Where the money isn't

Investments
Anthony Aboud

Anthony Aboud

Portfolio Manager
I rob banks because that’s where the money is.

Willie Sutton


There is a lot to like about the big four Australian banks. They are in a select club of global lenders with AA- credit ratings from S&P, dominate domestic market share and generate significant earnings from the residential housing market.

Then there’s the dividends – on average 6% fully franked. That’s appealing when you consider the Reserve Bank has reduced the official cash rate to 1.75% and our 10 year bond yields have fallen to the lowest levels on record.

So it comes as no surprise that investors have turned to bank shares as a source of income in a low yield environment. When bank deposits are paying interest of around 2.8%* and dividends are returning 6%, surely the smart money flows out of bank accounts into bank shares?

On face value it may seem like a clever way to secure a future income stream. But should investment decisions be based on the dividend a particular stock is likely to pay?

I don’t think so. The current levels of bank dividend payments are simply unsustainable. And here’s why…

Regulatory headwinds will strengthen

In my view the Australian Prudential Regulation Authority (APRA) will require banks to increase the amount of capital they hold – this should reduce their capacity to keep up future dividend payments.

APRA requires banks to hold capital to protect against:

  • Liquidity risk – banks need an equity buffer to protect depositors from a liquidity crisis should people all want to withdraw their money at the same time – commonly called a ‘bank run’.
     
  • Solvency risk – if a bank has a sharp increase in bad loans the value of its assets falls and there is less shareholder equity. Banks need some of their own capital (cash etc) to protect against this solvency risk.   

There are many different tools which APRA uses to enforce the amount of regulatory capital required to be held. The main ratio that the regulator and banks focus on is the common equity tier 1 ratio (CET1 ratio). In Australia this is required to be above 8% although most banks mandate a buffer of at least 8.8%.

The big issue is whether or not risk weightings will continue to move higher or the minimum CET1 ratio will be set at a higher rate. I believe that both scenarios are extremely likely given market conditions and regulatory pressures. Both of these options require the banks to increase the amount of equity held and aside from issuing more shares, their most obvious response to that scenario is to cut dividends.

Dividend policy too high at this end of cycle

Banks are cyclical businesses. Many in Australia don’t appreciate this given the 24-year bull run in property prices that the banks have enjoyed. In a weaker economy, not only is the probability of mortgage default higher, but also the value of the collateral behind those loans is likely to be lower. That means provision for bad and doubtful debts is likely to increase sharply in a weakening market – with a consequent drop in bank earnings.

My view is that good long term capital management policy for cyclicals like banks should be to put some capital aside during the good times so they do not need to raise equity at depressed prices (resulting in dilution when the share price is at its worst).

The banks are not doing this.

A complicated table with a clear message

Not only is very little being put aside for a rainy day, the current dividend policy (with the exception of ANZ) is eating into the capital being generated. The table below shows the movement in the CET1 capital ratio from the H1 16 results. On the positive side of the ledger, the cash the banks are earning increases bank capital. This figure is offset by growth in risk weighted assets – which requires more capital to be held – as well as other capital deductions. The result is the total organic capital generated – an amount from which the bank pays the dividend.

If you look at the percentage of organic capital paid in dividends, you will see it is more than 100% for the NAB, CBA and WBC. They are paying out more in dividends than they are generating in organic capital. So their dividend policies are eating into their capital base.

H1 16 Movement in CET1 capital Ratio (bps)
NAB
ANZ
CBA
WBC
Cash Earnings
83 87  122  107 
Risk Weighted Assets Growth
-10 -28  -22 
Other/Capital Deductions
-10  -12 -15 -13
Total Organic Capital Generated
63 76
79
72
Dividend Paid (Gross of DRP) – H2 15
66
70  94 82 
Organic Capital Generation (post dividend)
-3 6 -15 -10
% of Organic Capital Paid in Dividend
105% 92%  119%  114% 


There are a few of points worth making:

  1. Dividend Reinvestment Plan (DRP) not included 
    I haven’t included the Dividend Re-investment plan when looking at organic capital generation. An underwritten DRP is just another name for an equity raising and to me raising equity to pay a dividend is like robbing Peter to pay Paul.
     
  2. Negative organic capital generation 
    The banks (except for ANZ) are paying out more dividends than the capital being generated. While there is nothing wrong with this, it is not sustainable. If banks continue to pay dividends higher than the capital being generated, they will need to raise equity through DRPs or more capital raisings which will likely further dilute returns on investment in the long term.
     
  3. Banks should be preserving capital
    Bad loans are made in good times and the markets seem to miss the point that banks are cyclical businesses. We are currently at a relatively low point as far as bad loans are concerned. During these periods of cyclically high profits, the banks should be putting capital aside for the bad times. If they don’t do it themselves, the regulator will likely force them to.
     
  4. No consideration for future changes in capital requirements 
    Dividend policies aren’t factoring in the probability that the regulator will likely want more capital in the future. This has repeatedly been proven as a wrong assumption. To be fair to the banks, this is very hard to predict, and you can’t plan your business based on what the regulator might or might not do. However, I would argue that given this regulatory uncertainty, a management team doing some long term thinking should put more capital aside – and do now.

 

Implications for investors

When considering the likelihood of further regulatory capital requirements I believe that the banks are materially over-paying dividends. While there is no immediate threat of a credit crunch we believe that some of the lead indicators are indeed worrying, specifically the explosion of apartments being built in parts of Sydney, Melbourne and Brisbane. So I think the argument that dividend yield is a good reason to buy the banks is dangerous over the medium term.

As my colleague Nathan Parkin explained in a recent video, at Perpetual, we look beyond short-term factors (like high dividends) at the underlying quality of a business. That’s because it is the quality of a company’s management, franchise and financials that determine how sustainable dividends really are. In our view the Australian banks are now nowhere as attractive as their dividends make them look.


*1 year term and a deposit amount of AUD$10,000, as per www.infochoice.com.au, 24 November 2015

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