We have climbed down from our soapbox today, in order to take a look at the banks. Or, more precisely, the dividends on bank shares.

Today’s Age reports that “Australian banks pressured to lower dividends.” It’s a touchy subject for the four major banks. If there are two things Australian income investors like it’s a nice juicy dividend and 100% franking.

With interest rates falling, investors will naturally be looking for other sources of income. And with bank share dividends offering yields of about 9% it is a pretty attractive investment.

For instance, take a look at the four major banks:

ANZ Bank - yields 9.7%
National Australia Bank - yields 10.2%
Commonwealth Bank - 8.1%
Westpac Bank - 8.5%

And Queensland based Suncorp can offer a dividend even better than that. It is yielding 11.7%.

Add in the franking credits and the yield gets another boost.

For those that rely on income streams from their investments, falling interest rates can make a big difference. Supposing an investor has $500k in their account to live on in retirement, a cut in interest rates from 6% to 5% results in an income reduction of $5,000 per year.

For that reason bank shares should look attractive. $500k could potentially provide an income of about $45,000, compared to only $25,000 if held in cash at 5%.

But it is a big, big risk. Especially for those in retirement. Many will have seen a drastic reduction in the value of their share portfolios. They would be the same people who assumed investing in the banks was safe and reliable. They would have convinced themselves that banks shares couldn’t fall - not by 50% anyway.

The big question for them is, has the market discounted the price of bank shares in the belief that dividends will be cut? You would think it has. So far the Australian banks have weathered the global credit problems quite well.

Not that they have got off completely. But unless something really bad comes out of the woodwork it seems likely that all the ‘bad debt’ risk is already built into the share price.

So it can only really mean that expectations are high for a dividend cut. As Bell Potter research director Peter Quinton points out in The Age article, “It’s increasingly untenable to be paying out 90% of profits as dividends when all banks around the world are rebuilding their capital.”

If we assume a reduction in the yield to about 7% then the banks are now trading around that level. That should reduce the chances of them falling much further in the event that dividends are cut.

Considering that if banks do reduce dividends there is little incentive for investors to jump in as they won’t benefit from the current yield anyway. Therefore it would seem probable that despite the appearance of being good value, bank shares will remain low until there is an indication on the next round of dividends.