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What does 2014 hold for Australia’s banks?

2013 will finish as one of the best years in recent memory for banks and bank shares (excluding the 2009 recovery following the GFC). The profits and dividends at Australia’s big four banks increased by 10% in 2013, propelling the companies to strong outperformance versus the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO).

National Australia Bank (ASX: NAB) was the standout, with a return of 39%, compared with 29% for ANZ (ASX: ANZ), 24% for Commonwealth Bank (ASX: CBA) and 23% for Westpac (ASX: WBC). Amazingly, NAB was actually shown up by its smaller rival Bank of Queensland’s (ASX: BOQ) 65% gain for the year.

Overall, the finance sector was the second-best performing in 2013, beaten by only consumer discretionary stocks. But what will 2014 hold for the banks? Can they repeat their performance of 2013?

Low growth a concern

In 2013, dividend yield and dividend stability was considered before earnings per share growth (EPSG), as historically low interest rates forced retirees and risk-averse investors from term deposits into shares in search of income. The banks and Telstra (ASX: TLS) fulfilled this need and their share prices rose as a result. In 2014, analysts are expecting that the prospect of medium-term interest rate rises will result in investors shifting their focus to companies that exhibit strong earnings, margins or market share growth. While the banks are expected to deliver EPSG between 5 and 8% in 2014, this will be achieved through cost cutting and low bad debt expenses, as opposed to increased sales or demand-driven margin increases.

Rock solid businesses and dividends are still important

While impending interest rate rises may see some funds leave the banks, any outflows should be balanced by risk-averse investors left with few other options but to re-invest dividends and spare cash in the banks in 2014.

The banks offer a unique combination of a solid 5 to 6% fully franked dividend, a low risk of a major blow-up, and are currently in a cyclical low point of bad debt expense.

But risks remain

A blow-up of the housing market, a severe drop-off in mining capex resulting in an Australian recession, faster than expected tapering of economic stimulus in the US, and an earlier than expected rise in interest rates could all see the banks’ share price drop substantially. Indeed, between mid-November and mid-December the share price of the major banks dropped between 8 and 15% as tapering fears took hold.

Foolish takeaway

I think the big four banks are still the best bet for low-risk income stocks in 2014. While risks remain, support from investors seeking passive income should act to keep the share price from falling too far during any market corrections. NAB is touted as having the greatest upside, as the recovery in its UK operations gains momentum, while ANZ’s Asian strategy could come under some pressure from new rules relating to capital ratios.

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Motley Fool contributor Andrew Mudie does not own shares in any companies mentioned