Key takeaways:

• The big banks are on the verge of receiving a major tailwind as existing rate hikes, and future rate hikes flow through to mortgage payments, restoring margins

• Lending competition is expected to remain tough as home loan borrowers move en masse from fixed rate loans to variable loans in 2023

• Inflation is being felt right across the economy, and the RBA could be forced to go much higher with interest rates to bring it under control 

Already among the most popular stocks in the Selfwealth community, the nation leading banks are firmly in the spotlight as investors assess what higher interest rates mean for the Australian economy.

On the one hand, banks typically benefit as interest rates rise. However, with the fastest rate tightening cycle in nearly 30 years, there are growing concerns that the Reserve Bank of Australia could tip the economy into a recession.

It is perhaps good timing then, that three of the Big Four' banks in ANZ (ASX: ANZ), Westpac (ASX: WBC), and NAB (ASX: NAB) have all reported earnings over the last fortnight.

Here are three key lessons investors can take away from the most recent earnings reports of the major banks.

Net Interest Margins are Starting to Improve

Net Interest Margins (NIM) are the difference between the rate at which a bank lends money to borrowers, and the rate at which it borrows from depositors. It is one of the fundamental measures of how a financial institution is performing.

At first glance, the major banks reported a large drop in NIM over the last year. However, this was already known by virtue of the fact that it is a lagging indicator, and rates only started to rise in May.

Instead, the devil is in the details. Each of the big banks made it clear that NIM has started to improve through the second half of the financial year. Due to the lag in how rates are passed on, the effects of the first few rate hikes only started to flow through in recent months. 

While competition is expected to remain intense, and wholesale funding costs will rise, rate hikes are expected to translate into higher margins for the banks as the RBA continues to tighten monetary policy.

Additionally, a significant volume of the industry home loan portfolio is currently made up of lower-margin fixed rate home loans that are scheduled to roll over next year onto variable mortgages. This looks set to provide a further tailwind for the banks in restoring margins.

For investors, the unfolding trend could also pay dividends - literally. ANZ, Westpac, and NAB all declared a higher final dividend this earnings season, and improving NIM could provide a foundation to gradually increase dividends further.

Consumers Have Shaken Off Higher Rates to Date

While consumer confidence is below GFC levels, and business confidence is also in the gutters, one of the remarkable highlights from the major banks earnings reports is that spending hasn't really slowed down thus far. 

Not only have consumer prices soared, but the official cash rate has increased by 270 basis points from its pandemic low. Normally, this would lead to some degree of financial stress, be it loan defaults, or delinquencies. However, data from Westpac showed that its stressed' loans are at a four-year low of just 1.07% of total committed exposures.

In the housing sector, delinquencies and impared loans are sitting at just 0.75% of its near $500 billion home loan portfolio, with household savings playing a major role. The amount of stressed construction loans on Westpac books has also fallen over the last year, despite obvious headwinds.

More surprisingly, in the discretionary leisure sector, where Westpac has $10.2 billion in total committed exposure, stressed loans are down from 12.4% of its portfolio this time last year, to 6.8%. Even retail has managed to keep steady footing across nearly $12 billion in exposure.

Westpac is not an isolated example. NAB reported the number of loans more than 90 days overdue represents just 0.66% of its portfolio, which is 0.28% lower year-over-year. At the same time, around 70% of ANZ one million strong portfolio of home loan customers are ahead on their repayments.

There are some positive signs here for investors in bank stocks, not to mention areas like consumer retail where spending remains strong. However, investors should also monitor consumer and business psychology around inflation expectations, which could adapt to current trends and lead to entrenched inflation.

Not Even the Banks are Immune from Inflation

Much has been said about how inflation is a threat to households and the economy at large, but it would seem the banks are also vulnerable to inflationary pressure at this time.

Westpac was forced to abandon its target of reducing core expenses to $8 billion by 2024, instead aiming to reduce expenses to $8.6 billion. A $600 million shortfall might not seem like much for a multi-billion dollar bank, but it is representative of the difficult macro environment at this time, as well as the effects of ongoing compliance and regulatory costs. 

In the case of NAB, its expenses throughout FY22 rose 5.8% to $8.3 billion, with technology costs increasing, and higher employee pay reflecting the state of the current jobs market.

Meanwhile, ANZ provided guidance that its operating costs would increase 5% in FY23, with expectations that expenses could reach as much as $9.6 billion, despite the bank only recently shifting away from an $8 billion target.

It no surprise that each of the Big Four are predicting tough times for the economy, including a higher terminal cash rate that pushes up unemployment. 

NAB is predicting the RBA will lift rates until it reaches 3.6% in March next year, while both Westpac and ANZ are tipping a peak interest rate of 3.85%. Investors would be wise to review how their portfolio is positioned to cope with these potential rates.

Final Thoughts

Big Four earnings tell a story of two halves. It would appear that there are a number of promising signs for the sector and investors, with Net Interest Margins set to improve as the RBA lifts rates higher, and borrowers well positioned to cope with higher rates at this time. 

However, the uncertainty of the global economy, ongoing competition in the mortgage space, and the far-reaching implications of inflation have the potential to disrupt, or even offset the above mentioned tailwinds. At this stage, bank shareholders can weigh up all the permutations, and wait for further direction on terminal interest rates, inflation, and the direction of the economy.