Aussie banks $34bn surplus points to more shareholder dividends, buybacks

-- | 06/07/2021

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Read Zaia's special report 'Australian banks give investors 30 billion reasons to smile'

Emma Rapaport: Hi, and welcome to Morningstar I'm Emma Rapaport. We're here today with equity analyst Nathan Zaia to talk about his new banking special.

Nathan, thank you for joining us.

Nathan Zaia: Thanks for having me, Emma.

Rapaport: Nathan, I found the the top line figure in your report $34 billion in excess capital currently with the banks to be quite an amazing figure. How come they have all this excess capital on their balance sheets.

Zaia: So there's been a few things that have contributed to, to get them to the position they are in now. I'm sure shareholders remember dividends were cut, quite materially. They even paused for a little while, during 2020. Partly because the regulator forced the banks to do that. So that's helped build up some capital. There's been a number of divestments, most of the banks getting out of wealth and insurance, and even some parts of their financing and unsecured lending. Two of the banks, NAB did a big equity raise and Westpac underwrote the DRP. So that added to the capital surplus as well. And I think the other component, which probably doesn't, or isn't as obvious, is the banks also looked at, where they're lending and where their focus was trying to shift more towards those categories, like home loans, where you don't have to hold as much equity against each loan. So, that frees up some extra surplus capital as well. So there were a few different things which contributed. And I think its important point to cover off, because I think shareholders should be aware that, yes, they have all this capital now. But it doesn't mean that, you know, they'll be able to build up this sort of capital surplus again in the next five years. So there were some unique circumstances that were behind it.

Rapaport: In your perspective, you think that the best thing the banks could do right now is return that capital to shareholders - why do you think that and not plough it into growing their business?

Zaia: That is the alternative option, right, try to grow the business, the (thing's) about how the banks can do that. They can try to grow their loan books. They already make up over 70% of the mortgage market. So it's quite hard to make huge market share inroads, you know, they already are so big. We don't expect the market to be growing extremely strongly either. So they simply don't need the capital to support loan growth. If you think about M&A, it's very hard to imagine ACCC, letting one of the major banks buy a smaller lender, whether it's AMP or even Suncorp Bank, so I don't really think that's on the cards for the majors. M&A outside of banking well, you know, they're just, like I said, getting or unwinding some of these investments that they've made over a number of years that haven't really worked out that well. So I don't really want the banks to go down that route. It doesn't really add to their competitive advantages. I don't think they are higher returning businesses. So, now you just give it back to shareholders, if you don't need it.

Rapaport: What do you think is the best use of this excess capital?

Zaia: Yeah, I think that's an interesting one, in terms of how the money is given back to shareholders. In our view, we think it would be great if you know, the banks have their current payout ratios, which is 65%, 75% vary slightly between the banks. If they just use this capital to pump that up to 100%. That would be a really nice steady income stream for shareholders, it wouldn't be sustainable, obviously, there'll be a point where they've returned all the surplus. But it also lets them do it gradually. So, they are still sitting on a nice buffer, while economic uncertainty plays out, and you never know what might pop up. So I think that would be a nice, smooth way to do it. And shareholders wouldn't have to do anything either, right? They just receive the dividends and the franking. But the barriers to that, you know, 25% of shareholders, are not Australian shareholders, so they don't really benefit as much from the franking. So that's where a buyback probably becomes a little bit more equitable. So you know, they get the the added upside from the EPS and DPS accretion that you get from buying back your own shares. Our preference would probably be cleaner, simpler, is just pump up the dividend, but yeah, franking and foreign ownership, they make it a little bit more difficult. And that's why we think off market buyback's probably the approach that the banks will take.

Rapaport: In your report you talk about the fact that they could do both off market and on market buyback. Can you explain quickly, just the differences between those two, and what the benefits are each of them to shareholders?

Zaia: Yeah, sure. So with an off-market buyback, I think the the key differences and why Australian shareholders do benefit. A component of the buyback price is treated as a fully franked dividend. So for shareholders that are in low tax brackets, especially, that's quite beneficial. And so it's still a great way for the banks to get those franking credit balances to shareholders. And they're reducing shares on issue, the added benefit, they generally will buy these shares back at 10% to 14% discounts, 14% is the maximum from the market price. So yeah, those shareholders that aren't participating, the bank's buying back shares at a 14% discount to the share price. So that's a good thing for all shareholders. So the reasons why we have broken up, what we think they can do on an off market versus what they'll do on the on market, is simply because of the franking credit balances. We don't think they have enough franking to be able to return all this surplus through dividends and off market buybacks. And that's where an on market might come into play. So they're just buying back the shares on market.

Rapaport: You do still expect that they'll return some of that money to investors via higher payouts, but you expect this to happen over time, as opposed to, everything happening in big bang at the end of the year?

Zaia: Yeah, I think so. So, with an off-market buyback, you're going to, you probably just want to do it in one hit. It is a little bit of work for advisors and for shareholders, you know, you apply to sell your shares into the buyback. And then you find out how much has been bought back. But then if you wanted to keep that position, you'd have to go rebuy. So, the banks won't want to do that, like again and again. Whereas an on-market buyback, we've (pencilled) it in to happen all in the one year. But again, there's no reason why they can't just be buying back on market over different periods. But it's impossible to know when those buybacks will happen. So for visual purposes, we've just shown the total amount in one year. And similarly for dividends, we've just assumed that they put some of that surplus towards the dividend each year.

Rapaport: Are there any -- is there a catch involved in this? It all sounds good for shareholders but do you think that these sort of payouts are sustainable long term?

Zaia: I think there's a catch. I think where we're sitting today, the banks are well capitalised. They've got large loan loss provisions in place, and things are looking okay. I don't see a need for them to hold this capital. So, I think that can be returned. And I think that's a problem. Yeah, the way the banks have reset the dividend payout ratios to 65%, 75%, I definitely do think that is sustainable. I think that's more than enough to fund loan growth, reinvest in the business and part of the spend that's capitalised.

Rapaport: I guess the biggest question, at least that I have, and I understand there'll be nuances per bank, but do you think these yields that you're expecting, do you think that they're attractively priced?

Zaia: Yeah, most of the banks are trading a little bit below our fair value. CBA is the only one that trades at a bit of a premium. And if you look relative to other sectors of the market, I mean, they still are good dividend yields, fully franked dividends. Yeah, I think relative to the market, the banks are looking reasonably attractive still.

Rapaport: And your estimation that CBA is overpriced at this point. How come they're different from the other banks?

Zaia: Yeah, I think it's the largest bank, it's the highest ROE generating the most organic capital. It's had the strongest capital position. And importantly, in the last couple of years, it feels like the majors have had turns at sort of dropping the ball or tripping themselves up in the home loan market, whereas CBA has, they've shown that they can just keep powering ahead. You know, we've had refinancing application volumes go through the roof. But it hasn't impacted CBA like it has the others. People are pricing in all that quality and everything that's been going right for the bank, but it trades at a premium to most banks globally. Yeah, it feels a little bit rich at the moment. And I think part of that is the retail investors chasing those dividend yields. CBA, they managed the downturn very well. Their dividend was cut by the least, maybe there's a little bit of, investors more confident in the dividend outlook for CBA as opposed to some of the others that paused or materially slashed dividends. I think that might be playing into a little bit as well.

Rapaport: Okay. Well, thank you very much for joining us today. If you'd like to read Nathan's banking special, it's up on Morningstar Premium and there'll be a link at the end of this video. Nathan, thank you very much for joining us.

Zaia: Thanks, Emma.

This report appeared on 2022 Morningstar Australasia Pty Limited

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