There are 8 big 'problem areas' for Australian banking

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After several years of record profits and a surge in demand for investment loans through the property booms in Sydney and Melbourne, this year has been more troublesome for Australian banks. Global banking rules insisting they hold more capital and a crackdown on investment lending by the banking regulator APRA have forced change across the industry, reflected in increased interest rates and the majors going to the market seeking billions in capital.

So Australian bankers will be looking forward to the Christmas break.

And rest up they should, because next year could be another testing one, not least with fallout from the festival of property investment lending that the sector witnessed over the past few years.

The transition in the economy at the moment comes with pain points, especially in mining regions where unemployment has risen rapidly and property prices have fallen in the aftermath of the boom.

Increasingly investors have been wondering what consequences this might have on banking profitability. Bank stocks have been progressively marked down over the course of the year. Financial stocks are down 23% since March, while the overall index is down 13%.

Executives from all four of the major Australian banks attended the recent Morgan Stanley Asia Pacific Summit. In a note to clients, Morgan Stanley’s Richard Wiles and the Australian equity research team summarised some of their key findings.

Banks are reasonably upbeat on profitability because the investor loan interest rate increases introduced during the year will offset discounting on new owner-occupier mortgages. Business lending is steady and there’s “no material shift in deposit competition”.

Morgan Stanley writes: “Problem areas are unlikely to have a material impact on loan losses: Australian credit quality was described as ‘good’, ‘robust’ and ‘benign’, and there was a particular focus on the importance of the services sector and the benefits of a weaker A$.”

But there are patches of concern about the health of some loans. They continue:

However, there is a list of problem areas: mining services; mining towns; NZ dairy; drought-affected agriculture; high-rise apartments in Melbourne; commercial property in Perth; high-street retail; and restructured industries.

We’ve confirmed this is an aggregate list of the “problem areas” as reported by various banking executives themselves in different sessions at the summit.

It’s from the horses’ mouths.

Now that’s not an insignificant list of areas where there could be some bad credit lurking. Farms. Apartments. Mining. Retail. You’d be within your rights to ask what else is left over.

As Morgan Stanley says, “banks think impairment charges will rise in FY16E, but they don’t expect a “sharp” increase from these “pockets of weakness”, and they downplayed the risk to earnings growth.”

Their conclusion:

We think: (1) margins will be flattish, with upside potential at the retail banks; (2) thereis risk of worse-than-expected loan losses in 2H16E and FY17E, due to weak domestic demand; (3) there will be a further capital build of ~A$23bn by FY17E; and (4) dividend payout ratios are elevated, with little margin for error at ANZ and NAB.

In other words, if you think this year has been tough, let’s wait and see what the next two years have in store.

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