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Fitch confirms challenging 2014 for Banks

Fitch Ratings, one of the big three ratings agencies alongside Moody’s and Standard and Poor’s, released its 2014 outlook for Australia’s banks last week with a downbeat assessment that highlighted a number of risks for the sector.

Australia and New Zealand Banking Group (ASX: ANZ), National Australia Bank Ltd. (ASX: NAB), Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) have been some of the best performing shares in the ASX 200 since 2012, rising over 50% in some cases. As prices have gone up, yields have come down, and forward yields now range from 5% to 6% after being upward of 7% only 18 months ago. While great for long-term holders of banking shares, the question often asked is: If it’s too late to buy into the banks?

Foolish investors understand that past performance cannot be used as a guide for future results, and as such Fitch’s assessment of risks is important when considering if the banks will continue to outperform.

Risks

Fitch highlighted a number of risks that investors should be aware of. Fitch believes that profit growth for the big banks will continue to be subdued as moderate credit growth and supportive funding costs will likely be offset by an increase in bad debts (defaults on loans) and strong competition between the large and small players for the relatively small amount of new home and business loans.

Fitch notes that cost reduction will also continue to play a part, though further reductions will be less significant than in previous years. Additionally, exposure to Asia represents both an opportunity and a risk, as Australia’s reliance on Chinese trade would see banks suffer if China were to experience a severe slow-down. However, earnings diversification from the region may provide a buffer should Australia’s economy underperform. ANZ Bank is the most heavily exposed to Asia of the big four.

Finally, the agency noted that the banks’ reliance on offshore capital markets may leave them susceptible to fluctuations in global markets, however improved capital ratios since 2008 should provide a buffer for short-term issues.

Outlook

The outlook for banks remains stable, despite the risks present. While the risks above are certainly plausible and real, they are just risks at this stage and Fitch notes that the funding and capital position of the big four should continue to improve in spite of the weak operating environment. It should also be noted that the banks are still highly profitable, with consensus earnings estimates expecting growth over 4%.

Foolish takeaway

Fitch’s outlook for the banks in 2014 paints the picture of a sector with a number of headwinds. It appears that in 2014 it will be more difficult for the banks to boost profit through cost cutting and reductions in bad debt expense. In addition, organic growth will be difficult to come by as credit growth remains subdued in the absence of any government intervention (i.e grants or tax breaks). One positive is that yields remain sustainable and are likely to continue growing by between 3% and 7% annually, and new capital allocation requirements for 2016 are already satisfied. The big banks will continue to see demand from income-seeing investors and international funds if the Australian dollar continues to fall.

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

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