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Protected banks may still come undone

10 September 2014  |  News

ProtectedBuying banks shares is extremely popular with DIY super investors. The tax advantages from dividend imputation make it one of the best ways to get a sound after tax yield. But it is not without risk. Australia's banks are heavily exposed to an overheated local property market because so much of their business is based on lending for housing (much of it now for investors who are negative gearing). That means a correction in the property market will have big implications for Australia's banks, and, for that matter, the whole Australian economy.

The banks could prepare by retaining capital for bad times. David Murray, former head of CBA and now heading up an inquiry into Australia's financial system, has suggested this. He is saying the banks should be shoring up their capital base to be ready for a correction in asset prices “inflated by unprecedented global monetary stimulus.”

UBS has calculated what this might mean:

"Australia’s major banks may have to raise as much as $41.1 billion in response to David Murray’s financial system inquiry, UBS’s top ranked bank research team says – almost double its previous estimate. Australia’s four major banks are pushing aggressively to avoid any increase, which would immediately lower their leverage and world-beating returns on equity."


The inquiry is looking at non-recourse “bail-in” bonds, which is a method of government guarantee that is just the kind of thing that overheats an already overheated market. Take away investor risk and it is obvious what you get.

As the AFR notes, the problems that led up to the GFC remain. It is a caution about investing in banks:


"Bankers have convinced governments they can have their cake and eat it. They are being allowed to retain excessively high leverage, which is a key determinant of the returns on equity that top bankers’ bonuses are based on, and will only have to deleverage after a crisis hits.

The government already guarantees bank deposits and is prepared to step in and provide $300 billion of “emergency” loans to banks at an insanely low annual interest rate of 2.9 per cent via the Reserve Bank of Australia’s new Committed Liquidity Facility. This bailout program was expressly designed to ensure banks don’t trade insolvent in a liquidity crunch that would kill most normal businesses.

Given the banks’ explicit government backing, equity investors should be prepared to accept total returns that provide a still decent, say 4.5 per cent to 5.5 per cent, risk premium above long-term government bond yields (or 8 per cent to 9 per cent in total today). Instead, Commonwealth Bank’s return on equity is north of 18 per cent.

Contrary to popular rhetoric, cutting bank leverage would actually help them raise debt and equity capital more cheaply, and would certainly make it easier to access funding during crises.

What the community does not need is Treasurer Joe Hockey letting the banks off the deleveraging hook by establishing non-recourse loans that ironically embed higher moral hazards than the “jingle-mail” products that caused so much havoc in the United States. (The mail jingled with the keys to the equity that borrowers were giving lenders as a substitute for repaying them.)

Governments should man up and force banks to take their own medicine. During the GFC banks furiously resisted government interference with the loans they had given to borrowers. Since then they have required corporate and residential borrowers to protect them by stumping up with more equity and less leverage."


There is no lack of warnings about the property market -- although unsurprisingly they are not coming from the banks. The Australian Prudential Lending Authority (APRA) has released data showing an increase in risky loans, including interest only loans. Investment loans are now 37.9 per cent of the total as investors seek alternatives. Credit agency Moody’s has warned about growing risk, noting that the banks’ credit growth has greatly outpaced the systems’ growth. Jeremy Lawson, chief global economist at Standard Life, reckons the Australian housing market is 30 per cent over valued. Australia has the third-most overvalued housing market on a price-to-income basis, after Belgium and Canada, according to the International Monetary Fund.  

What that means for property investment is understood well enough. What it means for the major banks' business is less often considered.



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