Australia’s largest banks have endured a controversial year defined by public relations nightmares and opportunistic government interventions.

So far 2017 has seen the implementation of the Federal Government’s bank tax, followed by a failed levy by the South Australian state government, significant noise in the lead-up to the Australian Prudential Regulatory Authority’s (APRA) definition of ‘unquestionably strong’ and scandals relating to alleged money laundering and inter-bank lending rate rigging.

These issues have taken their toll on the major banks’ share prices, with all except NAB in negative territory in the calendar year to date.

We believe this negative background provides a trading opportunity and the October and November 2017 earnings season is a catalyst for revaluation.

Dissecting the drivers of banks’ earnings – their profitability is determined by simple factors:

  • The cost of funds
  • What the banks charge to lend funds
  • Asset quality
  • The amount of capital they need to hold.

With this in mind, we have closely assessed earnings, asset quality, capital and dividends to inform our outlook for the sector this reporting season.

Stronger earnings

The key measure of bank profitability is the net interest margin (NIM) – the difference between interest income received from customers and interest paid to lenders, relative to the bank’s assets.

If we take a closer look at the costs of funds, term deposit rates have fallen from the elevated 2016 levels due to increased competition for funds as the banks moved to adhere to liquidity requirements under the global Basel III banking reforms. This will provide a tailwind for banks earnings in this next reporting period. The reforms are focused on amending the composition of banks’ funding and view term deposits as a favourable component. Wholesale funding to banks has been flat to slightly down, reducing interest paid in the NIM equation.

On the income side, banks have repriced mortgages multiple times this year through out-of-cycle interest rate increases and we expect this to contribute to a strong reporting period. The banks with the greatest exposure to this tailwind are the big mortgage banks, Commonwealth Bank (ASX: CBA) and Westpac (ASX: WBC).

While the bank tax still needs to be accrued, overall we expect banks to deliver strong net interest margins and increased earnings.

Sound asset quality

The quality of bank lending, including housing, business and personal loans, remains sound with issues confined to pockets in Western Australia and regional Queensland.

We expect the banks to deliver benign asset quality reports and low non-performing loan rates. However, we will closely examine personal lending for any deterioration given pressures on household spending from increased energy and mortgage costs amidst stagnant salary growth. The large, specific charges should be very low given there have been no notable collapses this period.

Healthy capital positions                                                                   

For the first time in the sector’s recent history we think capital will be a non-event this reporting period. We expect the major banks will move well along the curve towards the APRA required capital ratio of 10.5% as divestments and capital generation add to the healthy positions reported last quarter.

Dividends maintained

Given their strong capital positions, we expect the banks will meet or exceed the market’s expectations regarding dividends, and in our view dividends will at least be maintained.

Standout performers

The Bank of Queensland (ASX: BOQ) commenced the sector’s reporting period on Thursday 12 October 2017 with a sound result that confirmed many of our estimations. The remaining banks are set to report later this month and throughout November. We believe the sector as a whole stands to surprise the market. We are particularly positive about National Australia Bank (ASX: NAB) and Westpac. We think CBA’s result will be solid and that the share price reaction has more than compensated investors for any likely fall out from the anti-money laundering case.