Uncertainty is feeding everyone's fears. Besides the massive fall in commodity prices pushing some miners to the wall, companies including Dick Smith and Slater & Gordon have raised concerns about who might be next and which bank might be exposed.

But when banks get into trouble it is generally due to property.

Australian banks are heavily exposed to property assets, so if the property bubble were to burst, it would spell disaster for the banks.

West Australia and Queensland

This nagging concern about the property market has been fuelled by some pockets doing badly. These include rising default rates on residential mortgages in the mining states of West Australia and Queensland, almost one-fifth of Perth offices sitting empty, and a correction in the apartment market in Perth and Melbourne. A recent article in The Australian Financial Review said apartments in central Melbourne were being resold at up to 30 per cent less than their off-the-plan purchase price.

Cartoon: Rod Clement

For now bad debts are under control, interest rates are low, assets prices are high and compulsory super is turbo-charging the financial system.

But it is the fear of what might happen that is driving investors to sell bank shares.


Rising debts translate into falling profit, falling share prices and falling dividends.

History has shown that when things go wrong they turn fast. It happened during the GFC and the banks' share prices quickly plunged close to net tangible asset backing.

A substantial escalation in bad debts will see the banks' meagre EPS growth stall and at least for some, if not all, the EPS will go backwards.

Australia and New Zealand Bank

In ANZ's case, it is odds-on favourite to have the lowest return on equity of the big four banks, the highest level of bad debts and the lowest dividend payout ratio. They are all connected.

Brett Le Mesurier of APP Securities says ANZ's Asia Pacific, Europe and America division (APEA) represented 15 per cent of ANZ's loans in the second half of 2015, which was $87 billion out of a total of $568 billion for the ANZ group.

He estimates that APEA institutional provided 25 per cent of the group's risk-weighted assets, 10 per cent of its income and 6 per cent of its profit in the second half. He estimates that its return on equity was 4 per cent per annum. in that period. This was apparently the ANZ growth engine. No need to refill this tank.

If this business is halved in size, then $5 billion in equity is liberated (being 10 per cent of ANZ group equity excluding goodwill) at a cost of 3 per cent of group profit. Le Mesurier says the outlook for ANZ includes the following: lower income growth than many of its peers, which should be matched by lower expense growth (excluding a potentially large restructuring provision) and the worst asset quality of its peer group. If ANZ sold its grab-bag of Asian partnerships, it could release $5 billion of capital and reduce profit by 8 per cent. But the chances of that happening are slim, says Le Mesurier.


ANZ under its new chief executive, Shayne Elliott, plans to shrink its presence in Asia and sell minority stakes in Asian banks, but this might not be as easy as it sounds. Buyers hardly seem to be lining up for those stakes and the institutional business has a large cost chirping for revenue to feed it.

National Australia Bank

NAB is likely to have the second-worst return on equity. It recently sold the bulk of its life insurance business, floated its UK banking operations and has committed to sharpening up its business banking division. Nevertheless, bad debts are on the rise and the spectre of a cut in dividends or a dividend reinvestment plan, is mounting.

Investors are battling this at a time when the banks are facing the uncertainty of the size of the additional capital requirements to be imposed by the prudential regulator. Will the banks need 5 per cent, 10 per cent or 20 per cent more capital? Regulatory uncertainty has dogged the sector for more than a year.

Global regulators want to strengthen the capital base of banks and to this end they have been releasing papers in recent weeks, aimed at fixing up problems they introduced under the advanced accreditation system, where banks were allowed to use their own bad debt experience to determine their capital requirements.

Banks spent a fortune introducing advanced accreditation models, which they may now have to substantially junk.

With several headwinds, including some legacy issues still to deal with, bank talk is increasingly dominated by trying to balance the varying needs of customers and shareholders, just as both become harder to please.

To this end, the banks have chosen to exercise their ability to pull the interest rate lever and they have done so in a curious display of unity in amount and timing. This should be good news for shareholders. But the problem is that they then passed much of this back to new customers in an equally curious display of unity.


General insurers

The dramas facing general insurers are far less. For starters they don't have regulators breathing down their necks to set aside more capital and they don't have a bad-debt problem. With the notable exception of QBE, the biggest insurers can distribute all their profits to shareholders if they wish. Their biggest challenge is competition, which is keeping a lid on profit growth and in turn EPS growth, which can be expected to be negligible.

If the banks have no EPS growth then that will be due to higher bad debts from miners, over-leveraged industrials and households relying on these companies for a living. If these sectors have no growth then where will investors find solace?

The general insurance industry is not the answer. Infrastructure? Construction? Probably not unless there's an interest-rate cut, but we're starting to run out of room on this option. Mining doesn't seem to be the answer either – it's already part of the problem. Broader industrials? That's probably what the market is really worried about when it comes to bad debts for the banks.

Banks loom large in the economy and the economy looms large in the banks. They dominate the sharemarket and they contribute substantially to the country's economic growth. They are the canary in the coal mine and the coal mine isn't worth as much as it used to be.