The recovery for Australia's banks will be a drawn-out affair. Earnings at the country's banks should remain adequate to absorb elevated credit losses. However, banks will struggle to regain pre-COVID earnings metrics even as credit losses recede.

Overall, we believe that Australian banks should be able to preserve their creditworthiness in the next two years. This is despite the unprecedented economic disruption due to the COVID-19 outbreak and containment measures. Economic risks facing banks operating in Australia are certainly tilted to the downside. However, the banks should be able to withstand a moderate rise in economic risks at current rating levels.

Credit losses are set to rise multifold off the historical lows of 2019. Indeed, our forecast that annual credit losses will peak at about 85 basis points (bps) of gross loans remains unchanged. In addition, low interest rates, weak credit growth, and a drop in fee income threaten to curtail bank earnings. However, we expect even the reduced earnings will remain sufficient to absorb the higher credit losses.

The recovery of earnings and credit losses to pre-COVID levels will be drawn out. Banks will struggle to regain earning metrics, reflecting the longer-term trend of gradual erosion in earnings, and low interest rates that are likely to prevail for some time. Delays in finding an effective vaccine, recurrence of COVID-19 outbreaks, and escalation of the strategic confrontation between the U.S. and China could prolong or deepen the economic downturn beyond our base case. Those remain the biggest risks to the recovery of the banking sector.

Negative Outlooks On Five Larger Banks Reflect Sovereign Risks; Ratings On Other Banks Resilient

The main risk to our ratings on the larger Australian banks comes from the negative outlook on the sovereign. We expect to lower our issuer credit ratings on the four major Australian banks (Australia and New Zealand Banking Group Ltd., Commonwealth Bank of Australia, National Australia Bank Ltd., and Westpac Banking Corp.) and Macquarie Bank Ltd. if we downgrade the sovereign. This is because we apply an uplift in our ratings on these banks, reflecting our view that the Australian government is likely to support them, if needed. A lower rating on the sovereign would imply diminished capacity to support banks. Consequently, we have negative outlooks on these five banks.

Apart from the five larger banks, our outlooks on all remaining banks in Australia are stable, except for one. We have a positive outlook on Suncorp-Metway Ltd. due to improving group creditworthiness. We expect to maintain our ratings on all Australian banks even if the economic hit is somewhat more severe than our base case, other things unchanged. Broad-based ratings downside stress could emerge if the economic downturn is substantially longer or deeper than our current base case. Delays in finding an effective vaccine, recurrence of COVID-19 outbreaks, and escalation of the strategic confrontation between the U.S. and China could trigger such a scenario.

In our base case, we expect the economic recovery in Australia to begin by the end of 2020. Until the recovery substantially progresses, economic risks facing the banks will remain tilted toward the downside, in our view. The COVID-19 outbreak and containment measures have precipitated an unprecedented and substantial shock to the economy. There remains material uncertainty on the eventual damage that businesses and households would suffer. The outbreak of a second wave of COVID-19 infections in the country's second-most populous state of Victoria underscores some of these risks.

National House Prices Likely To Fall By 10% From Peak

We forecast national home prices to fall by about 10% from the peak in about April-May 2020. National average home prices have slid by about 3% from that peak, with Melbourne showing a more than 5% drop. We expect further declines in property prices in the next several months--especially when more businesses and households face greater financial distress. At the same time, low interest rates, easing of responsible lending rules, and an economic recovery in 2021 should prevent a significantly bigger decrease than our estimate. We consider that our forecast fall should not present material risks to the banking sector. We note that the current decline follows about a 10% rise in home prices in the nine months preceding the recent peak.

Elevated unemployment, weak sentiment, net outward immigration, and restrictions affecting home inspections and sales will contribute to this drop, in our view. We expect that the dip in prices would vary significantly across different geographies. In our view, most susceptible to a fall will be the regions where the economies are most disrupted by COVID-19, and regions that witnessed the greatest price rise in the past 18 months.

Government Support And Loan Repayment Deferrals Will Delay Credit Loss Recognition

Australian banks' bad and doubtful debts will inevitably rise from the historical low of about 13 bps in calendar 2019 (see chart 1). The economy is experiencing unprecedented stress fueled by the COVID-19 outbreak and containment measures.

Chart 1

Still, we expect a relatively muted jump in credit losses in 2020. Massive fiscal support by the government to businesses and households, together with accommodative loan repayment moratoriums by the banks, will cushion the blow to banks' asset quality. In addition, accounting standards and prudential regulation will likely suppress recognition of bad and doubtful debts until mid to late 2021.

We forecast annual credit losses to peak at about 85 bps of gross loans in the next year or so. Businesses and geographies dependent on tourism, travel, and retail services will drive the rise in credit losses. Our credit loss estimates are in line with our forecast that there will be a severe but temporary economic downturn.

We forecast the economic recovery to get underway by the end of 2020. Consequently, we forecast that after a jump in 2021, credit losses will ease to levels close to our expected long-term average in the subsequent years. Nonetheless, many businesses and households will suffer from the structural changes to the economy due to the downturn, in our view. Consequently, a large number of borrowers will struggle to meet their financial commitments even when the broad-based recovery takes place.

The combination of a jump in unemployment and fall in home prices would contribute to a rise in credit losses given that home loans form about 60% of Australian banks' loan books. We consider that losses will be concentrated in weaker borrower segments: for example, where households and businesses lose their incomes because of dependence on the industries hard hit by COVID.

Loan Loss Provisions Possibly Understate Asset Quality Problems

In general, we expect that the banks have adequately raised their loan loss provisions, to the extent permitted under accounting standards and regulations. In current operating conditions, shareholders are likely to be tolerant of a bank aggressively raising loan loss provisions, despite the consequent drag on earnings. Indeed, in the six months to June 30, 2020, the four major banks have topped up their loan loss provisions by an average of 0.23% of their gross loans (see chart 2).

Chart 2

Yet, we expect that cumulative credit losses in the next two years will be greater than the existing stock of loan loss provisions. In our view, credit losses will rise after fiscal support from the government tapers and the loan repayment moratoriums end. In addition, accounting standards and regulation could be currently constraining the banks' ability to make greater provisions. For example, the regulator has directed that banks must not classify deferred loans as stage-2 loans. In addition, under IFRS-9 accounting standards, the banks need to make provisions on stage-1 loans for the expected losses only over the next one year. Still, banks have added materially to the provisions under the "economic overlay."

As a proportion of gross loans, the four major banks' stock of loan loss provisions are broadly comparable. The level of provisions under another lens--as a proportion of S&P Global Ratings' risk weighted assets--paints a slightly different picture. On this measure, the Commonwealth Bank of Australia seems better provisioned than the other three.

We expect that banks will continually review their estimates of credit losses that will emerge in the next year or so. Banks typically have access to granular information on borrowers seeking loan repayment deferrals--substantially more detailed information than what is publicly available. For example, the banks have visibility on the inflows and outflows in the bank accounts of these borrowers. The banks may also use analysis based on data from one geography or segment and extrapolate this to the rest of their portfolio, after applying appropriate refinements. In addition, the banks can leverage off the analytical tools and internal models based on several years' data.

High Loan Deferrals Don't Necessarily Portend Massive Credit Losses

Headline loan deferrals appear high at 8.5% of outstanding mortgages and 16.2% of loans to small and midsize enterprises (SMEs), as of Aug. 31, 2020 (see chart 3). Nevertheless, we consider that these data could overstate the eventual credit losses. For example, many households and businesses possibly took the deferral option simply because it was available. In addition, SME loans form about 11.5% of the Australian banks' total loan books. Consequently, deferred SME loans form only 1.85% of the gross loans. Unsurprisingly, contributions of retail trade, tourism, hospitality, and entertainment related businesses to loan deferrals are significantly more than their natural share.

Chart 3

We do not view the deferred loans data available as alarming. Even in a high severity hypothetical scenario, we estimate that credit losses from deferrals would form only about 1.2% of total gross loans in Australia (see table 1). The estimated credit losses from deferred loans under our high severity scenario is comparable to our expected total credit losses over the next two years, although the latter includes losses incurred on the rest of the loan books.

Table 1

Importantly, we believe that deferral data across banks are not comparable. For example, individual banks' definition of SME lending differs. Furthermore, the banks have different approaches to the moratorium periods and periodic check-ins.

Central Bank Support Has Alleviated Funding And Liquidity Risks …

Early, decisive action by The Reserve Bank of Australia (RBA) alleviated funding and liquidity concerns--traditionally considered among the biggest risks facing Australian banks, particularly during periods of economic or financial market dislocation.

In addition to the RBA funding, banks are flushed with customer deposits that have jumped in recent months. In the six months to Aug. 31, 2020, gross loans in Australia have shown minimal 0.3% growth; actually declining by a small amount each month after the initial rush to draw down committed facilities by businesses in March and April. In the same period, customer deposits have risen by 10.5% (see chart 4). Consequently, the major banks are in a highly unforeseen situation in which they don't need to issue bonds to replace term funding maturing in the next six to 12 months (see chart 5).

Chart 4

Chart 5

We believe the banks will fully (or nearly fully) utilize their allocation of the RBA's term funding available to them at a very low cost. But banks risk damaging their franchises, particularly in the international funding markets, if they totally stop issuing debt for a prolonged period. We expect that banks will manage this risk by issuing in smaller amounts, to a more targeted investor base for the next year or so. In addition, the banks may look at tapping the same investor base for raising the tier-2 capital needed to meet the regulatory requirements for total loss absorbing capacity.

… But Funding Riches Are Unlikely To Spur Credit Growth Until Business And Household Sentiment Improves

We believe that weak business and consumer sentiment is likely to remain the main impediment to credit growth. We expect credit growth in the next one year to be close to zero, before bouncing back reflecting our broader economic forecasts. Actions by authorities to encourage businesses and households to borrow include availability of cheaper funding for banks, low interest rates, and proposed changes to the responsible lending regulation. Certain new businesses and business growth opportunities would arise due to the economic disruption. Also, finances would remain robust for a section of households. These businesses and households are likely to seek credit from the banks.

Nevertheless, we believe strong, broad-based credit demand would likely resume only when businesses and households are more confident of their future earnings. We expect a vast majority of businesses and households to remain circumspect in their behavior for the next two years. A number of households and businesses will face financial distress once the government support tapers and loan deferrals end. Consequently, we expect subdued sentiment to persist for some time. In its recent budget, the Australian government has announced a number of measures to support the economy. These measures should help in boosting consumer and business confidence.

Weak immigration will also mean that demand for housing is unlikely to reach the heights that has typically spurred house prices and household debt. Finally, we expect that relaxation in responsible lending rules would reduce some administrative burden for the banks and borrowers. Still, the banks will likely continue to approach their lending decisions cautiously in the next year reflecting the weak economic outlook.

Earnings Unlikely To Recover To Pre-COVID Levels In Foreseeable Future

COVID will hit bank earnings hard in the next two years. Low interest rates, weak credit growth, and drop in fee income--in addition to elevated credit losses--will weigh on bank earnings. We expect the banks to accelerate their technology projects and cost saving programs, partly in response. Still, competitive forces and reduced demand for services are likely to lead to weaker earning metrics than pre-COVID levels, even as credit losses recede. Even the reduced earnings should remain sufficient to absorb the higher credit losses, in our view (see table 2).

Table 2

We expect the profitability of the Australian banking sector to remain a strength compared with most of the larger European banking systems (see chart 6). In our view, the banks will continue to price rationally for risks, affording them a buffer for unexpected situations such as the current scenario. In the longer term, however, continued weak bank earnings could engender greater risk taking.

Chart 6

Delays in finding an effective vaccine, recurrence of COVID-19 outbreaks, and escalation of the strategic confrontation between the U.S. and China could prolong or deepen the economic downturn beyond our base case. Those remain the biggest risks to the recovery of the banking sector, in our view.

Bank Capital Positions Likely To Remain Strong

We forecast that most Australian banks' capital ratios, based on S&P Global Ratings' risk adjusted capital framework, will marginally strengthen in the next two years despite weakened earnings (see, "Top 100 Banks: COVID-19 To Trim Capital Levels," Oct. 6, 2020). This is because we expect that loan growth will be minimal and the absolute amount of capital held by banks will likely remain undiminished as the banks cut their dividend payouts.

For the banks following internal ratings-based approach for their regulatory capital, credit migrations in their internal capital models may result in some fall in the regulatory capital ratios, however. We expect that the banks should be able to raise their capital levels, if needed, largely through retained earnings.

High Degree Of Uncertainty Remains

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.