Why near-term bank dividends should remain strong

Why near-term bank dividends should remain strong

We recently held a webinar to discuss our thoughts from the August reporting season. First, I would like to thank those that listened to the webinar. In this series of posts I would like to provide thoughts on some of the questions about the bank stocks that were asked by those attending starting by answering: What are your thoughts on the major banks for the medium and long term for their dividends?

Firstly, a breakdown of dividends, dividends are a function of the following:

Earnings per share (EPS) generated by the banks

Earnings have recovered from their pandemic lows, however most of the change is due to a reversal in provisions for bad debts. Provision charges increased materially in the pandemic as the banks brought forward coverage for an expected increase in defaults. With the economic fallout likely to be significantly less than initially feared, these provisions are now being written back. This has seen EPS go from below sustainable or trend levels last year, to above sustainable levels this year.

While provision write backs are likely to bolster EPS in the next few earnings periods, at some point they will normalise, with EPS moving back toward the sustainable trend.

In terms of the trend for earnings performance, the primary drivers are the outlook for credit growth (which is positive at the moment), net interest margins (which are likely resume their declines now that there is little room to re-price deposit rates down further), and operating cost growth (which remains stubbornly high due to compliance costs, investment and inflation offsetting efficiency benefits).

EPS is likely to moderate in coming periods as provisions return to normal levels.

The amount of surplus capital held

The major banks had already been building CET1 capital to meet APRA’s new ‘unquestionably strong’ requirements. Surplus capital has also been built up due to the rationalisation of business models back to core banking activities with the sale of wealth management and insurance manufacturing operations.

With economic risk normalising, capital returns are likely to remain a feature in the next 12 months as bank boards become more comfortable in reducing CET1 capital ratios toward the post ‘unquestionably strong’ target rate of around 11 per cent.

The outlook for earnings growth

While credit growth is accelerating with a strong housing market, and more recently, improved demand from business, this is likely to be offset by a return to downward pressure on net interest margins. Bad debt provision expenses will increase as the write backs of last year’s increase in overlays are completed. Efficiency gains are expected to accelerate in coming years, but the performance on operating costs has tended to disappoint due to stubbornly high growth in compliance and regulatory costs.

Overall, earnings growth remains challenging for the banks despite accelerating credit demand on a medium to longer term basis.

The return on equity (ROE) generated from incremental earnings 

As we have discussed many times, the return on incremental capital a company invests to grow its earnings is a major factor in determining the quality of business. This is because a company with high incremental returns on capital does not need to retain as much capital as a low return company, freeing up more of its earnings to return to shareholders or invest in acquisitions.

ROE has been under pressure due to falling net interest margins as a result of the low interest rate environment and increasing capital requirements. The capital intensity of a bank is essentially variable as a percentage of the value of its loan book (excluding the impact of changes in the mix of risk). Therefore, as credit growth accelerates, the banks will be required to withhold more equity to fund this growth. If net interest margins continues to fall, the marginal return on equity will remain under downward pressure unless costs can be reduced sufficiently as an offset. This would require an increasing proportion of the earnings to be retained to fund a given rate of growth, leaving less and less to return as dividends.

This is a bit of a lengthy answer, but I thought I would provide the various moving parts to help investors gauge the outlook for dividends in future.

In terms of the near-term outlook, dividends should remain strong while the provision increases from CY20 are being unwound, while further buy backs are also likely as the bank boards become more confident about the economic recovery, ASIC’s revisions to capital and risk weights are finalised later this year, and the proceeds from various residual asset sales are received.

You can watch the full webinar here: Montgomery’s reporting season review

The Montgomery Funds owns shares in Westpac and Commonwealth Bank. This article was prepared 07 October 2021 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.