Australian Banks Crashing; Regulatory Risks Threaten Their Overvalued Shares

Australian banks have been a class of their own, for decades now, thanks to its continually growing economy.

The oligopolistic structure prevents mergers between the big four banks. The loyalty of self-funded retirees also plays a huge part in the local stock market. They have been valued as though they are in a profoundly different business from counterparts in other countries.

Westpac Banking Corp., Commonwealth Bank of Australia, and the Australia & New Zealand Banking Group Ltd. were valued at a more than three times their book value.

It’s extraordinary in the banking industry where share price should tend to cleave reasonably close to the value of net assets. Large banks in developed markets have a median valuation of 0.77 times the book value.

Tuesday’s announcement that Brian Hartzer- Westpac Chief Executive has resigned should be a wakeup call. He resigned after the company was accused of 23 million separate breaches of money-laundering regulations.

Valuations have dropped in recent years, thanks to a teetering housing market and the government’s inquiry into the sector. But Australian banks still have further to fall.

Return on equity of the big four banks is distinctly in the middle of the road. They are all around the median deciles relative to their peers in other countries. However, the case is different for the Commonwealth Bank, with National Australia Bank Ltd slightly below the midpoint.

But if you switch to price-book value, they come close to the top of the pack, with the Commonwealth becoming third globally.

How Does This Work?

The best explanation is probably their reputation for being excellent dividend payers. Uncertainties are vast around bank earnings due to regulatory requirements, and the fuzziness of working capital and capital expenditures. So, dividends are often regarded as the most reliable basis for a realistic understanding of a bank’s future cash flows.

Considering that shareholders ultimately pay for a right to a slice of the bank’s cash flows, it’s normal for banks with above-average dividend yield to have above-average valuations.

Australia is reasonably exceptional on the front.

All the big four barring the Commonwealth are in the second-highest decile among their peers- based on analysts’ estimates for blended-forward 12-month dividend yields.

Australian affluent retirees show unusual loyalty to household-name blue-chip companies that pay a reliable income stream of shareholder returns. No wonder the sector is outperforming.

However, there’s a problem on the horizon.

According to Bloomberg News, the dividend party could be coming to an end. Westpac and National Australia Bank have reduced their payouts. ANZ has reduced the amount eligible for tax refunds, as the regulator has forced big banks to set aside more capital.

A balance sheet reinforcement like this should at least be a temporary measure, but there are further risks to cash flows even after they have paid.

Australia’s Economy Is Slowing

Interest rates look closer to those in the U.K than the country’s bank valuation peers in Canada and the U.S. That’s likely to have a rough knock-on effect on earnings given the close relationship between borrowing costs and net interest margins. A critical basis of banks’ profitability.

Even if the current recovery in the housing market translates into a more sustained upswing, there are challenges. Banks who want to take advantage of it by lending more aggressively still have to find a way to attract more deposits. It will always put further pressure on margins, given the low rate environment.

All these should serve to reduce the reliability of those dividend payouts. Without it, Australia’s retirees may find other blue-chip companies worthy of investment.

Westpac shares have responded positively to the update of cleaning-out at the top of the bank. But, we shouldn’t expect the big four banks to find a smooth recovery from their malaise.

Australia’s banks have been cash machines in the prospering economy. As it fights to rekindle the fire that powered it for the past three decades, that money could be drying up, too.