The Dilemma For Bank Investors

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A generally positive outcome for banks during the profit reporting season should be viewed through the prism of longer-term structural forces.

-Cyclical recovery for credit and capital
-Ongoing suppression of net interest margin
-Dividends to normalise from the second half FY21?

By Mark Woodruff

In the wake of a supportive reporting season and news regarding potential vaccines, it’s timely to examine the investment thesis for Australian banks.

A conundrum arises for investors when faced with competing tensions for the short and longer-term. Prima facie, the reporting season was seen as positive in terms of a cyclical recovery for credit and capital. Alas, this needs to be weighed against pre-existing structural headwinds that don’t look like abating anytime soon.

Structural Headwinds

In the midst of bank reporting, the RBA reduced the official cash rate to 0.10% from 0.25%, the lowest it’s ever been. In addition, the central bank will purchase $100bn of government bonds with maturities of around five to ten years, officially putting it on the quantitative easing path.

This latter move shows a determination to keep rates lower for longer. As a by-product this also sets the tone for future core earnings of the banks, which are best reflected in the net interest margin (NIM). While lower rates are seemingly positive for the economy (and by extension banks), they also crimp bank earnings by suppressing the NIM.

The NIM is a measure of the difference between the interest income generated by banks (mortgages and loans) and the amount of interest paid out to their depositors and lenders.

Some take a more optimistic stance toward these NIM headwinds. Citi calls out the core-earnings defeatists. While conceding the banks are unlikely to suddenly turn into growth stocks, the broker perceives a larger, more positive story. This comprises the whole gamut of asset quality, valuation support and dividends in a yield-less world.

The broker also expects some relative sector performance. Having recently witnessed other sectors rallying upon confirmation of a milder covid-19 outcome than expected, it is now considered time for the banking sector to perform.

Another prevailing headwind is the growing competitive pressures for the banks. With the improving credit outlook, sound capital positions and ultra-low rate outlook, banks have signalled that competitive pressures are to remain intense. While Macquarie believes the bank sector’s performance is likely to be supported by macro themes in the near term, the longer-term fundamental outlook remains challenging.

Positives from the reporting season 

Better-than-expected credit quality was the recurring theme throughout the recent reporting season.

Credit Suisse points out balance sheets for the majors benefitted from lower risk weighted asset (RWA) balances. This in turn resulted in a rise for bank CET1 (tier one capital) ratios. The less risky an asset, the lower the risk weight, and less capital is required to maintain minimum capital (solvency ratios).

In a further positive, banks have highlighted improved mortgage deferral trends, with deferrals down around -60-70% relative to the peak. Credit Suisse points out Commonwealth Bank of Australia ((CBA)) has the highest remaining deferral balance given its larger mortgage portfolio. 

In addition, banks reported improved business deferral trends, with deferral balances down circa -70-90% from the peak. National Australia Bank ((NAB)) is the most exposed with around $5bn of SME deferrals remaining.

Drilling down to the ‘real’ results

The banks delivered disappointing pre-provision results in the second half FY20, according to Macquarie. (As most readers would be aware, the financial year closes for Commonwealth Bank on June 30, while the remaining majors close on September 30).

The disappointing results were driven by declining revenues and higher expense growth. Three of the majors (excluding Commonwealth Bank) saw pre-provision earnings decline by -2-12%, with ANZ Bank ((ANZ)) performing better than peers.

Banks' revenue performance was even more disappointing after excluding more volatile markets and trading income. Underlying pre-provision earnings excluding markets income declined by around -6-17% in the second half FY20, with NAB delivering better trends than peers.

Effect of a vaccine

Recent news of potential vaccines was a clear positive for value and cyclicals. However, Citi warns the vaccines still need to be fully approved and logistics navigated. It’s considered asset quality faces its true acid test when government stimulus begins to taper.

UBS believes credit charges could fall sharply with the positive vaccine news. This likelihood gains further momentum when one considers the substantial policy support directly targeting both the housing market and SME employment.

When will dividends normalise?

Citi thinks APRA’s new guidance on dividends (which the broker expects to be delivered sometime in January) will reflect the reality of the outlook. 

Since the cap was first put on, we have seen a material build in capital, a rapid return to repayments for the majority of the deferred loan book and government stimulus delivering a material boost to the household sector. 

In short, asset quality has performed better than expectations and the banks have built capital responsibly.

The last piece of the puzzle is the regulatory forbearance on recognising impaired loans in capital. However, that relief is set to expire in March, and with that expiry the broker sees little further justification for regulator imposed dividend restrictions. 

As a result, Citi expects dividend payout ratios to begin to normalise from the second half of 2021.

FY23 offers prospects for the combination of normalised bad debts and payouts. On that basis, the broker sees dividend yields of around 6-7% across the sector. This looks attractive relative to other income stocks, many of which are sub-5% yields, and often without franking.

For the retail investor, the attractiveness of these cash yields is boosted by the addition of franking credits, as well as the comparison to deposit products which have followed the cash rate down.

Lending in a pandemic 

Trends within certain lending sub sectors provide some insight into the psychology of individuals and entities during a pandemic.

Mortgage credit growth has showed slight improvement by rising 1.1% across the majors in the second half of 2020, points out UBS. 

On the other hand, non-housing lending growth was negative across the majors in the second half FY20, as some borrowers repaid drawn facilities during the first half. 

Every bank saw their personal loan books contract. Personal loan and credit card run-off accelerated as customers used government stimulus and superannuation withdrawals to pay off debt.

Interest-only lending across the sector continues to fall and Macquarie notes the proportion of interest-only loans has reduced by around -15-30% since the first half 2017.  Also since that time, UBS notes SME business loan growth has been stagnant for the major banks.

Meanwhile, institutional loans declined sharply as corporates that drew down liquidity at the onset of covid-19 raised equity and debt capital over the second half of FY20.

Revenue and Expense Takeaways

Banks are seeing lower levels of customer activity and transaction volumes leading to lower non-interest income. Banks have also given fee waivers to support customers during covid-19 leading to further decreases.

Despite the challenging revenue environment, Macquarie notes banks have been unable to reduce expenses as investment spend requirements have continued to grow for technology, risk, and compliance.

Credit Suisse agrees on technology and highlights write-downs of capitalised software balances. Nonetheless, the broker forecasts tailwinds going forward as a result of investments in technology and productivity initiatives.

Conclusion

After a reporting season that was best characterised as a beat on asset quality and capital, and positive sentiment surrounding a vaccine, momentum is currently with investors in bank shares. Whether this impetus can be maintained will likely depend on vaccine approval and delivery logistics in the short to medium-term.

Fundamental to the ongoing investment thesis, however, is how the ongoing suppression of interest margins and ever increasing competitive headwinds play out for the banking sector.

Tha table below indicates broker preferences and consensus data. In terms of ratings (Buy, Hold, Sell), it must be acknowledged that some brokers rate banks stocks relative to the ASX200 and others relatively among the bank stocks.

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
ANZ	7/0/0	21.72	22.24	1.35	20.7	51.2	56.6	4.1	13.4	35.6	67.7	5.6
WBC	6/1/0	19.02	20.37	5.12	100.0	100.0	58.0	4.4	7.1	30.3	70.5	5.7
NAB	4/1/2	21.84	20.77	– 6.77	19.2	42.6	59.4	3.8	8.0	28.9	70.8	4.9
CBA	0/4/3	75.39	68.59	– 10.94	– 0.4	– 10.6	64.7	3.5	7.6	22.6	73.8	4.2

When FNArena last updated the table in May, mid-lockdowns, the net order of preference was NAB, ANZ, Westpac ((WBC)) and CBA. Most notably back then, all earnings per share and dividends per share growth forecasts were to the negative, and APRA had placed restrictions on dividends. Coming out the other side (South Australia notwithstanding), those numbers look at lot more healthy — indeed more healthy than they've ever been — but that's coming off a very low base (including previously deferred or heavily slashed dividends).

The standout on the table is the seven for seven Buy ratings for ANZ — a first for any bank (in the history of this table). This despite Westpac showing greater upside to target. CBA is always, at the bottom, because bank analysts for decades have refused to afford the biggest bank a premium for being, well, the biggest bank. With only the very odd exception, CBA is always least preferred on a valuation basis.

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