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Morningstar | Lower Net Interest Margins Surprise in Westpac's 3Q18 Update. AUD 35 FVE Unchanged.

Lower net interest margins, or NIMs, surprised in wide-moat Westpac Banking Corporation's third-quarter fiscal 2018 update covering capital, funding, and asset quality. Despite weaker margins, the update was in line with our expectations, underpinning our unchanged AUD 35 fair value estimate. Westpac Bank is our preferred major Australian bank, trading 20% below valuation and in a good position to deliver solid profit and dividend growth on the back of strong market positions and a resilient economy.

We make no changes to our fiscal 2018 forecast cash profit of AUD 8.4 billion and fully franked dividend of AUD 1.88 cents per share, or cps. Prior to the update, consensus estimates were for a cash profit of AUD 8.5 billion and AUD 1.89 cps dividend. The bank continues to leverage strong east coast economic conditions, with 73% of new home loans in the June quarter settled in New South Wales and Victoria.

NIMs declined 11 basis points in the quarter to 2.06% from 2.17% for first-half fiscal 2018 due primarily to the sharp increase in short-term wholesale funding. Westpac estimates a five basis point movement in short-term wholesale funding costs, known as bank bill swap rates, or BBSW, impacts NIMs by approximately one basis point. During the third quarter, average BBSW rates were 2.02%, about 24 basis points higher than the first-half fiscal 2018 average of 1.78%. Higher average BBSW rates reduced the bank's margins by five basis points.

Despite the surprisingly soft NIM outcome, our full-year fiscal 2018 margin forecast of 2.13% is unchanged as short-term wholesale funding costs have eased a little since end of June, with 90-day BBSW rates falling from a peak of 2.12% at end June 2018 to about 1.96% currently. We are not sure if short-term funding costs will continue to fall, but if they remain elevated for long, we expect the bank and major bank peers, to increase variable home loan rates to offset the higher funding costs.

In addition to higher BBSW rates, Westpac suffered from a four basis point decline in Treasury margins, principally due to fewer opportunities in markets. "Others" accounted for a two basis point decline due to ongoing changes in the mortgage portfolio mix with less higher margin interest-only lending and increased "front book" discounting on new mortgages. These negatives were partially offset by some deposit repricing positively impacting margins.

We like the strong capital position, modest risk-weighted asset, or RWA, growth, sound asset quality, and slowdown in higher-risk residential lending to investors and interest-only borrowers. The 0.1% decline in the common equity Tier 1 ratio in the quarter to 10.4% at June 30, 2018 reflected the 0.70% net of dividend reinvestment impact of the fiscal 2018 interim dividend, substantially offset by third quarter earnings, converting preference share conversion, RWAs, movements, and other capital changes. We have long argued Westpac, and major bank peers, are well positioned to meet the banking regulator, Australian Prudential Regulation Authority, or APRA’s, "unquestionably strong" benchmark of 10.5% by January 2020.

Westpac's internationally comparable capital ratio was a globally top quartile 16.0%. Westpac Bank estimates the impact of regulatory model changes during fourth quarter fiscal 2018 will add approximately AUD 11.5 billion in RWA, representing about 0.30% reduction in the common equity tier one capital ratio. Most importantly asset quality remains strong despite widespread focus on stressed household budgets. The group loan loss rate was not disclosed, but we maintain our fiscal 2018 forecast of 0.13%, in line with the historically low outcome for fiscal 2017.

Westpac's Australian mortgage 90-plus day delinquencies increased three basis points to 0.72% of total home loans. Australian unsecured 90-plus day delinquencies increased five basis points to 1.76%, but auto loan arrears rates are increasing. Pockets of mortgage stress remain in Western Australia with 90-plus day arrears rates remaining elevated. Australian home loan loss rates remain insignificant--barely a rounding error. Residential properties in possession declined in the quarter to just 392 across Australia. Group impaired assets are stable at AUD 1.54 billion with no new large individual impaired loans over AUD 10 million recognised in the quarter. Stressed assets declined by a modest 0.01% to 1.08% of total committed exposures.

APRA macroprudential limits are being comfortably managed with residential interest-only lending steady around 24% of total new lending in the June quarter, well within the maximum 30% limit. The volume of customer-initiated home loans switched to principal and interest from interest-only, remains relatively high at AUD 4.0 billion in the quarter but declined sharply from the September quarter spike of AUD 7.9 billion, prompted by the increase in interest rates for interest-only home loans. Macroprudential tightening is successfully slowing the rate of mortgage growth across the industry with Westpac no exception. Westpac has consistently led peers with the highest proportion of investor mortgage lending, but tighter regulatory criteria have dampened Westpac's investor annual growth to 3.7% at June 30, 2018 from 5.9% at Sept. 30, 2017. Annual growth in owner-occupier loans is picking up with the year-on-year increase of 6.0% at end June 2018 up from the year on year growth of 4.8% at Dec. 31, 2017.