Bank shares offer potential despite ongoing dramas and bank bashing

Bank shares bashing Commonwealth Royal Commission
Irrespective of the ongoing royal commission into Australia's banks, they are still wildly profitable.

It is hard to remember a worse time to be a banker in Australia.

Indeed, you could excuse bankers for pretending to be used car salespeople or even journalists at parties, just so people didn’t attack them quite as badly!

The continuing revelations of bad banks behaviour from the Hayne Royal Commission has piled ever higher and looks set to get even worse as the big bank chief executives are summoned one by one over the coming months to get a dressing down at the Commissioner like a bunch of errant students.

Even the share prices of the major banks have taken a significant tumble, as investors factor in the cost of new rules and regulations, the potential of a slow-down in the property market and the deteriorating outlook for the bank’s wealth management businesses.

Those investors have been proven right too, with the results from the big banks and Macquarie and AMP showing that peak profitability could be in the rear vision mirror.

In average terms, bank profitability was down in the range of 11 to 14 per cent, with Commonwealth still leading with around 14-15 per cent.

There are significant headwinds ahead as well, quite apart from the ritual humiliations before the Hayne Royal Commission and the eventual beefing up of expensive rules, regulations and independent umpires.

Banks will need to adopt a much more cautious and rigorous approach to consumer lending and their compliance costs are set to surge in line with the Royal Commission recommendations.

Falling property values could increase defaults

With property prices falling in the major markets of Sydney and Melbourne, loan growth is set to fall as well.

No less an authority than Macquarie (ASX : MQG) said the bear market in property prices could be much more protracted and ugly than it initially thought, with price declines of between 15 per cent to 20 per cent now likely in Sydney and Melbourne.

Overall, the Macquarie economics team predict that prices will fall 10 per cent across Australia, making it the largest peak to trough decline in nominal housing prices in almost 40 years.

While the accuracy of that prediction is yet to be tested, falling property prices will be bad for the banks in two ways.

One of the keys to the fantastic profits the banks have earned up to now is that bad and doubtful debts have fallen to incredibly low levels.

That means that the banks are collecting interest payments on a very high percentage of its their outstanding loans and not having to write off too much in the way of bad debts, effectively turbocharging their profit performance.

You would expect that position to change in the coming year as more loans switch from interest only to interest and principal – increasing pressure on borrowers – and interest rates also possibly rise a little as higher offshore interest rates filter through.

Less activity will stifle loan growth

The slower activity in the property market – plus the higher standards required to actually get a loan – is expected to reduce lending growth for the banks.

Much of the profit growth of the banks over the past 20 years has been driven by increasing loan volumes and an improvement in bad and doubtful debts and that growth avenue appears to be closing off.

Getting out of wealth management

Another reason why profit growth could be hard to find is that the banks – with the notable exceptions of Westpac (ASX: WBC) and Macquarie (ASX: MQG) – are getting out of wealth management by selling off their financial planning arms.

As the Royal Commission showed, wealth management has produced some of the more spectacular rip-offs that have left customers in dire situations.

Losing their wealth arms would also be expected to slice bank profits and reduce their growth options.

Still spectacularly profitable

One of the dangers of all of this negativity is to lose sight of the fact that the big banks are still spectacularly profitable.

While their profit margins may have fallen to the 11 to 15 per cent range, that is still not too shabby in a relatively low interest rate environment.

While we can expect regulatory and compliance costs to rise following the Royal Commission, the latest results from the big banks has shown that they have the capacity to absorb refunds and costs and still turn in acceptable results.

Thy may not be as spectacular as the results of the past but they are still nothing to sneeze at.

Even Commonwealth Bank’s (ASX: CBA) $1.1 billion of extra costs to pay for the money laundering breaches, risk and compliance provisions and one-off-regulatory costs still saw the bank record a full year net profit of $9.38 billion.

That represents a 4 per cent fall, so if that is as bad as it gets for the big banks, it is not the end of the world.

Admittedly there are headwinds on several fronts but with dividends remaining strong and the big banks still representing a huge slice of the Australian share market, investors will keep a close eye on them in case an investment opportunity comes along.

John is a highly experienced business journalist and formerly chief business writer for the Herald Sun. He has covered Federal politics in Canberra, was Los Angeles Bureau chief for News Limited and was also chief of staff for the Herald Sun. He has covered a wide range of small and large cap ASX stocks and has a special interest in mining, technology and biotech.