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Should you invest in Commonwealth Bank shares?

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The big four Australian bank shares enjoy a unique space in our economy. In part, this is due to Paul Keating’s 4 Pillars policy, originally 6 Pillars. A policy that prevents them from taking over one another.

However, a foreign bank or company could take over any one of them. One of the results of this policy is that they are all in the top 30 of the world’s largest banks by market capitalisation. In fact, the price of  Commonwealth Bank of Australia (ASX: CBA) shares makes it the 13th largest bank in the world by market cap.

As the coronavirus pandemic rages on, it has become clear just how important our banks are. They have proven to be one of the nation’s great economic weapons. When used in conjunction with our superannuation system, they have cushioned the short term blow of the pandemic. In fact, to an outsider, the banks must appear as if they were an arm of government. 

Given their intrinsic importance to the economic well-being of the country, I wonder if they are still a good investment. Or, does their national role prevent that?

Banks and the pandemic

The banks are regulated by the The Australian Prudential Regulation Authority (APRA). This regulator is charged with maintaining a “stable, efficient and competitive financial system” via prudential standards and practices. This is where it all gets interesting for me. Moreover, we saw this in action during the early stages of the lockdown.

APRA allowed the banks to provide a range of assistance. First, it allowed a loan repayment deferral period of up to 6 months without being in arrears. This is part of the support available to small business also.

Second, it allowed banks to extend or change the type of loan without serviceability assessments. For example, a mortgage change from principal and interest, to interest only. Under the APRA guidelines, this can happen without having to prove it can be paid for.

To help the banks further, the regulator requested that they “limit discretionary capital distributions in the months ahead”. Instead, asking them to maintain a buffer to potentially support the economy. This meant no dividend payments. 

At the time of writing, APRA has extended this from 6 months to 10 months, or until 31 March 2021, whichever comes first.  In addition, it has changed its advice on dividends. Effectively capping them at a maximum of 50% of profits. I think these factors are holding down the price of Commonwealth Bank shares.

The impact on Commonwealth Bank shares

The basic business model of a bank is arbitrage. That is, take in funds at a specific short-term interest rate, and then loan it out for longer terms at higher interest rates. Banks have already agreed to a 6-month deferral of loan repayments, and are likely to be under massive pressure to extend for the full 10 months. This is a major hole in revenues.

Additionally there is the risk of loan defaults. Over the past 5 years, the average number of companies to declare themselves insolvent is about 600 per month. However, according to TradingEconomics.com, only slightly more than 400 companies have become insolvent during April and May.

Moreover, we can see rising unemployment and the gradual winding down of JobKeeper. It is clear to me that there is going to be a tidal wave of defaults in both business and personal loans.

CommBank is the largest provider of home loans and business loans in Australia, therefore likely carrying the most risk of defaults. This is just one of the potential consequences of the interests of the nation overriding the interest of the shareholders. It may well be the right thing to do, or even the ethical thing to do. Nonetheless, that doesn’t make it in the best interests of the shareholders.

Could Commonwealth Bank shares grow?

There is a reason why banks are often seen as lumbering, overly cautious enterprises. Of the four major banks, only CommBank has a large, successful international operation. In addition, unlike the other banks, it is the only one to make a move into the buy now pay later (BNPL) sector via its deal with Swedish bank Klarna. However, across all of the bank’s traditional verticals there are piranhas nipping at its heels. 

For example, CommBank is the nation’s largest provider of digital payments services. Nevertheless, companies like Tyro Payments Ltd (ASX: TYR) are making solid inroads into national market share. Tyro has set itself up as the largest EFTPOS provider among all authorised deposit taking institutes (ADI) outside of the big four banks. Moreover, credit cards are under fire by other BNPL companies such as  Afterpay Ltd (ASX: APT) and Zip Co Ltd (ASX: Z1P).

In loans, the bank is under fire from start ups like WISR Ltd (ASX: WZR), as well as a range of neo-banks mostly dedicated to having only an online presence. Companies like Moneyme Ltd (ASX: MME) or the private Judo Bank. In addition, debtor finance is becoming more of a respectable mechanism to access short term funds. This includes companies like CML Group Ltd (ASX: CGR).

Foolish Takeaway

I strongly believe that if the 4 Pillars policy didn’t exist, at least one, maybe more, of the large banks would have disappeared. Therefore, if I had to invest in any bank equities, it would be in Commonwealth Bank shares. However, it would be primarily for the possibility of moderate share price growth. Nevertheless, there is no way I am going to invest in any banks at present.

The ability of the regulator to direct a bank to take actions potentially detrimental to shareholders adds a level of risk. Moreover, the banks now have their dividends effectively capped. So the main reason why many investors held them in the first place has disappeared.

Lastly, as we emerge from coronavirus, it is clear that the banks still have a lot of bad news ahead of them. Meanwhile, competitors are actively slicing away market share in various areas. There are many other opportunities on the ASX if you are willing to do the work to find them. 

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Daryl Mather has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Tyro Payments and ZIPCOLTD FPO. The Motley Fool Australia owns shares of AFTERPAY T FPO. 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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