Westpac Banking Corp (ASX: WBC) released softer-than-expected numbers this morning, reigniting concerns that Australia’s banking sector is poised to fall. Westpac’s results were dragged down as a result of a higher-than-expected amount of bad loans in its institutional lending arm.

The results have dampened sentiment towards the entire banking sector, with Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), Macquarie Group Ltd (ASX: MQG) and National Australian Bank Ltd (ASX: NAB) all plummeting on concerns of widespread rising bad debts.

Whilst today’s falls might be overdone, two key events this week make me think bank shares are set to experience more volatility in the coming days, making them investments only for the brave.

RBA to the rescue?

The Reserve Bank of Australia (RBA) is widely expected to cut Australia’s cash rate when it meets on Tuesday. The expectation comes as Australia suffered its first quarterly deflation in more than seven years, after March inflation figures came it at -0.2% for the quarter. This dragged the annual rate of growth down to 1.3%, well below the RBA’s target band of 2-3% annual inflation. The soft inflation figures are expected to force the RBA’s hand to act, requiring it to cut the cash rate from 2% to 1.75% — a new record low.

A cut would be beneficial for bank shares because it makes their yield even more important; at current prices, ANZ, CBA, Macquarie, NAB and Westpac trade on a trailing yield between 5.5% to 7% (plus franking credits), making them one of the only places for reliable income in the current interest rate environment. Therefore, demand for them is likely to increase if bank deposit rates drop further.

In addition, a lower cash rate is likely to increase margins and increase demand for lending (due to increased economic activity as a result of the interest rate cut), positioning the banks to grow earnings going forward. However, the risk of rising bad debts will remain for the banking sector, making it subject to further falls if the concerns eventuate to reality.

These concerns are likely to be exacerbated if there are surprises revealed around property investing in the Federal budget.

Federal budget

The Turnbull Government is set to announce its first Federal Budget on Tuesday night. Of relevance to bank shares will be any announcement regarding changes to negative gearing and the current capital gains tax (CGT) exemption provided to investors who hold a CGT asset for longer than 12 months.

These key ‘tax breaks’ are predominantly used by property investors in assessing the feasibility of property investment. Often, these investors borrow money from Australian banks, making any changes to these policies quite influential on bank earnings. It follows therefore that any adverse changes could lead to lower demand for borrowing, stalling lending growth for all banks and causing further drops to the share price.

Foolish takeaway

Even though uncertainty always remains around regulatory and government policies, investors should pay particular attention to this week’s announcements as they have potential to alter the entire banking sector. Although it is unlikely that major changes will be made, given current sentiment towards the sector, it might be prudent to wait for the outcomes of the RBA announcement and Federal budget before buying.

Therefore, whilst the banks’ current share prices might be a bargain in hindsight, I won’t buy any of them until Tuesday’s two announcements pass.

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Motley Fool contributor Rachit Dudhwala owns shares of National Australia Bank Limited and Westpac Banking. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.