Summary: Banks are inherently capital intensive businesses that constantly need new equity to grow their lending books. Banks manage the issue by offering dividend reinvestment plans and large capital raisings, which have been sustained by high bank share prices. But if a bank is struggling, the share price will likely be low, resulting in increased dilution at the next capital raising.
Key take-out: A combination of subdued earnings growth, continued share dilution and lower bank share prices is likely to lead to lower dividend per share growth in the future and a reasonable possibility of reduced dividends.
Key beneficiaries: General investors. Category: Bank stocks.
It might sound a bit of a reach to compare Australia’s big four banks with a Ponzi scheme, but there are certainly parallels.
In its simplest form, a Ponzi scheme is where investors receive dividends or distributions from new capital provided to the scheme rather than from profit earned. The similarities come down to one little understood fact about banks: they are inherently capital intensive businesses that constantly need new equity to grow their lending books.
This point can be illustrated in a simplified example of Westpac’s capital ratios.
The banks use a measure known as Core Equity Tier 1 to ensure (for themselves and for APRA) that they are adequately capitalised. This is a ratio of the banks’ core equity capital to a risk-weighted measure of their assets. Westpac aims to keep this ratio at around 9.0 per cent.
During the 2014 financial year, Westpac’s risk weighted assets (RWA) grew by 7.4 per cent from $307.4 billion to $331.4bn as it grew the size of its loan book. To finance this growth in lending during 2014 and maintain its capital adequacy ratio at the same levels, Westpac required $2.2bn in additional equity.
In 2013, Westpac reported cash earnings of close to $7.1bn and paid out approximately 76.5 per cent of those as a dividend. That equated to a dividend payout of around $5.4bn, leaving about $1.7bn, or $0.5b short of the $2.2b required.
Hence, the bank needed new capital from investors to maintain its dividend payments to shareholders and still maintain asset growth, not unlike a Ponzi scheme.
There are a number of ways banks manage the issue. One is by simply offering dividend reinvestment plans (DRPs). These schemes automatically raise a substantial portion of the shortfall.
Another is large capital raisings. The banks can be a little bit sneaky here. Whenever a bank conducts a substantial acquisition it will almost certainly accompany it with such a raising. However, banks are also always selling off assets as well (the recent sell down of BT Investment Management by Westpac is an example). When they do so, they rarely return the capital to shareholders via share buy-backs or a capital return. These measures help add to a bank’s capital base.
It has also resulted in a large increase in the number of shares on issue for the major banks. From 2004 to 2014, Westpac increased its number of shares on issue from approximately 1.8bn shares to 3.1bn, an increase of 72 per cent. This is at odds with the banks’ stance on capital management 15 years ago. At that time the banks were focussed on reducing shares outstanding with significant buy-backs. Now the banks have embraced their capital intensive nature and issue shares at the drop of a hat.
One factor that has helped sustain this practice is – by worldwide standards – high bank share prices. Essentially, the higher the price that a bank can issue shares at when it raises capital, even if it is just the DRP, the less dilution to the number of shares on issue. This will have a positive flow-on effect to future earnings and dividends per share, so banks are highly incentivised to raise capital at the highest share price possible.
This has worked well while the banks have been reporting strong earnings and dividend growth. However, the converse also applies. If the bank is struggling then the share price will likely be low resulting in increased dilution at the next capital raising, compounding the negative impact on future earnings and dividend per share growth.
One thing that appears a constant is that the banks will continue to issue shares. So while the Ponzi scheme analogy might be a bit harsh, given the banks’ propensity to maintain high dividend payout ratios and fund lending growth, constant capital raisings are inevitable. They simply can’t finance their asset growth from retained earnings alone and maintain such high payout ratios.
There is nothing inherently wrong with these continued capital raisings. After all, it has been working successfully for many years. However, investors need to be aware that a combination of subdued earnings growth, continued share dilution and lower bank share prices is likely to lead to lower dividend per share growth in the future and (dare we say it) a reasonable possibility of reduced dividends.
Brad Newcombe is the head of research at Millinium Capital Managers.