requests. In times like these, banks may need to free up extra cash by either selling off assets or borrowing money from investors, banks or central banks.
When people withdraw their money from the bank, they expect to receive their money without any delays. Therefore, banks need liquid assets that can be converted to cash quickly – it’s no good owning a bunch of high rise buildings that take months to sell, if the bank needs cash to cover withdrawals from customers who want their money today.
But liquid assets aren’t good enough on their own – banks need stable liquid assets that have relatively low price volatility, so that when the bank goes to sell these assets they actually get enough money for them to cover customer withdrawals.
If a bank doesn’t have stable liquid assets, they may find that these assets have decreased in value substantially when they need to sell them to cover customer withdrawals.
If the volume of withdrawals is too great, the bank may simply run out of money when trying to cover these withdrawals, known as a bank run.
This was the case during the great financial crisis, where many banks were holding large quantities of risky assets, which had depreciated in value almost completely by the time banks went to sell them, leaving not enough money left over to cover customer withdrawals.
Since the GFC, G20 countries launched a major overhaul of banking regulations, known as Basel III, to address systemic issues and reduce the chances of such events occurring again. This gave rise to some of the capital adequacy and liquidity ratios that we’ll be looking at in more detail during our analysis of Westpac.
Capital Adequacy ratios
Capital adequacy ratios assess the quality of a banks assets. Basically, capital adequacy ratios look at the percentage of a banks capital that is good quality versus their more risky assets.
But what are quality assets? Factors that help determine the quality of an asset include;
- risk and volatility; how well the asset holds its value,
- liquidity; how easily the asset can be converted to cash,
- cost of capital; how expensive it is to generate cash from the capital (ie at a basic level, issuing common shares can often be more cost effective way of raising capital than issuing bonds because a bank doesn’t have an obligation to pay interest on the shares).
Common equity tier 1 (CET1) capital, which includes common shares in the bank, retained earnings and a number of other types of capital, is considered the highest quality capital because it does not result in any repayment or distribution obligations on the bank.
One of the most important capital ratios for assessing the quality of a banks capital is the common equity tier 1 (CET1) ratio, which looks at the proportion of a banks CET1 capital against their total risk weighted assets. To ensure banks have adequate amounts of quality capital, regulators, such as central banks, specify minimum CET1 ratio levels.
When calculating the CET1 ratio, the total value of a banks assets is adjusted based on the risk they carry, known as risk weighting, which gives a more reliable view on the proportion of a bank’s good quality assets.
As an example of risk weighting; government bonds are generally considered to be low risk assets, which is mainly because governments tend to have a good reputation for continuing to pay interest to investors during economic downturns – as it turns out, money from taxes provided governments with a pretty solid income stream to pay interest to bond holders.
Plus, if a bank wishes to sell their government bonds, there’s usually always going to be someone willing to buy, wish is useful for freeing up cash. On the other hand, a mortgage contract will be deemed to be a more risky asset for a bank because there’s a chance that the customer might not be able to pay the money back. Therefore, since government bonds are generally considered to be low risk they would not require their value to be adjusted, while home loans are considered to be higher risk, so you might adjust the total value of home loans by say 50% to calculate the risk weighted value of a banks assets.
If we take a look at Westpac, we can see that their CET1 ratio of 11.1% as at Dec. 3, 2022, comfortably meeting APRA’s benchmark of 10.5%.
Capital liquidity ratios
Next up, we’ll take a look at the liquidity of Westpac’s capital.
But first, we’ll provide a bit of background to illustrate why capital liquidity ratios are important.
Banks primarily generate income from interest on loans, which is designed to provide a steady stream of profit at regular intervals over many years – if the loan gets paid back. These loans can be viewed as an asset to the bank because they are a contractual agreement that requires the customer to pay the loan back at some point in the future, along with interest on top.
However, many loan terms, such as home loans, can extend across 10-20+ years, which means that these loans may not generate enough liquid cash from interest to cover customer withdrawals from the bank. Therefore, as discussed earlier, banks need liquid assets that they can sell to provide cash to cover customer withdrawals.
In the lead up to the GFC, banks had been relying heavily on short term asset such as mortgage backed securities and reverse repo share buybacks to provide liquid cash to try sustain long term lending – which didn’t turn out so good.
To give a quick overview of the assets we touched on above; mortgage backed securities are a type of investment vehicle where banks package up a bunch of long term mortgages and sell them to investors as securities/shares, and the investors receive interest on these mortgages in return. On the other hand, reverse repos are when a bank sells their shares to investors under the agreement that they will buy these shares back from the investors at a higher price, which helps the bank to free up cash to cover customer withdrawals.
The problem is that many of the loans underlying the mortgage backed securities were incredibly risky due to being offered to customers who could not afford to pay back the loans, leading to defaults on mortgages throughout the market – which sent the value of the mortgage backed securities plummeting to almost zero.
This created an even bigger problem for banks who were relying on selling mortgage backed securities to provide cash flow to cover customer withdraws, because these mortgage backed securities had become almost completely worthless, meaning that the banks no longer had any money left for customers to withdraw, triggering the collapse of a number of financial institutions, such as Lehman Brothers and Bear Stearns.
With the collapse of a number of highly leveraged financial institutions, the share market also took a nose dive, dealing another blow to banks who were relying on selling their shares through reverse repo agreements to generate cash flow, as these shares had also lost a lot of their value and in some cases did not provide enough cash for banks to cover customer withdrawals, leading to the collapse of further financial institutions – all in all, the perfect storm.
To avoid issues arising from using short term assets to cover long term loans made from customer deposits, regulators typically require banks to hold a larger amount of liquid assets with longer maturities. These long term liquid assets, such as government bonds, provide banks with an additional income stream in the form of interest, while also being valuable sources if they need to be sold to meet short term funding mismatches.
The main liquidity ratio we’ll be looking at is the net stable funding ratio (NSFR). This looks at a banks available liquid capital with maturities greater than one year, against the required amount of stable funding, as specified under Basel III guidelines. The amount of assets a bank is required to hold under is Basel III guidelines is determined based on the type of asset, depending on the risk that type of asset carries.
When looking at Westpac, they have an NSFR of 121%, above the recommended 100%, indicating they hold adequate amounts of liquid capital to sustain their long term lending.
Last but not least, we’ll have a look at Westpac’s credit ratios.
Credit ratios
At the end of the day, a bank will only be able to survive in the business of issuing credit if most of their customers pay them back for the credit. Even loans that are deemed as low risk carry a chance that the customer may not be able to continue servicing the loan – it’s an unfortunate reality, but circumstances can change over time; people can get sick or lose their jobs and may not have adequate insurance to cover their mortgage, interest rates may rise beyond limits that people can afford, and political events such as wars may wipe out assets, along with the loans that funded them.
That’s why we look at credit ratios, as they help to give a gauge on the actual credit issued by the bank, not just the quality or liquidity of the types of assets issued, which we had previously assessed based on the CET1 ratio and NSFR ratios, respectively.
Two key credit ratios to look at include:
- top 10 exposures to corporates and non bank financial institutions as % of total committed exposure.
- loan impairments as % of total committed exposure.
Looking at the top 10 exposures is important because it provides a gauge on the concentration of a banks credit. As investors, we’re well aware that we should avoid putting all of our eggs in one basket – and the same goes for lenders like bank, seeing as the more money that is lent to a concentrated group of business or individuals, the greater the impact will be if these people cannot pay the loan back.
When assessing the concentration of a banks credit, we tend to focus on loans made to businesses and non bank financial institutions because the value of these loans tends to be higher than loans to individuals, meaning that defaults on these loans may have higher impacts – plus the way limited liability companies are set up as separate legal entities to individuals, declaring bankruptcy can sometimes be a more favourable option for companies if they are unable to make loan repayments, which can increase the likelihood of defaults on loans by companies.
As of Sept 22, Westpac’s top 10 exposures to corporates and non bank financial institutions amounted to 1.1% of their total committed exposures (TCE). Also, as of Sept 22, Westpac’s proportion of impaired loans amounted to 0.3% of their TCE.
Finally, banks typically put aside money to cover for expected credit loss. This amount for expected credit loss (ECL) is a probability weighted estimate that takes many factors into account, including the probability of a customer defaulting on their loan, predicted growth in a banks balance sheet, predicted changes in interest rates set by central banks, predicted changes in property prices and so on. In 2022, Westpac had $4.6 billion in ECL provisions put aside to cover for potential rises in stress.
Given that forecasting the ECL based on such an extensive array of complex economic factors is well beyond our skills and expertise, we’ll have to trust that their ECL provisions are enough, so it’s a figure that’s worth keeping an eye on.
How reliable are capital ratios?
But if we take a step back and reflect on current market events and recent bank collapses, you may be wondering – if a bunch of professional financial analysts and fund managers around the globe failed to predict the collapse of Silicon Valley Bank (SVB) and Credit Suisse, among others, what chance do the rest of us have when it comes to sensing when banks are going bad? Also, since it seemed like no one detected that things had been going downhill for these banks, how reliable even are these capital ratios?
Put simply, Silicon Valley Bank (SVB) defaulted because they did not have enough liquid cash to cover the money needed for customer withdrawals. But why did it seem like no one saw this coming?
Interestingly, very few people could actually get a gauge on Silicon Valley Bank’s liquidity situation because they never disclosed Net Stable Funding ratio (NSFR). This was because Silicon Valley Bank claimed that they weren’t a big enough bank to be required to report on their NSFR, which allowed them to continue as if nothing was wrong, despite all the issues that were boiling away underneath the surface.
On the other hand, Credit Suisse is another bank that recently ran into liquidity issues and started to topple, before being brought out by UBS to prevent a complete collapse. Unlike Silicon Valley Bank, Credit Suisse had actually been publicly reporting on their liquidity status by publishing NSFR ratios in their quarterly reports – which raises the question, why we didn’t hear about Credit Suisse being on the brink of collapse a lot earlier?
As it turns out, Credit Suisse had been on a slippery slope for a wee while. Despite their NSFR being above regulatory requirements, Credit Suisse had been experiencing major runs on customer deposits (ie many customers all trying to withdraw money at once) stemming from a number of issues, such as spying scandals involving senior executives at the bank, failure of the bank to detect large scale money laundering operations conducted by Bulgarian cocaine traffickers, and rotating senior leadership – eventually resulting in Credit Suisse running out of money to cover customers trying to make withdrawals.
In the case of Credit Suisse, this provides a good reminder that while credit ratios are helpful for getting a gauge on a bank’s financial health, they don’t show the complete picture.
It should also be noted that credit ratios are only an indicator for a banks financial health, not a definitive measurement, which means they won’t always be accurate – plus, things can change a lot since a bank last published their quarterly reports, so capital ratios won’t always be reflecting what’s going on in a bank at the instant you’re considering on making an investment.
Overall, Westpac scores well across a number of different credit ratios, which suggests they are in a relatively healthy financial position. On top of this, as a one of the largest banks in Australia and New Zealand, Westpac can benefit from their scale and large customer deposit base (approx. $AUS600 billion) to target further growth in lending and earnings in future years.
Conclusion
Well… if you’ve got this far, thanks for sticking around. When setting out to write about Westpac, we didn’t plan to dive quite so deeply into how banks work and how they’re regulated – so apologies if you came here looking for a short and sweet analysis of Westpac as an investment, and ended up getting roped into a rather chaotic Finance101 lesson.
Things to watch for Westpac moving forward:
- Credit ratios – CET1, NSFR, along with credit ratios such as % impaired loans and top 10 exposures to corporates and other non bank financial services.
- Profitability – with interest rates continuing to rise, along with Westpac focussing on simplifying their operations by selling of non core businesses we’ll be keeping a close eye on their profitability.
- Dividends – one of Westpac’s big attractions to investors is their 5.74% dividends. However, paying dividends isn’t an obligation and can be paused at any time at their discretion, so we’ll be keeping a close eye on these dividend payments.
Also, one last thing to be aware of is that Westpac’s dividends are fully franked, which means that they have tax credits attached to them to reflect the fact that Westpac has already paid tax on these dividends at their company tax rate before distributing them to investors.
While Australian tax residents have the opportunity to claim these franking credits to potentially reduce their overall tax bill, this does not appear to be the case for NZ tax residents as the IRD specifies that it is not possible to claim tax back on franking credits.
So, from our understanding, this means as NZ tax residents who receive Westpac dividends would get taxed twice; first, when Westpac pays tax to the Australian Tax Office (ATO) before distributing the dividends, and second, when paying resident withholding (RWT) tax to the IRD on any dividends received from Westpac.
This being said, we’re definitely not experts on the matter – and didn’t have much luck finding any clear cut guidance around this double taxation issue on the IRDs website, so we’d suggest running this by a tax specialist to be 100% certain of any implications for Westpac’s dividend yield before making any investment decision.