Are the banks too risky?

Top Australian economist Adrian Blundell-Wignall has recommended that the ‘four pillars’ policy should be continued, ensuring the independence of the big four banks.

This is significant because Prime Minister Abbott recently announced an inquiry into the financial system as part of the coalition’s “deregulation agenda.” The inquiry will be headed by David Murray, a former chief executive of the Commonwealth Bank of Australia (ASX: CBA).

Deregulation can cause problems in the banking industry, because competition can drive banks to take on too much risk. In banking “competition is good” says Dr Blundell-Wignall “but not too much, that’s the reality… having just one bank is very high risk… coming out to four, five, six, the risk goes down.”

In recent years the four biggest banks, Commonwealth Bank, Westpac (ASX: WBC), ANZ Banking Group (ASX: ANZ) and National Australia Bank (ASX: NAB), have dominated the Australian economy. These four banks were able to use instability created by the GFC to consolidate their dominance in Australia. For example, in 2008, Commonwealth Bank took over BankWest and Westpac took over St George.

The next two biggest banks on the ASX are Bank of Queensland (ASX: BOQ) and Bendigo and Adelaide Bank (ASX: BEN), although Macquarie Group (ASX: MQG) also has a banking arm. Macquarie Group moved its traditional banking operations into a non-operating holding structure (NOHS) in 2007, which allowed Macquarie Bank to remain resilient throughout the global financial crisis.

Dr Blundell-Wignall argues that “Any bank that goes above 10 per cent in derivatives . . . should be forced by regulation to split off.” In effect this would mean that the bank would move to a non-operating holding structure, thus separating its traditional bank from its investment banking.

This is precautionary, and allows the retail banking operations to be somewhat insulated from riskier investment banking. A furthur precaution would be to force banks to hold more capital in reserve than is currently required. Although this would impact on profit in times of economic growth, during a recession this would make the banks stronger.

The risk of investing in banks is that the share price will take a massive dive when the economy does. This can happen because rising unemployment can lead to higher loan defaults. As Dr Blundell-Wignall points out, “What you say on your risk of capital determines how much capital you hold. Banks are trying to maximise their return on equity and are going to minimise their capital.” As I argued in this article, falling provisions for bad debts made a major contribution to the record profits of the banks in FY 2013.

Foolish takeaway

When bankers think that their risk of defaults is low, lower provisions are required. However, should defaults increase, banks would have to increase their provisions, further eroding profits. At present, investors are focused on the large dividend that the big banks pay. Little thought is given to the possibility that these dividends are unsustainable. This Fool believes that there are other shares available that have a much greater margin of safety, and more chance of generating capital gains.

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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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