Fresh worries about the sustainability of dividends paid by the Big Banks could not have come on a worse day with economic jitters sparking a bout of panic-selling on the market.
Shares in Australia's largest mortgage lenders have slumped heavily and a report claiming that their returns are the most vulnerable to tighter regulatory requirements is an added burden that shareholders will have to shoulder.
Banks are being forced to increase their risk weighting on mortgages by banking regulators as part of global push to ensure the financial system can withstand an external shock, and Morgan Stanley warns that this puts bank dividends and capital returns in jeopardy.
Australian banks have some of the lowest mortgage risk weightings in the world at around 10% when US banks average about 53%.
This is about to change with the Australian Prudential Regulation Authority (APRA) mandating that the Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), Australia and New Zealand Banking Group (ASX: ANZ), and National Australia Bank Ltd. (ASX: NAB) have to lift the risk weighting to 25% by July next year.
Investment bank Macquarie Group Ltd (ASX: MQG) is also affected by the new requirement.
The higher the risk weighting, the more cash and liquid assets the banks will have to set aside to act as a buffer against a market collapse.
This means less cash to pay out in dividends and it will also materially lower the Big Banks' return on equity (ROE) – a key measure of profitability.
CBA has the highest ROE among its peers and that is why it has long traded at a premium to the sector. Morgan Stanley estimates that CBA's retail banking division generates one of the highest ROEs among global banks of 43%.
But this will drop to below 25% if the risk weights were increased to 32%, which is more aligned to what banking regulators in other developed countries are pushing for.
What's more, the Big Four will have to raise a further $8 billion to $10 billion if they are to meet the even stricter global banking standards.
CBA, ANZ, NAB and Westpac have already raised in excess of $15 billion by selling shares and hybrid notes following APRA's decision to increase the sector's capital adequacy ratios.
But the Big Four can offset some of the cash pressure by increasing interest rates on loans, according to Morgan Stanley.
This probably won't be in the immediate horizon as there is a price war between the lenders right now as they try to win market share with lower rates and other rebates.
If push comes to shove and banks have to weigh up options to lift their cash holdings, I am sure loan rates will rise before dividends get cut.
However, these doubts about the Big Four's cash adequacy will only make investors more nervous about the sector following Citi's prediction that the banks will have to cut dividends by 2018.
I don't rate this as a likely scenario and I think shares in the Big Four are cheap, although it is important to be cognizant of this growing risk.
Westpac tumbled 3.1% to $30.16, CBA fell 2.6% to $71.89, ANZ shed 2.3% to $27.20 and NAB declined 2% to $29.89 in lunch time trade.
