New rule may test dividend tradition
Hong Kong banks have a record of delivering dependable returns to shareholders. On the rare occasions that earnings growth has faltered, payout ratios have generally been tweaked to maintain remarkably consistent dividend yields.
Yields offered by the sector now hover near 4 per cent on average, on par with utilities. Factoring in share price gains, bank stocks have been clear winners since 1994, providing a compound annual growth rate over the period of 15 per cent versus 11.1 per cent for utilities, 0.3 per cent for the property sector and minus 2 per cent for conglomerates.
Interim profit reports for the industry, to start rolling out next week, can be relied on to deliver more of the same for investors, which is one reason banks are beloved of fund managers.
They have weathered challenges to their operating environment as dramatic as those presented by the Asian financial crisis of the late 1990s while keeping their dividend records largely intact. That meant soaking up the punishment delivered by a 70 per cent collapse in property prices, a sharp retreat in loan demand and interest margins, and a surge in bankruptcies and bad loans.
But now an entirely new challenge looms to maintaining those consistent dividend payouts - not only for banks, it must be pointed out, but all corporates.
From next year, under International Accounting Standards 32 and 39, all Hong Kong corporations will be required to record derivatives at market value at every balance sheet date.
Under this new accounting rule, changes to the fair value of derivatives not used by banks for hedging purposes will have to be booked into profit and loss accounts. That could lead to greater earnings volatility, posing a threat to those cherished dividend payouts.
For the moment, the people who should know - bank managers and their regulators, big institutional investors and bank analysts - are unconcerned about the effects of the new rule.
In the worst-case scenario, reported earnings from banks might become more 'chunky', or erratic; but the swings captured at one point in a reporting cycle would become roundabouts at the next, leaving longer-run underlying cash earnings - and dividend payouts - more or less unaffected.
Analysts and shareholders may start valuing their investments on a price-to-book basis, rather than price-to-earnings, an approach commonly used in the property sector.
The prospect that reported bank earnings might oscillate more widely is therefore well understood by institutional investors and bank analysts. Retail investors may initially be baffled by occasional differences arising between headline earnings reported by their bank and the underlying cash earnings per share.
But they will learn to tell the two apart soon enough.
But there is a snag to this sanguine view. Before they distribute dividends, banks are required to get approval from the Hong Kong Monetary Authority, which assesses the ratio of the dividend payout to earnings.
In the event of a big one-time variation in reported earnings resulting from fair-valuing derivatives, the HKMA may be counted on to be accommodating, particularly given the surplus capital in the sector. It might even allow a payout of up to 100 per cent of reported earnings in order to maintain dividend yields.
It might. Once. But the chances of that relief being granted a second time will be slim indeed if a bank's derivative portfolio goes sour and does not recover in time for the next half-yearly earnings statement.
In those circumstances, what you see in reported earnings is likely to be what you'll get.