Markets: Bring on the banks

Tomorrow, Commonwealth Bank will be the first of the majors to report and all eyes will be on dividend policy amid an escalating residential mortgage lending battle.

Bank profit season kicks off tomorrow, with the most popular bank among retail holders, Commonwealth Bank of Australia (CBA), leading the way.

CBA has maintained its popularity with investors by being one of the dividend darlings and share price performers of the market. They have pleased investors with their semi-annual gift, with dividends steadily increasing since their reduction in 2009 at the height of the global financial crisis.

There is speculation CBA could pay a special dividend this half-year, delivering some extra cash to investors. Depending on final profit figures, this will ultimately be determined by their franking credit balance as they wouldn’t want to hinder offering franking credit with future ordinary dividends.

With the Reserve Bank trying to spur growth we now have historically low interest rates which are tipped to help domestic home lending recover. This is set to spur banks' residential mortgage lending.

Yesterday we saw National Australia Bank (NAB) aggressively target mortgages, offering $1000 cash back on refinanced home loans and also waiving the $600 application fee – two welcome gifts going to mortgage holders for simply refinancing.

With interest rates falling to 50-year lows, the strategy from NAB is timely. Historically speaking, in period of lower interest rates borrowers are inclined to repay their loans quicker, shrinking the balance of loans outstanding and exposing the banks to contraction risk. To replace mortgages repaid and keep their loan books balanced, it requires some creative thinking on the banks behalf – NAB have hit the ground running on this.

Maybe the RBA hasn’t thought of contraction risk. They have plans for you to spend your new-found cash on clothes, movies or restaurants.

Australia’s largest bank, CBA, has the most exposure to low-cost deposits which equates to funding cost advantages compared with its competitors. The cheaper financing has meant a better total return to investors. Looking at revenue growth since the second half of 2010, CBA has outshone its peers.

Share price performance over this time has CBA gaining 57 per cent, giving more to investors than any other bank. Only Westpac is the other major to beat the banking index, putting on 50 per cent against the index's 45 per cent.

Westpac actually led the way in giving something extra to mortgage holders – they cut their standard variable rate more than the 25 basis point rate cut last week. It was a great public relations exercise for them, but it only brought their standard variable rate just under 6 per cent, still the highest of the big four.

The risk to the banking sector is going to be falling net interest margins. With falling interest rates locally and globally depressed rates, combined with falling yields on assets, lower net interest margins are likely. As an investor in any bank, this matters – bottom line is falling profitability.

One surprising thing, looking at APRA data, is that insolvencies are actually down 0.8 per cent year-on-year. Economic conditions have been tough, particularly in mining-focused areas, so it is pleasing to see this is not increasing. However, this could become more relevant next reporting season.