28 May 2019
Reach Markets publish the notes from our analyst meetings with company management. They should be read in conjunction with the research we’ve completed. Reach Markets endeavour to provide self-directed investors a seat at our investment meetings. We publish these notes in a conversational format to get these out as quickly as possible for your consumption.
We recently had a one-on-one meeting with Andrew Bowden from Westpac Banking Corp (WBC). The meeting was used as a refresher on the WBC story as well as to reassess our investment thoughts on the Company. Below are the key points from our discussion.
Thoughts on Royal Commission
Mr. Bowden began our meeting by providing his thoughts on the Royal Commission by saying what Royal Commission is trying to do has been little frustrating because of their process. Mr. Bowden noted in the words to the effect of, “if you look at the cases for us that were brought up most were actually where third parties were trying to fraud us…so if you get to the source of it is actually a third party providing lending that was not adequately controlled…banks have been lending on the basis of credit quality for years and have got a proven track record for doing this stuff…the tightening standards regarding the income and expense verification is actually quite irrelevant in terms of the credit approval process…in terms of assessment of the risk our fault if there was a fault on that side is that we have always been very focussed on credit risk and the model for mortgage for example has 200 rules in it so doing more work on that doesn’t add any value…there is no correlation between the income surplus of the individual and the delinquency profile, so people that have got low income surplus don’t have higher delinquency than the others so when you are doing a check for someone the things like stability is very important…people don’t pay their mortgage when they lose their job or their circumstances change.” Mr. Bowden thinks that the Royal Commission report would be focused on the incentives that have gone to the individuals and things that have caused issues in the bank processes.
Mr. Bowden noted in the words to the effect of, “…banks collect enough information from the customers to approve a loan and we go through the process of getting their bank statements looking at their current pay slips and if someone has gone through the process of giving you the false bank statement and false payslips and then signing a form that it’s all true, that is fraud…if you look at the delinquency profile, of course there are incidents there…we do have a secondary check where 5-10% of the applications are reviewed to make sure all the process are going forward then we have a second audit team and that audit team can look for trends and the actual process is they look at top 20 finance managers and do a negative check if the broker is doing an offshore activity or a lot of people from a particular community and looking at these elements…so the mortgage book looks in pretty good shape and if there were issues you would start to see it…the way we analyse the portfolio, people are just looking at fraction of the stuff that we have on the quality of the book…so if you look at a mortgage what typically happens is that delinquency profile starts at 0, starts to scale up and once you get past 2 years your mortgage is pretty much done in terms of risk profile so you can map different coverts against that profile and you can look at individual coverts, look at delinquency profiles in different suburbs…there is obviously a separation in duties between home finance and credit process and the same thing with mortgage brokers that mortgage is more like an introducer rather than an originator so we are still responsible for them checking the verification process it’s still subject to fraud if they falsify all the documents but then its fraud…most people are not going to sign a document that says that my salary was $100k but it’s now only $50k, very few people are going to do that”.
Credit growth – can the regulators become a bit too conservative
Mr. Bowden gave his views on credit growth stating in the words to the effect of, “One of the challenges at the moment is that housing markets for example they are based on confidence and we are going through a natural cycle at the moment where housing prices have risen in the past and in Sydney the cycle is very consistent, usually goes up rapidly for a period of time and flattens off…the thing that frustrates me is that people say house prices are tanking or the property is in freefall it’s just rubbish…2% or 3% would be good for the economy in a protracted period of rising, but you have still locked in 30% of gain, even if it falls 10% it’s still 20% up so it’s not a major issue for anyone, unless someone has borrowed in the last 6 months…as long as they have got the income and unemployment numbers are fantastic, employment growth is going through the roof so actually the conditions for credit are looking very good…so not particularly right but we are going through a cycle there has been some pushing on that cycle by the government and it doesn’t help when they come and say the property market is in freefall…so the question is if the labor comes in power and pushes hard and introduces negative gearing we would say what’s the problem that you are trying to solve because if you look at the housing market today and you go negative gearing it’s going to affect the investor…how do you think about growth I think you put the stake on the ground and say its normal income and then you get some variation around that about where are you in investment cycle and I think we have passed the phase…the super cycle of the banks has been going since the GFC and we think the consumers geared up are unlikely to see that gearing or credit growth bump up above that, let’s say 5%-6% is the normal income growth and its unlikely to go above that, business credit is soft for a long period of time and that’s broadly what we expect.” Mr. Bowden thinks that reinvestment in businesses could potentially come through in services sector particularly health, education and tourism.
View on consumer health
We were curious to get a view on the consumer’s health especially as the consumer is levered up and savings ratio is well below the 4% mark and wage growth isn’t coming through, on which Mr. Bowden noted in the words to the effect of, “We have got a compulsory superannuation regime that is where most of the savings are going and I am more interested in if the people are gearing up or not rather that where the savings ratio is…there will be de-leveraging and less interest only lending will be a catalyst to it.”
Interest only vs principal loan interest
Mr. Bowden noted, “The thing to think about interest only is that it’s not a product it’s a feature…most people come in and ask for loan and it gets approved on the basis of capacity to repay it and we can offer interest only on that and it works well for the investor as it maximises tax deductions and it works well for home occupiers too…but it’s wrong to perceive it as you can borrow more than you can afford and then pay interest only on that…we have interest offset accounts which for people with interest only is 4 times the size of a personal principal interest so they are behaving normally and there will always be cases where a person who has borrowed within their capacity and they pay interest only as it helps them support a better lifestyle…the proportion is now falling and we have tightened the requirements like for owner occupied you will not get interest only as there is no real incentive why would you pay an extra 15bps to having interest only when you don’t need to so the proportion has fallen from 50 to 37 in last 12 months…at the moment we have 0% growth in investor and 5% growth in owner occupied.”
View on non-bank lenders
Mr. Bowden noted in the words to the effect of, “I keep saying to the people if you are looking at a lender today the first question you should ask is how are they being funded because that’s where the banks have a competitive advantage as banks can raise money cheaper than anyone else and that includes so small players struggle to get deposits which is the cheapest source of funding and they have more difficulty raising money offshore and we have a AA rating so we raise money cheaper so that gives us competitive advantage…my question is what happens in the next downturn, you have already seeing the BBSW rise and that falls directly through the securitization cost and pushes up the cost of funding whereas we can sit back for 6 months but they can’t do that, they are price takers…so for me it’s just that what happens in the next cycle and the interesting thing is if you borrow money you are not really at the risk because you have the money…so if you get to a situation where you have to refinance they will try and run down their book to refinance and if conditions are materially tight its harder for people to refinance.”
Overseas funding costs
2018 has been the year of ups and downs in terms of overseas funding costs, which have risen due to interest rate hikes in the U.S., so we were curious to know how it has effected the margins (if it has), on which Mr. Bowden noted, “at the very start of the year November to February were happy days when funding was cheap…then the trade war and interest hikes came in which is why the BBSW went up as cash was being pulled out of the country and invested in the U.S…prior to that we were getting a lot of funding from Apple and Google which all dried up…the thing is we are AA rated so we get good access to markets offshore…there are times when its challenging…there are discussions about rates in the U.S. going up so the funding cost should go up but people actually don’t understand how we fund…we swap everything back to 90 day bank bills in Australia so you are effectively paying the 90 day date rather than what happens in the U.S…we raise a lot in the U.S. and there is disruption in terms of trend that I talked about a lot of tech money that was helping support the banks has dried up but there are other sources…if you look from a geopolitical sense the growth in China is probably the one that’s biggest influence on us and just the sheer weight of that slow growth helps Australia with tourism and education.”
Cost to income ratio – are the targets achievable
We were curious to know if the cost to income ratio targets set by banks were actually achievable. Bowden noted in the words to the effect of, “Few years ago, we put in a target of 40% and we haven’t got there. Now if you look to the numbers the biggest issue has been compliance costs, which have been massive, and no one expected that…getting stuff through ASIC has been one of the biggest holdups…we have a couple of things going on and it has taken 6 months…APRA the other day said banks are not spending enough on their core systems and there are increased fails which is not true and actually the statistics show system outages have been much lower than they have been in the last 10 years.”
Mr. Bowden gave an overview of the technology changes coming to Westpac, stating in the words to the effect of, “the panorama platform is about 50% cheaper than the existing platforms…right now we are running 3 platforms but ultimately panorama will be the core banking platform in wealth but it’s still 3 years away because we have to get people off the existing platforms and that’s hard work…the problem at the moment is that if you get regulation change you have to throw people at it first, which is where we are at the moment…in banking we have got Westpac and St. George still operating and we are putting in a whole new platform and ultimately that will collapse those two and we will run the whole bank of a single platform and there will be significant savings associated with that…we are one of the first banks in the world to move to a cloud but the term is it’s a private cloud so IBM is operating the system…its same as a bank having its storage disks sitting at a warehouse but it ultimately gives us the ability to expand and there are significant cost savings associated with that one you start to use that data…there is still a long pathway to it…we would have been further down the path if we didn’t have compliance costs because we are spending $1bn on compliance…we have got so many projects that we would like to do but we can’t do because we have a capacity and when you are filling up that capacity bucket the compliance stuff gets poured in first so I think you are still 3-5 years before you see this…the panorama would take about 3 years, the customer service hub that we are doing would start operating properly next year and for Westpac and St George to come on the customer service hub and make it a banking platform would take about 5 years…ATM’s will start to reduce this year and we are closing 40 branches a year.”