A UBS analysis has said that banks may have to adjust their target ROE given the current environment is not favourable to high profitability.
The UBS banking sector update asked whether the major’s 15 per cent ROTE targets were justifiable or sustainable in the current low interest rates.
The recent tailwinds to the banks enabled most of the RBA’s 50 basis point rate cuts to be passed through to mortgagors, however with further cuts on the way many deposit products have already hit or will hit zero interest rates.
Over the past five years there have been higher levels or regulation, compliance, and scrutiny placed on the banks and UBS said despite all that the major banks kept targeting 13.5 per cent ROE and 15 per cent ROTE across the sector.
UBS said that banks generated an ROE 6 per cent above their cost of capital at their peak between 1994 and 2015 but this was “aided by deregulation, lower levels of capital, weaker funding mix and rapid consumer leveraging”.
If banks did reach their target ROEs their relative returns would be consistent with pre-GFC levels which UBS said may be difficult to justify and may impact their ability to meet community expectations.
Currently only Westpac had provided an explicit ROE target of 13-14 per cent ROE or ROTE of 16-17 per cent, but UBS had a way to work out the targets of the other majors.
“While the other banks do not provide public targets, each of the banks' boards undertake a ‘budget’ Cash NPAT or ROE which is used as a benchmark in executive remuneration. While this is not technically the same as a public target, it provides a good indication of where the boards believe returns should land,” it said.
UBS found it concerning that the banks continued to have that target labelling it “unrealistic in the current environment”.
“We believe that if management are held to these targets (especially for remuneration purposes) there is an incentive not to pass further RBA interest rate cuts through to borrowers given the negative impact on NIM," UBS said.
“Thus, it is also arguable that such elevated ROE targets by the banks may inhibit the effective implementation of monetary policy.”
If interest rates continue to fall and deposit spreads fall toward zero the major banks’ competitive advantage would be eroded particularly if banks attempt to maintain profitability and not pass on further cuts.
In positive news for investors UBS said it believed a credit crunch was less likely in Australia due to APRA’s removal of the serviceability floor and the re-election of the coalition.
“We believe that the regulators have not indicated that they pursue ‘what it takes’ to avoid a hard landing; however the Australian housing market is not out of the woods and the fundamentals remain very stretched given house price-to-income multiples,” UBS said.
Despite this UBS remained cautious on the Australian banks, questioning whether the “treatment is worse than the disease if further stimulus from the RBA, APRA and government is required”.