Twelve months ago, the ASX financials sector was the talk of the market.
The S&P/ASX 200 Financials Index (ASX: XFJ) rose 24.3% in FY25, making it the best-performing sector of all eleven ASX 200 market sectors.
Commonwealth Bank of Australia (ASX: CBA) was the standout, rising 45% to close FY25 at $185, just days after hitting a record high of $192.
Investors who held the banks through FY25 were handsomely rewarded.
FY26, however, was a completely different story.
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What the numbers show for FY26
CBA shares fell approximately 11% over FY26, reversing a significant portion of the 45% gain that made the sector's FY25 performance look so impressive.
National Australia Bank Ltd (ASX: NAB) shed approximately 4% over the full year. Westpac Banking Corp (ASX: WBC) fell approximately 11%.
The S&P/ASX 200 Financials Index moved into negative territory, making it one of the weaker sector performers in a year when the broader market managed only a 3% gain.
Why did this happen? Three specific forces converged to drive the banks from sector darling to under-performer in the space of twelve months.
Force one: three rate hikes the market did not expect
The RBA delivered three consecutive cash rate increases in February, March, and May 2026. This took the official rate to 4.35%, its highest level since late 2011.
Higher rates are a double-edged sword for banks.
On one side, rising rates expand net interest margins as lending rates reprice faster than deposit costs.
On the other, they increase mortgage stress across the banks' enormous home loan books, raise the risk of credit losses, and weaken demand for new lending.
In FY26, the second side of that equation dominated.
Force two: the valuation problem
Coming into FY26, CBA was trading at approximately 26 times forward earnings. This was one of the highest valuations in its history and a premium that left virtually no room for earnings to disappoint.
When CBA's Q3 FY2026 trading update showed flat operating income and a 1% decline in unaudited cash NPAT. These results came in below the elevated expectations the market had built in, the shares fell sharply.
A premium valuation stock that misses elevated expectations does not merely stop going up. It falls hard, and it falls fast.
NAB and Westpac faced similar dynamics, with both trading at multiples that reflected optimism rather than the more cautious credit environment that was actually developing.
Force three: the policy shift that hit the mortgage book
The federal budget's decision to restrict negative gearing for established residential properties directly hit the banks' most profitable mortgage customers.
Jarden analyst Matthew Wilson estimated the changes could cut housing credit growth by as much as 25%, naming CBA as the most exposed given its investor loan concentration.
CBA's own economists confirmed the policy would reduce dwelling prices by approximately 3% relative to what they otherwise would have been. They forecast dwelling price growth of just 3% to December 2026, down from a prior forecast of 5%.
For a sector whose earnings are deeply tied to the health of the Australian property market, that represents a direct headwind on both credit quality and lending volume simultaneously.
Where CBA, NAB, and Westpac stand heading into FY27
The picture heading into FY27 for ASX financials is nuanced rather than uniformly bearish.
CBA remains the most expensive of the three at approximately 25 times forward earnings, leaving it the most exposed to any further earnings disappointment.
NAB is cheaper at approximately 15 times forward earnings but faces its own credit quality headwinds given its business banking concentration.
Michael Gable from Fairmont Equities retained a sell rating on NAB shares, saying:
Despite a significant share price fall, NAB valuations aren't cheap, leaving the stock exposed to downside risk.
Westpac, with approximately 69% of its loan book in residential mortgages, is the most directly exposed to any further deterioration in the housing market.
The RBA's decision to hold at 4.35% in June and signal that further hikes remain possible but are not certain is the most important variable for all three heading into FY27.
A rate-cutting cycle, when it eventually arrives, may change the sector's fortunes.
Until then, the forces that drove FY26's underperformance have not fully resolved.
Foolish takeaway for ASX financials
The ASX financials sector went from the best performer in FY25 to an under-performer in FY26 because three specific forces hit simultaneously: unexpected rate hikes, stretched valuations, and a direct policy attack on the sector's most profitable customer segment.
None of those forces have completely reversed.
FY27 will test whether the rate cycle has peaked and whether Australian credit quality holds up.
The answer to both questions will determine whether the sector can recover.
