In the aftermath of the global financial crisis and the near collapse of Spain's banking system on the back of speculative property bubbles combined with the JPM Morgan "whale trade" and the LIBOR scandal, there has been a significant focus on the health of banks globally. This has seen many investors become particularly concerned as to their investability and whether they truly offer a value investment opportunity. With the slowing of the Chinese economy and the falling demand for resources there has been renewed speculation that banks in resource driven economies such as Australia may be facing renewed financial pressure as the economic strength of these economies decline.
Notwithstanding these challenges, I see opportunities for investors within the Australian economy and in this article I will provide an overview of the Australian banking system and examine their funding issues as well as their performance to date. Following this article I will present a series of further articles providing a detailed analysis of each of the Australian banks in comparison to their international peers with a focus on asset quality, profitability, future growth opportunities and valuation. This is aimed at those investors seeking banking exposure in developed economies outside of the U.S.
The Big 4 (Australia's Four Pillars)
While Bank of America (BAC), Citigroup (C), JP Morgan (JPM) and Wells Fargo (WFC) make up the four largest US banks by market capitalisation, in Australia the four big banks are known as the four pillars of the Australian banking system, or more commonly referred to as the Big 4. They are Westpac Banking Corporation (WBK), Commonwealth Bank of Australia (GM:CBAUF), National Australia Bank (GM:NAUBF), and Australia and New Zealand Banking Group (OTCPK:ANZBY). They are regulated by the Australian Prudential Regulation Authority [APRA], and one of the reasons they are referred to as the four pillars is that they represent the foundation of the Australia's banking sector and financial services industry. This has seen each of the major banks become involved in the provision of the full spectrum of financial services ranging from traditional lending and deposit taking to insurance and funds management.
As such, APRA along with the Australian Competition Consumer Commission (ACCC) prevents any mergers between these big four banks, so as to maintain adequate levels of domestic competition while preventing any one financial organisation becoming "too big to fail." It is this notion of "too big to fail" that was a common criticism of the U.S. banking system in light of the GFC and now Spain's recent banking meltdown.
The prudential regulation of the banking industry in Australia is one of the key reasons why Australian Banks fared much better than their American and U.K. peers during the global financial crisis. In fact APRA and the banks have been accused of being overly conservative in protecting their capital in comparison to overseas banks.
Currently there is some significant sentiment that the Australian banking industry is the next in line to experience a significant financial meltdown resulting from a collapsing real estate bubble caused by a significant slowdown of the Chinese economy and broader wholesale funding pressures surrounding raising new capital.
As of mid August 2012, Australia's banking sector by market capitalisation is the second largest in the world at US$433 Billion, or 8.3% of the world's finance industry. Of note is that this market capitalisation increase has been gradual and sustained, both pre and post GFC, whereas the increase in the European Union banking sector has been exceptionally more volatile both pre and post GFC.
Performance and Capacity of Australian Banks
The performance and capacity of the Big 4 banks are detailed in the table below. In compiling this data I have integrated information from a variety of sources including Bloomberg Finance, Yahoo Finance, the Australian Stock Exchange, a KPMG audit report, and financial information available on each of the banks respective web pages. All figures are expressed in Australian dollars [$AUD].
Share Price Performance - 12 months YTD
Over the last 12 months each of the Big 4 banks has outperformed the Australian All Ordinaries (All Ords) Index. The All Ords is represented by the ticker [ XAO] on the 12 month performance graph:
While each of the banks have outperformed the All Ords, both Westpac and National Australia Bank have taken a 25% hit on NPAT versus their 2011 financial year end results, while the Commonwealth Bank has increased NPAT by 11% and ANZ Bank has generated the highest return at a 19% margin over 2011 results.
Exposure of Australian Banks to Subprime and Non-Performing Loans [NPL]
A key contributor to the global financial crisis was the collapse of the U.S. property bubble fuelled by rising rates of home ownership driven by the availability of cheap easily obtainable mortgages in the form of sub-prime loans. The contagion was then spread through the transfer of risk by trading packages of these subprime loans between financial entities as collateralized debt obligations (CDO's).
There have also been speculative property bubbles in Ireland, Spain, the U.K and Portugal which caused many of those countries major financial institutions to fail when the bubbles burst and it has been argued by many that a similar phenomenon will be experienced in Australia.
That is, there is a perception that a massive housing bubble exists within Australia, on which I wrote about recently ("Is Australia Still The Lucky Country" Part 1 and Part 2), and the reality is that the exposure to non-performing loans is significantly lower than these other countries. This can be attributed to the lack of subprime or substandard loans products in Australia which can be attributed to the higher degree of prudential regulation combined with a more conservative risk appetite among Australia's banks. A standard residential loan application requires 10% deposit, however 20% deposit is preferred; anything lower than 20% requires the loan applicant to take out mortgage insurance before the bank will consider the loan for approval. The lack of a speculative property development bubble as seen in Spain, Ireland and Portugal also contributes to a different property investment environment.
The aggregate exposure for Australian banks to non-performing loans is shown below compared with Canada, the U.K., the USA and the PIIGS:
The small percentage increase of Australian NPLs during the GFC can be seen in 2008 and 2009, and has held relatively constant since (the same for Canada). By comparison, the U.K., USA and PIIGS have seen exponential increases in NPLs, and in some cases still rising. Near zero interest rates have held NPLs in the U.S. residential markets, but that pain has demonstrated potential to increase significantly, if and when the economy improves and inflation takes off. Whereas in the Australian markets the majority of bad loans have already been reduced during the GFC, hence the stabilisation of NPL figures overall. It does not gel then that Australia has a housing bubble forming of the magnitude of the USA, U.K. or the PIIGS.
The RBA breaks down the above NPL data in the graph below, of which housing is the lowest share of bad loans:
Looking at the Banks Asset quality ratios, the exposure of gross impaired assets and loans 90 days overdue for each bank is as follows, and it would appear are contained and manageable:
The Australian Economy
Generally speaking, the Banks asset quality ratios and their net impaired assets have been reducing since the GFC, and I plan to examine each banks performance in this area more closely in future articles. That said, the banks are not immune to pressures the Australian economy may face pending a further contraction in iron ore pricing, any significant escalation of unemployment, and any subsequent increase in non-performing loans. To counter the impact on the Australian economy from a further economic headwind of a significant scale, APRA and the banks have been implementing the updated Basel requirements. This has seen Australia's banks focus on increasing their capital adequacy and improving liquidity so as to be better equipped to manage adverse events. An assessment on how Australia would fare in the event of a further global financial crisis is provided here by Treasury Secretary Dr Martin Parkinson:
"Our banks are well-capitalized and have sufficient resources to withstand a freeze in international capital markets for several months. They are also well-regulated and, since the GFC, the regulatory framework has continued to be refined. Some 99 per cent of all deposit accounts are protected through the Financial Claims Scheme. So on the direct - and in some ways most dangerous - financial transmission channel, we are well-placed.
Australia is also well-placed to respond to demand and confidence shocks emanating from Europe."
The Treasury Secretary also goes on to explain how the macroeconomic framework for Australia is driven by three fundamental principles:
"The three pillars of Australia's macroeconomic framework are: a floating exchange rate that acts as a shock absorber for the economy; independent monetary policy focused on managing the level of demand to keep the economy on a stable growth path consistent with low inflation; and fiscal policy aimed at running budget surpluses over the cycle in order to contribute to national saving."
Australia's financial sector regulation continues to evolve and has been adjusted through booms as much as it has been adjusted in response to tough economic periods, such as the inflationary period of the 70's, the 1991 recession, the dot com bust, and more recently the global financial crisis. The strength of Australian banks during these periods reiterates their bottom line value as an investing asset; not to mention that the Big 4 banks have been resilient to these negative influences and in the main have rebounded quicker than other sectors post crisis.
The Challenges Facing Australian Banks
Listed below are a number of challenges often cited as a precursor for Australian banks to have difficulty in raising capital funding:
- A flat housing market / and a perceived housing bubble.
- Decreasing iron ore spot price and slowing demand for resources.
- Iron ore demand flow on effect to the broader economy (consumer spending and domestic housing construction).
- Availability of disposable cash for investment and loans, versus capital requirements under the Basel Accords.
- High costs of funding for banks.
- Tightening of wholesale funding markets internationally as the appetite for risk has declined in light of the European sovereign debt crisis.
At this stage though Australian banks have been able to maintain their funding requirements, with their funding profiles shown below:
And despite these challenges, Australian banks are continuing to perform, even given difficult economic circumstances. For retail funding, "household saving has increased to 9.5% of disposable income and remained there, at a significantly higher level than previous years." While all banks are generating the necessary funding capital, both Westpac and National Australia Bank have taken sizeable hits to revenue recently, whereas the Commonwealth Bank and ANZ Bank have continued to grow revenue and profit. Which therefore begs the question, what value do Australian banks offer U.S. investors? In a review of return on equity, all four Australian banks have outperformed their USA peers; their performance against their leading global peers is shown below:
The Extent of Debt in the Australian Economy
In comparison to many other developed and some emerging economies Australia's private sector debt to GDP ratio is quite conservative as the chart below illustrates.
Source data: World Bank
This indicates that there is still some room for growth of Australia's banks and interestingly it is Australia's private sector debt is significantly lower than the ratios for those countries that have experienced significant upheaval in their financial systems like the U.K, U.S. and Spain.
However, Australia does have a particularly high mortgage to GDP ratio, which is higher than many other developed economies as the chart below shows.
This article has highlighted challenges facing Australian Banks in a resources driven (up until now) two speed economy, and suggests that despite predictions to the contrary, Australian banks are well prepared for tightening economic times and a further funding squeeze should the respective fiscal challenges to Europe and the USA worsen. In terms of "which bank" offers the most opportunities within the Australian banking sector, I will look at each them in detail following their final 2012 annual results being published, and write a comparison that addresses asset quality, cash flow, retained earnings, and the impact of medium term economic challenges affecting their bottom line. My initial opportunity to highlight though is ANZ Bank; they have a strong credit rating, sound capital adequacy and funding relative to their peers, and more importantly they are five years into a strategy of establishing themselves as a leading bank within the Asia Pacific region, in an effort to increase revenue and funding from markets external to (and limited by) Australia. I will address these issues in my next article on Australian banks.
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