Some time in the next few days, weeks or perhaps even months, our major banks will learn whether they need to raise more capital, and if so, whether they will have to undertake a dilutive equity capital raising to achieve this.
How do I know this? That’s because APRA Chairman, Wayne Byres, has said that APRA will complete its thinking on what “unquestionably strong” means and set out a timetable for the banks to achieve this.
Back in February, Byres said:
“The main policy item we have on our agenda in 2017 is the first recommendation of the Financial System Inquiry: that we should set capital standards so that the capital ratios of our deposit-takers are ‘unquestionably strong.’ We have been doing quite a bit of thinking on this issue, but had held off taking action until the international work in Basel on the bank capital regime had been completed. Unfortunately, the timetable for that Basel work now seems less certain, so it would be remiss of us to wait any longer”.
In April, he expanded on this saying:
“Our plan is to issue an information paper around the middle of the year, which will set out how we view the banking system through the various lenses that I have just mentioned, the extent of further strengthening required, and the timeframe over which that can be achieved in an orderly manner.”
Apart from becoming more profitable and generating capital organically, banks can improve their capital position through a number of means. Firstly, by selling non- performing or poorly performing assets or businesses, and redirecting the capital to more profitable activities. Secondly, they can reduce their dividend payout ratios and retain more capital, rather than pay it out to shareholders. An alternative (and less painful option) is to run dividend re-investment plans and not act to neutralize them. Finally, they can issue new shares through a rights issue (as each of the majors did in late 2015 – see table below).
2015 Bank Capital Raisings
* Institutional investors paid $30.95. Retail investors participated in subsequent share purchase plan, capped at $15,000, and paid $26.50 per share.
The importance of the impending APRA announcement is not whether they will need to boost their capital ratios (which is expected) but the quantum of the boost and the time they will be allowed to get there. If only a moderate boost is required, the banks should be able to get there by doing what they have been doing – organic capital generation, selling assets and dividend re-investment plans. If a major boost is required, or the timeframe to comply is short, then the banks may have to undertake major capital raisings.
What does the market think? In the main, most investors and analysts feel that the banks will have enough time to comply without needing to do major raisings. This is borne out by the price action on the market, and the banks’ own actions (for example, Commonwealth Bank’s decision to increase its interim dividend by 1c in February).
But there are some analysts who disagree. AFR columnist, fund manager and bank guru Christopher Joye expects that APRA’s announcement will result in “further de-leveraging, further equity capital raisings and lower return on equity”. You can watch his interview with Peter here [1].
One of the points that Joye makes is APRA’s renewed focus on total capital rather than capital measures based on risk weighted assets, which results in a concessional treatment for exposures such as housing loans. This chart from APRA below shows that while the banks have improved their tier 1 capital ratios considerably since the GFC, their leverage ratios have barely moved.
Noting that the global pressure for better capitalized banks is starting to ease (witness the approval the other week by the Federal Reserve for 34 US banks to increase dividends and undertake buybacks), my sense is that that APRA will give the banks adequate time to comply with the new directive. This means that they will raise capital through the sale of assets/dividend re-investment plans/organic generation, rather than undertake major capital raisings. For shareholders however, this still means a lower return on equity and negligible dividend growth, possibly even a small cut to dividends.
How to play the banks
The banks are under considerable pressure to grow revenue, as slower loan growth and APRA’s prudential measures to soften the housing market start to bite. The latest measure to restrict interest only home loans to no more than 30% of the bank’s loan book is having a major impact on some banks. The Federal Government and possible SA Government bank levies will also reduce earnings.
On the positive side of the ledger, the decline in net interest margins has probably come to an end and small increases may even be on the agenda. This will be helped if the RBA nudges up the cash rate, which could come in the first quarter of 2018. Also, the banks still have material opportunities to reduce expenses, such as paring back on their branch networks.
However, in an environment where the possibility of dilutive capital raisings can’t yet be ruled out, caution is warranted. Any such raisings would be done at discount to the current share price, and depending on the size to be raised, would see a fall in the share price in the order of 10% to 20%. Further, more capital means lower earnings per share and lower return on equity.
Given that bank share prices have bounced off their lows, I think this is the time to be neutral (index weight) on the sector and wait till APRA issues its determination.
What do the brokers say?
The major brokers are also largely neutral. As the following table shows, the consensus target price is close to the current share price for each of the major banks. Westpac is seen as having the most upside (a target price of $33.08 compared to Friday’s closing price $30.59), while CBA is trading marginally above its target price.
Broker recommendations and target prices are set out below (source: FN Arena), with each broker’s highest recommendation(s) marked in yellow:
Broker Recommendations and Target Prices as at 7 July
Forecast earnings multiples and dividend yields are set out below. Tellingly, earnings per share growth between FY17 and FY18 ranges from a low of just 0.5% for the NAB to 2.9% for the CBA.
Forecast Earnings Multiples and Dividend Yields
Which bank?
Eight weeks ago (see here [2]), I wrote: “In a very, very tight race, my order is:
- Commonwealth
- ANZ
- NAB
- Westpac”
Somewhat remarkably, that it exactly as it has panned out over this period, although most bank returns are negative (see table below).
I don’t see any reason to move away from this order, but do acknowledge that the differences between the major banks in terms of strategy and capability to execute are marginal. So, if you are underweight banks, that’s my recommendation. Personally, I am waiting for APRA (or CBA back in the mid seventies) before I look to increase my exposure.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.