While global policymakers have been managing both the health and economic crises brought about by COVID-19, global banking regulators have also been busy. Financial regulators around the world have announced measures to ensure that the banking system is ready to weather the stress to come with the impending (but still uncertain) economic slowdown.
While Australian banks have been well (tightly) regulated and their balance sheets are very strong, the message is clear from our regulator APRA, setting the expectation that banks will "limit discretionary capital distributions in the months ahead… including prudent reductions in dividends".
It is estimated that retail investors own about 47% of the shares of our four major banks. While their earnings growth profile has changed significantly over recent years reflecting their lower growth environment, it is fair to assume a major factor attracting retail investors to the banks is their high level of dividends. As we discussed in our previous blog: "While the world isn't going to end, it will likely look and feel different once this crisis is over", we expect Australian investors will finally view major bank shares as other international equity markets do: focusing more on the investment fundamentals than the dividends they pay.
What has changed?
- In the United States, banks have agreed to halt any buybacks of their shares. Note that US equity markets tend to prefer buybacks over large dividends;
- The Bank of England followed with more comprehensive measures, directing banks to suspend dividends and buybacks until at least the end of 2020 and banning cash bonuses to senior management;
- The European Central Bank recommended banks not pay dividends for both the end of the 2019 and upcoming 2020 financial years while also refraining from undertaking share buybacks during this time;
- New Zealand's Reserve Bank announced a similar ban on dividends and management bonuses. This was a notable development as 90% of the country's banking industry is owned by the major Australian banks, who rely on their New Zealand profits to fund ~10% of their shareholder dividends; and
- Finally, Australia's regulator APRA followed suit last week instructing bank Boards to manage "prudent reductions in dividends" and placed similar limits on executive remuneration.
What does this all mean for the Australian banks and their shareholders?
In Australia APRA's message was clear: banks are to use their effective government guarantee and access to extremely cheap capital (afforded by the record low interest rates and guaranteed cheap funding from the RBA) to support their customers and our economy, rather than benefit shareholders. This should also ensure their balance sheets will be strong enough to withstand the expected increases in loan impairments amongst their customers.
Each of the major banks will be providing trading and profit updates in late April and early May. We expect to see bank dividends cut in the order of 50% at the updates. Many will assume this is temporary and dividends will revert once we are on the other side. While dividends may increase, we do not expect them to revert to where they were in the past considering profit margins will continue to be materially diluted by record low interest rates, the divestment of their wealth management operations, and that their need to reinvest in their businesses has never been higher as various fintech disrupters and smaller competitors continue taking market share across their lending books.
We believe the new normal will see long-term dividend payout ratios cut from their historically stretched 75% to 85% levels to a more sustainable 50% to 60% range.
While payout ratios may settle about 25% to 30% below current levels, dividends may be down more accounting for the impact of COVID-19 on earnings and the dilution of profits as banks also seek to raise capital by underwriting Dividend Reinvestment Plans.
However there are a few silver linings. Unlike 1992 and 2008/09, major bank balance sheets are incredibly strong thanks to more rigorous regulation, with the expected upcoming dividend cuts only reinforcing this position. This means we're less likely to see heavily discounted (and dilutive) equity raisings. Further, major bank hybrid investors will not see their distributions impacted by the above regulatory directives. Instead, cuts to shareholder dividends are positive for hybrid owners as they will further strengthen each bank's capital base.
What does this means for the share price?
After enduring a Royal Commission and countless customer and risk management-related scandals, the current environment is an opportunity for our major banks to demonstrate their value to the economy and the Australian public. However, this will come at a cost for bank shareholders. We will be closely monitoring the upcoming earnings and dividend announcements and management commentary, taking appropriate action in client portfolios.