At the end of a huge week for the big four banks, it’s time for those reliant on dividend income to think hard about the longer-term implications of official interest rates being lower for longer. There is no need to panic. But as official rates set by the Reserve Bank of Australia move to 1 per cent and possibly 0.75 per cent over the next six months, there will be enormous downward pressure on bank profitability.
Investors have already started to twig to the medium-term threat to bank dividends. This is evident from the recent solid demand for utilities, real estate investment trusts, monopoly-style assets and defensive stocks such as Telstra. The yield offered by the big four banks remains high despite the prospect of them losing about $3.5 billion in revenue from their hedging portfolios over the next few years, according to UBS banking analyst Jon Mott.
This loss in income would be a function of capital and liabilities invested in assets with average yields of up to 2.2 per cent rolling over into assets with average yields of 1.1 per cent. The yield is falling because of the prospect of interest rates being cut to reverse the slowing economic growth and lower unemployment.
The big four banks primarily make money from the spread between the interest earned on assets, such as loans and acceptances, and the interest earned on liabilities, such as deposits and wholesale funding. Profits suffer when loan volumes slump and when there is a squeeze on net interest margins.
As official interest rates fall so does the spread between assets and liabilities. In normal times, banks can maintain or even expand their NIM by cutting deposit rates by more than they cut interest rates on loans. But when deposit rates get to zero, which is not far off, there is no room to manoeuvre. For example, the interest rate on the country’s most popular savings account, the Commonwealth Bank of Australia’s Netbank Saver account is 0.50 per cent. A decision is yet to be made by CBA whether or not to cut this by 25 basis points.
Extremely competitive rates
The door will be open to lenders with wholesale funding sources to offer loans at extremely competitive rates. Mott this week downgraded his profit forecasts for the big four by 2 per cent in 2020 and 5.5 per cent in 2022. But he said an official cash rate below 1 per cent would lead to further downsides to earnings and dividends.
It will be hard for the banks to not pass on most of the future rate cuts judging from this week’s response from the Treasurer Josh Frydenberg and RBA governor Philip Lowe to the failure of ANZ Banking Group and Westpac Banking Corp to pass on the full 25 basis point rate cut to home loan borrowers.
The government, the RBA and the Australian Prudential Regulation Authority are doing all they can to boost home lending. Of course, this is encouraging more leverage when households have debt equal to about 200 per cent of income.
The consequence of interest rates being lower for longer is a decline in the return on equity earned by the big four banks from double digits to single digits. The exception to this is CBA, which has the financial muscle because of its scale and the size of its low interest earning deposit base to maintain double digit ROE. This may explain the 10 per cent surge in the CBA share price over the past month.
Article Source – https://www.afr.com/chanticleer/bank-dividends-under-threat-20190606-p51v8l