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Commonwealth Bank facing some headwinds, say analysts

Banking analysts have given Commonwealth Bank of Australia's interim results the thumbs up but have highlighted "soft" capital generation, higher costs, and ongoing margin pressures as issues to watch.

CBA's $4.6 billion first half profit should bode well for the performance of other domestic banks, as it suggests few borrowers are defaulting on loans and lending to big business is picking up, analysts say. 

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All the major banks share prices opened higher on Thursday morning although CBA was trading lower mid-morning. 

Australian Prudential Regulation Authority chairman Wayne Byres told a Senate committee on Wednesday night that the regulator had been keeping a close eye on global volatility in financial markets "but the declines in stock markets and the increases in credit spreads that have occurred in recent times have been quite manageable given the sector's strong starting position".

"Indeed, this is why we require regulated institutions to maintain buffers over and above our minimum requirements – so that this sort of volatility can be absorbed without any significant stress," Mr Byres said. 

After CBA delivered a 4 per cent rise in earnings and kept its interim dividend on hold for the first time since 2008, the reaction from analysts has been mainly positive, despite signs banks are not without challenges. 

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Macquarie titled its note on CBA on Thursday: "The wheels keep on turning"; the UBS note was headed: "Like driving a steam roller."

UBS analyst Jonathan Mott said: "In banking, boring is good - the current environment is a case in point. CBA's result contained few surprises and we think the underlying franchise remains in very good shape."

Credit Suisse analyst Jarrod Martin said CBA's earnings set a positive tone for the sector because two key fears - a significant rise in bad debts, and a potential cut in the dividend - had not eventuated.

As global share markets this week have dished out the punishment to bank equities and pushed the spreads on bank debt wider, Goldman Sachs analyst Andrew Lyons said the recent de-rating of the sector had been overdone given CBA had reported a strong asset quality, said funding developments are manageable and reiterated group dividend guidance for a full year payout ratio of between 70 per cent and 80 per cent.

Other positive aspects of the CBA result were the 19 per cent growth in loans in its institutional banking arm, and a solid showing in New Zealand, where CBA's profits grew 5 per cent.

"In an unforgiving equity market with a sharp eye for negative announcements, the CBA result provided some welcome relief for de-rated Australian bank stocks," said Mr Martin, who has an "outperform" rating on CBA.

Against these signs of strength among the big four banks, analysts also pointed to potential signs of weakness in its profit margins and rising costs.

Analysts at UBS, Credit Suisse and Deutsche Bank all trimmed their profit forecasts for CBA slightly after the result, which included a moderate increase in its bad debt charges, even though these were flat as a percentage of loans.

Several analysts pointed to the potential for volatility in the funding markets to put pressure on net interest margin. Mr Mott, who has a buy recommendation on CBA, said he expect CBA's net interest margin to expand in 2H16 as the full period benefit of mortgage repricing flows through, "however, this may be at risk if funding market volatility continues, especially if this flows through to deposit competition." He also pointed to the 6 per cent increase in staff costs and 13 per cent rise in IT expenses as issues of concern. 

Macquarie analyst Victor German, who is neutral on CBA, said re-pricing benefits from the increases to interest rates on mortgages pushed through last year outside the Reserve Bank cash rate cycle were largely offset by ongoing competitive pressures in the retail bank, margin compression in the Institutional division and in NZ, he said. 

Capital back in focus 

With levels of bank capital remaining a hot topic given APRA's push for banks to hold capital that makes them "unquestionably strong", analysts were underwhelmed by CBA's capital generation. The common equity tier 1 (CET1) of 10.2 per cent was down 20 basis points on the CET1 in FY 2015 once adjusted for the $5 billion entitlement offer last year.

CLSA analyst Brian Johnson, who has a sell recommendation on CBA, said CBA was $10.7 billion short of CET1 relative to CLSA's expected CET1 target of 10.5 per cent. 

Citi's credit sector specialist Anthony Ip told clients that while there are many levers CBA can pull to boost organic capital generation – for example, cutting dividends, increase loan pricing or reducing credit growth –"it's clear to us under current settings that it's a challenge for major banks to "earn their way" to stronger capital ratios….All things equal we see the solution to meeting tougher regulatory hurdles being via more issuance (either equity, or AT1 and T2 [different debt instruments])." 

Mr Mott said: "Although CBA believes it is strongly capitalised, we believe further capital accumulation is necessary to lift its proforma CET1 ratio and to account for higher RWA with the adoption of Basel 4 and APRA's interpretation of "unquestionably strong"."

After opening in black, CBA shares had turned negative by 1045am AEST, and were trading down 0.5 per cent at $73.80 while all the other banks were trading higher. 

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