Should bank investors be alarmed by the proposed levy?

Should bank investors be alarmed by the proposed levy?

The Federal Government’s proposed bank levy has opened up a battlefront with the major banks, not to mention shareholders and bank staff. On face value, the 6 basis point levy seems relatively benign. But we think it will increase investment risk in an already overvalued sector.

The Federal Government surprised the major banks last week with a new levy that is budgeted to raise A$6.2b over the next 4 years, including A$1.6b to be raised in the year to 30 June 2018. As part of the Government’s ‘Fairer and more accountable banks’ initiatives, it will charge a 6 basis point levy (charged at 1.5 basis points quarterly) on banks with liabilities over A$100b. The levy will apply to all bank funding other than additional tier 1 equity and deposits covered under the Financial Claims Scheme (FCS). The FCS was established by the Federal Government to protect depositors from potential loss in the event of the failure of an authorised deposit taking institution. It applies to aggregate deposits for each account holder up to a limit of A$250,000.

The A$100b threshold means that the four major banks plus Macquarie Bank will be covered by the legislation.

Given the budgeted A$1.6b of revenue to be raised in FY18, the 6 basis point levy would need to be applied to at least A$2.5 trillion of liabilities. To the extent that the levy is deductible from a bank’s corporate tax liability, the pre-tax amount of the levy would need to be higher than the net receipts budgeted (ie more than the forecast A$1.6 billion of net revenue) to account for the reduction in corporate tax payable. Offsetting the net impact of low corporate tax payable, there is a resulting reduction in the value of franking credits utilised by shareholders as a result of the reduction in tax payable.

The details on how Treasury arrived at a 6 basis point levy raising A$1.6b a year have not as yet been released. Suffice to say, the precise detail regarding how the levy will work has not been released by the Government yet.

However, if we assume that the A$1.6b of after-tax revenue is realised a year by the Government, this would need to be increased by around A$690m as a pre-tax change to offset the deduction from corporate tax, less the proportion of franking credits that are utilised by domestic shareholders. Assuming that around 80% of franking credits released through dividends are utilised and that the dividend paid falls by the amount of the reduction in profit resulting from the levy, the net tax offset would be around A$138m (20% of the A$690m reduction in corporate tax payable), meaning the pre tax levy charged would need to amount to around A$1.74b to raise A$1.6b of revenue on a net basis.

The question that has primarily occupied the press commentary has been who should and will pay this tax.

The Government has repeatedly stated that it believes the banks should ‘absorb’ the cost of the levy. What this actually means is that shareholders should bear the cost through lower dividends. Essentially, the Government is suggesting that the levy should really be an additional tax on the ‘excessive’ returns earned by anyone that owns shares in the major banks and Macquarie.

In terms of the impact the levy would have on dividends if the levy were to be ‘absorbed’ by shareholders, it must be remembered that dividends are a function of the amount of surplus capital a bank generates in a given year in excess of the amount of profit it needs to retain to fund future growth. The levy does not impact the dollar amount of profit the bank will need to retain to fund future growth, unless it is assumed that the levy negatively impacts the growth outlook. Therefore, the whole A$1.6b of net tax receipts payable to the Government would need to flow through to a reduction in annual dividends if the banks do not take measures to offset its impact on earnings.

Over the last 12 months, the four major banks and Macquarie have paid dividends totalling A$22b. Therefore, if the entire levy were to be ‘absorbed’ by shareholders, the income generated by shareholders in these companies would fall by around 7% in aggregate going forward.

The alternatives are for the levy to be either passed on to customers through higher lending rates, lower deposit rates or higher fees, or to be offset by incremental cost reductions.

According to the most recent APRA statistics, the aggregate gross loan and advances balance for the four major banks and Macquarie totalled A$2 trillion at the end of March. In order to fully pass on the entire pre-tax levy charge of around A$1.6b, the average lending rate on Australian loans would need to rise by around 8 basis points. However, given that the banks have far lower levels of pricing power in the corporate and institutional market, they would need to reprice consumer and SME loans more significantly than 8 basis points to recover the cost of the levy.

The ABA has also suggested that deposit rates could fall to fund some of the levy payments. This does not make a huge amount of sense. The levy is charged on wholesale funding, with deposits under A$250,000 exempt from the Government charge. For a bank, the levy makes wholesale funding incrementally more expensive relative to retail deposits. The lower relative cost of retail deposits is more likely to lead to increased competition between the major banks for this source of funding. As a result, interest rates on retail deposits would be expected to increase marginally on the back of the levy.

Fees could also rise, but the banks have had difficulty raising the level of fees over the last few years.

Last, there is the potential for the banks to recoup the levy by reducing operating costs. The impact of the levy on profitability could see the banks step up their focus on reducing operating costs. The banks are already investing heavily in technology, which provides both a revenue benefit through improved products and services, as well as lower costs by replacing labour with automation. Any step-up in investment is likely to focus on replacing lower paid jobs with automation.

From an investment perspective, the introduction of the levy is a negative. Even if the banks can mitigate the impact on profits by passing the cost onto customers and reducing operating expenses, the stocks were previously priced for growing net interest margins acting as an offset to slowing loan book grow now that the long term structural decline in interest rates ended. Weak fee growth compounds the anaemic outlook for net interest revenue growth. If the banks need to lift lending rates to merely offset a further increase in funding costs, it uses up some of the potential for re-pricing that was otherwise expected to drive profit growth.

It also flags heighted political focus on the banks, increasing the risk attached to any further out of cycle rate increases.

As was experienced in the UK, once a levy was brought in, increases became a politically expedient way to raise more budget revenue in subsequent budget periods.

Consequently, the levy changes the outlook for margins and ROE for the banks, coming on top of the impact of ongoing increases to capital requirements.