Summary: Australia’s major banks have become too big and too important to fail. Regulators will want them to put aside more capital to make them safer in a crisis. That could result in lower returns on capital and suggests that banks are fully valued.
Australia’s big four banks have expanded into most areas of your financial life: not just home loans and deposits, but also financial planning and funds management. Most of us also own the big banks directly or indirectly through super funds.
Becoming big in many areas has helped the banks post record profits. But, just like you, the Australian economy has become too intertwined with the major banks. The banks are now too big to fail – if NAB, ANZ, Westpac or CBA get into trouble it would be disastrous for the Australian economy.
Governments have no choice but to act. They either bail banks out when they fail, or they force them to stump up more capital so they can withstand a crisis. The latter is looking more likely.
Indebted Australians
Australians have never had more debt. The household debt to household income ratio is running at 150 per cent – a record level. Most of the debts are mortgages.
Figure 1. Household Wealth & Liabilities
Sources: ABS; RBA; RP-Data Rismark
Since the GFC general credit growth has stalled and recent growth has been dominated by mortgage lending. In the last 6 months 85% of bank asset growth has been housing related finance. This has led to a concentration of risk such that Australian banks are becoming increasingly exposed to the price level of city housing.
Overvalued homes
As we’ve noted, Australian homes are overvalued and many households are carrying too much debt against the value of their house.The lift in Sydney residential property prices has become particularly concerning. Recent surveys have suggested that average Sydney home prices have reached $800,000 or 40% above their levels of 2006.
Too much capital and long-term savings in Australia have been directed at the housing market, particularly towards housing speculation, rather than strategic lending for economic growth initiatives.
The high household debt ratios and high property prices expose the Australian economy, and banks specifically, to the risk of a number of economic shocks, such as a surge in unemployment.
It has happened before: in the 1992 recession unemployment grew to 12 per cent and the number of Australians defaulting on personal and home loans blew out. The banking sector recorded combined losses then. Westpac crashed and ANZ was found to be continually short of capital.
Australian superannuation investors are hugely exposed to bank shares and their retirement aspirations could easily be cruelled by a repeat of the GFC or a major Australia-centric recession like that which occurred in 1992.
Another concern is that the reported levels of bad debts as a percentage of loans are higher today than they were prior to the GFC for all areas of lending. This trend needs to be monitored, and particularly because bank provisions for bad debts are actually at historic lows.
More bank regulation coming
Today banks and all other lending institutions have stronger capital ratios than they had in 1992. Whilst that is good news, it appears to us that this higher level of capital is absolutely required to support the higher household indebtedness and the risk of a rise in bad debts.
Australia’s banks are much more embedded in the financial economy of the nation than any other banking sector in the world. That increases the need for Government regulation – to regulate the banks more strongly in terms of their capital.
If banks are too big to fail, then governments will be forced to bail banks out when they fail. But as we’ve seen overseas, bail outs cause the economy to slump into a long-term low-growth recession. The last thing you want is to have government stacking on debt to underwrite banks.
The other way to mitigate against risk to the economy is to ensure banks have higher levels of capital than currently required in offshore jurisdictions.
Former CBA chief, David Murray, who is running the Government’s inquiry into the banking system, has flagged higher capital requirements for banks to cut the risk of them failing in tough times.
Australia is not going to regulate the market shares of banks so we think higher capital requirements are likely.
Banks fully valued
What does this mean for bank shares and bank investors?
Essentially Australia’s banks will become overcapitalized by requirement and their return on equity (ROE) – the key measure of performance – will suffer.
Regulation will offset their growing market dominance. Don’t expect banks’ ROE will increase just because they have got more dominance in the market. We suggest the opposite.
The economies of scale story of banks has pretty well played out. They’re now about to experience diseconomies of scale through regulation.
All up, it’s another reason why we think bank shares are fully valued, except perhaps NAB and ANZ, and why there is not much margin of safety in the big four banks.
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