Banking shares have given a lot of positive momentum to the ASX in 2019 so far, but according to the Australian Financial Review (AFR), bank shares like Commonwealth Bank of Australia (ASX: CBA) could be in for a cold shower.
Commonwealth Bank shares have delivered investors a solid 8% return for the year so far (not including dividends), but the CBA share price fell back to earth this month after the company reported a set of less-than-beautiful numbers in its full-year results. This included an 8.1% decline in statutory net profits after tax and a 4.7% drop in cash net profit after tax. The dividend yield is safe (for now) at $4.31 per share.
The problem is interest rates, according to Commonwealth Bank CEO Matt Comyn: "There are $160 billion of deposits where we can't pass on (a rate cut) at all or in full… and each subsequent rate reduction costs more."
In other words, margins are being squeezed.
This sentiment was echoed by analysts from Morgan Stanley, who warn of the increasingly 'non-linear' relationship between the cash rate and CBA's profitability.
A margin squeeze?
Under a 'normal' interest rate environment, a rate cut would result in the variable mortgage rate charged by CBA being reduced by the same (or a similar) margin. This would then be recouped by cutting the rates that banks pay out in cash instruments such as term deposits and savings accounts.
The problem now is that at 1%, interest rates are no longer in a 'normal' environment, and term deposits can't go much lower without risking customers dumping them (who wants a 0.5% term deposit after all?). CBA estimated that the Reserve Bank of Australia's interest rate cuts in June and July alone knocked 4 basis points off the FY20 interest margin – translating to a $344 million earnings hit.
Foolish takeaway
The AFR notes that in countries where interest rates have been near (or below) zero for extended periods, retail bank share prices have been decimated, which could be sign of things to come for CBA and our other major banks if these experts are to be believed. If our cash rate falls to 0.5% or lower (as many are predicting), CBA shareholders might start really feeling the pain as earnings dry up and pile pressure on the dividend payout.
