Building Societies and Credit Unions

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1 Building Societies and Credit Unions 2004 Flourishing in a cooler market 28 October 2004 Introduction Building societies and credit unions performed solidly in the year to June Building societies results were the stand out with profit after tax increasing by 23.2%, however, this includes windfall gains on the sale of Cashcard. Excluding income from Cashcard, profit after tax grew at a more modest 7.1%. Credit unions increased profit after tax by 13.2% on a normalised basis 1. The cooler housing market had limited impact on profitability, with asset growth remaining over 10%. Low bad debts expense was also a major contributor to the 2004 results. Building Societies Market share of top 5 by total assets (2004) 7% 7% Credit Unions Market share of top 10 by total assets (2004) 18 % 19 % 48% 21% 28% 7% 7% 8% Other Newcastle IM B Heritage Home Wide B ay Other ACCU Savings & Loans QSCU Police & Nurses QLD Teachers ANCU CUAL NSW Teachers M embers & Education CPS CU The market share of the top five building societies and top ten credit unions remained stable during 2004 at 81% and 52% respectively, with no significant acquisition occurring. Australian National Credit Union became the largest credit union by total assets due to asset growth and low use of securitisation relative to its competitors. Building society numbers remained constant at 14 in 2004, while credit unions numbers decreased steadily from 187 to Smaller credit unions remain ripe for consolidation and we expect their numbers to fall again in We would like to thank all of the building societies and credit unions who participated in our survey. 1 The impact of gains or discounts on acquisitions in the 2002/2003 financial year for Credit Unions have been excluded. 2 Source: APRA 2004 KPMG, an Australian partnership, is part of the KPMG International network. KPMG International is a Swiss cooperative. All 1

2 Asset Growth Total assets for building societies and credit unions increased by 11.6% and 10.3%, respectively. This growth was underpinned by continued strong growth in consumer lending, particularly housing. Asset growth would be higher still after considering securitised assets, which increased 32% to $5.5 billion during The top five credit unions recorded growth of 10.9% in 2004, which is greater than the overall growth for credit unions. Further, these five credit unions securitised assets of $1.1 billion during the year. This indicates that small to medium size credit unions are being left behind by their larger competitors. $m 30,000 Total Assets 25,000 20,000 15,000 10,000 5,000 - Building Societies Credit Unions The use of mortgage brokers is now an embedded feature of the Australian mortgage market. The increased use of mortgage brokers by building societies and credit unions flies in the face of their traditional strategy to establish close and direct relationships with members. However, many building societies and credit unions could not resist the benefits to asset growth and geographical diversification offered by mortgage brokers. Building societies in particular have embraced mortgage brokers, with 69% originating loans through them in These building societies sourced 52% of their new loans from mortgage brokers in 2004, up from 42.0% in Total assets for building societies using mortgage brokers increased by 9.5%, which is less than the building society average. Even after taking into account assets securitised during the year, these building societies have not significantly outperformed building societies overall. This suggests that building societies who have focused on growth through their traditional channels have been as successful as those who have accessed mortgage brokers. Credit unions have not embraced mortgage brokers to the same extent, with those using brokers (29%) writing 20.8% of their residential loans through this channel. Some credit unions are restricted from lending outside their traditional membership base and therefore cannot use mortgage brokers. Others are too small to be attractive to the leading mortgage brokers. The rise in mortgage brokers has been accompanied by a period of high loan growth. It will be interesting to see how brokers respond to the decline in volumes, with real concerns that they will replace lost volumes by encouraging borrowers to refinance. Another frequently expressed concern is that brokers will push through lower quality loans. Building societies and credit unions need to ensure they have robust broker accreditation and performance monitoring processes in place to manage these risks. 2

3 Asset Growth (continued) Total branch numbers for building societies and credit unions increased just 0.9% during 2004 compared to 3.3% in Frequently, building society and credit union have opened branches in areas where banks have closed branches. With banks such as Bank of Queensland and Bendigo Bank aggressively increasing their presence in regional areas these opportunities may be limited going forward. Member loyalty will be tested as competitors open branches and utilise their marketing clout to attract new customers. Indeed, some of the larger building societies and credit unions now see their primary competitors as the regional banks, not other building societies and credit unions. The size of individual building societies and credit unions should not be underestimated, for instance Newcastle Permanent Building Society has total assets of $3.4 billion, compared to Bank of Queensland with total assets of $9.9 billion at 31 August Growth in Total Assets 20% 15% 10% 5% 0% Credit Unions Building Societies Majors Regionals For the Majors asset growth is for the consumer portfolio only and is sourced from the 31 March 2004 half year Major Banks Survey. For the Regionals asset growth is for consumer portfolio only and is sourced from the 2004 Regional Banks Survey. Consumer includes housing loans and credit cards. Household debt grew at 18% during 2004, moderating slightly since 2003 (20%) 3. Housing loans represent a relatively high proportion of assets for both building societies and credit unions. Therefore it is not surprising that asset growth slowed in As can be seen in the graph above, declining asset growth is now an established trend across the entire industry. Based on the June 2004 results of the building societies and credit unions, we expect the major banks to report lower asset growth in their September 2004 results. With the growth in household debt expected to slow further during 2005, substantial asset growth is unlikely. Overall, we expect single digit asset growth for building societies and credit unions in Building societies and credit unions have traditionally enjoyed high customer satisfaction ratings relative to banks. Further, their major competitive advantage has been based on being mutual organisations, owned by their members and providing superior service to those members. The major banks have recently turned their minds to improving customer experiences, for instance Westpac s Ask Once program. While the ultimate success of these initiatives is uncertain, any progress they make will reduce the competitive advantage currently enjoyed by building societies and credit unions. Credit unions and building societies are responding to this challenge with campaigns to highlight their focus on member service. 3 Source: ANZ Economic Snapshot, September

4 Funding Building societies and credit unions have enjoyed significant growth in deposits over the last few years. Deposit growth cooled during 2004, with the top five building societies and credit unions increasing deposits by 11.3% and 10.1%, respectively. However, these growth rates remain strong relative to the banks (10% for the majors and 15% for the regionals). Deposit Growth - top 5 versus majors and regionals (2003 vs 2004) 25% 20% 15% 10% 5% 0% Building Societies Credit Unions Majors Regionals Deposit Growth - Credit Unions Deposit Growth - Building Societies 50% 30% 40% 25% 30% 20% 15% 20% 10 % 10% 5% 0% ANCU CUAL NSW TCU ACCU S&LCU 0% Newcastle IM B Heritage Home Wide Bay ANCU s deposit growth for 2003 includes the impact of the City Coast Credit Union merger. Most of the top five building societies and credit unions experienced a decline in deposit growth in Savings & Loan Credit Union and Newcastle Permanent Building Society were the notable exceptions with deposit growth in excess of 15%, possibly due to expansion with both increasing branch numbers during Building societies and credit unions are highly reliant on retail deposits for funding relative to banks. Lower deposit growth will therefore cause some concern. Securitisation is the most popular alternative to deposits, but this means higher costs, particularly with the small tranche sizes offered by building societies and credit unions. Lower asset growth, hence lower demand for funding, is expected to partially mitigate this issue during

5 Funding (continued) For credit unions, the ratio of loans and advances to deposits decreased from a peak of 102.5% in 2000 to 92.5% in December , indicating a significant improvement in liquidity. Despite low interest rates, investors found deposits relatively attractive due to the relatively poor performance of the stock market during much of this period. Stock market returns have now improved significantly, with the All Ordinaries Index climbing to new highs during We expect the improved performance of the stock market to act as a drain on deposits during Competition for deposits is intensifying, with regional banks such as BankWest entering the internet based deposit market with aggressive marketing campaigns. Some building societies and credit unions offer similar online deposit products, allowing them to compete directly in this part of the deposit market. However, these products are likely to contribute to margin erosion due to the fierce competition and typically high interest rates offered. 4 Source: APRA Insight, Quarter

6 Asset Quality Although household debt continued to rise in 2004, low interest rates and the lowest unemployment rates since the early 1980 s 5 mitigated the pressure on serviceability for the average household. Asset quality measures improved for both credit unions and building societies, consistent with the experience of the banks. For credit unions, bad debts expense as a percentage of gross assets decreased from 24bps to 16bps. This percentage represents a historical low for credit unions, which had experienced a percentage around 30bps or higher for the last decade. For building societies, this percentage decreased from 15bps to 7bps. Total bad debts expense for the top five building societies and top five credit unions decreased 24% to $14 million in (%) 0.5 Bad debts expense to average gross receivables Building Societies Credit Unions Majors Regionals Building societies and credit unions have a relatively high exposure to housing loans, which represent 85% and 70% respectively of their total loans compared to 55% for the banks 6. For credit unions, this ratio has increased from 50% in 1995 largely due to a contraction in personal loans. Personal loans have shrunk as a proportion of total loans due to consolidation into mortgage loans and, in particular, the use of mortgage redraw facilities. Rising interest rates may be a cause for concern going forward. For instance, net interest payments as a percentage of household disposable income climbed to over 9% 7 during 2004, the highest since 1989 when housing loan interest rates peaked at 17%. With most forecasts predicting interest rate increases during 2005, we expect an increasing number of households to have difficulty servicing their loans. However, we note that credit quality for credit unions and building societies did not deteriorate significantly in Further, the predominance of housing loans, the proven determination of Australian households to pay off their housing loans and ultimately, access to the underlying security of houses, should prevent any significant losses. 5 Source: Australian Bureau of Statistics 6 Source: APRA Insight, Quarter Source: ANZ Economic Snapshot, September

7 Profitability Overall, building societies and credit unions recorded increases in profit after tax of 23.2% and 13.2%, on a normalised basis respectively 8. The building society result includes profits of approximately $12.4 million after tax related to the sale of Cashcard during None of the survey participants recorded a loss, reflecting the conducive economic environment throughout $000s 200,000 Net profit after tax 180, , , , ,000 80,000 60,000 40,000 20,000 - Credit Unions Building Societies Key factors influencing the profitability of building societies and credit unions include the following: increased net interest income, where volume increases were partially offset by declining margins; increased non interest income generation, primarily driven by profits on sale of Cashcard and increased loan volumes; and technology and regulatory costs continue to be a significant cost, driven by the rapid pace of change in the regulatory environment and the need to provide services through an expanding range of channels. Return on equity for the sector remains around 10% in Although this return is modest, it needs to be considered in the context of the mutual status of most of these organisations. As a result, profitability is somewhat of a paradox for them. Their fundamental philosophy and reason for existence is to provide services to members, which suggests that break-even results would be preferable. However, retained profits are their primary source of capital as the issue of equity instruments would breach mutuality restrictions. Profitability is therefore required to increase capital as the balance sheet grows. 8 The impact of gains on acquisitions in the 2002/2003 financial year for Credit Unions have been excluded. 7

8 Interest Margin Margin compression continued in 2004, with net interest income as a percentage of average assets decreasing from 2.55% to 2.53% for building societies and 3.84% to 3.77% for credit unions. This reflects the increasing price sensitivity of consumers, whereby building societies and credit unions must be price competitive with a growing range of alternative lenders and alternative deposit products. % Net interest income to ave. total assets Building Societies Credit Unions Majors Regionals Net interest income as a percentage of average assets is higher for credit unions than banks due to different product mixes and lower interest expense. Credit unions fund the majority of the business from relatively inexpensive retail deposits. Although building societies have a similar proportion of funding from retail deposits, the benefit of these deposits to net interest income appears to be offset by lower yields on holdings of investment securities. As previously mentioned, many building societies have enthusiastically embraced mortgage brokers as a source of loan growth. As there is no established client relationship, attracting customers through this channel requires extremely competitive pricing. This appears to have impacted margins, with the ratio of net interest income to assets averaging 2.34% for those building societies using brokers compared to 2.96% for those not using brokers. Credit unions using brokers also have lower net interest margins (3.40% versus 4.01%). While there are many other factors to consider when deciding to use mortgage brokers, such as the reduced processing costs and increased commission expenses, it is clear that there has been a negative effect on net interest margins. 8

9 Non Interest Income Due to their focus on providing the best possible value for members, building societies and credit unions have historically charged minimal fees for members transactions. As interest margins have declined, the need to maintain overall profitability has forced them to reassess this policy. While fees have been introduced, these fees are primarily aimed at recovering the costs of members transactions. Building societies increased non interest income significantly in 2004, with the non interest income as a percentage of assets increasing from 1.12% to 1.30%. Several building societies booked significant profits on sale of Cashcard to First Data Corporation in March Income from securitised loans also contributed to non interest income growth, with securitised receivables managed by building societies almost doubling during the year. We do not see any indication of a significant increase in the level of fees charged by building societies during Further, the level of non-interest income remains significantly below that of credit unions and the banks. For credit unions, the increase in non interest income during 2004 was largely in line with asset growth, with non-interest income as a percentage of assets falling from 1.89% to 1.85%. % Non interest income to ave. total assets Building Societies Credit Unions Majors Regionals Wealth management is an attractive option for building societies and credit unions looking to diversify their income. There are typically two ways to achieve this goal; acquisitions or alliances. Wealth management businesses have historically traded at significant multiples to earnings, primarily due to the expected synergies with banking operations and forecasts of exponential growth in funds under management. However, significant doubts remain about the true value of a wealth management business to a bank, suggesting that the market s appetite for these assets may have cooled. Any moderation in prices for small to medium wealth management businesses will make acquisitions increasingly attractive, particularly for the larger building societies and credit unions. Alliances with established wealth management operations such as Bridges Financial Services (formerly owned by CUSCAL) allow building societies and credit unions to earn commissions for customer referrals. Alliances are often preferable due to the small investment required and lower ongoing compliance burden. Similarly, alliances with insurance providers is a source of commission income. 9

10 Cost to Income Credit union cost to income ratios decreased from 77.5% to 76.1% during 2004, continuing the trend of steady improvement over the past few years 9. Cost to income for building societies increased from 73.3% to 74.2% during 2004, however no clear trend has been established. The gap between the cost to income ratios of the banks and those of building societies and credit unions is primarily due to scale. Similarly, building societies tend to be larger than credit unions and have lower cost to income ratios. The declining cost to income ratio for credit unions is in part due to consolidation, which has increased the scale of credit unions. Outsourcing services such as those offered by Credit Union Services Corporation (Australia) Limited (CUSCAL) are crucial for credit unions to overcome the disadvantages of their smaller scale. % 80 Cost to income ratio Building Societies Credit Unions Majors Regionals Factors effecting the cost to income ratios of the sector include: Increased personnel costs, with employee numbers increasing by 4.5% for building societies and 3.9% for credit unions; Increased regulatory costs, with building societies and credit unions incurring costs associated with the implementing Financial Services Reform Act during Implementing International Financial Reporting Standards (IFRS) is also a significant burden for credit unions and building societies, however they have responded much slower than the banks. As a result we expect a significant proportion of IFRS implementation costs to be incurred in 2005; and For some building societies and to a lesser extent credit unions, commission expense increased due to the use of mortgage brokers. Cost increases can be easily overlooked in times of significant growth. With asset growth now slowing, cost control will take on renewed importance in The impact of gains on acquisitions in the 2002/2003 financial year for Credit Unions have been excluded. 10

11 Outlook As we look to the 2004/2005 year for building societies and credit unions, we believe that the following issues will influence performance: We expect the cooler housing market to have a more significant impact on asset growth and profitability in In addition, building societies and credit unions face increased competition in their traditional domains of customer service and regional presence. The strategies of several regional banks place building societies and credit unions directly in the firing line. Building societies and credit unions will need to adapt to overcome this growing threat. Periods of slower growth offer management time to take stock and reassess their long-term strategies. Management can easily avoid hard decisions when things are going well. We expect that tightening economic conditions will spur further consolidation in the industry. Deposits will be increasingly harder to attract due to the recovery of equity markets and growing range of high interest / low fee deposit accounts offered by competitors. This will pose significant challenges to the sector, particularly if a high demand for loans continues. This will increase the attractiveness of securitisation or alternative funding strategies. While no substantial decline in asset quality is expected in the short term, we believe that signs of a down turn may emerge during Movements in interest rates will heavily influence the magnitude of any change in credit quality. However, we consider it unlikely that this sector will suffer significant credit losses, given their high proportion of residential mortgage loans. The proportion of residential loans sourced from mortgage brokers is likely to increase in With residential loan growth slowing, less disciplined mortgage brokers may be tempted to push through lower quality loans or refinance existing facilities. Building societies and credit unions will need to carefully monitor broker accreditation processes and performance. The above observations point to increased pressure on building societies and credit unions. We predict that there will be increased focus on reducing costs and therefore further consolidation in the sector. However, the focus that the banks are placing on improving customer service highlights the value of the customer relationships developed by building societies and credit unions. Provided they continue to excel in this area they should continue to provide a valued alternative source of financial services to their members. For further information, please contact: Tim Hargreaves National Manager of Financial Services Telephone mailto:thargreaves1@kpmg.com.au Please visit to learn more about KPMG s Financial Services practice. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. 11

12 Appendix 1: Survey scope This survey includes 13 of the 14 building societies and 55 of the 177 credit unions authorised by APRA as of 30 June The survey participants represent more than 84% of building societies and credit unions by total assets, net assets and profit after tax 10. The percentage of credit unions surveyed by number is relatively low at 31% due the large number of small credit unions, with the top 40% of credit unions holding 90% of total credit union assets. According to APRA, there are 72 credit unions with total assets greater than $90 million. This survey includes 54 credit unions with total assets greater than $90 million. Based on this, the survey represents approximately 54 of the top 72 credit unions (75%). Percentage of building societies and credit unions surveyed 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Total assets Net assets Profit after tax Number Building Societies Credit Unions 10 Based on APRA data as of 31 December Source: APRA Insight, Quarter KPMG, an Australian partnership, is part of the KPMG International network. KPMG International is a Swiss cooperative. All 12