The Westpac Banking Corp (ASX: WBC) share price is up 0.6% to a 52-week high of $29.98 today as investor confidence returns to the banks on the back of recent data suggesting credit and home loan growth is growing strongly again.
Banks turn profits by making more on what they lend than they pay on what they borrow with the spread being the net interest (profit) margin.
Traditionally they 'lend long' and 'borrow short' with the most profitable long-term lending being home loans commonly over periods of 20 to 30 years. Borrowing short via money markets, paper or debt, sometimes based on BBSW also helps the treasury teams in charge of their huge balance sheets crank profit margins.
In Australia the home loan market is dominated by the the big 4 of Westpac, Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Australia & New Zealand Bank (ASX: ANZ) all competing for a slice of the lucrative home loan market.
This week Westpac has announced it intends to reduce the serviceability test it applies to mortgage applicants to 5.35% from 5.75%.
The test assesses whether a borrower can afford to pay back the loan at the 'serviceability' rate given their assessed income and expenses. The lower the serviceability rate the more the bank can potentially lend and in turn win more more business from rivals. The flip side being it's taking on a larger risk of the borrower defaulting.
Banks now have more leeway to use their own serviceability levels as the banking regulator APRA recently scrapped its 7% serviceability test imposed on banks. This was because it didn't make sense anymore given falling benchmark rates mean banks can now offer loans as low 3%-3.5%.
Serviceability rates applied are controversial though as banks are highly leveraged operations relying on potentially fragile counterparty and depositor confidence in their soundness to operate as going concerns.
For example if the value of a bank's assets fell significantly (via plunging property prices) the consequences could quickly leave it unable to service its debts without a major capital injection from shareholders.
Regulators of course require banks to carry capital in reserve to mitigate this risk, but there's little doubt a significant property market reversal would have bad consequences for the leveraged banks.
As such while shares in Westpac and other banks might seem attractive for their fully franked dividends and perceived 'defensiveness' believing them to be immune from big falls is a mistake.
Especially as the ultra-low interest rate world means the equity capital of banks accounts for an increasingly low proportion of overall funding.
These risks are before the problems lower benchmark lending rates bring to the banks' net interest margins.
How lower net benchmark lending rates can hurt banks' net interest margins is an issue I first covered in early May 2019 and since then it has been more widely reported and factored into banks' valuations.
