Sharpening the cost discipline

Deloitte recently issued its 2024 Financial Services Industry Outlooks, of which the Banking and Capital Markets Outlook considers a number of global insights relevant to the New Zealand context.

Sharpening the cost discipline

The growing need for cost discipline is a key call out from the report as there is rising pressure on revenue generation globally. Cost discipline will be a priority for banks and possibly a competitive differentiator. In New Zealand, while at the total sector level, costs are around 40% of income (in other words, it costs 40c to generate $1 of revenue) and have declined from 49% in 2020, there are material differences at an individual bank level, particularly when assessed against the scale of the entity. Figure 1 plots bank cost to income ratios (CTI) against total lending.  Whilst Heartland Bank and Rabobank are outliers, there is a clear relationship between scale and efficiency, particularly as the regulatory cost to be a bank has increased materially since the global financial crisis.

Banks with a high CTI and relatively low asset base correlates with a lower return on equity (ROE) (Figure 2).  This creates a headwind to generating sufficient capital from their core business activities (i.e. deposit taking and margin on lending) to meet increased capital requirements prescribed by the RBNZ. This clearly creates some challenges for these banks as they struggle to reconcile strategic aspirations with the ability to fund these aspirations. Furthermore, their performance against peers affects the attractiveness of the entity to new investors.

New Zealand has proved to be a market where it is difficult to build scale, the history of the New Zealand market illustrates that it is easier to defend scale than to build scale. Because of this, the smaller banks cannot simply grow their way to a better CTI, they need strategies that deliver efficiencies without scale and reduced CTI. Some strategies are as follows:

• Automation and simplification of processes and operations to create capacity to focus on competitive strengths and ensuring cost growth linked to wage inflation is minimised.
• Optimising balance sheet risks – particularly interest rate and liquidity risks.
• Outsourcing activities that don’t provide a competitive advantage to a third party who can safely deliver outcomes at a lower marginal cost.

Each of these initiatives, if executed well, will reduce the marginal CTI, improve ROE and ultimately generate sufficient capital to meet the needs of all interested stakeholders. 

Deposit costs and the impact of interest rate increases

The report also highlights that during 2022, net interest income (NII) increased significantly in many jurisdictions as interest rates rose, but that elevated rates, combined with customer expectations and increased competition is pushing bank funding costs higher and squeezing margins.

At a macro level, New Zealand’s total banking sector NII also benefited from rising interest rates with RBNZ data showing that June 2023 quarterly NII was $3.9bn, versus $3.4bn in June 2022 - an increase of 14%. This flows through into net interest margin (NIM) which also increased from 2.17% in June 2022 to 2.38% in June 2023 (Figure 3).

As with so much in life, the devil is in the detail. While NII overall increased 14% over the year to June 23, it could have been considerably higher as interest income from lending assets rose 78%.  The offset was interest expense from deposits and wholesale funding (i.e. cost of funds) which rose considerably more at 188%.

Relatively higher growth in funding costs shouldn’t be a surprise as banks are in the business of maturity transformation through lending for longer term fixed periods (generally 1-3 years) and funding those loans with shorter term deposits and a mix of short- and longer-term wholesale funding. With the OCR increasing from 0.25% to 5.5% in a little over 18 months – a rate of increase never experienced before in the history of the OCR - it stands to reason that the funding costs of deposits and wholesale funding will increase at a faster rate than price changes on fixed rate lending.

In fact, the increase in the cost of funding could have been even higher had it not been for at least two factors at play.

The first is the changing liability mix of bank balance sheets. Banks have been increasing the proportion of equity capital, particularly since 2021, in line with increased capital requirements prescribed by the RBNZ (Figure 4), which will place New Zealand bank capital levels amongst the highest in the world. As a result, the proportion of interest-bearing liabilities (i.e. deposits and wholesale funding) to interest earning assets has reduced from around 87% to 83% (because equity is not an interest sensitive form of funding). But it is the most expensive form of funding because the providers of equity (shareholders) require the highest return in the form of dividends and capital gain, given they are first to lose their capital in the event of a bank failure.

To illustrate the impact of the change in funding mix towards equity, if in June 2023, interest earning assets (loans) were funded by the same proportion of equity as back in June 2019 (around 8%), interest-bearing liabilities would be just over 1% higher than is currently the case. While that doesn’t seem like much, it equates to an extra $6bn of interest-bearing liabilities and an additional $260m of interest expense for the June 2023 quarter (a 5% increase).

A second driver is an increase in deposit margins from 2020 which correlates with a material increase in the supply of money in the financial system at a time when the Large Scale Asset Purchase (LSAP) programme (a form of Quantitative Easing) and the Funding for Lending Programme (FLP) was introduced – to the point where a 6-month term deposit rate was lower than the 90-day wholesale bank bill rate in the latter half of 2022 and the first half of 2023 (Figure 5). As in other countries, these extraordinary monetary policy settings are normalising. In New Zealand, broad money supply growth rates have reduced below pre-pandemic levels. Whilst there is uncertainty regarding all the impacts of quantitative tightening, this will likely lead to deposit margins coming under pressure, adding to overall interest expense growth particularly for those banks with fewer funding options outside of deposits relative to their peers.

What we can conclude is that while at a headline level the numbers show a solid NII and NIM performance, looking more closely indicates that interest rate risk has materialised as interest rates have increased at the fastest pace in history, but the impact has been masked by a shift in liability mix to non-interest sensitive equity, and been partially offset by the significant injection of liquidity into the system post-pandemic increasing deposit margins.

In the near term, interest costs will likely continue to outpace interest income as deposit margins normalise and the impact of a combined 5.25% tightening in the OCR increases works its way through bank balance sheets, although this will be dampened somewhat for those banks still required to increase equity to meet RBNZ prudential requirements by 2028. There is also the possibility that if interest rates decline from these levels there is an NII tailwind in the short term as funding costs become cheaper relative to existing lending assets.

Increased funding costs, operating cost pressures, and continued demands on shareholders for additional equity, will likely pressure bank profitability and ROE. Those banks with strong balance sheets and who are equipped to actively manage their balance sheet risks, who can identify and source non-interest related capital-light revenue and execute on reshaping costs bases will be well positioned to weather the challenges to emerge over 2024 and beyond.