Commonwealth Bank of Australia beats expectations amidst money laundering allegations

The Commonwealth Bank of Australia (ASX:CBA) dividend will please investors.

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The Commonwealth Bank of Australia (ASX: CBA) posted its full year results for the financial year ending June 30, 2017 this morning. Below is a summary of the results with comparisons to prior periods.

  • Statutory net profit of $9.928 billion
  • Final dividend per share of $2.30, total annual dividend of $4.29, compared to $4.20 in prior year, ex-dividend Aug 16
  • Earnings per share of $5.74, prior year $5.55
  • Operating income up 3.8%
  • Net interest margin of 2.11%, 3 basis points (bps) lower than prior year
  • Customer deposits as percentage of funding 67%
  • Loan impairment expenses (bad debts) at 9-year-plus lows of 15 bps
  • Return on equity of 16%, down 50 bps
  • Underlying cost-to-income ratio of 41.8%, 60 bps lower on prior year
  • CET Tier 1 (capital adequacy) ratio of 10.1%
  • Announced plans to sell its capital-intensive Life Insurance business

Another impressive operational result from Australia's largest bank as home-lending growth continued, while bad debts and home loan arrears remain at historically low levels. These outcomes are underpinned by macroeconomic conditions including the RBA's interest rate cutting cycle that has fuelled demand to borrow by property investors, owner-occupiers, or credit-seeking businesses.

Banks turn a profit by making more on what they lend (their assets) than they pay on what they borrow (their liabilities), with the spread between the lending and borrowing rates known as the net interest margin (NIM), as the key measure of bank profitability.

At 2.11% CBA's NIM came in 3 basis points worse than the prior year in a result it attributed to competition and higher wholesale funding costs marginally offsetting its ability to lift rates on loans. Notably, the bank funds 67% of its lending from customer deposits.

The CBA must also keep capital in reserve for a rainy day, which is recorded as its capital adequacy ratio or the percentage of liquid assets held against risk-weighted assets on the balance sheet. CBA's CET 1 ratio came in at 10.1% and it's moving to sell its life insurance operations probably to raise capital, while lowering the overall capital-intensity of its operations.

Money laundering allegations

The elephant in the room is the allegations from the anti-money laundering (AML) and counter terrorist financing (CTF) regulator AUSTRAC that CBA breached its obligations on a wide scale over suspicious transaction reporting in accepting customer deposits. Notably the more customer deposits the bank takes, the more profitable it should be in theory.

For Authorised Deposit-taking Institutions (ADIs) across Australia compliance with the reporting requirements of the AML / CTF Act 2006 (monitored by AUSTRAC) is an expensive burden, as it's a serious responsibility, with Australia's criminal, cash economy, still a significant problem.

Therefore, CBA's alleged failure to meet these requirements could have explosive consequences.

Serious regulators and governments overseas treat these kind of failures unambiguously. In the U.S. for example in 2012 British Bank HSBC was fined a total around A$2.4 billion over its failure to identify and report suspicious transactions globally. In 2017 Deutsche Bank was fined around A$822 million by the U.S. regulator  over its compliance failures related to money laundering activities in Russia.

Politically, CBA may now feel the heat, with treasurer Scott Morrison (the architect behind the arbitrary 6 basis points tax grab on banks' liabilities) describing the allegations as "very, very serious". This sounds ominous given that CBA may have been growing its deposits (that it makes profits on), while failing to comply with laws designed to promote the safety of all Australians.

How Australia's regulators assess and treat the issue remains to be seen, although I wouldn't bet against political pressure producing an unexpectedly large fine.

Outlook

Thanks to the totally dominant market position of Australia's major banks, CBA remains a sound investment over the long term, especially for dividend seekers. A rising base lending rate environment will also help expand CBA's NIM, as rates at which it lends rise faster than those on which it pays to borrow.

The bank though does trade on an expensive multiple to book value and at $80.65 shares change hands for 14x trailing earnings at a slight premium to historical averages and rivals like Westpac Banking Corp (ASX: WBC). Therefore income seekers in the banking space may prefer the potentially better value on offer from the likes of NAB or Westpac.

If CBA can escape any major fallout from the alleged compliance failures and Australia's residential property markets escape a bust, it remains a reasonable bet for income-focsued investors.

Motley Fool contributor Tom Richardson has no position in any stocks mentioned. You can find Tom on Twitter @tommyr345 The Motley Fool Australia owns shares of National Australia Bank Limited. 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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