Beware banks yield­ing div­i­dends

The Pak Banker - - OPINION - Lionel Lau­rent

SHARE­HOLD­ERS are fi­nally look­ing for­ward to a re­ward for buy­ing beaten-up Euro­pean bank stocks. Lenders have shrunk bal­ance sheets, bol­stered cap­i­tal and shunned com­plex risk -- all while promis­ing big­ger div­i­dend pay­ments.

Con­sen­sus ex­pec­ta­tions sur­round­ing div­i­dends haven't been this fever­ish for a long time: the div­i­dend yield on the Bloomberg Euro­pean 500 Banks In­dex has climbed to 6.5 per­cent, the most in al­most five years. It's also nearly a per­cent­age point more than the yield from the re­gion's bor­ingly re­li­able in­sur­ers.

Sim­ply put: banks have more cap­i­tal, are start­ing to gen­er­ate more prof­its and have promised to re­turn a greater pro­por­tion to in­vestors -- and div­i­dend yields are re­flect­ing that ex­pec­ta­tion. Bloomberg In­tel­li­gence's Jonathan Tyce notes the cor­re­la­tion be­tween val­u­a­tions and div­i­dend yields or pay­out ra­tios has grown stronger in re­cent quar­ters as lenders near or ex­ceed their cap­i­tal tar­gets.

But there are warn­ing signs as earn­ings sea­son be­gins. The one-time hits to earn­ings keep com­ing and in­ter­na­tional cap­i­tal re­quire­ments are in­creas­ingly be­ing tough­ened by lo­cal reg­u­la­tors. Royal Bank of Scot­land this week an­nounced 3.6 bil­lion pounds ($5.2 bil­lion) of charges for mat­ters rang­ing from lit­i­ga­tion to cus­tomer com­pen­sa­tion -- prompt­ing JPMor­gan an­a­lyst Raul Sinha to cut his cap­i­tal re­turn ex­pec­ta­tions on the stock by 40 per­cent. Lloyds may fol­low with more charges that will limit the bank's scope for pay­ing div- idends, ac­cord­ing to some an­a­lysts. Nordea's shares plunged this week af­ter the head of Scan­di­navia's big­gest bank said it was wrong to prom­ise a pay­out ra­tio of "at least" 75 per­cent of prof­its.

There are more red flags else­where. While banks are ex­pected to re­port in­creased earn­ings, at least ac­cord­ing to con­sen­sus es­ti­mates, div­i­dend fu­tures are much less bullish. The Euros­toxx div­i­dend fu­tures in­dex has dropped since mid-Au­gust -- not just be­cause the de­cline in the oil price will cut into that in­dus­try's div­i­dends but also be­cause of con­cerns about the banks, ac­cord­ing to Ed­mund Shing, a de­riv­a­tives strate­gist at BNP Paribas.

To be sure, some banks are pay­ing divi- dends: af­ter a gru­el­ing over­haul, UBS de­liv­ered a spe­cial div­i­dend for last year, while ING, the bailed-out Dutch bank, has paid its first div­i­dend since the cri­sis. In the U.K., banks pro­duced 10.8 bil­lion pounds in div­i­dends last year, 22 per­cent more than in 2014, ac­cord­ing to Capita. Life in­sur­ers paid out 3.6 bil­lion pounds, a far less racy in­crease of 4 per­cent. That com­par­i­son with in­sur­ers is im­por­tant: they sim­ply have a more re­li­able track record of earn­ings and div­i­dends than banks. Euro­pean in­sur­ers' earn­ings per share have en­joyed com­pound an­nual growth of 7 per­cent for the past five years. For banks, EPS shrank by 5.8 per­cent. In­sur­ers' div­i­dend yields, which trailed those of banks through­out the 1990s and early 2000s, have ex­ceeded them com­fort­ably since the fi­nan­cial cri­sis.

This all may be ob­vi­ous when you con­sider the dif­fer­ent reg­u­la­tory bur­dens be­tween the two in­dus­tries: banks have faced far more scru­tiny over as­set-qual­ity and cap­i­tal strength than in­sur­ers. Tougher post-cri­sis bank rules un­der Basel III were agreed five years ago; in­sur­ers' new Sol­vency II regime only kicked in this year. While that might sug­gest the pres­sure is only just be­gin­ning for in­sur­ers, banks are still in a fog of con­fu­sion sur­round­ing regulation and lit­i­ga­tion a full eight years since Lehman Brothers' col­lapse.

On the pos­i­tive side, some lenders have in­creased their pay­out ra­tios over the past five years, while in­sur­ers' have barely budged. But that's not a wholly healthy sign for lenders: man­age­ment can't gen­er­ate rev­enue growth and in­crease the stock price and so has to find an­other way to re­ward share­hold­ers. That sug­gests the in­gre­di­ents for a sea change in bank div­i­dend pay­outs aren't there yet.

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