PORTFOLIO POINT: Investors holding bank shares should be aware their risk profile is increasing, making deposits more attractive.
Banks have been essential to Australian investment strategies for many decades. Prior to the mining boom, they dominated the Australian All Ordinaries index.
Many advisers claimed it made much more sense to invest in bank shares because they provided a much higher yield than bank deposits after taking into account franking credits. More recently, after the global financial crisis, Australian self-managed superannuation funds and private investors became more risk-averse and have turned to bank deposits where rates on offer have almost doubled in three years.

The yield offered by bank deposits in most of those three years have often been at or above 6%, which gets close to the prospective long-term returns calculated by actuaries for the sharemarket.

In the next two years, interest-bearing security investors are going to have a much wider choice of opportunities, including a lot more corporate bonds and government backed securities. Later in this column I will look at the alternatives now available in bank deposits.

But for those holding bank shares, there has been a sudden increase in the risk profile. The banks and the Australian Parliament are at war. The last time an Australian company took on the government was Telstra and the government beat it to a pulp.

The government can’t do that to banks because if it decimates their share capitalisation overseas lenders, which finance about 40% of bank most Australian bank balance sheets, will slash their lending to the banks and Australia will go into a deep recession.

Nevertheless the banks find themselves fighting both the Opposition and the Government; it’s probably a unique situation. Shadow Treasurer Joe Hockey is goading Treasurer Wayne Swan to take action against the banks. Swan has to do something to bloody their noses or he will lose great credibility in the Parliament.

In fact both Swan and his predecessor, Peter Costello, used strong rhetoric against the banks but have not taken serious action for fear of damaging the banking system.

But this time around the banks have made a major management mistake and the risk in bank shares is now greater than has been for decades. I can understand why Commonwealth Bank chief executive Ralph Norris lifted interest rates beyond the Reserve Bank’s 25 basis point hike, and why there is pressure on all the banks to follow.

The cost of overseas borrowing is rising and the banks do not want to sacrifice their margin. But the political atmosphere is so hot that Norris found himself under fire in the press and the Parliament after CommBank’s 45 basis point rise.



Such an attack was almost inevitable given the blows landed on Westpac chief Gail Kelly when she led the interest rate rises earlier this year. Both Norris and Kelly have made fundamental errors in not selling their message. Any of the big four banks wanting to increase interest rates beyond the Reserve Bank levels needed to go on talkback radio almost every day and cover every town in the nation for more a month before taking action.

When you take on the government you can’t simply make statements at shareholder meetings, institutional briefings and a few lunches; you have to go into the community and make people understand the issues facing the banks. When CommBank made its rate increase decision, Norris was not even in the country to defend himself and so copped a withering blast. By lifting rates without selling their case to the community the banks have dramatically increased the risk profile of their shares.

And so if Wayne Swan moves soon, he will find his job in jeopardy.

Accordingly, those who have investment portfolios dominated by bank shares should understand their risk profile has now increased and lighten their load a little.

Had the bank chief executives gone out on to the hustings the relationship between the cost of bank deposits and the cost of foreign borrowing, after adjusting for currency hedging, would have been a public issue. CommBank says it has more depositor clients than home mortgage borrowers, which is a great place to start a debate.

Banks have been literally flooded with deposits, which has reduced the need for overseas borrowing but given the looming increase in competition for this sort of money the banks will need to increase their borrowing rates if they are to maintain their current share of savings.

Back in September 2007, bank term deposits totalled $211 million. Three years later, by September 2010, they had almost doubled, rising to $419 million. Deposits are predominantly short-term because investors feared interest rate rises and had in mind putting some of their money back into the sharemarket.

Moreover, only two banks now actively compete for longer-term deposit money: Westpac and Bendigo & Adelaide Bank. ANZ, NAB and CommBank offer five-year rates that do not compare with the 7% offered by Westpac/St George and Bendigo. Around December, January Westpac/St George were offering 8% for five years and were rushed; they have since have reduced their five-year rate to 7%. Bendigo & Adelaide Bank joined them at this level.

Given that rates are rising, it is dangerous to have big proportions of your interest-bearing securities tied up in longer-term currencies. Having a portion of your interest-bearing securities at 7% makes sense if you fear the Australian economy is going to be crippled by big interest rate rises, so that the current forecasts of further increases of at least 1% will prove wrong.



In my view, if interest rates are lifted by another 1% there will be a substantial rise in housing bad debts and a significant downturn in the capital cities. If I am right, then the 7% rate for five years offered by Bendigo & Adelaide Bank and Westpac will prove attractive. But given current trends and the fact that new securities will be issued by corporations in the next two years, it makes sense to pick a shorter-term rate for the vast majority of the income securities portion of your portfolio.

Among the smaller banks, Members Equity is very competitive at the very short end. Most of the banks offer 6% for one term less than 12 months: usually between six and eight months. But be aware that interest rates for all the periods around that headline period are well below 6%. All the banks except Westpac are offering a standard 6% for 12-month money. Westpac is offering 6.05%. As you can see, competition has gone our the window.

Still, if you have substantial sums to invest, make sure you talk with your bankers because they will normally add 0.1%.

Bank hybrids carry much higher risk than bank deposits but it is inconceivable that the big banks would be brought down so they are an important part of interest bearing security portfolios; but if there is a change in risk ratings they can fall in price. Conversely, their returns rise (and fall) with market rates.

Despite all the controversy, Australians should not despair of their banking system. We could face the US situation. America is going on a binge of money printing partly because its banks completely messed up the housing market and consumer confidence with it.

Currently there are large numbers of houses that should be foreclosed because the payments have fallen behind, but the loans have been stymied in the courts. The US banks needed to regain control of these loans and not leave them in the securitisation cesspool but so far it hasn’t happened. The global financial scene needs the US government to push banks into financing homes on reasonable terms, where the borrowers have a strong income profile.

In Australia our banks have been careful to maintain current high housing values by squeezing the amount of money they lend to developers but allowing consumers generous terms. In other words, boost the demand but restrict the supply. But banks are about to be punished and investors should take into account the much higher risk profile bank shares now carry.