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Banks On Top Down Under

Australian banks' balance sheets have never been stronger, which cannot be said of the overwhelming majority of European and U.S. banks

Christine St Anne, 7 December, 2011 | 3:28PM

As part of Standard & Poor's new global bank ratings criteria, Australia's big four banks were downgraded a notch from AA/stable to AA-/stable. Despite the latest credit ratings downgrade, these four major banks are still in relatively good shape.

Commonwealth Bank of Australia (CBA), Westpac Banking Corporation (WBC), Australian and New Zealand Banking Group (ANZ) and National Australia Bank (NAB) have maintained strong credit ratings thanks to leaner businesses and manageable gearing levels. All four major banks posted a combined $31.9 billion (before tax) profit for 2011, up a solid 12% from 2010.

Australian banks are also well-placed to meet the new capital requirements under the Basel III regime. Under these reforms, banks will be required to have a sufficient deposit of high-quality liquid assets.

Lessons Learnt
Australia's major banks did not always have robust business models. The sector was caught up in the property bubble of the early 2000s. High lending and borrowing costs forced the banks to write down significant losses. However, the banks learnt from that crisis. Lending practices were tightened and debt levels became manageable.

Australia's banks subsequently emerged from the global financial crisis (GFC) relatively unscathed. The government's guarantee on bank deposits certainly helped them garner the support of investors. Financial services also play a dominant role on the Australian Securities Exchange. It's not surprising that Australian banks are among the top large-cap holdings of an investor's portfolio. Strong growth in dividends has also made these banks favoured stocks among Australian investors.

Australian investors also benefit from franking credits that support higher dividend payouts in Australian companies. Banks have traditionally tended to pay higher dividends compared with other local firms.

Morningstar head of Australian banking research David Ellis says he has always been a long-term supporter of the major banks. He believes banks will continue to deliver sustainable strong dividends due to solid earnings, an insignificant exposure to European sovereign debt, and strong capital positions.

Fidelity Worldwide Investments portfolio manager Paul Taylor also holds a favourable outlook for Australian banks. "Australian banks are reasonably valued at the moment. They are offering a good dividend yield. While their lending growth is slow, their margins are improving. So, from a sector point of view, I think banks are reasonable investments at the moment," Taylor says.

Taylor leads the Fidelity Australia Fund (available for sale in the U.K.), which has a 35% allocation to the financial services sector (as at October 31, 2011). CBA, ANZ and NAB are among its top 10 holdings.

Another Australian equities investment manager also has a positive view on Australian banks. Karara Capital investment manager Rohan Walsh says Australian banks are still well-placed to sustain and even grow their businesses in the current environment. Walsh also believes these firms will continue to post strong dividends. "The banks will have no problem sustaining their dividends. The payout ratios of the banks have been around 65% to 70%, which is more than sustainable," Walsh says. "The underlying profits of these banks are good, and they continue to grow their earnings, contain costs and maintain their margins. The overall capital position is still pretty good."

The Ironbark Karara Australian Equities Fund has an overweight position in the financial services sector, with all four major banks in the portfolio's top 10 holdings.

Banking On Headwinds
Despite their sustainable businesses, banks still remain under pressure amid the current volatile global market environment. Bank share prices have lagged the S&P/ASX 200 Index, but Morningstar's Ellis says bank shares are mispriced. "We believe bank share prices are currently significantly mispriced. Australian bank share prices suffer due to negative sentiment from international economic weakness, sovereign debt contagion and increased global banking risk," Ellis says.

Australia's major banks continue to attract attention from international investors and hedge funds, who have been shorting the banks. These investors believe subdued credit growth and expensive funding on the wholesale markets will impact Australian banks' earnings growth, putting further pressure on share prices. According to Ellis, these investors have been shorting the Australian banks and are wrong in taking such positions.

Ellis believes Australian banks have access to domestic funding through healthy levels of domestic retail deposits. At the same time, growth in the loan books remains subdued. This will offset their need to access global wholesale markets for additional funding. Moreover, these banks could be tapping into additional sources of funding from institutional investors in the northern hemisphere who are looking for yield, and emerging markets investors looking to diversify into the relatively strong-performing Australian economy.

Karara Capital's Walsh says these higher funding costs could have a real impact on Australian banks, but for the next six months any impact on growth would be around 2%. Term deposit rates have also fallen from 6% highs at the beginning of 2011 to around 3%. The steady fall in term deposit interest rates over the past quarter will also help bank margins, according to Walsh.

Credit growth in Australia also remains weak and concerns remain about whether banks can continue to grow their asset base. Ellis believes banks will be able to grow their profits despite subdued credit growth. This is because banks will be focusing on productivity improvements by reducing their expenses and fine-tuning their margins. "The return on equity continues to improve, getting the key profitability measures much closer to pre-GFC levels despite a very subdued credit growth environment," Ellis says.

Walsh notes that banks have been able to grow their asset base by 4% to 5%. While this is lower on historical numbers he says such growth is still a good outcome, particularly in this environment. Some international investors also believe Australian housing prices could eventually collapse, which would adversely impact the banks' balance sheet assets and earnings. However, Ellis says these challenges are not new and the major banks have dealt with them for many years, while at the same time delivering solid earnings and dividend growth.

Australian banks also have the benefit of a huge diversified revenue base, a wide distribution network, and strong pricing power within an oligopoly. "The major banks' balance sheets have never been stronger. This cannot be said of the overwhelming majority of European and U.S. banks," Ellis says.

Christine St Anne is online funds and ETFs editor for Morningstar.com.au, an Australian site site to Morningstar.co.uk.

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