National brand damaged

National Australia Bank yesterday acknowledged the damage to the bank’s brand in Australia from the drawn out power play over the bank’s $360 million in foreign exchange option losses uncovered four months ago, and also admitted to a pattern of reactive investment in the business in Australia and Europe, and excessive caution towards business customers.

In investor and media briefings held to present the bank’s result for the half year to March 2004, new managing director John Stewart said that the bank’s core business in Australia was, “off the boil a bit. It will take 12 to 18 months to reverse the brand damage and get Australia back to where I’d like it to be.

“We’ll minimize the brand damage as we reorganise over the next 12 months.”

The repositioning of National means the bank will struggle to match its previous, and inflated, level of profit.

“The franchise is more important to me than short term profit,” Stewart told investors yesterday.

“I want it to become of the best [banks] in the world. There is not much wrong with this bank, but will take a year or two years [to fix] and become a powerhouse of providing shareholder value.”

Stewart also conceded the “distraction” of the brawl within the board, something that consumed about half his time since his appointment three months ago.

NAB profit falls

• Underlying banking profit fell seven per cent to $2.76 billion in the March 2004 half, from $2.97 billion in the September 2003 half.

• Cash earnings for National Australia Bank before significant items fell nine per cent to $1.85 billion in the March 2004 half, down from $20.4 billion in the September 2003 half.

• Pre-tax profit fell five per cent to $2.0 billion from $2.1 billion.

• Net profit increased four per cent to $2.1 billion from $2.0 billion (thanks to significant items).

• Diluted cash earnings per share, before significant items, fell nine per cent to 119.9 cents from 132.2 cents.

• The group net interest margin declined to 2.40 per cent in the March half from 2.5 per cent in the September half.

The sale of the holdings in St George Bank, AMP and HHG resulted in a net profit of $315 million, while the group also wrote back to profit a provision $64 million raised in relation to HomeSide. Both helped offset the forex option loss, and other adverse factors such as currency movements, which exacerbated an already weaker contribution from the bank’s businesses in Europe.

Most of NAB’s segments are dealt with below, but a couple more profit measures to note are:

• Cash earnings from total banking operations, before significant items, fell 10 per cent to $1.72 billion in March from $1.92 billion in September.

• Financial Services Australia increased three per cent to $999 million in March from $967 million in September.

Dead hand of costs

John Stewart talked yesterday of the “dead hand” of costs, and complained of misdirected investment in the business in compliance or remediation projects or other preventative work, which did not do much to grow the business.

“When I joined [in August 2003], the UK banks had stalled. It was a direct result of short term. We have not invested to the extent that we could.”

Even so, the efficiency targets established under the prior management’s “positioning for growth” were met only in Australia, but exceeded in Europe and within the institutional bank.

In addition, the bank’s staff numbers jumped about three per cent in the half, largely as the result of more remedial work arising from the numerous projects required to bring the bank into line with the banking regulators numerous new requirements.

Surrenders home loan market share

National estimated that its share of the home loan market in Australia dropped to 18.1 per cent at March 2004, down from a peak market share of 18.6 per cent at June 2003.

Housing loans in Australia increased by seven per cent in the six months to March 2004, and by 17.9 per cent in the year to March, and compares with system growth of about 24 per cent. Housing lending in Australia stands at $88.8 billion.

Chief financial officer Richard McKinnon said that “the bank took the view that parts of the market were overheated,” with a detailed review of the bank’s approach to lending on inner city properties, as well as wider review.

NAB reduced the maximum loan to valuation ratio on inner city properties to 70 per cent, and the maximum LVR on investment properties to 75 per cent, and also ceased writing low documentation loans.

Not that NAB ever really began writing low doc loans. The bank’s “easy doc” product, offered through the HomeSide brand, lasted in the market only a few months.

In addition, NAB’s caution on low doc loans must have a lot to do with the loss of sole traders over the last year (see below under business banking).

Judging by the number of low doc loans with face values in the low millions written by the likes of Liberty and Bluestone, plenty of sole traders are selecting low doc loans as a business financing tool.

Term deposits drag down profits

National resorted to selective, and for profits, damaging, pricing tactics over the last four months to retain customers, with personal bankers in Australia given latitude to engage in “conversations” with customers that would persuade them to keep their business with the bank.

In short, National dangled high interested rate in front of customers as a retention strategy, with higher rates on offer to any customer in the process of closing an account, and (unknown) rates in excess of the bank’s advertised term deposit rates.

The result was a jump of 1.19 percentage points in the average rate paid on term deposits in Australia in March 2004 compared with September 2004.

Cards a soft spot

Credit card balances in Australia increased by three per cent over the half year, and nine per cent over the full year, to $3.97 billion, and reflects a loss of market share over the half.

The bank said that card interchange margins fell by either $20 million (as stated in the result) or $17 million (as stated by CFO Richard McKinnon in the investor briefing).

The bank also blamed lower credit card interchange as one of two main contributors (along with lower profits from property) as the main driver of the flat earnings from the core banking business in Australia.

Meanwhile the subdued growth in cards balances has caught the attention of NAB’s top management. John Stewart named personal loans and cards as a “soft spot”, both in Australia and in Europe, and said that in Australia he expected the bank ought to be able to “punch above its weight” in this segment of the business.

Business banking clamp too enthusiastic

In Australia, National estimated that it “maintained a leading position in business lending” with a 26 per cent share in early 2004, though this fell from a share of 26.5 per cent a year ago.

In agribusiness lending, National estimate that its market share increased to 28.9 per cent in early 2004 from 21.7per cent in early 2003.

The bank’s chase for more security for business has worked too well. The bank said that over the last year, business banking increased its proportion of fully secured lending from 58 per cent to 64 per cent of the portfolio.

John Stewart said this approach was “too enthusiastic. We have underperformed in this area … where there are high margins and high fees. We intend to ease off our risk profile.

“It’s not reversing our de-risking … it’s touches on the tiller to be where we wanted to be in the first place.”

Ian McDonald, the bank’s key executive in Australia, said the bank lost market share among sole traders over the last year.

Institutional bank reeling

In the corporate and institutional bank:

• Underlying profit fell six per cent to $567 million in the March 2004 half, from $602 million in the September 2003 half.

• Cash earnings before significant items fell 16 per cent to $375 million from $447 million. This excludes losses announced in January 2004 related to unauthorised trading in foreign currency options of $360 million pre-tax ($252 million after tax) which have been classified as a significant item.

Domestic earnings were flat at $199 million compared to $202 million for the corresponding period, and the real damage was sustained in the offshore operations.

Europe was down 21.2 per cent at $82 million (2003 $104 million); New Zealand down 20.3 per cent at $59 million (2003 $74 million); USA down 34.6 per cent at $17 million (2003 $26 million) and Asia down 25 per cent at $18 million (2003 $24 million).

CIB’s performance has also suffered from NAB’s long-standing policy of not hedging its structural foreign exchange risk. With half of its cash earnings arising offshore, the appreciating Aussie dollar is responsible for almost 50 per cent of the earnings decline over the 2003 corresponding half.

However, although currency movements have devalued earnings, they have also helped to mask a substantial blow-out in operating expenses, which rose 6.3 per cent in Australian dollar terms, but a massive 16.4 per cent in local currencies. NAB attributes this to annual salary reviews for higher numbers of staff, occupancy cost increases and higher computer software amortisation charges.

The cost to income ratio has blown out to 41.4 per cent – compared to a target for the division under the bank’s Postioning for Growth strategy of 36 per cent – while cash earnings per employee crashed from $342,000 in 2003 to $279,000 this half.

CIB also took an $88 million hit for bad debts with the specific provision more than trebling from $26 million in the corresponding half last year.

John Stewart reported there had been no significant loss of corporate business as a result of the recent turmoil at the bank.

However, he said staff at least were “still reeling from the affects of the forex trading. The focus in the short term is to retain customers and retain the staff and so protect the franchise.”

The overall VaR limit for trading risk has been reduced to $40 million – a figure that CEO John Stewart considers appropriate for a bank of NAB’s size. In fact, Stewart lamented the dealers not using more of the available limit – not surprising, perhaps, after the currency options fiasco, but still representing an under-utilisation of the bank’s risk, and hence earnings, capacity.

Bank of New Zealand improves

Bank of New Zealand is one part of National’s business performing to plan.

• Underlying profit increased three per cent to NZ$284 million in March 2004 from NZ$272 million in September 2003.

• Cash earnings before significant items increased five per cent to NZ$180 million from NZ$172 million.

The bank estimated that housing volumes increased by 18.7 per cent, compared to systems growth of 16 per cent. The growth in market share was achieved despite the decision last year to stop sourcing loans via brokers.

Repair work needed in Europe

In Europe, National’s profits are falling both due to weak sales and rising costs.

•Underlying profit fell 17 per cent to £234 million in March 2004, from £282 million in September 2003.

• Cash earnings before significant items fell 20 per cent to £129 million from £162 million.

John Stewart appeared to foreshadow a new strategy for NAB’s European operations as their performance continues to be a drag on the group – not helped by the appreciating Australian dollar.

Cash earnings (after tax) for the half were $394 million – down almost 30 per cent on the corresponding period past year. Retail banking dropped 37.1 per cent to $309 million (2003 $491 million) and wholesale fell 21.2 per cent to $82 million (2003 $104 million).

In local currency terms, total income fell two per cent due to unexpectedly low growth in lending volumes and a decline in net interest margin of 15 basis points to 4.16 per cent.

However, this was overshadowed by a massive 18.4 per cent increase in operating expenses to £374 million (2003 £316 million). Of this, £39 million ($98 million) was for additional pension costs and £14 million ($35 million) for regulatory compliance – or more accurately, non-compliance as these were largely costs and penalties for breaching various UK financial regulations.

Stewart described the UK operations as having been run for short-term profit and starved of long-term investment.

NAB’s inability to drive out economies of scale in Europe has resulted in a cost to income ratio of 61.5 per cent – by far the highest in the group. Despite at least two major failed projects to rationalise computer and back office operations over the past decade, all four banks continue to run substantially different banking systems, albeit from one data centre in Glasgow.

But, despite the disappointing results, and relentless pressure from analysts, Stewart doesn’t think the time is right for selling the UK and Irish banking subsidiaries.

“We should repair these banks. They'll be a real good source of earnings for this company in about three years' time,” he said.

Foreshadowing a major change to his predecessor’s UK strategy, Stewart said acquisitions "are not a major part of our strategy".

He sees niche opportunities to compete with the major UK banks without the need to acquire the critical market share that was an objective of former CEO’s Don Argus and Frank Cicutto. The new European strategy is expected to be unveiled before the end of the current financial year.

Currency options fiasco results in $3.2 billion additional capital raising

NAB’s 2004 half-year results reveal the additional capital required to satisfy the Australian Prudential Regulatory Authority imposed sanctions following the currency options fiasco in January this year.

The sanctions are: that the bank has to cease trading in currency options; approval of NAB’s internal market risk model is withdrawn and APRA’s standard method is to used for calculating market risk; and total capital must be increased from eight per cent to ten per cent of risk weighted assets.

The additional capital requirements, in turn, provide further clues to the true cost to the bank of mismanaging its currency options desk.

The market risk component of risk weighted assets at 31 March 2004 jumped by $17.875 billion as a result of using APRA’s standard calculation method instead of the bank’s internal model – resulting in a 6.9 per cent increase in the group’s total risk weighted assets.

The bank has announced two measures to cater for this increase and raise the overall capital ratio above the ten per cent threshold.

The dividend reinvestment plan for the March 2004 interim dividend will be fully underwritten by Merrill Lynch. This will raise $1.2 billion of additional Tier 1 capital from either participating shareholders or the underwriters.

A further $2 billion of subordinated debt will be issued and qualify as Tier 2 capital.

The bank believes this additional $3.2 billion of capital will be sufficient to maintain total regulatory capital within its new target range of 10-10.5 per cent.

While it is impossible to estimate the cost of withdrawing from the currency options market, applying the NAB’s 11.5 per cent internal cost of capital to the new issues gives an annual cost of $368 million.

All of this can be attributed to corporate and institutional banking and, together with the one-off currency option losses of $360 million, is a big hit for a division that contributed cash earnings before tax of $1,037 million in the last 12 months.

Contact The Sheet here: ian@thesheet.com