Although well positioned heading into the recent pandemic crisis with strong levels of capital, Australia's banking sector is facing significant headwinds as many customers face financial stress as a result of deteriorating economic conditions flowing from the COVID 19 pandemic. As a result, banks are now facing an emerging challenge of a growing pool of bad and doubtful debts, which is the first time in many years they have had to deal with this trend.

Bad debts on the horizon?

The banking sector has faced several challenges over recent years, but we haven't seen a bad and doubtful debt cycle like we are now facing since the Global Financial Crisis in 2008.

National Australia Bank, Westpac and ANZ all reported a significant increase in bad and doubtful debt charges in their most recent results announcements. The Commonwealth Bank has also set aside a large general provision to protect against future losses, relating to similar concerns as its three major competitors.

The fallout from the shutting down of the economy in response to COVID-19 has yet to fully playout, despite the Government’s attempt to cushion the impact with stimulus packages. This will not only impact the level of bad debts but also the growth in lending volumes as consumers and business remain cautious. We already had seen a slowdown in lending prior to COVID 19 and this further exacerbates the growth challenge for banks.

Finally, the current very low interest rate environment makes managing the net interest margin for the banks more difficult.

Braced to weather the storm

However, the more reassuring news is that the balance sheets of our banks are strong with common tier one equity, a key measure of financial strength for the banks from both the equity market and the regulator.

Two of the major banks have suspended the decision on paying an interim dividend through this difficult time, while NAB paid a reduced dividend to shareholders and has raised additional capital to reinforce its balance sheet. We believe this response is understandable given the current environment and expect some recovery in dividends although with payout ratios likely to be lower than previously.

Going forward we think there will be some recovery in returns, particularly now the banks have simplified their businesses over recent years. Improving profits over time should also translate into fully franked dividends to provide income for the portfolio However, with increased competition, lower rates of growth and increased capital requirements, it is unlikely they will reach rates of return on equity that they enjoyed up until a couple of years ago. In this context, whilst banks form a reasonable part of the portfolio, AFIC is very comfortable being underweight the Australian market index in this sector.