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Is this the biggest risk to the big four banks?

One of the factors that has allowed Australia’s big four banks to prosper and report ever growing profits has been the steady decline of allowances for bad debts.

But that could be about to reverse course, according to some reports.

Under accounting rules, banks take an allowance for the write-down of bad debts through their income statement. As those estimates fall – usually as the economy grows – banks report increasing profits. Credit growth has been anything but on fire over the past few years, and so steadily falling bad debt provisions has become a major contributor to growth.

Now Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) could be seeing that cycle change, following the collapse of companies like Dick Smith Holdings, and the struggles of a number of highly indebted companies such as Arrium Ltd (ASX: ARI) and Slater & Gordon Limited (ASX: SGH), according to UBS analysts.

Dick Smith collapsed earlier this year, with debts reported of around $390 million, $140 million secured against assets, and another $250 million unsecured. HSBC had provided a $60 million overdraft, while NAB had a $35 million working capital facility and its New Zealand offshoot provided another $40 million working capital facility.

Steel producer and iron ore miner Arrium reported earlier this year that there was ‘material uncertainty as to whether the group will continue as a going concern’. In other words, the company was not making enough profit or cashflow to support itself and could easily fall into voluntary administration.

Arrium had net debts of just over $2 billion at the end of December 2015, including $2 billion in bank loans and $276 million of debt issued as US private placement.

Law firm Slater & Gordon had $793 million of net debt at the end of December 2015 – with a large part of that going towards its ill-fated acquisition of UK law firm Quindell’s Professional Services Division. Slater’s cash advance facility was provided by a syndicate of banks including Westpac and NAB.

No doubt the banks have more exposure to other corporates teetering on the brink of ‘failing to continue as going concern’, including indebted oil and gas companies struggling with oil prices under US$40 a barrel.

Foolish takeaway

Banks’ share prices may look cheap, but investors should remember that they can always get much cheaper from here too.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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