What Lies Ahead for the Big Bank Stocks?

In case you missed it, the Royal Commission into banking started in earnest this week. After such a big lead up, the whole thing started with barely a whimper.

That could be for a couple of reasons. Perhaps it got lost in the turmoil that has swept the markets.

Or maybe it’s because for one side of politics, the mere existence of the commission already spells victory. They can now move on to something else.

No doubt they won’t resist the urge, though, to pepper the government with any new stories of misconduct that the commission brings to light.

As investors know only too well, the uncertainty over whether there should be a commission put a lead weight over bank stocks last year. While overseas markets were breaking to new highs, the heavily bank-laden Aussie market struggled to move higher.

However, it wasn’t only a potential Royal Commission that put a cloud over the banks. Banks have been fighting on other fronts as well.

Bank overseer APRA (Australian Prudential Regulation Authority) had already moved to curb interest-only loans. On top of that, banks have been dealing with a cooling property market — not the crash, mind you, that some have predicted.

All the while, banks have had to bump up their capital to meet international standards.

Despite these challenges, however, the banks have been able to pump out handy profits for their investors. But could this all be about to change?

Setting the tone

Banks are the backbone of many investors’ portfolios. Their steady and growing dividends have been a boon for income investors. They are our biggest dividend payers.

The Commonwealth Bank of Australia [ASX:CBA] is not only the biggest bank, it is Australia’s largest company as well.

Because of that, it not only sets the tone for other bank stocks but the broader market as well.

Hidden among the turmoil last week was CBA’s half-year result. It is clear that the Royal Commission is very much on its mind.

Departing CEO Ian Narev conceded that the bank had made mistakes. No doubt the Royal Commission will take off another layer of skin.

However, the other thing the CEO noted is that the bank is in a period of lower growth.

CBA’s statutory profit, or accounting profit, rose 1.2%. However, its cash profit fell 1.9% to $4.7 billion.

And perhaps the thing CBA was most celebrated for — its incredibly high return on equity (ROE) — is also coming back to earth. 

CBA’s ROE was pushing 20% a few years back. The latest results show it is now at 14.5% — down 1.2% from a year ago. This reflects the additional capital banks have to carry.

However, you can also see in the following table that CBA’s interim dividend has plateaued over the last few years (red oval). Note: CBA went ex-dividend yesterday (14 February). The real growth stopped after the first half of 2015.

CBA half-year dividends

CBA half-year dividends

[Click to enlarge]

The table shows CBA’s one-cent increase in its dividend from the previous year. That works out to be about a half of one percent. To do this, however, CBA had to lift its payout ratio from 70% to 72%.

It needed to increase this ratio, even though its margins improved during the period. That is, the difference between what it lends and borrows at rose 0.06% to 2.16%.

It also came in a period when the number of customers in arrears was lower than a year ago.

It’s all about yield

The other thing that could cost banks more in the future is funding. The money CBA uses to lend comes primarily from its depositors. That is, term deposits, cash management accounts and the like. It also includes those accounts that barely pay a morsel of interest.

As at 31 December, this accounted for 68% of CBA’s funding. The rest they borrow (by issuing bonds) offshore. The very thing that spooked the market — higher bond yields — could add to this cost as lenders (bond buyers) seek a higher return in the future.

That means, for the banks to keep growing profits, they will now need to focus on costs more than ever. And that’s exactly what we saw when National Australia Bank Ltd [ASX:NAB] released its results in November last year.

Coinciding with the announcement of NAB’s $5.3 billion profit came news that up to 6,000 jobs will go. As the banks adopt new technology, it says it will need less people on the ground.

To be clear, I am not a bear on the banks. They continue to mint profits year after year despite their mistakes, many of which stem from dud offshore expansions.

However, trying to match the growth of years gone by is going to become increasingly difficult. And that’s why income investors can’t rely solely on the usual favourites — like banks — for all their income needs.

They will also need to look for the next generation of income payers, like we do at Total Income.

All the best,

Matt Hibbard,
Editor, Total Income

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years. Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

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