Bank shares – no matter how 'big' – are cyclical.
That means, along with their profits, bank shares will rise and fall.
Of course, they'll go up, down and across, in no particular order over time.
But depending how you look at it, cyclicality can bring opportunity for savvy long-term investors. For example, once you determine where the 'middle ground' of the banking cycle lies, you should be able to buy shares at reasonably compelling valuations.
One reason bank profits rise and fall so dramatically can be put down to their leverage. Banks take 'debt' from term deposit holders and international bond markets to then credit homeowners, businesses and fashionistas.
Unfortunately, or fortunately (once again, depending how you look at it), the credit card bills outgrow the wardrobes and business people fail to make satisfactory returns on their investments that they bought on credit.
Loans fail to get repaid and ultimately the bank is forced to wear the damages. It takes 'provisions' for these 'bad debts' ahead of time.
Usually, the ebb and flow of the bad debt cycle will take years. However, it makes sense for bad debts to grow following a period characterised by:
- Slower economic growth
- Rising unemployment
Overlay A and B above with record debt levels, and you've got yourself a recipe for falling bank profits.
Why?
Provisions for bad debts are deducted straight from bank profits, as is evidenced in the above screenshot from the Income Statement of Commonwealth Bank of Australia's (ASX: CBA) 2009 Annual Report.
As can be seen, CommBank's provisions rose from $434 million in 2007 (boom time) to $3,048 million in 2009 (the fallout of the Global Financial Crisis).
But it wasn't just a CommBank problem, the entire banking sector saw a steep rise in provisions.
Indeed, given its exposure to the UK economy – the home of debt prior to the GFC – National Australia Bank Ltd.'s (ASX: NAB) recovery took a little longer than its peers.
Before we go ahead, there are some prejudices we must acknowledge if we are to objectively discuss the 'Big Banks'. For example, the fact that the 'Big Four' banks have dramatically increased their loan books in recent years would suggest that, all else being equal, the dollar value of provisions should also rise. Therefore, there is nothing to worry about.
But by the same token, it's also important to remember that Australia hasn't had a recession since the early 90's. Along the way, the pendulum of interest rates has tanked to record lows while household debt levels have swelled to record highs.
2018: D-day for banks?
Acknowledging where they likely now sit in the bad debt cycle, and the recent developments in the local and international banking sectors, analysts at investment firm, Citibank, say Australia's major banks will be forced to cut dividends by 2018.
Quoted in Fairfax press, the note to clients said NAB, CommBank, Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ) will be forced to lower their dividend payouts (as a percentage of profits) to maintain their capital buffers and weather a slide in credit quality.
"On a 3-year view, we expect all the major banks to cut dividends," Fairfax quoted from the note.
If credit quality does fall, and dividends are expected to follow suit, is it any wonder big bank shares have fallen an average of 11.59% in 2015, compared to the S&P/ASX 200's (Index: ^AXJO) (ASX: XJO) fall of just 7%? I don't think so.
Buy, Hold or Sell
They'll come a time — and price — to buy big bank shares, but it is not now. Wait for the bad debt cycle to run its race and buy when the upside potential of bank stocks outweighs the downside.
