The big issue to watch in bank reporting season

Increased capital, restrained credit growth and lower interest rate spreads likely mean lower returns for bank shareholders. 

If you’ve ever wondered exactly how a bank makes money, the above image makes the point rather well.

Taken in a Suncorp Bank – owned by Suncorp (ASX:SUN) – branch last week, on the left is a leaflet promoting business loans at a rate of 4.39%. On the right is an advertisement for a term deposit paying 3%.

The difference between those sums, known as the ‘interest rate spread’, is one of the key factors determining how much money a bank makes. The higher the spread the more profitable a bank will be.

On top of the deposits it holds, a bank has to tip some of its own money (aka equity) into the pot which it lends out – to keep it honest, if you like. How much equity it has to tip in is determined by capital adequacy ratios (CAR), which express the bank’s capital (primarily its equity) as a percentage of its risk-weighted assets (read more about this here, if you must).

These ratios are set by bank regulators and, since the Global Financial Crisis, they’ve been going up. The idea is to make banks less risky by capping their leverage. Most notably, APRA has increased its requirements for the common equity tier 1 ratio (which measures shareholders’ equity against risk-weighted assets) and adjusted the risk weightings Australian banks must apply to their mortgages.

This has had several impacts. First, banks have been raising additional equity through rights issues, asset sales and underwritten dividend reinvestment plans, in addition to ‘hybrid’ debt products, which will convert into equity in extreme circumstances, like CBA PERLS, ANZ CPS and NAB Capital Notes. Chart 1 shows the overall impact.

Lower spreads

Second, increasing competition for bank deposits is putting downward pressure on the interest rate spread. My Suncorp teller, for example, told me that the rate paid on term deposits had increased twice in the last month alone. According to the World Bank, spreads in Australia have fallen from over 5% in 2006 to about 3% in 2015.

This downward pressure has been matched in the short-term by mortgage rate increases independent of the RBA, but it’s hard to imagine much more of this given the current political environment.

More capital and increased funding costs explain why bank shareholders can’t expect future returns to look as wonderful as they did in the past. Constrained credit growth and lower spreads – a direct consequence of regulators de-risking the banking system – mean less profitable banks.

As you’d expect, the sharemarket has taken account of these pressures, by knocking down the share prices of the big four banks by around a third since their peaks last year. With dividend yields now up around the 6–7% mark, valuations are beginning to look attractive, if earnings and dividends can be maintained and even grow a little.

Bank reporting season

That’s likely to be too big an ask for the weakest of the banks, ANZ (ASX:ANZ), which we expect to cut its dividend soon, if not tomorrow. At the other end of the spectrum, the higher quality (and our preferred) banks – Commonwealth Bank (ASX:CBA) and Westpac (ASX:WBC) – should be able to keep growth ticking along in the low single digits.

This will be the focus of James Carlisle’s analysis this week, with the biggest swing factor likely being impairment charges.

This morning Westpac announced an increase in its impairment charge to 21 basis points of average loans, from just 11 basis points a year ago, and ANZ has also ‘fessed up to a higher charge in its result to be announced tomorrow. NAB (ASX:NAB) will report its interim result on Thursday and CBA will report a week today. Look out for our updates.

In the meantime, many bank shareholders should get their head around the fact that we’ve entered a new normal and that past returns are not an adequate guide to future performance.

To get more insights, stock research and BUY recommendations, take a 15 day free trial of Intelligent Investor now. You can find out about investing directly in Intelligent Investor portfolios by clicking here.

Related Articles