The structural shift in banking

In the period between 1990 and 1992, our last official recession, our banking system was in crisis. Westpac received a lifeline from Kerry Packer amidst a bust in the property market.

Since then, our banking sector has been a pillar of strength to our economy and to investors, after the Government set some tougher regulatory requirements and built the foundation for the big four banks to thrive. It set the stage for a 25-year bull run that also saw our banks become the poster child for the developed world’s banking system during the global financial crisis of 2008-2009.

It is easy to understand that with this amazing track record of stability and growth, investors have become accustomed to receiving the riches from our banking system flow down into their cash accounts by way of strong and rising fully franked dividends, while also providing investors with an above average rate of capital growth. Australian bank shareholders have been trained to believe that banks are a defensive asset and that when things get tough, they can rely on the banks to pull through and steady the ship in their portfolio. For the past two decades, that seemed so true and believable.

What we have seen over the past couple of years however, is a steady but sure deterioration in the stranglehold that the banks have on our lives. Their size and importance to our economy have raised eyebrows everywhere, including the politicians in Canberra. For the first time, we are seeing a sure sign that the landscape is changing and an important structural shift in the banking environment has clearly begun.

Technology –

Banking executives know that they are standing in front of an incoming train. However, with so many legacy issues, systems to upgrade, costs to be maintained and a regulatory environment that is on their backs, banking executives are running just to stand still.

These days, disruption is on everyone’s lips. An array of small “fintechs” ranging from lending, insurance, funds management and payments are eating away the cream of banking revenue. On top of that, mega global companies like Amazon are gaining momentum through partnerships to tap into the banking space.

In the UK, the Government has begun trialling a technological revolution called “Open Banking” to provide greater competition and enable customers to gain more flexibility, find better deals and better manage their finances. If the outcome of this trial is successful over the next few years, it is probable that our Government will seriously consider implementing this system here.

Regulation –

The Royal Commission placed the behaviours and actions of banking executives on the front page. This comes at a time when overall sentiment towards the banks have already been declining.

As regulation heats up even further in the banking and financial services sector, banks have already begun the process of becoming a “simpler” institution. The financial systems enquiry has already forced the banks to dial back their loan growth while interest only loans are being scrutinised far more harshly. This is likely to mean stagnant credit growth. In the meantime, the provisions for doubtful debt could rise from the low levels if we begin to see more stress in household debt.

Our view

Overall, our big four banks are still undoubtedly high quality. Much of this quality is due to the favourable industry structure, whereby for the past few decades they have been perceived as being safe from bankruptcy due to their high importance to the financial fabric of our society.

However, we do see the headwinds strengthening. Higher capital requirements, tougher regulations, criminal liability and accountability will no doubt shift more of the focus back to consumers rather than the shareholders. Even after declining some 10%-15% over the past couple of months from their highs, our banks are still relatively expensive compared to their equally strong global counterparts. Moreover, we are also faced with a dilemma of “crossing our fingers” that property prices and borrowings do not fall too hard over the coming years.

As formidable as the banks are, they will be fighting hard just to keep their position and market share while working towards gaining trust back from customers that have been disgruntled for years. Balancing this all out, we have been advising caution on our banks and in a number of cases, we are trimming a bit of the often large bank exposures in portfolios.

Please feel free to discuss the above or any financial matters you may have with your advisers.