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Banks make hay while the sun shines - S&P

Monday 27th October 2003

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New Zealand banks continue to prosper in an operating environment characterised by solid asset growth, low cost-to-income ratios, and very low levels of nonperforming assets (NPAs). Banks are taking advantage of these favorable operating environments to generate strong profitability.

Risks to future performance centre on the sustainability of the currently very strong asset quality, and a competitive dynamic that is gathering momentum. The competitive environment is facing a shake-up following Lloyds TSB Bank decision to sell the National Bank to ANZ, and as new entrants build their fledgling New Zealand operations.

In 2003, profitability has improved in the banking sector, with the majority of banks delivering improvements in return on average asset ratios. All banks earned more than 1% on risk-weighted assets in 2003, a strong result internationally.

However, while generally profitability trends were positive, some mixed trends are showing through in the results to date.

Two major banks reported lower profit as a proportion of risk weighted assets in the year to June 2003, highlighting growth in higher risk assets, and a focus on market share rather than profit in the short term.

Loan growth has been solid for the rated major banks in the period to June 30, on average recording a solid 9.7% (annualised) increase. Net interest income grew, with the growth in loan volumes offsetting the impact of a moderate fall in net interest spreads on profitability.

The very low level of NPAs and consequent low cost of bad debts aided profitability as the benign credit environment continued in New Zealand. As a result, the cost of new loan loss provisions in 2002 was a low 2.2% of revenue.

Cost base reductions--often through integration with an Australia-based parent--has been a key driver of improved profitability in recent years, and this trend continued in 2003.

The cost-to-income ratio for the six rated commercial banks equates to a very good 46.9%. This year, a swing away from the aggressive cost cutting of prior years transpired, as some banks discovered that their single-minded cost-cutting focus had ramifications on customer satisfaction, market share, and asset growth, and, ultimately, profitability.

Standard & Poor's believes that cost-to-income ratios in the medium term will stabilise at about current levels and, in some cases, possibly increase, in order to provide the required level of customer service and local functionality to support vigorous franchises.

The overall level of NPAs for the rated New Zealand banks remains exceptionally low. The average level of NPAs for the New Zealand banks is a world-leading 0.46% of total loans, and this is despite the emergence of some large problematic loan exposures in the industry, namely Tranz Rail, Central North Island Forest Partnership, and Air New Zealand. This currently very low level of NPAs belies the underlying risk in some components of the banks' loan portfolios. In particular, the number and magnitude of large single-customer exposures is material as a proportion of capital, and exposes the sector to large lumpy increases in NPA levels and, consequently, profit and capital impacts. This will be a key risk factor in a less benign credit environment.

Changes in ownership, and changes in the number and composition of participants in the industry, were a feature of the past 18 months. Kiwibank began its operations in earnest; St.George Bank New Zealand entered the market via a joint venture with Foodstuffs, trading as "Superbank"; AMP Bank exited; and Lloyds TSB Bank PLC has sold its subsidiary, the National Bank to ANZ.

The good performance and relative stability of the banking sector provides an attractive environment for possible new entrants. The banks exiting the market have been driven by parents' reconsidering their offshore strategy and capital needs, rather than the poor performance of New Zealand-based subsidiaries.

These new entrants heighten the competitive dynamic in the industry, and now NBNZ has been sold to an established player further pressure will follow.

Although Kiwibank's operations to date remain relatively small compared with the major banks in New Zealand, its competitive offering has forced the existing banks to ensure that their own offering remains competitive and appealing to customers.

Superbank's unique distribution method, and consequent low-cost, no-branch operations could provide meaningful competition in the medium term. Given that there are currently five full-service commercial banks operating in the market.

S&P says ANZ's acquisition of NBNZ is unlikely to materially reduce the level of competition. However, it also says that assuming the two banks can be integrated successfully, competitors could face a more difficult task in attracting customers.

The credit quality outlook for the industry remains stable in the short term, supported by the banks' acceptable capitalisation, solid business profiles, robust profitability, and the current benevolent credit environment. The New Zealand banks' credit standing is further supported in their ownership by the highly rated Australia-based banks.

The key risks in the medium term are the high and growing level of private sector indebtedness in the economy, and the possibility of interest rate rises causing financial stress for borrowers and a lower level of growth in the economy.

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