The real reason banks are on a roll

If the banks can make record profits when they're having trouble lending, imagine how they'll go once the economy picks up. Between them they will have earned some $27 billion over the past year when NAB and Westpac report in the next few days.

No wonder the banks' market capitalisation, which takes into account the number of shares issued as well as the price, is also at a record.

It might be a stretch to say times are tough but very low interest rates haven't encouraged the borrowing binge that normally feeds them. On the contrary, more borrowers have just got ahead in their repayments. This drags down bad debt provisions and generates even more unneeded capital for the banks.

That's why they're like ATMs dispensing dividends. Indeed, much has been written comparing the return from their shares, which admittedly comes at a risk to your capital, with what you'll get on a term deposit.

Take CBA shares, which are the most expensive, both in price and value. Even they yield close to 7 per cent after you take the 30 per cent tax credit from franking into account. That's twice the pre-tax return from one of the bank's own term deposits.

Or if you'd bought the shares just before a dividend was declared and held them for 13 months, the grossed-up return - that is, after the franking credit and before tax - would have been more like 10 per cent. The reason? You'd be collecting three dividends. But wait, there's more. The extra month gives you the bonus of a 50 per cent discount on any capital gain when you sell.

There's still time for this with NAB or Westpac shares, since they're about to pay a dividend. But remember there's a real risk of the share price dropping, and bank stocks are due for a correction.

That's why many DIY super funds have been tempted into bank hybrids or converting preference shares.

It's true the values of these are unlikely to fall as far but then they only pay half the return. The banks even subtract the franking credit from the interest cum dividend they pay, something they'd never dare try on ordinary shareholders.

So on a hybrid such as CBA's Perls paying 6.4 per cent the bank only coughs up 4.5 per cent, leaving the taxman to make up the difference later.

The thing is, if you treat bank stocks like a five-year term deposit, which is to say you can't touch them, it's less likely you'll have the price pulled from under you. Besides, it's hard to imagine the share price dropping when dividends are rising, though when it comes to the sharemarket never say never.

And why would they keep rising?

For one thing, about a quarter of dividends are taken as scrip rather than cash. They're not quite self-funding, but they aren't as big a drain on capital as you'd imagine. Come to that, the banks are bulging with capital they don't really need.

This harks back to the global financial crisis, when they were panicked into building up their reserves. And because profits are increasing even when they aren't lending, the banks are generating more capital than they need. Analysts expect this will be returned to shareholders, probably the real reason bank stocks are on a roll.

More on bank shares in The Chartist, Page 6.

Read David Potts in Weekend Money, in

The Sunday Age this weekend.

Twitter @money potts