Australia’s major banks are a popular target for many of those that worry about our country’s financial stability. Our banking sector is too concentrated it is often argued, and our banks are overly reliant on mortgage lending and overseas financing.

Yet despite these criticisms, bank shares have enjoyed a strong run in recent years, underpinned by continued solid profitability. And notwithstanding the odd corrective pullback, to my mind the outlook for Australia’s banking sector still appears appealing for those seeking a relatively reliably income stream and capital protection. 

Indeed, their focus on residential property lending has left Australian banks among the safest and more profitable financial institutions in the world, with relatively transparent business models.

As noted in the Reserve Bank of Australia’s latest Financial Stability Review, the annual return on equity by our major banks is expected to remain at a relatively healthy 15 per cent this financial year, in line with the average over the few decades. 

Even during the financial crisis, their return on equity only slipped to around 10 per cent – much better than during the early 1990s recession. In turn, this was helped by a peak in bad debt provisions as a share of assets at only around 0.5 per cent, or around one third the level reach during our last great recession.

Of course, the challenge for banks is that a good deal of their profit gains in recent years have come despite soft credit growth, and more so reflect a post-financial crisis decline in bad debt provisions and very tight cost control – neither of which seem likely to be a source of strong profit growth for much longer. 

The RBA notes that the major banks’ aggregate charge for bad and doubtful debts fell by 17 per cent in their latest half-yearly results and, for the 2014 financial year as a whole, it is “expected to decline to a historically low level as a share of assets” – see chart above.

That may be, but I’d also note that some of the decline in bad debt provisions appears structural – due to the fact the share of bank lending going to property has increased relative to business lending, and the latter tend (at least historically!) to have much lower loan default rates. Meanwhile, impaired assets as a share of all loans is still above pre-financial crisis lows, suggesting there could be more cyclical improvement in this area to come.


Profits have also benefitted from cost reductions. The RBA noted the major banks cost to income ratio had steadily declined over recent decades, from 60% in the mid-1990s to 45% more lately. This cost ratio is now relatively low by international standards, even compared to other similar 'commercial' banking models globally – which tend to have lower cost ratios than so-called 'universal banks' as the latter also rely on high staff cost investment banking and wealth management activities to generate profits.   

According to the RBA, the relative cost advantage of Australian banks over even other global commercial banks has stemmed from the former’s greater focus on home loans which, being more 'homogenous' than business loans, have been more able to exploit technological advances that lower distribution costs, compared to more complex relationship-based business lending.

In other words, while some fret over the exposure of Australian banks to home lending, the evidence suggests this has help banks to boost profits by lowering their risk exposure in recent decades (especially compared to business lending) and also by allowing a greater ability to streamline operations and cut costs.

Of course, given their relatively simple business model, the question is whether our banks are able to cost costs even further – even though they are already low by global standards. As there are few comparable international benchmarks to go buy – it is not clear they can’t slice costs even further.

Another challenge facing banks is a likely lift in prudential capital requirements, especially for our largest banks that are deemed 'systemically important'.   

According to the RBA, however, "major banks are well placed to adjust to these higher requirements through earnings retention if current profitability persists". So far at least, banks have used dividend re-investment plans to build up equity, partly offsetting this boost to capital with share buy backs. Of course, the need to hold more equity could eventually crimp return on assets and dividend yields, though the upside is that investors could feel even safer holding bank stocks than they already do.

In the nearer-term, another headwind for banks is the possible imposition of 'macro-prudential' controls to slow frenetic investor activity in the property sector, especially in Sydney and Melbourne. To my mind, these would be an extremely dangerous step for the RBA and APRA to make, and we’d be better served reviewing rules related to property investing by SMSFs and foreign buyers. 

But again, even if macro-prudential controls are introduced, one upside is that it likely means interest rates will stay lower for longer. The RBA is not trying to kill the property upswing – our economy desperately needs it – but a better balanced and more measured upturn would be welcome. Whether clumsy macro-prudential controls can 'fine-tune' the property upswing in this way remains to be seen.