This is the big banks’ hidden plan to split the market to revive their sagging share prices

The move by the big banks to cut rates on mortgages is more than about protecting market share in the face of intensifying competition from non-bank lenders entering the market. The move could be a new way for the sector to revive its slumping share prices.

While the cuts might sound counter-intuitive to shareholders given the sharp rise in funding costs for the sector, the reduction in a number of mortgage products is a strategic move by the big four to split the home loan market into two distinct groups – prime borrowers (who are most able to afford their loans) and non-prime borrowers.

Investors should understand the strategic rationale and the implications for the move as they assess the attractiveness of investing in the sector.

This isn’t based on anything the banks have said but on my observations of what is happening in the market.

My take that the big four are putting a wedge in the market comes on the back of news that they are tightening their lending standards and as Australia adopts broader credit reporting standards that are not dissimilar to those used in the US.

The US lending market is more segmented than in Australia where housing loan applicants are seen to be relatively homogenised.

But the more detailed credit reporting rules that have just been adopted here will allow lenders to further differentiate borrowers.

The big banks want the prime borrowers and are willing to make less for dominating the segment. The economics could make sense.

If you think about it, there are three factors that will determine the profitability of the banks – market share, net interest margin and bad and doubtful debt provisioning.

The banks will probably have to give ground on two of the three in their pursuit of the prime market but that may be offset by provisioning. The drop in provisioning over the past few reporting seasons has effectively allowed the big banks to post pleasing profit growth figures.

I think the big banks are somewhat resigned to the fact that they will have to cede market share too. The question is how much. That’s not an easy question to answer given there isn’t readily available data on prime borrowers, although recent analysis on the quality of borrowers from the major banks suggests that around 30% are considered overstretched.

If we assume the rest are prime borrowers, it could mean the market share of the big banks will drop from around 80% to 60% of the total market over time.

But I believe the value drivers for the banks aren’t growth or market share gains. It’s about “shrinking to greatness” with the focus on improving shareholder returns.

This is the strategy that’s been effectively wielded by BHP Billiton Limited (ASX: BHP) and is one that is being pursued by Telstra Corporation Ltd (ASX: TLS).

The share prices of the big four, which include Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ) have underperformed the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) over the past year.

Their ability to lift their return-on-equity will be a more important valuation driver for the sector than top-line growth.

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Motley Fool contributor Brendon Lau owns shares of Australia & New Zealand Banking Group Limited, BHP Billiton Limited, National Australia Bank Limited, Telstra Limited, and Westpac Banking. The Motley Fool Australia owns shares of and has recommended Telstra Limited. 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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