Heartland takes aim at costs but Tripe sounds a warning
Heartland Group has always prided itself on being different.
A cynic might think this is making a virtue out of neccesity, given Heartland's origins of being formed by the 2010 merger of the old Marac Finance and two building societies.
That meant it started with a radically different sort of business than the mainstream banks.
But the business today is radically different again from what it looked like back then – now its main earners are reverse mortgages in Australia and New Zealand, both of which grew at more than 20% in the year ended June, motor vehicle loans, asset and livestock financing.
It also has a small but fast-growing mainstream mortgages business, although that too is quite different from the major banks in that it only accepts online applications and only from owner-occupiers with at least 20% equity.
And it has a similar business using automated online processing which lends to small businesses called Open for Business, although the economic climate has meant Heartland has stopped lending through this avenue at the moment.
In announcing its latest results last month, Heartland chief executive Jeff Greenslade announced a major new strategic initiative; a focus on cost cutting.
Heartland had got its underlying cost-to-income ratio (CTI) down 53 basis points to 42% in the year ended June and compared with 44.5% in the year ended June 2020.
Best of the best?
“That is about the same as the best of the major Australian banks, so what that says is that we have used technology to replace scale,” Greenslade told analysts.
“So, we're performing as if we had the same scale as those major banks.” The other smaller banks operating in New Zealand have CTIs between 50% and 80%, Greenslade said.
He has also set a target of getting Heartland's CTI down to 35% by 2028, is tying management remuneration incentives to achieving that goal, and said he isn't aware of any other bank in Australasia taking such an approach.
Perhaps not at the moment, but Australasian banks have had a keen focus on CTIs in the past, which I'll reveal later in this column.
“It's not parity with the major banks that we're seeking. We want to create a meaningful distance between us and the other banks in terms of the CTI ratio. We want to set ourselves apart,” Greenslade said.
Heartland didn't provide any earlier data on how its CTI has tracked over time, but, based on its accounts for the year ended June 2011, its CTI then was 64.8% - the company listed on NZX in February 2011.
CTIs at other NZ banks
So, there's no doubt Heartland has been able to substantially reduce its costs of doing business.
Greenslade may be right about the CTIs of the big four Australian banks, but the NZ subsidiaries of those Australian banks have a different story to tell in the calculations of Massey University banking professor David Tripe.
For the June quarter (as opposed to the year Greenslade was talking about), Tripe calculated Heartland's CTI at 44.17%, a smidge above Westpac's at 44.15%. But ASB's was 40.36%, BNZ's was 35.37% and ANZ's was 32.43%.
So, rather than equalling the best of the big four banks, Heartland's CTI is slightly higher than the worst of them.
But Heartland's CTI is still much closer to those big banks than it is to those of the other smaller banks – Tripe calculated TSB's CTI at 80.7% for the June quarter, so Greenslade's thesis about using technology to replace scale appears to hold.
Tripe explained TSB's high CTI as reflecting the cost of increasing regulatory requirements.
The way Greenslade sees Heartland achieving that lower CTI target is through digitalisation and automation and removing the need for Heartland staff to interact with customers.
Heartland wants to have automated 65% of manual back-end processing by June 30, 2025.
Self-servicing goal
The company also wants all its customers to be able to self-service and it wants them to mostly do so through using their mobile phones. It has set a goal of reducing inbound customer call volumes by 73% by June 30, 2025.
“We believe if a customer needs to ring us, we've failed,” Greenslade said.
He noted that 54% of customers visiting Heartland's reverse mortgage website in the latest year did so using a mobile phone, up from 51% a year earlier.
“That says volumes about the trend and myths about demographic resistance to technology,” Greenslade said.
Reverse mortgage customers are, by definition, old and so are many of Heartland’s depositors.
Heartland has also achieved a cost-saving victory on the regulatory front in that the Reserve Bank is proposing to introduce a new lower-risk weighting for reverse mortgages when the loan-to-valuation ratio (LVR) is below 30%.
Without going into the ins and outs of bank capital calculations and weightings, what it means is that the amount of capital Heartland has to hold backing its reverse mortgages will be significantly lower than the RBNZ had been proposing, thus reducing the cost of doing business.
The data Heartland provided with its results of the $889 million NZ reverse mortgage book showed a low-risk profile with the weighted average LVR at 21.3% at June 30, although rising interest rates lifted that from 18.3% a year earlier, and compared with the LVR at origination of 9.8%. None of the loans had LVRs above 75%.
Conservative in Oz, too
If Heartland receives regulatory approval to buy Challenger Bank, it is intending to fold its Australian operations, the $1.54 billion reverse mortgage book and livestock financing business, into the NZ bank.
But the profile of the Australian reverse mortgages is similarly conservative with an average 11.7% LVR at origination, a weighted average LVR at June 30 of 21.5% and a single loan with an LVR above 75%.
One indication of the drag additional capital can have on a banking business is the 169 basis point drop in Heartland's return on equity (ROE) ratio to 10.4%, which the company blamed on its $199 million capital raising in 2022.
“At the moment, we're sitting on more capital, more shares, than we've yet had time to utilise in terms of earnings, so that will right itself. We will get the ROEs moving back up to those 12% and beyond levels,” Greenslade told analysts.
But Tripe has a warning both to Heartland and analysts, as well as to investors in the company, that putting too much store in CTIs is a mistake.
The ratio is too open to manipulation and the way each bank calculates them can lack transparency, Tripe said in a 1998 paper on CTIs.
A sacking offence
For example, the ousting of former ANZ Bank New Zealand managing director Don Mercer was believed to have been prompted, in part at least, by the bank's relatively high CTI ratio.
As Tripe relates, ANZ had been including the gross income from the leasing business of its finance company subsidiary, UDC, in its income line and the depreciation of its leased assets in its expenses line, which had the impact of inflating the CTI.
After Mercer's departure, ANZ changed its accounting policy and instead only included the net leasing income in calculating the ratio and, hey presto, its CTI magically fell significantly!
“If one is using CTI ratios to compare banks, one needs to acknowledge that there are a number of factors which may cause them to vary from one bank to another,” Tripe's paper said.
“Also, adverse movements in CTI ratios are often used by bank managements as excuses for short-term cost-cutting, without regard to the cause of the changes.”
He cites a classic example of banks making older, more experienced managers redundant, pushing a body of corporate knowledge out the door, and then having to re-learn the lessons of the past those redundant managers would have known to avoid.
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