What every owner of ASX bank shares should know before making a move

It's a challenging period for ASX banks.

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ASX bank shares are operating in a challenging environment, but you wouldn't know it based on the share price movements this year.

Since the beginning of 2024, the Commonwealth Bank of Australia (ASX: CBA) share price is up 25%, the National Australia Bank Ltd (ASX: NAB) share price is up 25%, the ANZ Group Holdings Ltd (ASX: ANZ) share price is up 18% and the Westpac Banking Corp (ASX: WBC) share price is up 37%.

The S&P/ASX 200 Index (ASX: XJO) is only up 6% in 2024 so far, so banks have materially outperformed the market. If we excluded the banks from the ASX 200, the outperformance of the rest of the market is even more pronounced.

How strong was CBA's FY24 result to justify this rapid rise? Cash profit declined 2% to $9.84 billion, and statutory net profit after tax (NPAT) fell 6% to $9.48 billion.

Valuations are elevated

It's normal for share prices of good businesses to rise over time because profits for those companies tend to increase, justifying a higher share price.

According to Commsec, of the past nine financial years, only one year had an average annual price-earnings (P/E) ratio above 20, which was 21.3 in FY22 (when interest rates were low and arrears were relatively low). According to the independent forecasts on Commsec, the CBA share price is valued at 24x FY25's estimated earnings.

It's a similar story for the other major banks, where they're now trading at much higher P/E ratios despite the difficult banking environment, which I'll discuss below.

Arrears are rising

I think there are three key factors for deciding how much lending profits banks make. The first is the net interest margin (NIM), which is the profit of the overall loan rate of its lending compared to the costs (like savings accounts).

Second, there is the size of the ASX bank share's loan book – how much the bank has lent out to borrowers.

Third, is how many loans are in arrears and have turned into bad debts. It takes time for a loan in arrears to turn into a bad debt, so banks' rising arrears are a worrying sign for future profitability.

Seeing as CBA was the only major bank to report, let's look at what the company disclosed.

CBA reported that the percentage of its home loans in arrears by at least 90 days went from 0.47% in June 2023 to 0.65% in June 2024. While 0.65% is not high compared to pre-COVID times, it represented a 38% year-over-year increase compared to FY23, and FY25 could see another increase if interest rates aren't materially reduced over the next nine months.

Competition is strong

Every ASX bank share would like to protect and grow their loan books.

However, with the widespread usage of digital banking and loan brokers, mortgages have become more like commodity products. Lenders don't need a large national branch network to offer a compelling product. Just think how much market share ING and Macquarie Group Ltd (ASX: MQG) have captured without a national branch network.

In this environment, the price of a loan is a more important feature, and borrowers can easily compare options.

As Bank of Queensland Ltd (ASX: BOQ) managing director and CEO Patrick Allaway said:

Our heritage retail banking operating model that has served us well in the past, is no longer sustainable in its current state in a lower returning environment.

FY24 saw the CBA NIM decline 8 basis points to 1.99%, largely due to the impact of "competition and deposit switching". Unless some lenders exit the market, which seems unlikely, competition appears to be here to stay. I'd think twice before paying for the current high P/E ratios.

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