Why the big banks could be forced into capital raisings of $17.5 billion

It’s been a tough week for bank investors who have watched their shares drag the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) lower.

Australia and New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corp (ASX: WBC) have been the worst of the majors, sliding 3.8% and 3.7% respectively. Commonwealth Bank of Australia (ASX: CBA) and National Australia Bank Ltd. (ASX: NAB) haven’t fallen quite as hard, yet the pair are still down more than 2% each since the beginning of the week.

Indeed, it’s fair to assume that part of the decline is due to ongoing concerns related to Brexit. It is still unclear how Britain’s divorce from the European Union will impact the European and global economies, and whether there will be a contagion effect that results.

Although it’s easy to forget the banks are cyclical in nature, the four major banks would be vulnerable to a sell-off if the economy were to take a hit. This was demonstrated by a number of European banks in the wake of the Brexit decision, with shares of ASX-listed CYBG PLC CDI 1:1 (ASX: CYB) – or Clydesdale and Yorkshire Banking Group – also crashing as a result.

The uncertainty posed by the inconclusive federal election will also be weighing on investors’ minds, particularly with the fear of a potential royal commission into the banks from either the Labor party or a minority party.

More Capital Raisings

However, the recent selloff could also relate to expectations that the banks will be forced to raise more capital. All four banks were forced to increase their capital reserves in 2015, raising almost $20 billion in fresh equity which was achieved through share purchase plans, dividend reinvestment plans, placements and discounted rights issues.

The capital raisings certainly took their toll on the banks’ share prices. ANZ’s shares plunged nearly 7.5% on 7 August 2015, after it announced a major capital raising which ultimately diluted the ownership of existing shareholders of the company.

According to The Australian Financial Review, Morgan Stanley analyst Richard Wiles now believes that the banks will need to build at least another $17.5 billion in capital. He said (my emphasis): “We forecast a further capital build of >A$17.5bn for the majors, but believe it could be more.”

Indeed, recent data from the Australian Prudential Regulation Authority (APRA) shows that the major banks are now in the top quartile of banks internationally, which was deemed necessary in the 2014 financial system inquiry. The problem is, other banks around the world are still growing their capital reserves, setting a moving target for our banks to keep up with.

Bank investors should be prepared for another round of capital raisings, which would likely have an impact on the banks’ all-important Return on Equity (ROE) measures. The banks already ceased growing their dividends during the latest period, and dividend cuts could also be on the agenda if profit growth begins to slow, or if further capital raisings are deemed necessary.

Although the banks’ shares have fallen in price, they are still risky. For what seems like limited potential upside in the sector right now, investors may do better by focusing on other companies that also offer compelling dividend yields elsewhere.

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Motley Fool contributor Ryan Newman has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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