The Dilemma For Bank Investors

Australia | Nov 18 2020

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.

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