Yes, bank dividends are back but let’s not party like it’s 2019

The banking sector’s dividend party has kicked off again as earnings recover, but rather than returning to the pre-COVID rave it will be more akin to a dinner party.

Two of three banks that reported their half-year profits this week – Westpac and National Australia Bank – have told investors they won’t be allocating as much of their income to dividends.

Rather, they have reset their medium-term policies to hand shareholders about 65 per cent of profits in dividends rather than the roughly 80 per cent with which they rewarded shareholders pre-COVID.

ANZ Bank reset its dividend payout ratio to the 65 per cent level a few years ago.

NAB chief executive Ross McEwan.Credit:Alex Ellinghausen

Absent COVID, the dividend reset would have been met with pushback from shareholders. But having received few, if any dividends, last year shareholders appear to be relieved that payments have started up.

It is an opportunity that banks were not prepared to squander.

In the past the banks have, arguably, set dividends payments at an unsustainable level. In NAB’s case in the years leading up to COVID it had been caught on the dividend merry-go-round of needing to issue new shares in order to pay dividends – an exercise that further diluted earnings per share.

Large numbers of retail investors, particularly retirees, rely on bank dividends to provide them with income. Banks have always understood the share price risk associated with trimming dividend payments.

Yield-hungry investors have stuck with banks, despite the numerous earnings challenges and the behavioural issues they have faced over recent years in order to tap into that dividend stream.

The good news is that in the coming year at least bank earnings will likely piggyback off Australia’s economic recovery. As long as the economy recovers as it is forecast to do, the banks will continue to unwind the huge COVID provisions and bad debt charges they took a year ago – which will continue to bolster their earnings in the future.

Across the banks, provisions remain $5 billion above pre-COVID levels which provides an insight into how much profit upside there is when they are unwound.

It is true that a year ago taking those caution-driven provisions blew up bank profits and that dividends dried up as the prudential regulator virtually forced banks to preserve capital.

The flip side of that coin is that the massive profit boost banks are reporting now is the result of recognising in their accounts that the credit quality is way more positive than it looked a year ago. This is inflating their profit bounce back.

Once you strip out this credit quality adjustment the underlying bank earnings core profits are weaker, with ANZ, Westpac and NAB down by between 7 per cent and 11 per cent, and revenue is soft.

The reset in dividend payout ratios is prudent at a time when there are still some COVID related risks.

But a feature of the commentary from each of the three banks that reported this week is the huge growth all are starting to experience in home loan lending. The National Australia Bank, ANZ and Westpac are all looking to increase market share in lending to a mortgage market that is running hot.

The NAB is also seeing an uptick in business lending – a sector that has traditionally been its domain.

Across the three banks lending grew in the half by 0.7 per cent but this is expected to escalate in the current (second) half as first home owners continue to take advantage of the historically low interest rates to get a foothold in the market, existing home owners trade up and investors move back into the market.

The downside of the low interest rates for banks is the pressure it places on interest rate margins. This was managed well in the half as banks’ funding costs were lower and deposit rates were adjusted but it will remain a challenge.

Banks have responded by a relentless drive to lower costs.

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