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Are the banks overvalued?

Retail banking is fundamentally a simple business; and only has 2 productive segments: 1) borrowing and lending on money, usually at a 2% margin, and 2) proprietary trading, fees and other activities such as insurance and wealth management. Put together, these two segments typically generate a gross (before expenses) return on the asset base of about 3% — in a good year.

Of this 3%, half goes on the costs of doing business; leaving 1.5% to absorb tax and bad debt provisions before any final profit can be declared. With tax alone absorbing 30% of this, it’s not difficult to see banks as marginal commodity operations as far as return on assets is concerned. By way of a real life example, ANZ (ASX: ANZ) earned a net 0.88% on total assets in its last report.

So, what options do banks have to further improve financial performance? Essentially, there are only three: increase margins, reduce business costs or develop new profit centres. The problem with increasing margins is the level of exposure to the highly competitive residential property loans market. Commonwealth Bank (ASX: CBA) has a mortgage book of $320 billion, Westpac (ASX: WBC) $297 billion, National Australia (ASX: NAB) $196 billion, and ANZ is the least exposed of the big four at $178 billion. A moderate rise in housing default rates would have dramatic consequences for profit ratios, and the banks most likely to suffer are CBA and WBC.

banks

Residential lending is very competitive, and there is little scope to increase margins significantly. In addition the high fixed cost base of the major banks in bricks & mortar branches, technology and head office expenses means significant cost savings can only be achieved at the fringes.

ANZ is the most advanced when it comes to potential new profit centres, with increasing emphasis on Asia. NAB and Westpac are also making tentative moves to a lesser degree. Commonwealth (the market darling) pretty well stays at home in its operations.

Virtually all of the big four have wealth management divisions; however these too are facing competitive pressures and are yet to meet earlier expectations.

Over time, the adoption of private cloud services may open up opportunities for the big banks. However regulatory and compliance concerns preclude this at present. Briefly, cloud services can allow users to access information directly through a web browser (with the applicable rented software) rather than have to totally build expensive proprietary systems themselves. More information can be found in this article. The problem here is nimbler and smaller rivals are likely to get in first.

Foolish takeaway

Banks are essential services and will be with us for the foreseeable future — however, this doesn’t make them a good investment at any price. In this Fool’s view, major banks are over exposed to potentially vulnerable markets and despite reasonably good results the risks aren’t reflected in over inflated bank share prices. In addition small specialist rivals are nibbling away with better priced loans and friendlier processes. The retail banking scene is facing big changes on several fronts; and investors can find better value elsewhere.

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Motley Fool contributor Peter Andersen does not own shares in any companies mentioned in this article.

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