Are the big banks really that profitable?

The CEO of ANZ (ASX: ANZ) deserves praise for drawing attention to accounting standards that could ultimately increase the volatility of bank shares. Speaking to The Australian Financial Review, Mr Smith shed light on a major factor driving the profits of the banks in FY 2013, and warned of a ‘double whammy’ during an economic downturn.

On paper, the banks certainly had a good year. Westpac (ASX: WBC) increased its cash earnings by 8% and the Commonwealth Bank (ASX: CBA) reported a strong first quarter, suggesting that the bank will earn well over $8 billion in FY 2014. ANZ reported record earnings, which were up 11% to just under $6.5 billion. National Australia Bank (ASX: NAB) increased its cash earnings by over 9%, reporting $5.9 billion for the full year.

As much as these figures might impress you, investors should understand that the greatest source of growth in earnings was falling provisions for bad debts. Under the current rules, banks account for bad debts on an incurred loss basis, meaning that the future (expected) bad debts are not provided for on the accounts. When the economy is running strong, this doesn’t matter, but the banks know that the economy will not always run strong.

The consensus seems to be that there is no bubble in bank shares, despite the fact that the total market capitalisation of the banks makes up a higher proportion of the total domestic market capitalisation than ever before. Personally, I think that this measure demonstrates that the banks are slightly overvalued, and that when an economic downturn does occur, the share prices of the banks will fall even faster than the market.

A few weeks ago, Adele Ferguson explained on “Inside Business” that bank shares were on the rise because of the dividend yield and that was unlikely to change any time soon. And she may be right (I don’t have a crystal ball, either) but I think when it does change, the shares will drop in price to below current levels, leaving today’s buyers with a paper loss.

Motley Fool contributor Peter Andersen wrote in this article that banks are priced for a perpetual ‘Goldilocks economy,’ and I think he is correct. The current prices of bank shares only make sense if you assume that there won’t be another recession, inflation will remain low and that Australians will continue to borrow heavily to buy houses. The economy may be running ‘not too hot, and not too cold’ right now, but one day that is likely to change.

Foolish takeaway

To quote ANZ Chief Mike Smith, “in a good year you have to release [bad debt provisions], then in a bad year you have to make provisions and create another collective provision, so it’s a double whammy.” When this does happen, expect the share prices of the banks to take a dive, leaving dividend-seeking SMSF investors in the red.

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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