From Morgan Stanley:
We believe in general, retail investors hold too much of their portfolios in the major banks (ANZ, Commonwealth Bank, NAB and Westpac). We hear from investors that they are unwilling to part with their bank holdings because they have generally been such steady performers and pay attractive, fully franked dividends. While that view has been correct for a very long time, we believe the Australian banks are now at a crossroads where, at the minimum, investors should consider reducing their exposure.
We see the Australian banks facing three key risks: the need for more capital, ongoing margin pressure, and the risk of rising bad debts.
More Capital
The Australian Prudential Regulation Authority (APRA) is the body responsible for regulating the banks. Following the December 2014 release of the details of the Financial System Inquiry, APRA adopted the recommendation for the banks to have capital ratios that are “unquestionably strong”. However, APRA has yet to define what this means.
Morgan Stanley believe that APRA will set the Common Equity Tier 1 ratio (CET1) target at 10% versus the current average of 9.2% which should position the major banks in the top quartile of international banks. This means the major banks will need a capital build of approximately $17.5 billion in 2017.
Margin Pressure
Typically, when the Reserve Bank of Australia (RBA) cuts interest rates, the banks can protect their profit margins by lowering the amount they pay out on deposits. In this fashion, banks can protect their profits (or spread) by adjusting the rate they borrow at (the amount they pay savers) and the rate they lend money at (the amount they charge borrowers).
However, with the interest rate on savings accounts already at or very near zero, the ability for banks to manage their spread is diminishing. As such, Morgan Stanley estimates that every 0.25% cut by the RBA from here will reduce bank profits between 1.5% to 2%.
Further hindering their ability to manage their spread, there is an ongoing term deposit war between the banks. Spreads are getting squeezed as term deposits are little changed, and mortgage rates have moved lower since the last RBA interest rate cut in May. Morgan Stanley estimates that every 0.25% reduction in term deposit related spreads will reduce bank profits between 1.9% to 3.1%.
The banks are also facing fierce competition in their mortgage lending business. There is ongoing, aggressive discounting occurring within standard variable rate mortgages, which represent about 80-85% of their total loan book. Since December 2015, the average discount has doubled from 0.4% to 0.8% with some extreme discounts up to 1.4%. Morgan Stanley estimates that for every 0.1% reduction in the rate the banks
earn on their variable rate mortgages, profits would reduce by 2.5%.
Lastly, banks face margin pressure from their wholesale lenders. Australian households are encouraged to lend capital to banks with term deposit rates. Conversely, wholesale lenders watch the difference between the 3- month Bank Bill Swap Rate (BBSW) and 3-month Overnight Indexed Swap Rate (OIS). The difference between the BBSW and OIS has been getting wider meaning it becomes more expensive for the banks to borrow from wholesalers. For the six months ending June 2016, the difference has averaged 0.33% which is up from the six months ending December 2015 average of 0.25%. Morgan Stanley estimates that every 0.25% the difference expands, bank profits will fall between 6% to 6.5%.Bad Debts
Except for the period during the Global Financial Crisis, the major banks have enjoyed benign bad credit conditions. While Morgan Stanley is expecting credit conditions to remain relatively healthy, there is growing evidence of credit weakness in the economy. Banks speak of “pockets of weakness” in the economy as the resource sector continues to retrench. We have already seen impairment charges as a percentage of non-housing loans rise from 0.39% in FY15 to 0.54% in the first six months of FY16 (see Exhibit 1). Morgan Stanley is expecting these charges to continue to grow as the economy experiences a mild deterioration. Morgan Stanley estimates that every 0.25% increase in impairment charges will reduce bank profits by 5.5%.
That pretty much sums it up. I would simply add that the high payout ratios dictated by the dividend strategies mean amplifies the impact of all of these crimps on profitability. The banks simply have no fat to absorb headwinds.
MS reckons you should buy REITS instead for yield, which looks rather like a bubble to me already. Or, a spread of other yielding shares. To me, cash looks good for yield. Sure the returns are low right now but the risk is zero and we’re at that point in the cycle when risk matters.
