INVESTOR EDUCATION –Banks Get Bashed
Australian banks have been subject to a considerable amount of bad press over the course of the last 6
months. This has ranged from trader scandals and private wealth and financial advisor misconduct to
housing market concerns and bad debt loans. Collectively, the bad news has seen the banking sector
perform dismally.
An overview of the current banking environment
Financials are the largest sector of the ASX and comprise of almost half the index.
This means we banks perform poorly, the general market tends to also perform
poorly given their influence.
The largest 4 companies on the ASX alone are the major for banks and have a
combined weighting of almost 27%. Accordingly, the ASX is not very well diversified
and at the whim of the performance of banks.
The latest bad news surrounding banks hit late last week, with both ANZ and Westpac
issuing statements that their bad loans will be materially worse than they had
previously expected. This has seen almost $25 billion wiped off the big 4’s values in
just a matter of 2 days. Although the absolute quantum of bad debts may not be
large, it is what they signal that is more concerning to investors.
ANZ
ANZ’s has been the hardest with $6 billion being slashed from its value on the back of
news that its bad debts will rise by $100 million. ANZ shares are down 10% from their
recent high over the past five trading days. The bank on Thursday said its total charge
for bad and doubtful debts for the first half would be “at least” $100 million more
than the $800 million figure it had flagged in mid February. The cause for the
downgrade was “a small number of Australian and multi-national resources related
exposures”, it said ANZ’s warning on bad debts, while not significant on its own, added to other similar
warnings on credit quality, including one last month and another in August. The
recent announcement follows a warning by the bank that it is experiencing rising bad
loans in its south-east Asian lending businesses, a downgrade that prompted analysts to lower their profit forecasts for the lender.
Most of the concerns centres around ANZ’s institutional lending. There have been a
number of high profile company failures recently such
as Arrium, Peabody Energy, Dick Smith, and Slater & Gordon. Investors fear that there
may be more to come, particularly from the mining and energy sector and are
concerned over the quality of the remaining loans in the portfolio.
ANZ’s business mix is skewed more towards institutional lending, and it also has a
higher exposure to resources companies than NAB and Westpac.
ANZ has the second biggest amount of loans to commodities companies at around 1
per cent of its book after Commonwealth Bank on 2 per cent.
Westpac Meanwhile, Westpac has flagged a rise in personal loans defaults in mining-heavy regions. The bank said impaired loans in its unsecured lending portfolio will increase by $25 million, or 10%, in its upcoming half-year results. Although not a large number alone, it does bring into question the credit quality of personal loans in general and what and what the other banks may also have.
Westpac’s consumer bank, George Frazis, believes that the personal loan
impairments did not reflect broader problems, but there were a handful of big
institutional customers that would be a key influence on its provisions for bad debts
this half’s financial results.
Current issues
Unfortunately the banking industry’s problems are not just limited to raising bad
debts. Below is a list of the major four influences currently plaguing the industries
performance.
1. Increasing funding costs leading to lower profit margins
2. Increases in bad debts
3. Regulators are likely imposing further capital requirements, lowering banks
profitability
4. Low interest rate environment makes banking profit margins shrink
5. Non-interest income may be lower because of possible changes to
interchange fees
With the possibility of further capital required from a regulatory stand point in
addition to bad debts eating away bank capital, further capital raisings by the banks
may be needed. This already comes at a time when the sector is out of favour which
can make raising additional capital considerably more difficult and expensive.
When the banks raise capital, the share price tends to react negatively for a number
of reasons. Firstly, the dilution effect results in investor’s level of ownership
decreasing and consequently the current value of the investor’s holdings also
decreases. Secondly, investors may be concerned as to why the company needs
additional capital. Rising capital sends a signal that the entity currently does not have
enough free cash to support itself. It tends to be a key sign of struggling companies.
Alternatively, banks may be forced to cut dividends as opposed to raising additional
capital. Dividends are essentially capital that the company has earned and no longer
deem it necessary for the ongoing needs of the business. In other words, it is excess
cash the company does not need to operate and therefore want to return it to
shareholders. However, this would be another unfavourable move as investors have
become accustomed to the high payouts from the banks. Cutting the dividends may
deter a lot of investors from holding banks in their portfolios.
Outlook
does not currently hold any of the major 4 banks in its flagship portfolios. The
reasons outlined above are the major factors for avoiding banks. In particular we
believe regulation and increasing bad debts are likely to hinder their performance
over the near term.
Despite the recent share price correction we remain cautious at the current juncture.
A number of factors would need to be satisfied before we added a bank holding to
our portfolios. Most importantly we would want to ensure that the banks’ capital
requirements have been sufficed and no further dilution or cuts to dividends are
needed.
Secondly, we would want to ensure that the loan portfolios have been prudently
accounted for and in particular the mining and energy loans the banks hold would not
impair their performance. The housing market also remains a particular difficult
segment. It appears as though property prices have reached their peak and are now
correcting. Over leveraged investors may be forced to liquidate further pressuring
banks loan portfolios performance.
Finally, given the competitive nature of the industry at present we would want to
observe profit margins increasing and banks net interest margin rising (the different
between the rate at which banks borrow and then lead out to its customers).
Our core view is not for a collapse in the banking sector, rather a correction and poor
performance relative to other sectors. Accordingly, we are electing to focus on
industries where we see large potential and significant future growth.
