Within a few short months, the prospect of the Australian share market returning to pre-global financial crisis peaks has largely dissipated. Despite higher US interest rates, Australian interest rates remain at historically low levels and the economy has benefited from strong commodity prices and buoyant demand for our LNG exports.
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These factors underlaid a stronger share market until the proceedings of the banking Royal Commission and Labor’s proposal to cease cash refunds of franking credits unsettled investors. Changes to the imputation credit system and adverse Royal Commission findings could decrease the benefits and increase the risks of owning bank shares.
The biggest attraction of bank shares to individual and institutional investors is the high fully franked dividends available to investors particularly those paying no or low income tax. For a zero-rate taxpayer, the refund of franking credits increases the value of franked dividends by 42 per cent.
Losing access to this credit at the same time as bank profits are pressured by ASIC or royal commission changes would reduce market support for the banks already struggling to maintain their mortgage business margins.
Even if commodity prices remain strong, the high weighting of bank shares in the key market indices will provide a dampener on overall share returns especially in the popular market tracking passive index funds. Index funds will change their exposure to bank shares only if their weighting in the relevant index changes.
Stock selectors and active investors have scope to change the weighting of individual shares in their portfolios. The approximately 10 per cent recent fall in bank share prices could reflect anticipation of future problems for this key sector of our market.
For many investors adjusting portfolios involves paying capital gains tax on realised profits. On highly profitable long-term holdings of our bank shares, the capital gains tax liability can be as high as 24 per cent of the realised gain.
The reluctance of investors to trigger a capital gains tax liability by taking their profits increases the opportunities for short selling by traders who don’t own the underlying shares. There is no shortage of shares available for borrowing because our tax laws facilitate share lending by not treating the loan of the shares as a change in beneficial ownership.
The continuing stream of revelations to the Royal Commission appear likely to continues to provide adverse publicity for the major banks. This is fertile territory for short sellers to profit from the Royal Commission’s hearings. Short sellers and low tax rate active investors will continue to be the main beneficiaries of selling out or reducing exposure to bank shares before investors come to appreciate the full extent of the challenges facing our banks.
Daryl Dixon is the executive chairman of Dixon Advisory. comments@dixon.com.au
