What next for bank stocks?
Lower dividends likely as banks respond to more challenging environment.
Australia’s self-directed investors are understandably concerned about the outlook for Australian bank shares in this economic and political environment. In this article, we analyse some of the issues that are likely to affect the banks, their share prices and dividends over the next few years.
At the outset it should be noted that the seeds for the current troublesome trading environment for the banking sector were sowed over the past decade. Many of the responses and policies of central banks and governments in the immediate aftermath of the Global Financial Crisis continue today.
The biggest issue confronting banking operations and business will be the unwinding of the excessively easy monetary policy settings by central banks in the United States, Europe and Japan.
Australia’s current low interest rates do not imply a benign economy with low risk. To the contrary, low real interest rates have created an elevated risk for investors: our interest rates are the result of international manipulation rather than economic reality.
At some future point, today’s low interest rates will rise and challenge the value of assets. In this environment, capital maintenance should become every investor’s mantra.
Current environment for banks
Bank investors – focused on yield, enhanced by franking – need to consider the economic environment. Low interest rates and booming residential property prices are not markers for economic success, but rather economic excess. The banks have benefited from both the provision of abundant cheap debt to households and property speculators willing to borrow excessively.
The following chart suggests that residential property prices are moderately elevated at 14 per cent above their long-term trend, but this is an average. It seriously understates the excesses in Sydney and Melbourne.
Housing prices are significant for the operational risk of banks as they are the economy’s prime financial intermediaries. Property represents the primary security for the overwhelming majority of bank loans.
The banks raise funding through deposits and wholesale funding markets, and lend to borrowers (across sectors, but with a focus on residential property). In doing so, they must generate a margin that is primarily represented by the differential between interest paid and interest earned.
The recent history of net interest margins, represented in the following chart, shows a continual decline for the past 20 years. To offset this decline and so grow profits, the banks have increased the leverage on their balance sheets. They have lent more against their capital bases by adjusting down the risk weighting of their mortgage books.
In recent times, the financial regulator (APRA) has examined this approach and directed the banks to increase their equity and reduce speculative lending.
Supporting their business is shareholder capital, which normally generates a leveraged return in the range of 12 to 18 per cent per annum. This is shown in the next chart, which tracks the return on shareholders equity (profitability) of Australia’s banks.
It can be seen that the banks have experienced a decline in their profitability (as distinct from profits) from the peak reached just before the GFC. The chart shows the effect of the recession of 1992, which obliterated the equity of Westpac and ANZ. Investors need to understand bank leverage, because it magnifies returns in both good and bad times.
Shareholders equity is a regulated buffer, necessary to ensure the stability of the financial system as a backstop for banks during economic downturns.
The confidence of the providers of funding to the banks (mainly retail depositors) is driven by the perceived strength of the banks. Some of the elements of confidence flow from long-term financial performance, perceived good governance, strong capital ratios and the “implicit guarantee” of their deposits by the Australian Government. The recently announced bank levy was partly justified by the guarantee.
The next chart shows that the level of retail deposit funding of the banks has lifted substantially since the GFC. During the GFC, banks were exposed by their high levels of wholesale funding, particularly those drawn from international markets, which, at the peak of the financial crisis, were severely disrupted. Should there be another extreme international event, our banks are now far better funded.
The Australian economy draws substantial capital and debt from foreign sources, with banks accounting for $600 billion in foreign wholesale funding. Their cost of funding is affected by international events. For instance, when President Trump was elected in November, the wholesale debt market reacted by increasing interest rates because of a perception of rising risks of Trump-generated inflation.
Australia’s regulators have progressively increased their regulation of the banks’ capital bases. The full force of the GFC did not take Australia into recession, but it exposed the risky underbelly of the Australian financial system – excessive leverage to offshore funding.
The next chart shows the substantial improvement in the capital bases of our banks and the focus on equity (tier 1) rather than subordinated debt (tier 2).
The offset to increased equity or capital is the declining return on equity. While banks are reporting near-record profits, well above the levels before the GFC, their profitability (i.e. return on equity) has declined.
Outlook for bank shares
As noted, the banks have endured declining interest margins and declining returns on equity for the past decade. We expect interest margins will hold and possibly rise as commercial reality dictates.
There has been a recent adjustment of interest rates (for instance, interest-only loans) in response to tightening APRA regulations. To grow profits and maintain profitability, the banks need to be more focused on pricing risk rather than growing assets. That, in our view, is a good outcome.
Possibly the real determinant for banks will be a decline in the performance of bank assets (loans). Should assets move into the non-performing category, then interest income will be lost and write-offs occur. The potential for non-performing assets to rise comes back to the prevailing economic environment.
The unwinding of low interest rates across the world – as it flows through to mortgage rates and residential property prices – could become the first serious pressure point for the banks. The US Federal Reserve has begun this process. It has acknowledged that US rates are too low at this point in their cycle, but the adjustment upwards is being checked by the fear of stymying the already anaemic US recovery.
In preparation for the inevitable interest rate rises that await in the next few years, APRA has been enforcing stricter (higher) capital ratios to ensure the banks’ capital buffers are as high as prudently possible – they must be “unquestionably strong”. Time will tell if the highly leveraged household sector can cope with mortgage rate rises.
The excesses of the debt-driven property cycle in Australia are playing out. However, because they have occurred during a period of historically low interest rates, the work through (or work-out) will be more convoluted.
During this cycle, household debt grew faster than previous cycles and so have property prices in our most populous cities. The level of indebtedness flowed from cheap international wholesale funding transferred through banks’ balance sheets and the availability of cheap loans to property investors. At the bottom of the interest rate cycle, we saw peak levels of debt, high bank profits and high bank share prices.
Bank prices were pushed higher, not because of improved profitability, but by passive yield-chasing investors forced out of conservative bank deposits into bank shares and hybrid securities. This transfer of investment capital was also stimulated by franking credits that enhanced bank share yields.
The recent slide in bank share prices occurred directly after the Commonwealth Budget announced the bank levy. The bank levy is to be applied to bank liabilities, not profits. This is a sign that the growth of our major banks is to be checked. It may be somewhat haphazard, drawn from overseas precedents, but the intention seems clear. It again acknowledges that government guarantees cannot be open-ended.
The APRA directives to bolster bank capital ratios are designed to ensure that they have excess capital to ward off the effects of higher interest rates and/or a severe residential property correction. The pressing issue for the banks is how to grow and maintain this excess capital. Apart from raising new equity (which dilutes earnings), the more logical way is to grow retained earnings by adjusting down dividend payout ratios.
So, our view is this: the banks will realise that dividend payout ratios are too high and that retaining earnings is their most sensible capital management approach. As bank balance sheets are checked by the economic cycle and government intervention, banks will appreciate that share price growth will only occur if they limit share issues.
Bank investors and share prices will adjust to lower dividends, but with the potential for them to grow on a sustainable basis.
Of course, this outlook could be affected by an unforeseen event – particularly one emanating from overseas – but frankly, that is always the risk in today’s unpredictable world.
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