Stress-testing our big banks: invincible or vulnerable?

Bank shares are traditionally essential to any blue chip portfolio, but in light of recent global economic woes, what's the best way to assess the big four?

Over the last thirty years, the big four Australian banks have dominated the business scene. Highly visible because of their branch networks, and consistently profitable, they have also been viewed as an essential component of any blue-chip investment portfolio. Today they represent around 20 per cent of the value of the Australian equities market so they are almost a required holding for institutional investors.

Yet, we now hold bank shares somewhat nervously. The conditions that have underpinned bank performance – economic growth and the steady appreciation in asset values (particularly house prices) – have given way to deep-seated pessimism. Now we look more carefully at the composition of bank assets, and at their borrowings, and we question whether they are blue-chip investments after all.

And the authorities do not assuage our concerns. Our federal government insists that our big banks are in good shape, yet it moved to guarantee bank deposits during the GFC and the banking regulator (APRA) has now asked our banks to stress test their resilience to the unemployment rate rising to 12 per cent, to a 30 per cent decline in residential house prices, a 40 per cent decline in commercial property values and a contraction of GDP. This test presumably reflects the possible local outfall from a global economic collapse due to the European debt crisis.

So, how do we form an assessment of the ‘big four’? Are they robust, well-managed businesses or are they vulnerable to the new conditions? Are they similar, or do some stand out as more robust than others?

A good place to start is with the three tests that we should apply when assessing the investment merits of any business – return on shareholder capital, earnings growth, and gearing.

Return on shareholder capital

When we buy shares, we are buying into a pot of shareholders funds and we want that pot to be earning at an attractive rate. What we deem to be attractive varies with the risk profile of the industry but I suggest we would want the after tax profits of our banks to be at least 15 per cent of shareholder capital. Over the last decade the big four have generally met this test, with returns in the range of 11 per cent to 20 per cent. Westpac has tended to perform best on this test, and NAB the worst.

Earnings growth

Our second test is consistent growth in profits as measured by earnings per share. Here, I suggest we would want average growth of at least five per cent each year, and preferably more. Only the Commonwealth Bank (9 per cent per annum) and Westpac (7 per cent per annum) comfortably exceed this test. ANZ is marginal (at 5 per cent per annum) and National Australia Bank experienced no growth in earnings per share between 2002 and 2011.


Consistently reliable earnings outcomes will only be achieved if the business has an appropriate level of debt, where ‘appropriate’ depends again on the risk profile of both the industry and the business. This is where it gets difficult. Banks generally are highly leveraged businesses; in most countries bank shareholder capital represents 10 per cent or less of total capital deployed, with the balance being borrowed. In Australia, the big four banks are required to have capital equivalent to at least 8 per cent of risk-weighted assets, and they currently stand at around 11 per cent, with small differences. In stable economic conditions this has been adequate but in the United States, and now in Europe, collapsing property values have all but wiped out the capital of some banks and made them insolvent (although many have avoided catastrophe to date by continuing to hold assets on their balance sheets at more than their real worth).

Could this happen in Australia? About two thirds of the assets of our ‘big four’ consist of housing loans, either to owner-occupiers (around 46 per cent of assets) or investors (20 per cent of assets). Westpac is most exposed on this front, with 74 per cent of its assets in housing loans, followed by Commonwealth Bank (71 per cent). National Australia Bank has only 56 per cent of its assets in housing and has a commensurately higher exposure to commercial loans. ANZ is in the middle with 60 per cent of its assets in housing. Our banks have typically been willing to lend up to 80 per cent of valuation; even more with mortgage insurance. So, it is not hard to understand the nervousness of investors when rating agencies such as Moody’s warn that Australian house prices are not sustainable and place Australia’s mortgage insurance industry on a negative watch.

Of course, house prices are only half of the equation; the other half is the ability of mortgagees to service their debts. The critical metric here is the ratio of household debt to disposable income, which has more than doubled to 150 per cent over the last decade. The increasing sensitivity of Australian households to interest rate movements is a very visible consequence of this development.

What else do we need to add to the equation? Differences in strategy are important as they can substantially alter the risk/return profile of the bank. ANZ stands out here, with a clearly stated agenda of expanding the proportion of its assets in Asia from less than 15 per cent to 30 per cent by 2017. Whilst greater exposure Asian growth markets is, in principle, a good thing, the execution risk for ANZ would be a point of caution for some investors and may balance out the apparent benefits.

Finally, we can reflect on the uncertainty created by the greater dependence of our banks on offshore borrowings to fund their activities. It is this fact, and increasing uncertainty about both the availability and cost of such funds, that has been in the news in recent days.

Taking all things into account, it would not be unreasonable to conclude that the medium-term attractiveness of our big four banks has been substantially diminished by global economic and financial events. In defining its latest stress test APRA has got it about right. We need to think carefully about the consequences for our banks of a simultaneous decline in residential and commercial property values and a significant increase in unemployment.

In this context it is easy to envisage a break from the long-term trend of good returns on capital and rising earnings per share. The risks would now seem to demand a significantly higher dividend yield, and it is not surprising to see Westpac trading on a yield of almost eight per cent.

Christopher Tipler is a Melbourne-based management advisor and author of Corpus RIOS – The how and what of business strategy. His web site contains more material on this and related topics.

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