A leading ratings agency downgraded a number of Australian financial institutions last week but investors should not be too concerned. Despite the downgrades, the credit ratings of Australian banks are stronger than those of their global peers.
While there is cyclicality in bank earnings, the outlook for our banks remains sound despite the headwinds of a weakening residential housing sector and a “big bank tax”. Banks are money-making machines.
S&P Global Ratings downgraded its rating for 23 Australian financial institutions by one notch. Those institutions include AMP Bank, Bank of Queensland, Bendigo and Adelaide Bank, CUA, IMB, MyState, ME Bank and Teachers Mutual Bank.
S&P maintained the credit ratings for the four largest mortgage lenders – ANZ Commonwealth Bank, National Australia Bank and Westpac – and Macquarie Group. It maintained their ratings on the grounds that they may receive government support for the latent risk if the Australian property market takes a turn for the worse.
S&P says: “Economic imbalances in Australia have increased due to strong growth in private sector debt and residential property prices in the past four years”.
The agency believes the significant rise in housing prices in recent years has left Australian financial institutions vulnerable to the heightened risk of a sharp correction in property prices. Australian banks are more susceptible to housing correction due to residential home loans constituting almost two-thirds of the banks’ lending assets.
Moreover, persistent current account deficit and a high level of external debt could amplify the challenges of the Australian banks.
Implications for Australian economy
In modern-day economics, banks are considered the backbone of the economy. Although a rating downgrade could result in certain implications for affected banks, it is not likely to hinder Australia’s economic progress to a significant degree.
This is ascribed to the big banks (which have been excluded from rating downgrades) controlling almost 80 per cent of the financial system in the country.
Australian banks have consistently been among the most profitable banking entities globally. According to Bloomberg estimates, the banks’ return on equity stood at around 10 per cent in 2016. Conversely, ROE for American and European banks came in at 8.5% and 3.7%, respectively, during the same period.
What it means for affected banks
Downgrading the credit rating of smaller banks will certainly result in increases in their cost of capital. This growth in cost of capital and certain borrowing costs (largely from the debt markets) could hurt the banks’ earnings and eventually impact their stock prices.
Additionally, banks usually have numerous collateral agreements with clients and these, more often than not, have a rating trigger. A rating downgrade would compel a vast majority of the banks to set aside additional collateral without any additional rewards, which would ultimately dampen profitability.
The Australian government in its latest budget presented earlier in May unveiled a plan to implement a six basis point levy on deposit-taking institutions with licensed entity liabilities of A$100 billion or more starting 1 July 2017.
This step was considered the government’s attempt to provide a competitive boost to second-tier banks, as just the largest four banks were affected by the levy.
However, S&P’s downgrade is set to nullify the smaller banks’ potential competitive advantage.
Australia’s banking sector is considered among the safest in the world, with most of the country’s banks having high credit ratings from all major rating agencies. Despite strong credit ratings and considerable predictability of earnings compared with other sectors (except during economic downturns, when unemployment and interest rates rise sharply), Australian banks have been consistently trading at a discount to the broader market, offering lucrative investment opportunities to investors.
All banks continue to reinvent themselves, introducing new products, services and fees. While we may see the regional banks, which have a higher concentration of residential home loans, underperform relative to the majors, they may benefit as consumers move deposits away from the majors to avoid the commercial impact of the new deposit levy.
As a personal investor, I remain comfortable with continuing to hold my bank sector holdings. I remain comfortable with the outlook of our banking sector. Investors with longstanding holdings at much lower price entry need not consider triggering capital gains to offset any potential marginal underperformance.
Peter Leodaritsis is the founder, executive chairman and chief investment officer of Mainstreet Financial Group