First, let’s start with a brief overview of what is a balance sheet. This financial statement is a summary, at one point in time, of a company’s assets and liabilities. For example, an end of year balance sheet includes all assets and liabilities that a company has at the end of that year. Assets and liabilities can be both short and long term, meaning that they have a duration of less or more than one year.
Long term assets can be buildings or machinery because they will last many years, while short term assets are inventories or credits. For individuals, a long-term asset is usually their house, while cash is a short-term asset.
Long term liabilities include multi-year loans such as mortgages, while short term liabilities are, for example, debt that needs to be paid within 12 months (banks assets are loans provided to companies and individuals, while liabilities are debt toward other banks or deposits).
Banks, most of the time, work with short term liabilities such as interbank loans which, sometimes are as short as 24 hours loans that get continuously renewed, or with retail deposits. They use these short-term liabilities to finance much longer-term assets such as mortgages (a mortgage is an asset for the bank since it is a credit, while a liability for the consumer). Clearly, a 5-year mortgage pays (or costs a consumer) a much higher interest per year than a short-term liability and the bank earns the difference. For example, National Australia Bank charges 5.54% per annum for a 5-year residential mortgage. However, it only offers 1.9-2.5% for its saving accounts, earning the difference.
However, this mechanism is very risky when things go wrong such as during the global financial crisis (GFC). Banks had three main problems:
They had very high leverage, sometimes in the range of 1 to 30. This would translate in an individual buying a $1,000,000 house with a deposit of $30,000.
They had a mismatch in assets and liabilities duration. This means that they bought “their house” on a credit card with a 30-day payment period.
Their assets were very risky such as CDOs so their value fluctuated extensively.
These risky strategies did not pose major risks as long as house prices kept going up and until banks’ “credit cards” continued to be renewed. However, when their “1 million houses” suddenly were worth $900,000 banks’ equity were wiped out. Banks stopped lending to each other with a sort of financial system freeze. Banks could not extend their “credit cards” and therefore were not able to pay back the $970,000 of debt on their “houses” that were now worth only $900,000. These dynamics are also what causes banks to fail when there is a run on them which entails depositors withdrawing their deposits in mass and banks cannot easily sell their long-term assets to give money back.
Australian real estate market
The Australian real estate market has experienced a long stretch of house price increases. Sydney’s house prices have surged over the last decade. Suburbs that were cheap in 2012 have doubled in value in the last five years. The city’s median house price hit $1.15 million in April. We can see from the graph below that prices have increased approximately 8 times over the last 30 years. Unfortunately, income did not increase as fast.
This means that properties are less and less affordable for local residents. In fact, the graph below shows that 30 years ago the ratio income to property prices was 3/5, while now it is more like 6 to 12 depending on the region. This happened because a large amount of properties has been bought has an investment or by foreigners. In addition, low interest rates have increased the amount of liquidity in the market chasing the limited investments available, pushing prices even higher.
As previously mentioned, a booming real estate market makes mortgages a profitable and reliable business for banks. However, after many years of robust increases, prices are stalling, Australian consumers are leveraged, and banks face increasing risks. The graph below shows that Australia consumers never stopped adding to their debt pile which now reaches 200% of the national GDP.
Clearly this is a risky mix for Australia banks. Hence, here I discuss the major Australian banks’ balance sheet leverage and whether the duration between assets and liabilities match.
National Australia Bank (NAB)
NAB provides financial services to individuals and businesses in Australia, New Zealand, Asia, the United States, and the United Kingdom. It operates through Consumer Banking and Wealth, Business and Private Banking, Corporate and Institutional Banking, and NZ Banking segments. As of September 30, 2017, the company operated through a network of 796 branches and business banking centers, and 2,934 ATMs. National Australia Bank Limited was founded in 1834 and is based in Docklands, Australia.
As reported below, NAB historical debt is somehow stable. Currently its debt is A$265B, while its equity (difference between assets and liabilities) is A$51B.
(All the graphs are sourced from Simplywallst.com)
If we dig deeper, we can see how small is the net worth compared to the total investments. The equity is A$51B, while the total investments (assets) are A$600B long term, plus A$191B short term (total of A$791B). This means that the equity is only 6.5% of the total assets. This is much better than the 3% held by American banks during the GFC but still a hefty leverage. Further, we can see that NAB has A$600B in long term assets to cover A$148B in long term liabilities, and A$191B in short term assets to cover for A$589B of short term liabilities. This gives us a long-term coverage ratio of 24.8% and a short term one of 32.4%. We will see that these numbers are good compared to its peers.
Commonwealth Bank of Australia (CBA)
Commonwealth Bank of Australia provides integrated financial services in Australia, New Zealand, and internationally. CBA was founded in 1911 and is headquartered in Sydney, Australia. Its current market cap is A$125B and has 43,000 employees.
From the graph below, we can see that both the historical debt and equity of CBA have been increasing. Currently its debt is A$247B, while its equity (difference between assets and liabilities) is A$66B.
Now let’s see how assets and liabilities compare. The equity is A$66B, while the total investments (assets) are A$843B long term, plus A$119B short term. This means that the equity is only 6.9% of the total assets. This is a little bit better than the 6.5% held by NAB but still a hefty leverage. This means that a reduction of 6.9% of asset prices would wipe out the entire equity. Further, we can see that NAB has A$843B in long term assets to cover for long term liabilities of A$232B, and A$119B in short term assets to cover for $A664B in short term liabilities. This gives us a short-term coverage ratio of 17.9%. These figures are significantly below NAB, meaning that CBA has a much higher discrepancy in its durations.
(source: Simply Wall St)
Australia and New Zealand Banking Group (ANZ)
ANZ provides various banking and financial products and services to individual and business customers. It operates in Australia, New Zealand, the Asia Pacific, Europe, and the Americas. The company was founded in 1835 and is headquartered in Melbourne, Australia. The company has a market cap of A$77B and 45,000 employees.
From the graph below, we can see that both the historical debt and equity of CBA have been increasing. Over the last two years, though, debt started declining while equity kept climbing. Currently its debt is A$170B, while its equity (difference between assets and liabilities) is A$59B.
(source: Simply Wall St)
Now let’s check how assets and liabilities compare. The equity is A$59B, while the total investments (assets) are A$699B long term, plus A$199B short term. This means that the equity is only 6.6% of the total assets. This is in between the leverage we identified for NAB and CBA. In other words, a reduction of 6.6% of asset prices would wipe out the entire equity. Further, we can see that ANZ has A$699B in long term assets to cover A$105B in long term liabilities, and A$199B in short term assets to cover for $A733B in short term liabilities. This gives us a short term coverage ratio of 27.1%. These figures are in between what we found for NAB and CBA. Overall, short term liabilities are more urgent because they need to be paid back within a year, so having a better match in the short term is more important.
Westpac Banking Corporation provides various banking and financial services in Australia, New Zealand, Asia, the Pacific region, and internationally. The company was formerly known as Bank of New South Wales and changed its name to Westpac Banking Corporation in October 1982. The company was founded in 1817 and is headquartered in Sydney, Australia. Its market cap is A$97B and it has 35,000 employees.
From the graph below, we can see that both the historical debt and equity of WBC have been more or less stable over time. Currently its debt is A$230B, while its equity (difference between assets and liabilities) is A$61B.
(source: Simply Wall St)
Now let’s see how assets and liabilities compare. The equity is A$61B, while the total investments (assets) are A$778B long term, plus A$74B short term. This means that the equity is 7.2% of the total assets. This is higher than all other banks we have analysed. However, WBC is the bank with the most significant mismatch between durations. We can see that WBC has A$778B in long term assets to cover A$148B in long term, and A$74B in short term assets to cover for $A642B in short term liabilities. This gives us a short term coverage ratio of just 11.5%. These figures portray a rather dangerous combination.
Compare these figures to your house
Imagine if you had bought a house which is worth A$778,000. You financed this house with A$55,000 in cash (your equity), a 20-year mortgage of A$148,000 and the remaining A$575,000 with a mix of bank overdrafts and short-term debt. The idea is that your short-term debt can be renewed every time is due and it will cost you 2% a year instead of 5%, so this will give you significant savings.
However, what happens if your property declines 15% in price? Three things will happen:
Your credit card companies and banks will not see you as a safe borrower anymore and will ask you to pay your debt back immediately. Hence, all of a sudden you need to pay back A$575,000 of short-term debt.
You need to sell your house! The problem is that other people are trying to sell before prices go down even further. In addition, even if you manage to sell, your house is now worth $661,000. Once you have paid your mortgage on the house which is still A$148,000, you will only have A$513,000 available, so you are short of A$62,000 (575,000-513,000).
This basically means that you are bankrupt because, although you can try to sell your other assets such as a car, your debts are higher than your assets.
Therefore, in case house prices will decline, some Australian banks might have difficult times.
The Australian banking industry has experienced a few good years, fuelled by economic growth and booming asset prices. Now the market is recognizing the risks. This sent bank stock prices down and short interest higher. Over the last 12 months, these stocks have lost between 16% (NAB) and 19.8% (WBC). Current valuations are rather pessimistic and dividend yields quite high. For example, CBA and ANZ pay a 6% yield, NAB and WBC almost 7%.
However, although valuations are low, they come with risks. In this analysis, I compare the four main banks’ balance sheets.
|Cover ratio short term||32.4%||17.9%||27.1%||11.5%|
|Price to book value||1.51||1.91||1.31||1.59|
(Author calculations; data sources: Simply Wall St and 4-traders)
The above table shows that the leverage ratio is more or less similar across banks, hovering around 6-7%. However, we can see that WBC and CBA have much higher short-term risks. This goes against the current valuation multiples. In fact, WBC and CBA are currently priced at a much higher price to book compared to NAB and ANZ. Truth being said, NAB and ANZ have higher leverage ratios, but the difference in short term duration mismatch is a more serious concern in my opinion. The above analysis would suggest a strategy to go long NAB and ANZ and short CBA and WBC. However, the current analysis is not comprehensive. Interested investors should investigate further. For example, not every asset has the same quality. Some are better valued or easier to monetize. Further, the current analysis did not take into consideration revenue or profit trends or bank impairment reserves. Investing in Australian banks might generate good long term profits but it is important to assess the risks and differentiate between the different banks.
Disclaimer: The author is portfolio manager of Integer Investments. He does not directly own shares in Australian banks. However, he invests in ISHAUS200/ETF (IOZ) which might invest in banks.