Here’s why I don’t invest in bank shares like Westpac Banking Corp

The big four banks pay high dividends and on this basis they look like decent investments.

Australia and New Zealand Banking Group (ASX: ANZ) pays 6%, Commonwealth Bank of Australia (ASX: CBA) pays 6.2%, Westpac Banking Corp (ASX: WBC) pays 6.8% and National Australia Bank Ltd. (ASX: NAB) pays a whopping 7.5%. Even better, these dividends are all fully franked and so grossed up they are worth between 8.6% and 10.7%.

But the question is are such payouts sustainable?

After all, it’s no good receiving a healthy dividend for the next couple of years and then losing a bigger chunk of your capital further down the track. That question is hard to answer but I have plenty of doubts.

A bank’s dividend depends on its customers’ ability to pay both interest and the principal on the loans it writes. Crucially, because the consequences of defaulting are severe, debtors will do everything in their power to keep paying, including taking out more debt even when in reality they are insolvent.

At the same time, it is in the interests of many of those responsible for making lending decisions within a bank to lend as much as possible to as many people as possible. This is because just like in many other businesses, employee incentives are tied to driving revenue and profit growth.

It is easy to see how these forces could lead to a situation where a bank ends up writing a significant number of loans that will never be fully repaid. Since annual interest payments are typically so small relative to outstanding principal, even a small proportion of defaults can have large consequences.

These include the slashing of dividends and even recapitalisation at a heavily discounted share price diluting existing shareholders and permanently destroying their capital. This is exactly what happened to shareholders in several UK banks during the GFC.

I don’t know to what extent the big four are harbouring rotten loans on their balance sheets. The Financial Services Royal Commission has already exposed their lax lending standards, but given the sheer size of these monolithic institutions it is unlikely that anybody knows the true state of their loan books.

House prices relative to incomes are higher in Australia than pretty much anywhere else in the world, ever. This is worrying and may further hint at unsustainable borrowing. However, it only really proves that home ownership in many parts of the country is out of reach for the average first time buyer.

So the way I look at a potential investment in the banks is that at best I am buying into a strong dividend stream with modest scope for capital appreciation, say around a 12% total annual return.

On the other hand the downside risk represents a large range of outcomes, the worst being I lose almost all of my capital. What’s more, there are already a couple of dead canaries in the coal mine.

So if you were thinking of buying shares in the banks or already own some then why not check out these Top 3 ASX Blue Chips To Buy In 2018 as they may offer a better alternative.

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The Motley Fool’s in-house analyst team has poured over thousands of hours worth of proprietary research to bring you the names of "The Motley Fool’s Top 3 Blue Chip Stocks for 2018."

Each one pays a fully franked dividend. Each one has not only grown its profits, but has also grown its dividend. One increased it by a whopping 33%, while another trades on a grossed up (fully franked) dividend yield of almost 7%.

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Motley Fool contributor Matthew Brazier has no position in any of the stocks mentioned. You can find Matt on Twitter @MattBrazier2

The Motley Fool Australia owns shares of National Australia Bank Limited. 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 Scott Phillips.

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