According to an article in today's Australian Financial Review the expert banking analysts at Macquarie Group Ltd (ASX: MQG) have warned that big bank profits are set to take a material hit if the Reserve Bank meets expectations in cutting benchmark lending rates another 50 basis points.
According to the article the the profits of National Australia Bank Ltd (ASX: NAB), Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) could be dented by 8.6%, 7.4% and 5.8% in FY20 or FY21.
This follows on from a June 4 research note out of Goldman Sachs suggesting that the banks would need to hold back 10 basis points of every 25 basis point RBA cut just for the cuts to be "earnings neutral". Overall, Goldman's estimated that on average each cut would shave 4% off big banks' profits.
Although I'm no brain of Britain, I also warned back on May 3 that if the RBA embarked on a rate cutting cycle the big banks' profits, dividends, and share prices could all come down with it.
As I also outlined in this article on June 7 the problem the banks face as a consequence of the RBA cutting rates is falling net interest margins (as a key measure of profitability), which is something both the Goldmans and Macquarie analysts point to.
Banks make profits by making more on what they lend than they pay on what they borrow and they all employ treasury teams to manage their huge balance sheet assets (loans) and liabilities (deposits, etc) on a daily basis.
This is to manage liquidity requirements and crank net interest margins via the shifting of balance sheet securities and wholesale buying or selling money of market instruments related to the inter-bank lending rate the bank bill swap rate (BBSW).
However, as lending rates compress so will margins as the banks run out of room to cut rates on liabilities to offset the falling rates at which they're being forced to originate normally very profitable home loans as their core profit drivers.
Adding to the banks' problems is the fact that an ultra-low-rate environment means competition to attract savers and borrowers gets tougher as every basis point starts to count in terms of seeking the best deals. For example for a saver (who the banks also profit off) the difference between a 1.3% and 1.5% savings rate is proportionately larger than that between a 3.3% and 3.5% rate.
I've also written before how the almost-cartel-like status of Australia's big banks has helped them maintain net interest margins consistently above 2% over many years, which is far higher than many European or U.S. banks where markets are more competitive and benchmark rates have been ultra-low since almost the GFC.
For example the ASX's only listed overseas bank in UK regional home loan lender Clydesdale & Yorkshire Bank (ASX: CYB) is forecasting a net interest margin (NIM) between 1.6% to 1.7% in its financial year ending September 30 2019.
That compares to CBA's 2.1% NIM when it posted its interim profit report in February 2019.
If Australian banks' NIM's start to compress on RBA rate cutting it seems possible that Goldman's or Macquarie could be underestimating the hit to banks' profits. Goldman's price target on CBA shares is currently just $70.45 which is already a long way below the market's valuation of $81.45 today.
NAB has already been forced to cut its dividend, while Westpac's trailing yield sits at 7% plus franking credits based on a $28.13 share price today. An unusually high yield is normally a textbook sign more sophisticated investors expect a dividend cut.
Commonly, dividend-seeking retail investors tend to underestimate the impact dividend cuts will have on their returns via capital erosion and lower dividends, as we've seen from the effect of dividend cuts by Telstra Corporation Ltd (ASX: TLS) over the past few years.
As such I'm not a buyer of bank shares today and expect we could see all four big banks' share prices lower this time next year if the RBA does deliver more rate cuts starting at 14.30pm this afternoon.
