Over the past year, Australia’s big four banks – Commonwealth Bank (ASX: CBA), Westpac (ASX: WBC), ANZ (ASX: ANZ) and NAB (ASX: NAB) have fallen anywhere from 14% (CBA) to 21% (NAB) excluding dividends.
As a result, all four big banks now trade at attractive yields (which are all fully franked too):
Historical yield (%)
Let’s take a look at some of their strengths and weaknesses.So is now the time to buy the big four banks?
On the plus side of the ledger, the big four banks remain on oligopoly and, despite attempts by regulators to increase competition, are likely to remain so in coming years.
The big banks benefit from regulators allowing them to hold less capital against their assets (primarily residential mortgages) compared to their smaller counterparts including Bendigo and Adelaide Bank (ASX BEN) and Bank of Queensland (ASX: BOQ). This means they can charge lower interest rates on loans than their smaller competitors.
And whatever the politicians of either major party might tell you, due to their sheer size and influence on the Australian economy, the big four banks will likely be bailed out by the government should they ever get into serious trouble.
If this ever occurs, it will likely be painful for ordinary shareholders and owners of bank hybrids alike but this implicit government guarantee allows the big four banks (and Macquarie (ASX: MQG) too, for that matter) to raise funds at lower cost than their smaller competitors.
Finally, once a customer is acquired by a bank, the reasonably high switching costs mean it is likely that that customer remains with the bank for many years. Even more so if the customer not only has a savings account but also a checking account, credit card, brokerage account and mortgage with that bank too.
The proposed Open Banking regime is an attempt to reduce switching costs and thereby the big banks’ oligopoly, but switching cost are still likely to remain high enough to advantage the big four banks over their smaller competitors, particularly given these banks’ other advantages mentioned above.
On the other side of the ledger, APRA recently increased the amount of capital the big banks are required to hold against residential mortgages. From 1 July 2016, the big banks and Macquarie have been required to assign an average risk weight of 25% against mortgages. This is a significant increase from the average risk weight of 16% they previously applied and has reduced – but not eliminated – their competitive advantage over their smaller competitors in this regard, who are required to assign a minimum risk weight of 40% against mortgages.
While the Australian economy seems to be chugging along nicely, house prices have started to fall in both Sydney and Melbourne and so credit growth is likely to be slower in coming years than it has been in the past.
And credit is only likely to be even harder to obtain after the Financial Services Royal Commission is complete and many of its recommendations legislated.
Meanwhile, regulation keeps increasing as the new rules imposed by global banking regulators after the GFC gradually come into effect. These costs are of course unavoidable and so the big banks “compliance” costs are only likely to keep increasing in coming years.
As for other expenses, no doubt there is further scope for cost out as the banks invest further in automation. For example, in its 2017 result NAB announced plans to axe another 4,000 positions over the next three years. However, with cost-to-income ratios already low at around 40%, incremental improvements are going to be harder to come by.
And even though Australia hasn’t entered recession since the early 1990s, it’s important to remember that banks are ultimately cyclical companies. As such, with provisions currently at historically low levels – due to very low interest rates, house prices that have basically kept rising (at least until recently) and reasonable economic growth – it’s likely that provisions will rise sooner or later.
The potentially ugly
But to me, the biggest risk is a potential housing crash.
As mortgages are by far the largest exposure of all the big four banks, by betting on the big four banks you are essentially taking a bet on the performance of the Australian housing market.
While I am not predicting a housing crash, if one did occur, owning the banks at current levels will likely prove unprofitable.
(As an aside, it will be interesting to see the impact on the housing market, if any, of the banks passing on any further increase in funding costs to their customers. Will this exacerbate the current downturn in east coast house prices?)
While it’s likely the big four banks’ dominant market position will allow them to keep passing through increased funding costs like three of the big four did recently by increasing their variable mortgage rates, they are still suffering pressures elsewhere in their P&Ls.
This likely means moderate earnings growth in coming years and, with payout ratios already near the top of their respective target levels, moderate dividend growth too.
Other than a serious house price crash, however, all this has already been priced in by the market, hence the generous yields on offer.
Frankly, I don’t know how to calculate the odds of a housing crash occurring and so that is why I don’t own shares in any of the big four banks.
For those who don’t think a housing crash will occur, however, I’d suggest that all the big four banks are Holds.