Are the Big 4 Banks a Guaranteed Great Investment?

Many Australian investors feel comfortable having the Big 4 Australian banks – ANZ, Commonwealth Bank, NAB & Westpac – as a cornerstone of their Australian share portfolio given that they are generally regarded as good companies. Collectively, the Big 4 banks account for around 22% of Australia’s stockmarket capitalisation.

As Ric Battellino, Deputy Governor of the Reserve Bank of Australia (RBA), recently noted, the Australian financial sector benefited greatly from the credit boom that began in the mid-1990s and ended with the GFC[1].  The good work of regulators and the Federal Government over this period helped ensure that our financial system weathered the GFC better than most countries.

In recent times, the pace of credit growth has been much slower.  Ric noted that although history tells us that periods of weak credit growth such as the present one are relatively short-lived in a growing economy, it would be wrong to think that this guarantees a return to the growth experienced in bank balance sheets since the mid-1990s.

The past 15 years was an extraordinary period for the Big 4 banks driven by what was largely a one-off adjustment to household gearing following financial deregulation and the sustained fall in inflation (as the RBA formally adopted an interest rate policy to maintain an annual inflation rate between 2% and 3%).

In the economic climate likely to be faced by banks over the next few years – solid economic growth but with cautious behaviour by households and relatively low inflation – the RBA anticipates that the rate of growth in credit will remain somewhere in the single-digit range.

Competition for new credit lending should be strong, which can often coincide with a relaxation of borrowing standards.

Some research suggests that lenders are already cutting standards, for example increasing loan to value ratios[2].  These practices expose the lender to greater loss if they need to foreclose on a loan.

The number of loans in arrears – particularly those 90 days past due – is now at the highest level in 15 years[3].  Most of this troubled crop of loans was written in 2008 and 2009 – when government stimulus packages and interest rates falling from 7.25% to 3% fuelled vigorous property market activity.

The low doc loans that were prevalent during 2008 and 2009 make up a higher proportion of those that are not meeting interest payments.

There are other challenges the Big 4 banks may face in the near future, which include:

  • Uncertain impact of the Basel III reform[4].  A report released in early June by the Australian Centre for Financial Studies says the new rules could affect Aussie banks by requiring them to hold larger reserves of liquid assets for each dollar they lend.
  • Legislative issues, with Greens (who now control the Senate) proposing a tax on banking profits.
  • A report was released in May 2011 by a Senate Economics Committee into competition in the banking sector recommended initiatives to ease concentration in the industry and make banks more accountable for their margins and return on equity. That could lead to greater competition for the Big 4 banks.

The picture emerges of an industry that has long basked in near perfect conditions – strong credit growth, shelter from competition, a stranglehold on the home loan market, fat margins – but which may now be facing the gradually erosion of these strengths.

None of this analysis suggests that the banks are in any serious trouble, and the current level of loan delinquencies does not indicate there is a major problem.   The Big 4 banks remain very good companies.

However, you should not be misled to believe that a good company necessarily makes a good investment.

Over the 10 years to 31 May 2011, the average annual return of each of Big 4 stock was:

 

These returns are solid compared to the average annual return for the Australian stockmarket of 7.8% during the period.  However, in comparison, the gross return of our Australian share strategy for the period was 10.6% pa – or 2.0% pa higher[5].

Past performance is no guarantee of future performance, so we are not suggesting that the next decade will deliver similar results.  But what we do recommend is that investors maintain an appropriate level of exposure to the Big 4 banks in their portfolios, but also ensure their portfolio is positioned to capture the higher expected returns that small and value company stocks deliver compared to large companies like the Big 4 banks.


[1] Address to Annual Stockbrokers Conference, Sydney, 26 May 2011. GFC: Global Financial Crisis.
[2] Herald Sun, Peter Taylor, 7 June 2011
[3] Vintage Housing Bubble May Give Us Trouble, SMH, Elizabeth Knight, 1 June 2011
[4] The Basel Committee on Banking Supervision is an institution created by the central bank Governors of the Group of Ten nations, including Australia. The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision
[5] Source: Returns Program.  Returns are gross and do not include costs. 

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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.