Westpac Banking Corp (ASX: WBC) shares have fallen 8% in 2016, despite their recent rally.
It's been a tough run for most of Australia's big banks in 2016, with Australia and New Zealand Banking Group (ASX: ANZ) and Commonwealth Bank of Australia (ASX: CBA) tumbling down 14.8% and 13.8%, respectively.
Therefore, it would be safe to say that investors have taken a lesser view of the banking sector in the immediate future.
Economic headwinds
Of course, bank shares are intensely cyclical and subject to the ebbs and flows of the broader economy.
Just earlier this week, the Reserve Bank of Australia reported further falls in the official inflation rate, catching most investors off guard. While the effects of monetary policy can take a couple years to show through in consumer prices, lower inflation has implications for banks like Westpac because it can give rise to further expectations of an interest rate cut to stimulate a sluggish economy.
But perhaps the biggest concern for bank shareholders is a rise in bad debts. Indeed, as the economy ebbs and flows, rises in bad debts should be expected. Bad debts have a significant impact on reportable bank profits because they are deducted straight from the income statement.
Moreover, since the implementation of the International Financial Reporting Standards in 2006, bad debts have become more volatile with economic swings. Recently, economic conditions have supported lower bad debts.
Therefore, if the slowdown in the property sector continues, increased competition continues to drive down profit margins and inflation remains below expectations, the risk to owning bank shares is to the downside, in my opinion.
Foolish takeaway
Valuing and investing in bank shares is not without its risk. Moreover, investors must remain aware of the economic environment if they seek appropriate entry and exit points from their shares. In my opinion, the risk-reward tradeoff in holding Westpac shares has improved over the past year, but if I held shares at this time I may be inclined to take some profits off the table.
