Westpac and NAB Cut Dividends…What’s Next for ASX Bank Stocks?

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The big four Aussie banks have been front and centre of the news cycle for the last couple of years. Unfortunately, for them and their shareholders, it has been for all the wrong reasons.

Fees for services never rendered — including those deceased — grabbed plenty of headlines. Plus, a swag of other scandals rocked the banking sector as the royal commission ran its course.

With the banks having reported results since the commission’s findings, the costs are now plain to see. The big four have set aside billions of dollars to remediate their customers. Some estimates put this at nearly $9 billion by the time all actions have run their course.

This cost of remediation has taken a big chunk out of banks’ profits. Both Westpac Banking Corp [ASX:WBC] and National Australia Bank Ltd [ASX:NAB] saw their full-year profits dive 16% and 13.6% respectively.

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By comparison, ANZ Banking Group [ASX:ANZ] survived the fallout from the commission better than both NAB and Westpac. However, it too will pay out over $500 million in compensation.

While ANZ announced it would maintain its dividend, the franking component dropped from 100% to 70%. The next big question is whether the Commonwealth Bank of Australia [ASX:CBA] will be able to maintain its dividend when it delivers its half year results early next year.

Remediation is an expensive business. And not just in financial costs. With millions of customers involved, it is also extraordinarily time consuming.

The Australian Financial Review (AFR) reports that NAB have increased the number of staff to meet this huge demand — from 575 to 950.

While these costs are huge, they are in the main, one-offs. Once customers are fully compensated, these costs to the banks are gone.

With the costs of remediation stealing the headlines, the results belie something much bigger. That is, if you take out the costs of remediation, banks were already feeling the pinch.

Fighting on multiple fronts

Growth in banks’ lending has struggled since the heat evaporated out of the property market two years ago.

A recent pickup in auction clearance rates has been encouraging. However, new residential construction has fallen off a cliff.

In its most recent data, the Australian Bureau of Statistics (ABS) showed a dramatic drop in new dwellings. From September 2018 to 2019, new dwelling approvals dropped over 20%.

From the banks’ perspective, that’s a whole lot of people not applying for new loans. However, it is not just a slowdown in construction that is taking its toll on the banks.

Banks make their profits on their margins. That is, the margin between what they borrow at, and the rate at which they lend. It is called Net Interest Margin (NIM), and analysts watch it like a hawk.

The goal of the bank is naturally to make as much margin as the market will allow. If they try to gauge their borrowers too much, they will likely take their business elsewhere.

NIMs have increasingly come under pressure. First, from the aforementioned softening property market. And second, low interest rates. As rates have fallen, pressure on margins has increased.

While banks have tried to maintain their dividends — and grow them — they have reached a point where they have become unsustainable for some.

We’ll find out early next year what CBA will do with their dividend. As I mentioned above, ANZ was able to maintain its dividend this time — albeit, with lower franking.

However, both NAB and Westpac have had to make a cut. And it might not be the last. To maintain (and/or increase their dividend), the banks have continually had to increase their payout ratio to keep investors content.

However, there is another issue banks must deal with.

Another metric at play

Over the last decade, bank profits and dividends have headed one way in the main…up. However, over the last decade, one key metric was heading the other way.

Sure, it’s something that might not make a headline — especially when profits take a hit. But nonetheless, it highlights another factor banks are having to deal with. And that is, their return on equity.

Australian banks huge return on equity (ROE) was once the envy of the banking world. Just over a decade ago, they were pushing 20%.

As the latest results have shown, though, ROE has also taken a hit. For Westpac, ROE is currently 10.75%, with ANZ slightly higher at 10.9%. NAB’s is the lowest of the four at 9.9%.

CBA has typically enjoyed a higher ROE than its peers — 15.7% as of its results earlier this year. As the biggest bank on the ASX, investors will keenly await to see if CBA can maintain that into the future.

At first glance, a high ROE might seem like a good thing. After all, who wouldn’t prefer a high ROE over a low ROE. However, there is another component to it…debt.

If a company is carrying large levels of debt, combined with a low level of equity (shareholders’ funds), it can artificially inflate the ROE.

In other words, it can make the company look like it is in a better financial position than might actually be the case. Even if margins remain strong, a string of loan defaults (or arrears) can quickly burn a hole in that shareholder equity.

Managing risk

To help manage this risk, major banks worldwide adopted guidelines set out in Basel III — named after the Swiss city in which the bureaucrats of the Bank of International Settlements (BIS) meet.

In order to provide better protection, Basel III meant banks had to raise more capital. That is why we saw a range of banks undertake capital raisings as the first deadline approached a few years ago.

While the capital ratios of Australian banks remain among the highest in the world, it doesn’t mean they are immune from potentially having to raise more capital in the future.

In conjunction with its recent results, Westpac announced a $2.5 billion capital raising. By issuing new shares as part of its dividend reinvestment plan (rather than pay out cash), NAB has avoided the need to raise capital for the moment.

Both ANZ and CBA appear to have enough capital for now. But it is something that could change in the future.

So what next for the big four banks?

Whether we like it or not, almost anyone with superannuation will likely have a holding in each of the big four banks. As the big four represent around 30% of the index, any index-based fund will need to have a holding in each.

And while banks share prices are not much different to where they were a decade ago, they have maintained one thing in nearly all that time…regular dividends.

With interest rates at record lows, and term deposits paying a pittance, all those juicy dividends have helped investors supplement their income.

However, as we have discussed, banks are fighting on many fronts. Not least of all is capital. If they need to hold onto capital, that may mean further reductions in dividends.

There is also the issue of margins and low rates. If NIMs continue to be squeezed, and rates remain low (or go lower), it will be even harder for banks to maintain their profits.

Add in a slowing construction market — and a mixed bag for existing household stock — it is hard to see how banks can match their previous record of growth.

Those that run the banks know all this already. None of this is new. The market has already factored this in, as well as prepared itself for lower growth and dividends too. It might just be that banks surprise to the upside over the coming years. Ultimately, however, it is the strength of the economy that will determine how they fare.

In the meantime, banks will concentrate on things they can control, like trimming costs out of their business. Unfortunately, as forecast by the banks already, this could mean cutting a swathe through their number of staff.

And while still smarting from the royal commission for now, banks will get back to what they do. Selling products for profit.

Sure, their share price growth might not match what we’ve seen in the past. However, with a yield more than four times higher than those available on term deposits, they will likely remain a favourite for those chasing yield.

All the best,

Matt Hibbard,

Money Morning

PS: Check out this free report to discover five little-known dividend payers for 2020, that could boost your income big time.

About Matt Hibbard

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