Mutual banks use status to confront challenges
Mutual banks are confronting the same challenges as the rest of Australia’s lenders: higher rates leading to borrower stress, accompanied by funding volatility. Speakers at the KangaNews Mutual Sector Wholesale Funding Seminar, which took place in Sydney in June, highlighted the sector’s advantages but acknowledged its headwinds.
Chris Rich Staff writer KANGANEWS
Mutual banks – like the rest of the authorised deposit-taking institution (ADI) sector – emerged from the worst of the COVID-19 crisis in good shape, supported on the funding side by strong deposit inflows and the Reserve Bank of Australia (RBA)’s term-funding facility (TFF). Moving into 2022, greater competition for retail deposits, rising interest rates and wholesale funding market volatility are making the outlook – including the TFF refinancing task – more difficult.
At the same time, the perennial problems associated with operating a small bank business model – open banking, cyber security and the need to digitally transform – persist. But now the skills required to address these problems are in dire shortage across the Australian economy, exacerbating the mutual sector’s challenge to transform urgently, said Steve Targett, chair at P&N Bank, at the KangaNews event.
Ultimately, he added, further consolidation in the sector is inevitable. Targett foresees the mutual banking sector consolidating to around 15-20 “super mutuals” in order to offer a competitive alternative to the major banks – which can only be achieved through scale. “To appeal to the membership base, a mutual bank must get the right pricing and product set. And it cannot get the price right without capital and financial support.”
Consolidation in the sector is already endemic. Australian Prudential Regulation Authority (APRA) March 2022 statistics show there are 60 mutual banks in operation, three fewer than the same time last year and 15 fewer than five years ago. In September 2004, 184 mutual banks were in operation.
Some of the largest mutual banks announced mergers over the past year: Newcastle Permanent Building Society (NPBS) will merge with Greater Bank, while People’s Choice Credit Union will merge with Heritage Bank.
Targett estimates P&N Bank – like any other mutual bank – will need at least A$15 billion (US$10.4 billion) in total assets by 2025 to continue competing against the majors. Holding A$7 billion in total assets in 2022 – making it one of the 10 largest mutual banks – Targett said P&N Bank has a significant task ahead of it.
Mutual banks continue to explore growth avenues. For example, NPBS group treasurer, Brian Reid, said his bank’s partnership with Athena continues to expand in scale. “NPBS has A$550 million of Athena source loans on its balance sheet – we view it as an attractive alternative distribution channel with a partner who shares very similar values,” he said. “The partnership generates significant benefits for both parties. For Athena it represents a stable source of funding and it generates significant cost efficiencies for NPBS as Athena undertakes servicing of the loans.”
Lofty growth ambitions come as mutual banks face major economic headwinds, with the RBA’s cash rate hikes building pressure in the system. As the boost to liquidity from COVID-19 stimulus payments dissipates, Targett said boards will need to act fast in response to any signals that the economy is deteriorating.
“As soon as borrowers get knocked about by the economy and bad debts emerge, the whole banking landscape will change – and boards need to be alert to it.”
WHOLESALE FUNDING MARKETS
Favourable wholesale funding market conditions at the start of the year evaporated as Russia invaded Ukraine and inflation continued to rise. Speakers at the seminar discussed the challenging new market environment, which has been compounded by a sell-off in June.
Mutual banks face an uphill slog as the Australian banking system must refinance its drawdown of the A$190 billion TFF from the RBA, argued Lisa Barrett, director, financial services ratings at S&P Global Ratings. While they do not account for a large portion of the volume, mutual banks will be competing with the big four to refinance the entirety of their TFF holdings over the next 24 months. The majors also have the advantage of access to offshore funding markets.
Mutual banks will need to plan if they are contemplating access to wholesale funding markets, said Heather Gale, head of treasury advisory at Laminar Capital. The market will be distinctly less favourable than it has been for the past year and mutual banks will no longer be able to rely on raising negotiable certificates of deposit to refinance with a quick turnaround, she added.
“Even if an issuer does not have a TFF repayment, other banks investing with it might. If its traditional investors are focused on paying back the TFF, the bank may find a hole emerges in its funding sources,” Gale explained.
However, Barrett suggested there will likely be no rating pressure on mutual banks as a result of increased cost of wholesale or other forms of funding. S&P’s outlook on ratings for most Australian mutual banks is positive, driven by the rating agency’s view of structural improvement in funding across the system.
“Over the past 10 years – and even going back as far as the financial crisis – the system’s reliance on offshore wholesale funding decreased while deposit funding increased proportionally,” Barrett said. “We view deposits as a more stable funding source. The big question is what happens with the TFF refinancing. We will decide in the next year or two on upgrading ratings across the majority of financial institutions based on how much of the TFF is funded offshore versus onshore.”
Credit cost will increase across the system, she said, including for mutuals, “but it is coming off a really low base and we do not think it will rise to a significant level”.
Though on average 90 per cent of mutual banks’ balance sheets comprise residential mortgages, S&P does not view rising interest rates as a credit risk as it does not expect a major house price correction. Barrett cautioned, however, that higher interest rates will put some borrowers at risk of not being able to make repayments.
The TFF refinancing task comes at the same time as the economic outlook challenges mutual banks’ growth prospects, although Reid does not anticipate a material change in its growth outlook or ability to access wholesale markets.
Reid said NPBS’s focus on quality growth and a fund-first strategy provide significant balance sheet flexibility. NPBS’s balance sheet strategy favours net interest margin maximisation over outright credit growth, he said, and achieving 50 per cent of system growth via organic channels delivers a solid outcome across key measures.
“On the liability side, it is really a question of the relative risk and economic trade-offs across each funding option,” Reid added. “NPBS is predominantly funded by retail deposits, with wholesale funding providing structure for the liability book. Over the last couple of years, we have been overweight retail deposits, added longer-term issuance and continued to build out a funding curve. Looking ahead, retail funding is likely to rebalance as liquidity conditions normalise.”
As interest rates have started to rise, major banks have stepped up their competition for the mutual bank sector’s
traditional primary source of funds: deposits. This includes term and wholesale deposits. Speakers at the KangaNews seminar acknowledged that the steep steps upward in rates offered on deposit products by the major banks caught many off guard and added to the ongoing competition for mutual banks in this critical funding avenue.
Gale said the spread movement is an overcorrection and will settle down, but the signal that major banks will compete for retail term deposits poses a challenge to mutual banks. She expects it will force mutual banks to seek more wholesale funding.
The major-bank push into retail deposits is driven by attractive pricing relative to swap and the wind-down of the committed liquidity facility, said Reid. This has driven the need to optimise regulatory net-cash outflows. He expects the major banks’ aggressive pricing to play out for as long as margins remain sub-swap and there is no material cannibalisation of at-call books. “Once at-call books start to see material levels of cannibalisation, the strategy will likely run its course,” he added.
APRA’s new capital framework, effective 1 January 2023, is front and centre of capital considerations for mutual banks. The framework aims to lock in an unquestionably strong level of capital to ensure the banking system is equipped for future shocks.
The goals of the updated regulatory approach are increasing flexibility through larger capital buffers, enhancing risk sensitivity, supporting competition, improving transparency and increasing proportionality through the introduction of simplified capital requirements for small, less complex banks. The framework is also part of APRA’s expectation of banks’ integrated risk management.
“APRA is trying to streamline some of the reporting around risk,” said Jo Dodd, partner at King & Wood Mallesons. “In April, it released the draft reporting standards for APS 112 and APS 113, reducing numerous standards into two – presumably so they can be easily integrated.”
Apart from APRA seeking to level the playing field when it comes to the use of capital, Gale views the framework as an opportunity for mutual banks – but only for those willing and able to reflect on their capital calculations and how the balance sheet performs against certain metrics.
“It is an opportunity to consider the return on equity for products, their capital cost and whether they can be simplified. There are huge benefits in product simplification to allow banks to focus on where they can play to win,” Gale said.
Capital considerations should be embedded in the design of products, she noted, particularly in connection with redraw, overdrafts and undrawn lines of credit.
Despite long being touted as a possible capital game-changer, only one mutual capital instrument (MCI) has been publicly issued. Speakers at the KangaNews event explained the instrument is not generally a cost-effective method for mutuals to raise capital though it can be a useful capital tool if the right capex plan or project can be found.
Following the introduction of the Treasury Laws Amendment (Mutual Reforms) Act 2019, several mutual banks amended their constitutions to facilitate issuance of MCIs and additional-capital securities that convert to MCIs without risking demutualisation. Gale said: “Pricing is holding further MCI issuance back, but this is not necessarily a bad thing. It should be considered if a mutual has a specific growth objective or plan.”
Australian Unity issued its MCI in December 2020. P&N Bank issued a wholesale additional tier-one capital transaction in May which, in the event of non-viability, can convert to an MCI.
ESG as a growth opportunity
Panellists speaking at the KangaNews Mutual Sector Wholesale Funding Seminar believe mutual banks can leverage their social licence to pursue climate-aligned growth opportunities.
The modus operandi of the mutual banking sector – working in the interest of its members – affords it greater
social licence to operate than its peers. Mutuals are also not big enough to contemplate competing with the major banks for lending to fossil fuel companies.
Speakers at the seminar believe mutual banks stand on solid ground to pursue a growth strategy exploiting the sector’s natural alignment with environmental, social and governance (ESG) in an industry increasingly associated with enabling the continuation of a fossil-fuel backed economy.
This comes at the same time as a growing movement toward better practice ESG reporting purely from the implementation of legally required disclosures. Emma Newnham, senior associate at King & Wood Mallesons, said the movement accelerated at pace in the past year.
“ESG reporting has been pushed along by the Australian Prudential Regulation Authority’s prudential practice guide on climate change financial risks,” Newnham explained. “It is leading to more questions about whether companies
should be reporting against the Task Force on Climaterelated Financial Disclosures framework and other sustainability frameworks.”
Bank Australia is one mutual bank dedicated to pursing an ESG-led growth strategy. “We are starting to see higher expectations on financial institutions, including a focus on what is in their portfolios and how they can drive change in them,” said Jane Kern, head of impact management at Bank Australia.
Like most mutual banks, the majority of Bank Australia’s portfolio comprises residential mortgages. This led to the bank creating a green mortgage product to reduce emissions in its portfolio – aligning with its brand and business strategy to attract customers, said Kern.
Bank Australia launched its clean energy home loan in January 2020 – backed by a A$60 million (US$41.5 million) investment from the Clean Energy Finance Corporation – rewarding customers with a mortgage discount if they purchase or build a new green home, or make ambitious green upgrades to an existing home. After proving its business case, Bank Australia launched a permanent product a year later.
Because a lot of Bank Australia’s brand and strategy is built around ESG, customers joining the bank arrive with high expectations. This in turn drives Bank Australia to be more ambitious, Kern said.
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