On 15 July, David Murray (former Commonwealth Bank CEO) released an interim report on Australia’s financial system – the most significant of its kind in 16 years.
The scope of the report extends across banking, superannuation and financial advice. One of the more significant ‘takeaways’ from the report is concerns for the future of the banking sector, and in particular the Big Four Australian banks, which often form the centrepiece of Australian Mum & Dad investor portfolios.
Some key items to note from reading the report:
- Dependence on residential mortgages is a systematic risk to the Big Four banks. Since 1997, housing loans have increased from 47% to 66% of the banks loan portfolio.
There is an expectation in some parts of the industry that the Big Four banks will be required to hold more capital against mortgages to withstand future shocks to the financial system. Australia’s capital adequacy requirements are currently average by global standards. Also at present, the big banks are only required to hold half as much capital against mortgages as smaller regional banks. This allows them to write twice as many mortgages and impacts on the competitive landscape.
- A preference to loan against property has increased the price of business lending. In Australia, small and medium enterprises (SMEs) employ 70% of our workforce, which is high by global standards. Making it harder for SMEs to access and pay for finance is an issue for sustaining improvements to our national standard of living.
- Since 1997, only 10% of housing finance was for new dwellings. This means much of the borrowing has been used to bid up the price of an existing portfolio of assets – which has only marginal impact on improving our standard of living.
- The report also makes reference to the Reserve Bank of Australia (RBA) paper issued on 14 July entitled “Is Housing Overvalued?” This paper concluded that future house prices would need to rise at the same rate as over the past 60 years for owners to be as well off as renters (this is not easy to comprehend).
The RBA concluded that real house price growth (which means actual price growth less inflation) has averaged 2.4% per annum since 1955. As we’ve noted in previous research, over the long term the expected real return of residential property is closer to zero. So the past 60 years has seen residential property perform well in Australia. The RBA also noted that current house prices appear fairly valued if the historic rate 2.4% average annual real return is expected to continue. This is very hard to predict, though the RBA paper conceded most people it had spoken to anticipated lower future returns.
- Later this year another White Paper will be delivered to the Federal Government detailing recommendations for amendments to Australia’s tax system. Amongst some of the recommendations being discussed in the media are calls for negative gearing to apply to new homes only or quarantine losses from negative gearing so they can’t be used to offset gains from other income sources. If such proposals were eventually legislated, it will certainly have an impact on the demand for housing loans.
- The $250,000 deposit guarantee may create a moral hazard and reduce funding costs for banks.
The moral risk is that if taxpayers cover the first $250,000 of a person’s deposits with a bank in the event of failure (which is a guarantee that has remained since introduced during the GFC), then it may encourage banks to be more risky during the good times. The challenge is to make the financial system more credible without government support – remember the RBA also acts as lender of last resort to the big banks if they get into financial difficulty.
The report suggests that banks may pay an upfront fee for this guarantee to remain in place. Whilst the report unfortunately doesn’t try and quantify the value of the existing guarantee to the banks, the Customer Owned Banking Association has previously estimated the cost at $2.5B each year. This equates to 9% of the Big Four banks current $28B in combined annual profits.
The Murray report notes that banking sector returns are “comparable to those achieved by other large Australian companies”, but doesn’t mention that the other large companies don’t benefit from government guarantees.
Technically the risk of the big banks is lower compared to these other large companies (because of the actual or implied government support), so their returns should technically be lower as well. But in fact, numerous studies have shown Australia’s banks to be amongst the most profitable in the world. The Commonwealth Bank services a population of 24 million people, yet has a market capitalisation larger than Goldman Sachs or American Express. So are the big bank profits a function of skill or unpriced taxpayer/government subsidies?
More consultations will occur before the Murray report is finalised. Based on the interim draft, no radical recommendations will be proposed, but the playing field could be levelled for a number of smaller Australian financial institutions against the bigger banks.
Our comments above are designed to highlight the fact that having concentrated exposure to Australian bank stocks involves risk – and more risk then many Australian investors probably appreciate.
An equity portfolio concentrated in Australia is heavily exposed to the financial services and resource sectors – the Big Four Banks plus BHP and Rio comprise half of the ASX market capitalisation. Consequently the global price of a few commodities and Australian house prices could largely determine the success of many Australian family’s financial plans for their future. The Murray report gives us further reason to ensure client portfolios are appropriately diversified, and that action needs to be taken to systematically reduce high levels of concentration as the future may not be as protected (i.e. the Four Pillars policy) for the banking sector.
 Tax Breaks on Homes at Risk, Australian Financial Review, p8 16 July 2014
 Cold comfort for the small guys, The Australian, p28 16 July 2014
 Time for Discussion Over Meaning of Too Big to Fail, AFR, p10 16 July 2014
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.