Can mutuals seize the opportunity?
Australia’s mutual and customer-owned banks – often the forgotten sector of the local lending market – are at a critical juncture. The competitive environment presents an unprecedented growth opportunity but to take advantage many mutuals may need to overhaul their funding and capital strategies.
Laurence Davison Head of Content and Editor KANGANEWS
On 13 February, KangaNews hosted its first-ever Mutual Sector Wholesale Funding Seminar in Sydney. By coincidence, this proved to be the same day that the Treasury Laws Amendment (Mutual Reforms) Bill 2019 was brought before parliament. The bill – which became law on 8 April – fundamentally changes the way in which mutual entities can raise capital and potentially forms an important plank of sector growth.
The mutual and customer-owned banking market in Australia is made up of a disparate group of institutions numbering more than 70 according to Customer Owned Banking Association (COBA) data. Its combined assets are not inconsiderable, at A$117 billion (US$83.7 billion) by the end of March 2019, though they pale in comparison with the roughly A$3.5 trillion in combined asset value for the big-four banks.
The largest group of mutual authorised deposit-taking institutions (ADIs) comprises roughly 10 lenders – names like Heritage Bank (Heritage) and Newcastle Permanent Building Society – that can broadly be described as historically capital-markets relevant and which account for roughly half the sector’s assets. Most of these entities have issued either or both of benchmark-sized senior bond transactions (see chart 1) or public securitisations (see chart 2).
The record year for such issuance was 2017, when a vibrant Australian securitisation market drove the aggregate volume to more than A$4 billion for the first time. Last year was quieter, with just A$2.4 billion priced, though benchmark senior-unsecured issuance by mutuals set its own record at A$1.2 billion.
The rest of the sector is not necessarily unknown to capital markets but does not tend to issue in benchmark size. Names like Greater Bank, Members Banking Group, Police Bank, QT Mutual Bank and Qudos Bank have all issued senior deals, generally in the A$20-50 million range, in recent years.
Speaking at the KangaNews seminar, Lisa Barrett, associate director, financial institutions at S&P Global Ratings (S&P) in Melbourne, explained: “The smaller mutuals are foundationally funded by member deposits and, generally speaking, mutuals diversify their funding as they get bigger. This tends to start with wholesale term deposits [TDs] and then NCDs [negotiable certificates of deposit], then into securitisation – starting from warehouses and on into public RMBS [residential mortgage-backed securities] issuance.”
The number of mutuals engaged with capital markets could take a step up in the coming years. Sector advocates believe Australian consumers are more willing than ever to explore banking options outside the big four. COBA argues that growth data from 2018 showing the mutual sector outstripping the majors (see chart 3) are evidence of this trend.
The data may not yet be conclusive, but speakers at the KangaNews event agreed that the state of consumer sentiment should be conducive to mutual-sector growth.
“The royal commission has highlighted the importance of transparency and responsible lending across the banking and financial-services sector, with particular focus on mortgage and consumer lending,” said Rod Ellwood, general manager, debt markets services at Perpetual Corporate Trust in Sydney. “In my opinion, the mutual sector is well positioned to capture growth in the mortgage market because of its inherently high level of client advocacy and the culture of trust that exists within its client base.”
Source: KangaNews 4 April 2019
Source: KangaNews 4 April 2019
Source: KangaNews 4 April 2019
Jo Dodd, Sydney-based partner at King & Wood Mallesons (KWM), suggested the opportunity for mutuals is supported by the strong local community ties mentioned by Ellwood – including branch networks – which they can combine with increasing their digital distribution presence.
The issue of distribution is not straightforward, however. In fact, it is an area that some sector specialists believe presents as much of a risk to the sector as a challenge. Shortly after the KangaNews seminar, the Australian government backed away from a royal-commission recommendation radically to overhaul the way mortgage brokers are compensated. But there is still a widespread expectation that the broker sector will be under increased scrutiny – which could have a negative impact for mutual lenders.
Paul Williams, Heritage’s Brisbane-based chief financial officer, told delegates: “I think the recommendations could be challenging because a lot of larger mutuals rely on brokers for a significant part of their asset acquisition. Without a functioning broker segment it is going to be difficult for an entity like Heritage to sustain its balance sheet over the next few years.”
This is not just a question of sourcing new customers. Barrett suggested that if the mortgage-broker model becomes less appealing to borrowers there may be a negative impact on their marginal propensity to refinance. Along with the cost of regulation and governance, reduced velocity in the mortgage market could be a headwind for growth across the financial sector.
Ellwood remains upbeat about the mutual sector at least in relative terms. “The changes to the broker fee model are likely to have a significant impact on loan-origination lines. But I think the advocacy and trust the mutuals have earned in the community place them in a favourable position relative to other banks. I think it’s fair to hope that this translates into growth for the mutual sector.”
It may be that evolution of distribution strategy limits the ability of mutuals to exploit growth opportunities in the short-to-medium term but only while the lenders themselves adapt to a new environment.
Williams concluded: “As asset acquisition changes it could result in balance sheets going backwards for a period while we either establish digital channels, support our member value proposition or reinvent the branch-origination model.”
Regardless of the extent to which mutuals are able to exploit what should be a conducive environment for growth, industry experts believe it is inevitable that the sector’s funding mix will have to change. In particular, mutuals of all sizes – with the possible exception of the very smallest entities – should be contemplating increased engagement with capital markets.
Cameron Rae, managing director at Laminar Capital in Melbourne, believes the retail deposit market on which most mutuals, particularly the smaller names, have historically relied for the bulk of their funding is set for a shakeup. The deposit market has already become much more competitive in the years following the financial crisis, Rae says, because larger banks have become much more focused on growing their own deposit funding component and are thus much more competitive in the wholesale deposit space in particular.
Major banks are now willing to pay 80 basis points over bank bills to middle-market investors for their wholesale TDs, which has made this product an expensive form of short-term funding relative to an NCD programme.
A further development is coming, Rae told the KangaNews seminar. Again, digitisation is the reason. “The wholesale TD market is about to get a really big shake up again, coming from the challenger banks. We are seeing a whole group of challenger banks going through the licensing phase at the moment, and they have two initial sources of wholesale funding: securitisation and wholesale TDs.”
These challenger banks are generally establishing securitisation warehouses, Rae continued. But this is a relatively expensive form of funding – so much so that wholesale TDs may be more competitive even at 100-130 basis points over bank bills.
“The dislocation some of the challenger banks are going to bring will be challenging over the next 6-12 months, especially in the wholesale TD market for those smaller ADIs that rely on this type of funding to facilitate ebbs and flows in their balance sheets,” Rae predicted.
Williams acknowledges the threat. He said: “We could even see the inherent trust that mutual banks rely on to support their deposit base becoming dislocated as some of the new value-add propositions are rolled out to the market.”
In this context, mutual ADIs are being encouraged – and are making moves of their own volition – to explore alternative funding options. Some are more likely to see immediate takeup than others, but the products under discussion include NCDs, senior and subordinated wholesale debt, securitisation and even covered bonds. Where individual issuers lack the scale necessary to offer something suitable for the wholesale market, pooled vehicles may be worth considering.
According to Williams, Heritage and a number of “like-minded” mutual ADIs are already exploring how they can create efficiencies that will streamline access to capital markets and make it more cost-effective with the type of scale these issuers generate. This is not just a treasury responsibility, he explained, but one that requires new thinking around back-office functions.
“There are some long-held attitudes to change, though, and it has probably not progressed as far as some may have wished. But it is definitely on the agenda for a lot of our peers,” Williams revealed. “It may well be that we have reached a day of reckoning, where attitudes are changed simply by the necessity of acting in a more collaborative manner to achieve the efficiencies needed to sustain businesses into the future.”
One option that could facilitate access to capital markets for smaller mutuals is pooled funding vehicles. Borrowers with funding needs that are too small to be relevant to the institutional market could combine their needs, creating sufficient scale for a benchmark senior, covered-bond or – most likely – securitisation transaction. The concept is not without challenges but is being pursued with some optimism (see box).
The issue of scale is critical for mutual-bank issuers, sector experts agree. The domestic market is the most natural home even for the sector’s biggest names, and the Australian dollar investor base will inevitably be unwilling to resource credit analysis of issuer names from which it cannot expect to see consistent supply in reasonable volume.
Ellwood said: “As a mutual-bank treasurer, you should be trying to have all the funding tools available in your arsenal. This means keeping your asset-class franchises alive for whenever you need them – whether it be short- or long-term bonds, senior unsecured, securitisation or capital. The challenge is that you have to make sure they are all relevant to investors in order that they are available when you want to use them.”
Mutuals dip their toe in pooled funding
Pooled funding vehicles are not new to the mutual sector. But some believe they may become more prevalent as smaller issuers grapple with the desire to engage with capital markets and the cost of going to market solo.
In November 2012, the Australian Mutual Investment Trust (AMIT) issued A$57 million (US$40.8 million) in an additional-capital transaction that was effectively a pooled securitisation of capital issued by 17 mutual banks. The deal was an attempt to work around the challenges inherent to mutuals in issuing convertible instruments.
Another traditional pooled funding model was offered by Cuscal. More commonly associated with transaction-banking services like payments, cards and ATMs, Cuscal also provides treasury services to mutuals that historically included pooled securitisation vehicles. The market has moved on and its last public deal was a A$699 million issue in April 2014, however.
While these options do not provide consistent access to wholesale funds for mutual authorised deposit-taking institutions (ADIs) – and the legislative response to the Hammond Review into the sector may render the workaround offered by AMIT redundant – the concept of pooled funding has not gone away.
The idea of additional capital being a consistent part of the mutual-bank toolkit is a new one, and its emergence in part rests on the legislation put before parliament on the day of the KangaNews seminar. The new law is the direct product of a review conducted in 2017 by former KWM partner, Greg Hammond. Among various recommendations, it suggests that measures be taken to improve mutuals’ access to additional-capital markets.
The main challenge for mutual ADIs in issuing additional tier-one and tier-two securities – and common equity – is that any instrument that can be converted into equity can put mutual status at risk under existing law. Instruments that could convert into mutual equity instruments also receive unfavourable tax treatment relative to nonmutual-bank additional-capital securities.
The government supported the recommendations of the Hammond Review. In November 2017, then federal treasurer, Scott Morrison, said these ADIs “represent a real alternative model for delivering important customer and community-focused services”, and that previously the mutuals “have been underappreciated and ignored by our federal laws, placing them at a disadvantage to their much bigger competitors”.
The new law takes steps to facilitate mutual ADIs’ access to capital. It adds a new definition of “mutual entity” to the Corporations Act – a move which a KWM report says “gives mutual entities greater regulatory certainty and... expressly recognises mutual entities as a type of corporate organisation”.
It also amends demutualisation provisions in the Corporations Act, narrowing the definition of demutualisation to limit the risk of it being triggered by transactions that were not intended to have this effect – for instance the issuance of additional-capital instruments.
The law also introduces the mutual capital instrument (MCI). This is a bespoke type of share that can be issued by mutuals and which additional-capital instruments can convert into. Finally, the law changes effectively equalise the tax treatment of mutuals with MCIs on issue. However, they do not resolve the issue of whether MCI dividends can be franked or whether MCIs can be treated as ordinary shares for withholding-tax purposes.
Dodd explained: “The Hammond Review looked into the challenges mutuals face in raising capital and made 11 recommendations for change, all of which were directed at reducing barriers to raising capital and specifically would allow mutuals to raise capital directly without triggering demutualisation or otherwise affecting mutual status.”
As things stand, the mutual sector is not starved of capital thanks to the strong equity base its membership structure provides. KPMG research suggests the average total-capital position of the sector as a whole was 17.2 per cent at the end of 2017, with smaller mutual ADIs on average 1-2 per cent ahead of the top 10 by size. Both groups were comfortably ahead of the roughly 14 per cent total-capital position of the big-four banks at the same stage.
S&P’s Barrett told conference attendees: “Because they are well capitalised as it is, there is unlikely to be a rating impact even under a scenario where mutuals could issue additional-tier-one capital. The only way it could be a significant benefit for one of the smaller ADIs is if it were coming out of capital pressure, for instance as a result of significant growth over several years.”
With this in mind, Williams argued that the main benefit of the law change to mutuals may not be in the most obvious area of equity capital. He said: “I think the largely unheralded win out of the Hammond Review is that we can now satisfy prudential requirements to convert to equity at the point of nonviability. This gives us more prudential capital options, with opportunities in the additional-tier-one capital category of particular interest.”
While the mutual sector is broadly pleased with the outcome of the Hammond Review and its legislative adoption – excepting some unresolved issues at the margin – the real test of any new instruments issuers attempt to place will come in the market.
“A new capital instrument needs to be marketable – there is not much point having an instrument no-one wants to invest in,” Dodd said. “The key issue will be whether investors are happy to take an equity instrument in which they don’t have voting that is proportionate to their economic interest, which is the main restriction in the legislation and the prudential standards.”
Rae said pricing could be a challenge. He pointed out that big-four and larger regional banks are paying grossed-up dividend yields in the 8-11 per cent range, which would naturally be the first comparison potential investors in mutual ADI capital instruments look at.
Rae asked: “As an investor, what premium am I going to demand for an equity instrument that is probably going to be unlisted, at least for a small mutual, has a dividend that is limited to previously issued profits and is entirely illiquid? Mutuals will potentially be looking at a cost of capital that in the double digits while the average return on equity of the sector is 5.5 per cent. It’s hard to envisage mutuals falling over themselves to issue based on those baseline figures.”