Australia’s ‘Eggs-in-One-Basket’ Banking Sector

  • Rate this Story
  • 0
  • 0

By Dan Denning | November 20, 2012 10:52 AM EST

The last six weeks of the calendar year are usually a lot like the last two turns in a major downhill ski race. You get a couple of steep, sweeping bends and then the finish line. At this point in the race, you can only screw up. It's too late to make up for lost time. Most investors simply let their momentum carry them down the rest of the hill before snow-plowing into Christmas and the summer break.

But it may not be that easy this year. As Murray Dawes pointed out in his stock market analysis last week, both the S&P 500 and the ASX/200 are staring into the 'abyss'. That is, the major indexes are trading near or below their 200-day moving averages. When an index violates its long-term support like that, it's often the precursor to a major change (in this case bad).

If you were going to pick a catalyst for an end-of-year downer on the All Ordinaries, you might look at the International Monetary Fund's report on the stability of Australia's financial system. The report is full of many boring and inconsequential details about the Australian government and the Australian banking sector. But it does highlight how important the Big Four banks have become to the economy and to the share market.

The Big Four banks own 80% of all the assets in the Aussie banking system. They own 88% of all residential mortgages. Because of these facts, and a few other factors, the IMF report notes that any trouble in the Australian banking sector becomes trouble for the Australian economy. For this reason, it also recommends the Australian banks hold more high-quality, Tier-1 capital in reserve against a rainy day.

We'll get back to that in a second. But it was items 21 and 24 in the Executive Summary that caught our attention. One shows that the more interconnected things are in a financial system, the more dangerous things can get in a crisis. The other shows that Australia's real debt problem is household debt. Below, items 21 and 24 in their entirety. Emphasis added is ours.


'The concentration and interconnectedness in the banking sector mean that idiosyncratic risks may have a systemic impact. Australia's four major banks hold 80 per cent of banking assets and 88 per cent of residential mortgages. The major banks are highly interconnected, as they are among each other's largest counterparties, and their expected default frequencies (EDFs) from Moody's KMV are highly correlated. They have grown faster than the banking sector as a whole since the GFC, partly due to the acquisition of smaller banks and deleveraging by some foreign-owned banks. The major banks are highly profitable, enjoying a funding cost advantage derived partly from implicit government support and earning larger net interest margins than smaller banks and international peers. While their pricing power and greater risk diversification help sustain profitability, their size implies that, in the event of a failure, the impact on the financial system and the economy would be potentially substantial.

 'The combination of high household debt and elevated house prices is a risk to banks' large mortgage portfolio. As a ratio to household disposable income, Australia's household debt, of which 90 per cent are housing loans, is above the average of advanced economies in the G20. Strong house price gains over much of the past two decades have made Australia's house prices relatively expensive now. This combination exposes banks to negative income shocks generated by a sharp increase in unemployment. Moreover, around 30 per cent of new mortgages are interest-only, a potentially riskier type of lending than regular mortgages, and 55 per cent of those mortgages are interest-only investor loans.'

To be fair, the report also says the banking system is 'sound, resilient, and well-managed'. And while it frets over the size of household debts, it balances that by saying household assets (houses) are sizeable as well. All in all, it's exactly the sort of report you'd expect from a meddlesome, micromanaging, international financial body: sober, with the appearance of even-handedness, and recommending more regulation.

Investors will take what they want from the report. If the banks are forced to set aside more capital as a reserve against calamity, that means lower bank profits and potentially less money to be paid out to shareholders in the form of dividends. Lower profits probably mean lower share prices too, which would affect any super funds that own bank shares (which has to be most super funds, given how big a portion of the Aussie market's total capitalisation the banks make up).

If anything, the report is a reminder that the share market is a giant two-stroke engine of prosperity that's sputtering. The miners and the banks both face their own set of unique challenges.

Regards,

Dan Denning
for The Daily Reckoning Australia

  • Rate this Story
  • 0
  • 0
The article was first published by The Daily Reckoning Australia

Join the Conversation

IBTimes TV
E-Newsletters

We value your privacy. Your email address will not be shared.