A warning for bank investors

Recently, I shared a small personal example of a much wider issue – being that, in toto, I believe Australians pay way too much for banking services. It was already bad five years ago, but has gotten increasingly worse as competition dried up during the global financial crisis.

It's understandable that the crisis has increased the cost of borrowing for customers and even widened lending margins for the foreseeable future. But when it comes to other fees and charges, technology should be driving down prices. Instead, though, the reverse has been happening. And, in my opinion, it highlights a dearth of genuine competition in Australia's banking industry.

I was recently surprised by the number of Doddsvillagers who came out in support of the banks after my previous blog post. My intention here isn't to pick another fight with bank shareholders. Rather, I'm aiming to highlight a few risks to bank profitability beyond the more obvious ones, including the possibility of a significant correction in Australian house prices and our banks' reliance on foreign capital (which already seems to be putting a slight squeeze on lending margins.) I write this not as an expert on the nuts and bolts of banking (I'll leave that to colleague Greg Hoffman), but as an interested observer with a view on a matter that affects almost every Australian.

Bank shareholders currently have their fingers crossed that the highly profitable industry and economic environment remains so. Without being priced for perfection, Australia's major banks can afford to take a few knocks. But there's plenty of room for disappointment if expectations continue to rise.

There are also at least two other major risks that might undermine an assumption that bank lending margins and fees have reached a new, permanently higher plateau. The first is the potential for fresh competition and the second relates to the risk of political or regulatory intervention.

Competition will almost certainly heat up

The big four banks currently face barely any exogenous competition. Their collective share of outstanding Australian home loans, for example, has risen from about 67% to more than 75% in just the past two years.

That's because they've written almost every new home loan since 2008. Commonwealth Bank and Westpac seem to be writing about 75% of new loans at present, which is an extraordinary concentration. As you can imagine, this has been an enriching development for shareholders.

But competition is poised to intensify from these close-to-non-existent levels. That might even include fresh competition from inside the cartel – NAB is now successfully pushing for market share with lower variable home loan rates.

Unless intra-cartel competition makes inroads into margins, some form of new competition is bound to sprout up to replace non-bank lenders that were decimated in 2008; current margins are just too juicy for would-be competitors to ignore forever.

Perhaps the future will look something like the not-so-distant past, with non-bank lenders able to re-enter the market if the residential mortgage-backed securities market becomes liquid again. It's something that the likes of John Kinghorn's RHG Group are hoping for. The fact that the official overnight cash rate is 4.5% and most variable home loans above 7% is a large incentive for both new lending participants and the investors who will fund them, such as our superannuation funds.

But there is another potential source of competition that is less reliant on money market conditions. Banks owned by industry super funds, in particular ME Bank, seem likely to increase their influence. ME Bank is owned by several major industry super funds, and its substantial television advertising campaign (featuring John Wood) leaves little doubt about its plans for growth.

Like with building societies and credit unions, most ME Bank customers have a feel-good relationship with their bank. They don't feel like they're being ripped off at every turn (as many of us do with our existing bank). Unlike most credit unions, though, ME Bank could develop the scale and access to funding to emerge as a genuine bank heavyweight.

ME Bank has a massive potential retail customer base (5m industry super fund members) and also boasts the potential for a competitive edge in wholesale funding, through the investments of the same industry super funds that own the bank.

While the bank isn't technically a not-for-profit organisation (profits go to industry super fund members), it is built on the same principles as the industry super fund movement that revolutionised the fee structure of superannuation in Australia and has taken significant market share in the process.

It's an alternative I've personally found attractive. While I may currently be too busy to go through the process of changing my everyday account with the Commonwealth Bank, when I opened a First Home Savers Account recently, opting for ME Bank was a no-brainer. They've now got their foot firmly in the door for my next term deposit, savings account or loan.

Political and regulatory kick back

Another threat to the current level of big-bank profitability lies outside the competitive sphere, and it's a greyer area. As I explained in my previous post, the big banks have done a masterful job of increasing prices without large swathes of the 'disgruntled' population actually doing something about it. At least in the short and medium term, this is certainly the way to maximise profits.

But such behaviour can damage their 'social licence' (for want of a less obnoxious term). Large customer bases that loathe you and vote every three years leaves the door open for various forms of political and regulatory intervention, as Telstra shareholders recently discovered.

Politicians of all persuasions (particularly the minor parties) are taking pot shots at the banks. Yes, it's an election, but the cries seem louder this time, and perhaps not without reason.

The Greens have proposed changes to the trade practices laws to ban banks from charging non-customers $2 for using their ATMs, and have also even suggested a bank super profits tax. Such calls are likely to prove popular with many voters (although certainly not this one).

But it's worth noting that, given both the Mineral Resources Rent Tax and the Telstra intervention, the current Labor government have shown they're not afraid of challenging the status quo, especially if they think it will prove popular with voters.

Perhaps it's a little off track, but I also think the class action against the banks over exception fees, financed by litigation company IMF, is a sign of general discontent that might eventually hurt the banks. Hopefully the outcome of this case will not be swayed by populism. But it's telling that two months after the action was launched nearly 150,000 bank customers had already registered as claimants.

Even the Financial Services Union has called on banks to reduce customer gouging. Surely it's unusual for a union to call for a cut in the very revenue from which its members get paid, and from where future pay rises will come. Other than among shareholders, it's fairly clear that banks have recently been losing support among their customer base in a way that feels more substantial than the usual brand of bank-bashing that's become a national past time.

At least three of the four big banks currently have advertising campaigns revolving around the theme that they're different than the other big banks (ANZ has Barbara in Bank World, CBA is 'determined to be different', and NAB claims it's 'more give, less take'). Time will tell whether the sentiments are genuine or just spin, but it seems to be an admission that they're reaching some point of resistance with customers.

I don't pretend to know how this situation will play out. Perhaps the competitive vacuum of the past few years won't end and new competition won't pop up. Perhaps the banks' PR problem won't lead to any political or regulatory intervention. Perhaps us property price bears are flat wrong. Perhaps our banks' increasing reliance on foreign financing won't cause any upset.

In other words, perhaps the big four banks will emerge with an ever greater cut of Australia's economic pie. But there's also a substantial risk that the reverse might happen. At the very least, shareholders with a large exposure to Australia's banks should revisit their portfolio allocations to ensure a less rosy scenario won't have a serious impact on their wealth. Like most highly leveraged businesses, there's a small chance of a very bad outcome if things change. And it's this sort of broad appreciation for the small, but high impact events that Nassim Taleb tries to instill through his books The Black Swan and Fooled by Randomness.

By no means is this blog post a suggestion to sell all your bank shares. In fact, it's not even a warning against buying more. But if, like many Australian investors, you have significant exposure to the banking sector, then the potential for reversion to the mean on bank margins and fees is an issue that you might want to spend some more time thinking about.