Why Kiwibank's growth may slow as CEO Sam Knowles leaves

It's especially rare in this day and age to congratulate a banker for a job well done.

Many savers, taxpayers and businesses around the world have adulterated the word banker with the letter 'w' in the last couple of years since the Lehman Brothers collapse triggered the Global Financial Crisis.

But Sam Knowles, who announced his resignation as Kiwibank CEO today, deserves an awful lot of credit for leading the creation of a large and worthy institution that has shaken up the banking industry for the benefit of consumers.

Few people gave Kiwibank much of a chance when it launched in 2002. It seemed like a politician's idea for a business, which is usually a bad thing. It was also very small and up against four of the most powerful companies in the land. Breaking into a market as established as banking is always difficult, particularly when most people are reluctant to change their bank even if they're not happy. Yet Kiwibank has been extraordinarily successful by many measures.

It now has over 650,000 customers, 800 staff and more than 300 branches nationwide. It made an after-tax profit NZ$23.5 million in the six months to December 31, albeit down slightly from the NZ$25.8 million reported in the same half a year ago. It has built up NZ$420.5 million of equity over its 8 years of operation and had NZ$12 billion worth of assets at the end of 2009, up from NZ$9.43 billion a year earlier. Kiwibank's customer satisfaction rating, as measured by Roy Morgan has hovered between 80-85 per cent for most of the last 8 years, significantly above the big four at between 70 per cent to 80 per cent.

It's notable that the three laggards in terms of customer service in New Zealand banking over the last 10 years (BNZ, Westpac and ANZ) have all raised their game since Kiwibank's arrival in 2002. They have had to because Kiwibank has been a tough competitor. For a long period Kiwibank was able to pass on the relatively low costs of raising most of its money from Term Deposit customers rather than from 'hot' money markets.

That has changed dramatically in the last year now that the big banks are being forced to compete for those term deposits, driving up their cost and undermining Kiwibank's model. Still, Kiwibank's lending growth in the last two years has been spectacular. Kiwibank's mortgage lending has been growing much faster than the big four banks since the end of 2008 and it has competed hard for new business by offering discounted fixed mortgage rates and variable rates. It did this by using its 'cheap' term deposit funding and by choosing to sacrifice profits and dividends for growth.

Kiwbank grew its mortgage lending by NZ$3.84 billion since the Global Financial Crisis hit from July 2008.

That compares with ANZ National's mortgage lending growth of NZ$815 million, ASB's NZ$1.84 billion and Westpac's NZ$2.09 billion. That put an awful lot of heat on the big Australian banks. The net interest margin charged by the banks overall has dropped from 2.6 per cent in early 2003 just as Kiwibank got going to around 2 per cent now, Reserve Bank figures show.

The banks currently lend around NZ$300 billion to New Zealand households and businesses. If the banks were still charging the 2.6 per cent they were in 2003 that would cost households and businesses an extra NZ$1.8 billion a year. Added up over the last 8 years, you could argue that that reduced margin 'saved' New Zealand households and businesses around NZ$8 billion.

Of course, Kiwibank hasn't been the only reason for the reduced margin. Competition between the big four has also been intense and the recent shift to funding from term deposits rather than 'hot' international wholesale markets has also hurt margins.

But Kiwibank, and Sam Knowles, should take a lot of the credit. Launching any institution, building a business culture and taking on established competitors is never easy, particularly when your shareholder is the government. Sam Knowles was open to the media, showed real leadership of his people and shook things up. That's tough in a small town like New Zealand. Although to be fair, Kiwibank has had an awful lot of help from its shareholder.

There's actually been a lot more help than many realise. Kiwibank reports that it is profitable now, but there is a substantial ongoing subsidy in place that effectively pumps up its profit. Kiwibank received NZ$27.2 million in income from NZ Post for bill payment services in the six months to December, which is significantly bigger than its profit.

Kiwibank's profitability as a proportion of assets has also run at around 0.6 per cent, about half the profitability rate of its major competitors. Either the big banks are too profitable or Kiwibank is not profitable enough.

The next stage

Kiwibank's next stage of growth will be much harder. It was able until a year ago to use cheap term deposits to grow. It could also rely on the Labour-led government to keep topping it up with equity capital (or more correctly not expecting dividends) to back that lending growth.

That 'easy' access to funds and capital is now over. The banks are competing hard for term deposits. The government can't afford to keep pumping capital in, or more correctly, not taking dividends out. Kiwibank has been searching for alternatives for the last year or so. It has already gone into the Australian 'hot' wholesale markets to raise NZ$309 million of funds there. The irony of Kiwibank having to raise funds in Australia would not have been lost on Sam Knowles.

Kiwibank then raised NZ$150 million of tier one capital earlier this year from New Zealand investors in the form of perpetual non-cumulative preference shares. These capital raising options are now starting to run dry. That's why Kiwibank went to the government and asked to be allowed to continue to grow without producing dividends. Bill English's decision not to stump up with the capital is now forcing a debate about part privatisation.

Sam Knowles was clear in his resignation news conference earlier today that this was not the reason for him leaving. Nor did he have any problems with the board. 10 years is a long time in any job and he deserves a rest. He will be back and we can only hope it will be somewhere in a New Zealand business.

But the issue of Kiwibank's hunger for capital is the elephant in the room in this debate. Bill English is right to suggest a part privatisation through a stock market float to Mum and Dad investors, but there will be significant hurdles to jump, the least of which will be political.

The real hurdles are within Kiwibank itself. It would have to extract itself from New Zealand Post, which would be difficult given they share premises in those 300 branches and New Zealand Post provides a subsidy of around NZ$45 million a year for 'bill payment services'. Bringing in a cornerstone shareholder, which would have to be one of the big four banks, would be so difficult as to be almost impossible. Kiwibank's 'challenger' branding of being the anti-Australian bank would make that very tough.

The ultimate conclusion then is that until Kiwibank finds a new source of capital it may have to slow its growth. That would have a significant impact on the housing market and the economy, given that Kiwibank's lending has been a major prop of support since September 2008. It would also ease some of the pressure on the Australian banks.

Your view? I welcome your thoughts and comments below