I know many readers are probably sick of us writing about the risks for Australia's big four banks Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC), despite years of solid, consistent performance and juicy fully franked dividends.
We have certainly underestimated their ability to deliver strong growth in the past few years.
But, there's a method to our madness. Like all businesses, the banks will face periods when they will struggle –many investors have never had to face that and simply assume the good times will continue. However, putting one's head in the sand and ignoring the risks is not a sound investment strategy.
Australia's big four banks have profited from 25 years without a recession, strong economic growth thanks in part to the rise of China and its insatiable appetite for our raw materials. That has enabled the banks to grow market share, particularly after the GFC, cut their bad debt provisions, and raise capital at ultra-cheap prices thanks to low interest rates around the world.
Sooner or later, all things come to an end and the headwinds for the big four banks are rising.
- China's growth is slowing, while commodity prices have dropped and could fall further.
- Australia's economy, on which the big four banks are heavily dependent, is also facing its own challenges as the value of our exports declines due to falling commodity prices.
- Unemployment is slowly rising, which has implications for bad debts.
- Property prices have soared in the past few years, particularly in Sydney and Melbourne, as more and more investors jump on the bandwagon, pushing prices ever higher.
- Last October, Fairfax media reported that 1-in-6 homes was being bought by foreigners, and almost 25% for new homes in Victoria. Much of that is likely driven by Australia's falling exchange rate.
- A number of the banks have acknowledged the threat to their businesses by limiting the loan-to-valuation (LVR) ratio for investor loans to as low as 80%, rather than as much as 95%.
- Today, the banking regulator, Australian Prudential Regulation Authority (APRA) announced that the big four banks and Macquarie Group Ltd (ASX: MQG) will need to carry more capital against mortgages. The current risk weighting is around 16% and will need to move to at least 25%. In other words, for each $1 of lending, banks currently hold just 16 cents in capital.
As a result, the big four banks will need to raise an estimated $11 billion in capital, which could mean among other things issuing more shares, underwriting their dividend reinvestment plans, or lowering dividend payout ratios.National Australia Bank has already raised $5.5 billion in May this year, but will still need to raise more. Westpac today announced that it will need to raise $3 billion and says, "The cost of holding higher capital will inevitably be borne by customers and shareholders."
Foolish takeaway
Banks are not immune to business cycles and are highly leveraged businesses, a factor many investors seem to forget. We'll continue to bang on about the risks, but what that really means is buying shares now comes with much higher risks that a few years ago. We also wouldn't suggest selling out completely either. They are high quality businesses, but investors need to be properly diversified and aware of the risks.
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