In the latest iteration of the Firetrail Analyst Series we dive into an incredibly important sector for income investors and SMSFs: Australian banks.

Our Analyst Scott Olsson takes the view that banks will emerge from the crisis slowly as lenders navigate a crosscurrent of headwinds including COVID-induced bad debts, a slow economy and low interest rates which will all culminate into lower return on equity (ROE).

"Overall in the next three years, we're expecting about $50 billion of bad debt losses across the four major banks. That's about 40% of pre-provision profit. So it's a big hit to their P&L and dividends."

But for investors willing to look through the cycle, the days of 5-6.5% dividends will return as the major banks still command formidable franchises and will eventually re-fortify their balance sheets in line with regulatory requirements.

Watch the interview with Scott or read the Q&A below for our overall view on the sector and 2 bank stocks we like in the context of that view. 

Don't forget that this is the second of six exclusive reports for Livewire readers. Hit 'FOLLOW' on the left of the page for our next update.

What matters for the banks over the next 12 to 24 months?

The next 1-2 years is really about how the banks navigate COVID from a capital standpoint and obviously the big driver there is bad debt losses. What we've seen already is all of the banks have taken bad debt charges in the most recent reporting season to allow for that deterioration from the virus. There's clearly going to be more charges coming up and it'll probably be pretty lumpy because at the moment you've got all this stimulus in the system, so the experience is probably good at the moment.

But as that rolls off, we're going to see more bad debts coming down the line. It's very hard to pick where that's going to land and the way we're thinking about it is relative to the GFC. We think in areas like SME and credit cards, you're going to have losses that are worse than we saw in the GFC. Whereas areas like institutional lending are probably in a bit of a better position, so we're expecting that to be a bit better. 

Overall in the next three years, we're expecting about $50 billion of bad debt losses across the four major banks. That's about 40% of pre-provision profit. So it's a big hit to their P&L and dividends.

We've already seen that playing out with the dividend suspensions and NAB with its really low dividend. But the important thing is where capital gets to. Under that scenario, the capital ratios only really fall into the high 9% range. And that's well above minimums and not that far off APRA's unquestionably strong 10.5% benchmark. 

Within that NAB and CBA are the strongest; NAB, as you know, raised over $4 billion of capital just a couple of months ago. So that's helped them. ANZ and Westpac are the ones that are in that high 9% range, but we think they can get back to those comfortable capital levels on a three-year view, just with dividend cuts and some other action rather than big diluted capital raisings. So from a capital standpoint, they're actually in a reasonably good position this time around.

Can you describe some of the other headwinds and also the tailwinds they're likely to see?

When we look through to financial year 2022/23, that's the period where we think bad debts might be getting back to closer to mid-cycle levels, and that will drive an earnings recovery, obviously just from lower bad debts. So then you're looking at what the core operations of the banks are doing. And at that time they're probably still going to be facing the pressures that we saw them facing before COVID hit. And that is low interest rates pressuring margins, pressure on the fee income line and regulatory and compliance costs, which just makes it harder to lower the cost base of these banks. You have to pull out costs just to stand still. So they're all headwinds still. 

But when we look at the positives, we're starting to see a flight to quality. To explain, since the GFC, we've seen the flow of mortgages going to the majors steadily decline over time. And banks like Macquarie and the offshore lenders are picking up share. We've started to see data since COVID that suggests that a lot of mortgage share is going back towards the majors.

It's a short-term thematic at the moment, but that could actually support a bit of share stabilisation for the major banks in total. That was what we saw through the GFC, that flight to quality was a positive thematic. Despite that, we still think that the pre-provision earnings bases in FY 22 will be 10-15% lower than they were in FY 19. At that level, you're getting ROEs of 8-9% for ANZ, NAB and Westpac, and maybe closer to 10% for CBA. That's down from the low to mid-teens only a couple of years ago. 

That's sounding pretty bearish I guess but the positive spin on it is even at that level, if you're paying out 70% of your profit, the dividend yield is going to be 6-6.5% for ANZ, NAB and Westpac and closer to 5% for CBA. So it's a reasonable yield, but you have to get through FY 20 and 21 where dividends are going to be well below that level before you're getting your 5%+ per year.

Putting all that together, are banks a buy?

No, not in our view. They don't look expensive anymore. Those ROEs have obviously come down a lot, but you're paying a discount to book for all the banks except CBA at the moment. 

Where I would be a buyer is if the environment is a lot better than what we're thinking and maybe bad debts are a lot lower, but in that scenario, where the banks are performing well, we think other sectors and other stocks are going to be performing even better.

And so our thinking in the portfolio is we're allocating more capital towards those opportunities rather than towards the banks at the moment.

So which banks, if any, would you buy?

National Australia Bank (ASX:NAB)

NAB is our preferred of the majors. We really like the CEO and Chairman combo of Ross McEwan and Phil Chronican - they bring a lot of experience which you want going through a crisis like this. Obviously NAB is very overweight SMEs, so I think they will have higher bad debt losses than the other banks, but they've now got the capital position to deal with it. So I think that that is the key thing there, and their SME franchise is still a very valuable franchise. The new CEO, I think he's going to bring a lot of accountability to the business and pull out a lot of unnecessary costs. And when you're looking medium-term, I think there's an opportunity for him to improve the retail franchise. So we like the NAB story.

Virgin Money UK (ASX:VUK)

Another one that we like, which actually isn't operating in Australia, is Virgin Money UK. Now, I guess you can say the same things about the UK market. It's a very tough banking market. Globally banking is very tough and Virgin is the 6th largest bank in the UK. So you could say they're in a bad competitive position as well, similar to the regionals here. So there's a lot of negative points. Our thinking on that one though, is that the acquisition and rebrand to Virgin Money a couple of years ago gives them a lot of levers they can pull. I think there's a lot of opportunities on the asset and the liability side of the balance sheet and also a big cost-out opportunity and management has shown that they are good at executing cost out that business. 

When we look out to FY22 and 23, we think it can be delivering close to a double-digit return on its tangible equity base. And it's trading at 0.35x that tangible equity base at the moment. It's really priced for capital destruction and similar to the Aussie banks we see capital levels falling, but not getting anywhere near minimum levels and not to levels where they need to undertake a very dilutive capital raising.

They're the two financials businesses we like at the moment.

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We hope you enjoyed this wire on the banking sector. In case you missed it, here's our previous report on why we like Amcor. If you'd like to receive our other exclusive reports first,  hit 'FOLLOW' below.