Are banks stocks ready to turn corner?

Analyst fears that our banks may need more capital raisings are overblown.

There has already been a modest rerating of some banks.

Banks will be in the headlines this week, with the major banks set to appear before a parliamentary inquiry which starts on Tuesday. Meanwhile, ASX bank shares have still not recovered from the earnings dilution from last year’s multi-billion-dollar equity raisings.

Many analysts also believe there is still more capital raising to come. Indeed several analysts have large, dilutive rights issues in their valuations and it would not be an overstatement to say a handful of key analysts have hated banks for most of this year.

This is about to change and banks are about to find more support in the sharemarket. I certainly think fears of more capital raisings at the banks are overblown. If there are higher capital requirements at all, banks will be allowed to reach them gradually over several years.

Led by Bank of England chief Mark Carney, who said “there is no Basel IV”, European banking regulators have called more for adjustments to the existing Basel III rules rather than a wholesale new round of equity raisings.

The reason is the regulators perceive Europe’s economy as too fragile for the price of more risk mitigation (more capital) to be worth it. Higher regulatory capital levels reduce a bank’s ability to lend, and European banks are hardly enthusiastic about lending given the poor profitability caused by ultra-low interest rates.

Better days ahead

If there is no broad push coming for higher capital ratios at European banks, then Australian banks can hardly be expected to hold more capital given they already have some of the world’s highest capital ratios.

The Financial System Inquiry recommended banks be “unquestionably strong” and APRA interpreted this to mean domestic systemically important banks should have common equity tier-1 capital ratios in the top quartile of banks globally. Further, it is not the case that regulators desire banks to raise more capital forever. In stronger economies like Australia’s, higher capital levels could actually encourage banks to take imprudent risks to sustain earnings growth and meet management remuneration thresholds. Having succeeded at slowing the growth in bank lending to investors to 4.6 per cent over the year to August from a peak of 10.8 per cent in June last year, APRA will not want to create incentives to undo its work.

Long lead time

If higher capital ratios are required by, say, 2019, banks could reach them gradually by managing dividend payout ratios, dividend reinvestment plans and their mix of business. Business loans, being riskier, require more capital to be held against them than do less risky housing loans, so reducing the proportion of business loans in total loans reduces the amount of capital which has to be held. Lower payout ratios and discounted dividend reinvestment plans reduce the amount paid out in dividends and increase retained earnings.

There has already been a modest rerating of some banks. Since the end of July, ANZ and NAB have found a bid, which has rewarded the positions in our model portfolio. Our largest bank weighting is to ANZ, currently outperforming the sector.

David Walker is Senior Analyst at StocksInValue.com.au