The Big Four Australian banks may be dethroned as the world's most profitable as the quality of their earnings is tipped to fall to the lowest levels since the global financial crisis.
The average return on equity (ROE) for the big boys is forecast to fall to 14.5% from their current level of around 15.6% according to Bloomberg because of new capital rules imposed by the Australian Prudential Regulation Authority (APRA).
This would represent the lowest ROE for the Big Four since 2009 when average return fell to 13.5% as the global banking system was brought to its knees.
ROE is a key measure of profitability for the banking sector and the expected decline shows how far the tide has turned for the sector with the Bank for International Settlements declaring only a year ago that Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd. (ASX: NAB), Australia and New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corp (ASX: WBC) were the most profitable in the developed world.
But APRA recently decided that our biggest mortgage lenders will have to lift their capital ratio by 2 percentage points to better protect our banking system from losses on home loans, which is estimated to force the Big Four into boosting capital levels by close to $30 billion.
While the banks have anticipated the outcome and have started raising cash with Westpac the latest to issue $750 million worth of hybrid securities, they are left with a stark choice of having to lift mortgage rates and cut interest on deposits, or suffer the indignation of lower ROEs, which would trigger a de-rating in their stock prices.
They may not choose the former option as it could cost them dearly in terms of market share and the truth is some of the de-rating has already occurred with their share prices falling an average of 10% since April.
Further, I see yield support for the banks as they are very unlikely to cut dividends. If anything, cutting this payout will be the last resort as they know this is a sacred cow to investors.
The big question is whether the risks have been properly accounted for at current levels. I think NAB and Westpac are safer bets largely because the market has set a lower profit growth target for the two. NAB's earnings per share are expected to dip 1.3%, while Westpac is only expected to post a 2.2% increase in the current financial year.
My least preferred bank is ANZ with analysts penciling in the highest growth rate of the four at 3.9%, probably due to its Asian expansion.
However, I don't think the risks around this strategy are fully appreciated by many investors. ANZ's 24% stake in AmBank is just one example with the Malaysian bank mired in allegations of corruption.
