Stock_Rocommendation_-_Big_4_Australian_Banks

Question 1 You are a bank analyst for a Mutual Fund with $6 billion under management. The portfolio manager wants to allocate $500 million for purchases of banking stocks and bonds. Your task is to prepare a report making a recommendation as to which of the 'big four' Australian banks the portfolio manager should allocate her $500 million to. Whilst countries such as the United States and the United Kingdom with weak banking systems experienced a severe downturn in economic activity, the Australian banking industry has emerged from the global financial crisis in a stronger position. Historically the big four banks – Commonwealth Bank (CBA), ANZ, Westpac and National Australia Bank (NAB) – have delivered profits that rise consistently and are in a stable position to continue doing so in the post global financial crisis (GFC) environment thanks to unprecedented government support and regulation implemented during the GFC. In fact, the most recent annual reports show the big four banks have posted combined record profits of $28.5billion, a 26% jump from the previous financial year. Note however that this profit growth is expected to slow by many analysts in the post GFC era with changes in the regulatory environment and the rising cost of debt. Still, as Australian banks continue to be amongst the most highly rated banks in the world and the Australian financial system continues to outperform the global market, the big four remain an attractive investment. Taking an empirical analysis of the big four using historical data (Appendix 1), we can see that in terms of owner return on equity, CBA ranks first followed by Westpac and ANZ with NAB in 4th rank. On the surface it may seem most appropriate to declare CBA as the forerunner of the group. CBA’s large deposit base, its big funds management operation and the cost benefits from its technology upgrade make it appear to be a standout amongst the Australian banks in terms of profitability. However what is not illustrated in the Du Pont analysis are potential trading losses, offshore operating results, capital raised, asset mixes and riskiness to liquidity. A growing concern for the Australian banking industry is the rapid increase in the price of debt. Cash strapped European governments and other banks have created fierce competition for funds, driving up borrowing costs on global markets. With a high reliance on bank funding coming from wholesale markets, the Big Four are heavily exposed to fluctuations in the wholesale markets. This is the very reason why the banks have recently been put under review by ratings agency, Moody. Of the big four, the Commonwealth Bank has the biggest requirement from the wholesale markets, estimated at an excess of $50billion over 2010-11. With the rising cost of debt, this high reliance on offshore funding means a smaller interest spread as well as increased exposure to the volatile interest rates of the wholesale markets. ANZ, with plans to raise $20-25 billion in offshore markets appears to have least exposure to this risk. Australian banks also have high exposures to the highly indebted Australian household sector. Should the RBA increase interest rates then there is a risk of household defaults and bad debts. And with current Australian property prices being 56% overvalued the housing bubble is threatening to burst. This problem poses the greatest risk to the CBA and Westpac who hold 65% and 62% of their assets in the local housing market respectively. Comparatively ANZ again seems to be in the best position should the housing bubble burst, with a much lower market share of bank lending to Australian households. Furthermore, the current mortgage war between the banks has exposed them to more risk with the big four increasing their loan value ratios by up to 97%. The fall in lending standards combined with the trend for households to save rather than borrow creates a concern for the stability of the banks. The intense competition for both mortgage share and as well as retail deposits in the domestic economy facilitates an environment where lenders may take on more risk. Moreover banks that take these risks in order to garner more market share face the possibility of underpricing, diminishing profit growth even further. Evaluating the big four banks, ANZ stands as the most conservative with a maximum loan to value ratio of 90%. But what primarily differentiates ANZ from its other Big Four peers is its aspirations to establish itself in the Asian market, thereby decreasing its exposure to the perils of the local market. With an increasing cost of debt and intensified competition in the Australian domestic environment the four banks face the challenge of re-establishing equivalent or even better return on equity (ROE) of 20% levels they once enjoyed pre-crisis. It is ROE growth potential that differentiates ANZ. CEO Mike Smith has announced that the bank aims to get 25 to 30 per cent profits from the region by 2017 from around 14 per cent now. The Asian expansion plans provides promising long-term growth with underlying growth exceeding that of the other Big Four largely due to a heightened focus on non-interest income. Also note that ANZ is the most well placed bank to meet the more prudent Basel III capital requirements that are being phased in from 1 January 2013 to 1 January 2019, with a capital ratio of 10.08% (the highest of the big four). With higher capital ratios being required the banks may experience a decline in their returns on capital. Banks may make more profit but they are limited in being as profitable as they were prior to 2007. Again this highlights the importance for banks to take an increased focus on non-interest income and diversify their asset mixes. Predictions of doom and gloom in the local market aside, bank analysts largely agree that ANZ’s Asian expansion plan is what makes the difference. Combined with a lower dependence on both mortgage income and funding from offshore wholesale markets ANZ is comparatively the better investment prospect in providing sustainable growth. Destche bank, for one, believes ANZ could indeed lift its ROE from around a current 14% to 18-20% in the medium term. Final Recommendation: Invest the $500million into stocks of ANZ Banking Corporation. APPENDIX 1 Source: KPMG, (2010), ‘Major Australian Banks – Year End 2010’ REFERENCES Beyond ROE - How to measure Bank performance [online]. (2010) [Accessed 24 April 2011]. Available from: . Capital adequacy ratio [online]. (2011) [Accessed 24 April 2011]. Available from: . Financial Stability Review [online]. (2011) [Accessed 24 April 2011]. Available from: . Abernathy, J. (2010) Outlook for Australian banks. [Accessed 24 April 2011]. Available from: . Cratchley, D. (2011) Asia to drive ANZ profit by 2017[Accessed 24 April 2011]. Available from: Denning, D. (2010) Big four aussie banks used financial crisis to expand control over mortgage market [Accessed 24 April 2011]. Available from: . Dunn, J. (2010) ‘Big four aussie banks – buy or sell’ [Accessed 24 April 2011]. Available from: . Fullerton, T (2011), Big four banks face off for customers. [Accessed 24 April 2011]. Available from: . Global Finance (2010) ‘World’s 50 safest banks’ [Accessed 24 April 2011]. Available from: . Henry, K. (2010) ‘Australian banking system – Challenges in the post GFC environment’ [Accessed 12 April 2011]. Available from: . Hinchliffe, M. and Dickinson, A. (2010). Major Australian Banks: Year End 2010 [online]. [Accessed 12 April 2011]. Available from: . Janda, M. (2010), Bank profit growth to slow in post-GFC era. [Accessed 24 April 2011]. Available from: < http://www.abc.net.au/worldtoday/content/2010/s3022759.htm >. Johanson, S (2011) ‘Aussie home prices world’s most overpriced: Economist Survey’ [Accessed 24 April 2011]. Available from: . Johnston, E. (2011) Borrowing may become harder [Accessed 24 April 2011]. Available from: < http://www.smh.com.au/business/borrowing-may-become-harder-20110418-1dlpd.html>. Johnston, E (2011) ‘Rate pressure builds’ [Accessed 24 April 2011]. Available from: . Kennedy, S. (2009). Australia's response to the global financial crisis [online]. [Accessed 24 April 2011]. Available from: . Munchenberg, S. (2011) Balancing Bank Stability and Competition. Accessed 24 April 2011]. Available from: < Accessed 24 April 2011]. Available from: . Quarterly bank performance [online]. (2010) [Accessed 21 April 2011]. Available from: . Peel, G. (2011) ‘Upgrades for Australian banks’ [Accessed 21 April 2011]. Available from: . Saunders, A. and Cornett, M. (2011). Financial Institutions Management. 7th. ed. New York: McGraw-Hill. Unknown Author. (2011) ‘Moody’s put Australia’s big four banks on review’ [Accessed 21 April 2011]. Available from: . Unknown Author, (2011) ‘Banks continue to lower lending standards’ [Accessed 21 April 2011] -------------------------------------------- [ 1 ]. Henry, K. (2010) ‘Australian banking system – Challenges in the post GFC environment’ [ 2 ]. Dunn, J. (2010) ‘Big four aussie banks – buy or sell’ [ 3 ]. Janda, M. (2010), ‘Bank profit to slow in post GFC era’ [ 4 ]. Global Finance (2010) ‘World’s 50 safest banks’ [ 5 ]. Unknown Author. (2011) ‘Moody’s put Australia’s big four banks on review’ [ 6 ]. Johnston, E (2011) ‘Rate pressure builds’ [ 7 ]. Johnston, E (2011) ‘Rate pressure builds’ [ 8 ]. Johanson, S (2011) ‘Aussie home prices world’s most overpriced: Economist Survey’ [ 9 ]. Denning, D. (2010) ‘Big four aussie banks used financial crisis to expand control over mortgage market’ [ 10 ]. Unknown Author, (2011) ‘Banks continue to lower lending standards’ [ 11 ]. Johnston, E. (2011) ‘Borrowing may become harder’ [ 12 ]. Peel, G. (2011) ‘Upgrades for Australian banks’ [ 13 ]. Cratchley, D. (2011) ‘Asia to drive ANZ profit by 2017’ [ 14 ]. Peel, G. (2011) ‘Upgrades for Australian banks’