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Big bank investors caught unaware by this structural change to the sector

There’s a hidden threat to the profitability of the banking sector at a time when the share prices of the big banks are struggling against multiple headwinds.

It may sound crazy to many, but I think conditions for our bank stocks have not been this hostile since the GFC and at least one of the hurdles may be structural in nature.

The falling residential property market and the fallout from the Banking Royal Commission have been used as the key reasons for the underperformance of the big banks like Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), Australia and New Zealand Banking Group (ASX: ANZ) and National Australia Bank Ltd. (ASX: NAB), but the sharp rise in their funding cost poses as significant a threat.

The local rate at which banks can borrow has spiked to levels not seen since the dark days of the GFC when panic was gripping the financial markets, according to the Australian Financial Review.

Don’t beat yourself up if you didn’t know or understand the issue. Experts are also scratching their heads although there are a few plausible explanations for this highly unusual move.

Before I get into what these might be, there are two key things every bank investor should know about this issue.

The first is that the drivers for the painful rise in how much our banks have to pay to borrow (in order to offer loans to the community) looks structural to me – not cyclical. This means the elevated funding costs over the official interest rate are likely to stay for a very long time.

The second is that the higher costs will hurt bank profitability. Analysts speculate that the jump in bank borrowing costs will shave up to 4% off the sector’s bottom line unless they lift mortgage rates.

It’s not an easy decision as the political pressure on the big four make them reluctant to do so, while competition and other cyclical headwinds mean they could cede market share if they did so.

From that perspective, I am not counting on the banks to outperform the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) over the medium term and would stay underweight on the sector going into the August reporting season.

Back to some possible reasons for the jump in the bank’s borrowing rates. The AFR suggested that new rules drafted post-GFC to protect the global financial system from another meltdown have limited overseas and local banks from lending to the private sector.

We have not really felt the impact of this before as central banks from the US to Europe and Japan have been flushing the system with liquidity through record low interest rates and quantitative easing. This party has come to an end.

Tax changes could also be contributing to the squeeze. Multinationals can’t transfer cash between countries without getting a tax hit and that could be draining liquidity. Also, the lowering in US corporate taxes has prompted many US firms to transfer cash back to their home country – depriving economies like ours a funding source.

All these changes to the international wholesale market are prompting our banks to turn more aggressively to the local market. This increase in competition to borrow locally, is in turn, driving up costs here.

As I mentioned, many of these issues look structural to me and I wouldn’t have thought it’s an issue that would go away in the foreseeable future, at least.

The good news is that things may not get worse, just that it won’t get much better.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, National Australia Bank Limited, and Westpac Banking. 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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