The banks can ride the storm, but it hasn't passed yet.
NAB's result and ones from ANZ and Westpac that will shortly follow will confirm that the Australian banking sector has weathered the financial system shock, but that the transition from financial crisis to recession will keep their earnings under sustained pressure this year and next at the least.
National Australia Bank is the most vulnerable of the big Australian banks to the crisis and its outworkings, through its exposure to derivatives, its relatively heavy exposure to business borrowers and its ownership of a British banking franchise, albeit a small one, with a total British market share of about 2 per cent.
Higher provisions for bad and doubtful debt charges in NAB's business loans, institutional banking and the British franchise were the main force behind the 9.4 per cent lower first half cash profit of $2.03 billion NAB posted yesterday.
Bad and doubtful debt charges were $1.8 billion in the half, up sharply from $726 million in the March half last year, and specific charges totalled $1.2 billion, about a third of them related to large corporate exposures.
The NAB result confirmed, however, that the composition of the charges is changing as the crisis matures.
Last year saw big corporate provisions as NAB and the other banks began to write down their loan exposure to corporate collapses that accompanied the first full flowering of the financial markets crisis, and the evaporation of non-bank credit.
There was an additional layer of charges for NAB last year — and in the second half in particular — as it wrote down exposure to derivatives, primarily the collateralised debt obligations (CDOs) undermined by America's housing slump.
The good news in NAB's result is that the lumpy provisions did not flow as heavily in the latest half: NAB has added $160 million to its provisioning on derivatives and conduit positions, but its weight in total provisioning is minor, unlike the September half, when CDO write-downs accounted for close to half the total hit.
ANZ and Westpac should confirm this experience when they post their March half results, today in ANZ's case, and in a week's time in Westpac's.
It will be a bank balance sheet reflection of a period of relative calm so far this year: unnerving shocks to the system were still being absorbed in the December quarter when they issued their last profit reports but they have not, so far, been followed by others, and last year's crises are now largely accounted for.
Corporate borrowers that could have slid over into problem territory have also renegotiated debts, and bolstered their own balance sheets with fresh equity capital.
The less encouraging, but unsurprising, pointer from the NAB result is that provisions and charges are continuing to ratchet up. Instead of being tied to large specific financial exposures, they are being generated by the broader economic slowdown, and NAB's traditional strength in small and medium business lending means that it is feeling the shift keenly. Later, when debt service pressure begins to affect consumer loans, it will be relatively less exposed than its competitors.
Without another round of unexpected systemic shocks, NAB and the other Australian banks will continue moving from the extraordinary and dangerous scenario that applied last year to a more ordinary one.
The loan losses they book will be more comparable with earlier economic downturns, including the recession of the early 1990s, but they will be just as real, and because this downturn is likely to be deep and protracted, they will keep a lid on profitability.
For its part, NAB has increased total provisions by just over $2 billion to $4.86 billion in the year to March, and by $1.57 billion in the March half alone. Collective provisions stood at $3.6 billion at March 31, equal to 1.38 per cent of risk-weighted assets excluding mortgages, and up almost half a percentage point.
NAB chief executive Cameron Clyne says that, so far, there has been no serious deterioration in the bank's consumer credit portfolio, but he and everybody else knows that one is in the mail, marked "pay on delivery".
Unemployment is a lagging economic indicator: it continues to rise even after convincing signs of recovery are abroad. But for the banks, it is a leading indicator.
Continuing employment is central to household debt service capacity on consumer credit. Bad and doubtful consumer debts will track unemployment higher in 2010, probably for half the year, after the markets have decided that the seeds of economic recovery have been successfully sown.
NAB's $3.25 billion share placement and retail kicker last November was behind a jump in its Tier One capital base from 7.35 per cent to 8.31 per cent in the March half, and the ratio will improve to 8.45 per cent after the partial underwriting of its interim dividend, which was cut as expected by 25 per cent or 24¢ to 73¢.
At that level, the bank has a generous capital insurance against the certain increase in loan provisions as the recession expands, and against unexpected shocks.
But it comes at a price: weaker earnings and the fat capital cushion combined in the March half to knock NAB's return on equity by a whopping 4.1 percentage points, to a pedestrian 12.7 per cent for the half.
The bank does not need to run a ratio above 7 per cent to maintain its double A rating alongside the other three big Australian banks (and just four other banks world-wide), and Clyne said yesterday that NAB would wind its capital buffer back as conditions become more stable and predictable.
For the moment, however, the outlook is too uncertain, and the mantra of former chief executive John Stewart — "keep the bank safe" — still applies, and the capital buffer will be maintained.
NAB could in fact test the market's appetite for new hybrid equity before the year is out.
The Maiden family owns NAB shares.
