CBA faces margin squeeze, rising capital needs

The bank’s interest margins are squeezed, capital demands continue to grow and troublesome loans are rising.

Commonwealth Bank chief executive Ian Narev.

Commonwealth Bank’s record full-year profit hasn’t received the applause it would have expected, with investors left questioning whether the stock can deliver the returns needed to justify its premium valuation over its rivals.

As Australia’s largest bank, CBA is viewed as a yardstick of the industry’s financial strength. The 3 per cent rise in cash profit to $9.45 billion was in line with analyst expectations, with the bottom line fattened by a high demand for mortgages, fuelled by record low interest rates, and cost savings.

But beneath the headline generating 2016 profit, there were some red flags that investors need to watch: the bank’s net interest margin continues to be squeezed, capital demands continue to grow and troublesome loans are rising. No wonder it’s the worst performer among the big four banks with an 11 per cent decline in its share price this year.

At $76.30 a share on Monday, CBA trades at just under 14 times forward earnings and 2.1 times book value — that’s a hefty premium to the 11.6 times forward earnings and 1.5 times book value averaged by rivals ANZ, National Australia Bank and Westpac.

While CBA is known for having the highest return on equity among the big four, warranting a richer valuation, it is losing its lead over the pack. JPMorgan’s Scott Manning notes CBA’s once sector-leading return on total equity is reverting to levels seen among its rivals as it digests additional regulatory capital demands.

Manning has an underweight rating on the stock with a $76 a share target price. Fresh equity raised last year boosted core regulatory capital levels to a solid 10.6 per cent, but it reduced return on equity to 16.5 per cent from 18.2 per cent last year.

CBA may be forced to raise more fresh equity — and possibly cut dividends — as tougher capital requirements for mortgages and wealth management sink capital levels to about 9 per cent. Worse still, there’s the possibility that regulators could raise minimum core capital requirements to 10 per cent, from the current 8 per cent.

Faster earnings growth could offset some of the dilution from fresh equity being raised, but analysts are sceptical. Goldman Sachs analyst Andrew Lyons sees two major drags on earnings: skinnier net interest margins and higher bad debts. CBA’s net interest margin fell two basis points, although strong growth in lending amid a booming housing market boosted loan volumes and lifted net interest income by 7 per cent.

The Reserve Bank’s 25-basis-point rate cut this month coupled with CBA’s response in re-pricing rates on deposits and loans is set to further squeeze margins. There is also a growing risk of a “war on deposits”, notes Morgan Stanley analyst Richard Wiles. CBA has reduced the standard variable rate on home loans by 13 basis points but has increased the rates it pays on two and three-year term deposits by 50 and 55 basis points, respectively. Aussie savers may lock in rates with term deposits as the RBA warns of more easing, but it also means higher funding costs for CBA.

And while CBA’s bad debt disposal charge was lower than expected, Goldman Sachs’ Lyons expects it to “increase from here” as the credit cycle has troughed.

This is an edited version of a feature which first appeared in Barrons.com