Is it time to reconsider buying the big-four banks?

While the bank sector has been in the doldrums for some time, the 'big-four' have all trended higher since June on the back of the Reserve Bank’s (RBA) progressive rate hike that have taken the cash rate to 2.60%.

The meteoric rise in interest rates have been a welcome boost for banks' battered net interest margins (NIM) which tumbled from around 2% five years ago to 1.77%.

Why is the NIM an important measure for banks?

To the uninitiated, NIM is a bank's primary income source and reflects the difference between the interest income from its loan book, and interest paid out to depositors.

The higher ratio the better as it indicates bank efficiency. As a case in point, as a guiding principle, 0.25 of a percentage point rise in interest rates is understood to add 0.04% to a bank’s margin.

If you’ve already done the math, you’ll have worked out that there’s another 0.48% upside for banks’ NIM margin assuming the RBA’s rate increases top out at around 3%.

Pros and cons of higher rates

While higher NIMs are offset by higher rates to depositors, it remains to be seen whether banks can resist passing the full benefits of rate rises on to their customers.

Competition for lenders deposits is expected to heat up as $500bn of fixed-rate mortgages expire, plus another $250bn in split fixed and variable loans.

It also remains to be seen what higher interest rates will do to the mortgage loan business of banks.

Higher rates have already started to have a material impact on borrower appetite for debt and the alacrity with which investors were offloading their shares in the big-four speaks volumes.

Where are we at now?

Despite trending higher on the back of recent rate hikes, the share price for three of the big-four banks is materially lower over 12 months.

While Australia and NZ Bank (ASX: ANZ), Westpac (ASX: WBC) and Commonwealth Bank (ASX: CBA) are down -8.9%, -6.85%, and -4.06% respectively over 12 months, National Australia Bank (ASX: NAB) is the clear outperformer, up 10.61% for the year.

While consensus has a Moderate Sell on CBA, the other three big-four banks are rated Moderate Buy.

Valuation appears to be a major issue for CBA.

According to the brokers covering CBA (as reported on by FN Arena), the bank is trading at a -9% downside to the target price of $91.40.

By comparison, ANZ, NAB and WBC are trading with 6%, 6% and 2.7% upside to brokers target prices (as of 19 October).

Is NAB’s share price outperformance justified?

Given that only CBA works on 30 June financial year end – the others being 30 September – there’s a pesky time lag when comes to making meaningful [performance] comparisons.

While there are no buy recommendations on CBA, Macquarie recently upgraded NAB – the broker’s top bank pick – having concluded that it’s well placed to win market share due to competitive loan pricing and deposit rates.

Broker updates aside, based on financial measures, NAB doesn’t appear to have materially outperformed its peers. However, what may have curried market favour, along with Macquarie’s upgrade, are dividend payments which rose 111%.

Equally noteworthy, NAB’s total non-interest income (fees, service charges) – which accounted for 22.6% of total income - rose 12.9% in FY 2021.

Source: Market Index - banking updates

Making sense of other key metrics

The interest rate spread: The difference between the average yield the bank receives from the interest rate on loans and the average interest rate the bank pays out on dividends.

Interest rate spread: Is the interest rate charged by banks on loans to private sector customers minus the interest rate paid by commercial or similar banks for demand, time, or savings deposits.

Total net interest income: Reflects the difference between the revenue generated from a bank's interest-bearing assets and the expenses associated with paying on its interest-bearing liabilities.

Net profit after tax: Measures the operating profit of a business after all costs and expenses have been accounted for (including tax).

Dividend: A distribution of profits by a corporation to its shareholders.

Total non-interest income: Is the revenue generated from the non-core activities by the banks and financial institutions, including loan processing fee, late payment fees, credit card charges, service charges, penalties.

Dates to remember

Westpac: AGM 14 December 2022

ANZ: AGM 15 December 2022

NAB: AGM 16 December 2022

National Australia Bank: Share price movement over three months.