We recently reviewed key charts relating to Australian banks released by the Reserve Bank. The below charts are not predictive, but they do help guide analysts in their assessment of the banks. We will draw from these charts to forecast the operating performance of the banks over the next few years. Figure 1 tracks the profitability of the banks over the last thirty years. It also broadly tracks the bad debt experience of the sector. It shows that banks have operated in a fairly benign environment since 2009 -with ROE stabilising at historic average levels and bad debt charges declining. The bad debt charges incurred over the last few years are at historic lows. In our view, there seems no doubt that bad debt charges will trek higher over coming years. Whilst the recent concern has focused on commercial exposures our real concern is with residential property. However, we do not foresee a recession type adjustment to residential property but rather a correction phase from unaffordable levels and the risk of negative gearing adjustments. Figure 1. Bank Profitability* Source. Banks' Annual and Interim Reports; RBA Figure 2 below shows that net interest margins have been in steady decline over the last fifteen years. The panic of the GFC allowed banks to increase margins by charging more for loans (risk assessed) and offer less for RBA secured deposits. Recently, interest margins, which represent the bulk of bank’s revenue, have declined to historic lows. Whilst they may decline further we believe that banks will now push for margin recovery. For instance, a future RBA cash rate cut would not be fully passed onto mortgage borrowers. Figure 2. Major Banks' Net Interest Margin* Source. Banks' Financial Reports; RBA Figure 3 demonstrates the sustained improvement in bank capital ratios since the GFC. The recent acceleration is due to Australian regulators pushing Australian banks to become early adopters of international standards. The capital ratios have improved due to strong profitability (retained capital) and heavy capital raisings over the last few years. The chart also emphasises the focus on tier1 capital (ordinary equity) and away from subordinated debt issues (tier2). It illustrates that Australian banks have never been so well capitalised - but that observation should not be interpreted as suggesting that they would not be challenged by a economic downturn. As banks have heavily leveraged balance sheets, any increase in bad debts does have a magnified affect on bank profitability. Further, higher capital ratios will result in lower returns on that capital. We are now forecasting that ROE’s for major banks will decline to their lowest levels in 15 years as the residential property debt declines and demand for credit (business and consumer) slows. Figure 3. Capital Ratios* Source. APRA Prior to the GFC, the banks aggressively grew their loan books (i.e. assets) and funded this through excessive securitisation and wholesale funding programs. This was a period where banks created a dual risk on both sides of their balance sheet. The GFC exposed the risk of aggressive offshore funding in particular as credit markets panicked and credit spreads (cost of debt) blew out. The Australian banks embarked on an adjustment to their liability (funding) mix with a focus on retail deposits. We now perceive that banks will continue to aggressively maintain retail funding at over 50% of their funding mix. The recent jump in credit spreads (wholesale funding rates) once again emphasised the excessive risk associated with offshore funding. Further, if banks cannot grow their funding from retail sources then clearly, they will constrain their lending. Figure 4. Funding Composition of Banks in Australia* Source. APRA; RBA; Standard & Poors Lastly, figure 5 highlights the strong lift in earnings of the banking sector since the GFC – as well as the affect of a blow out in bad debts that occurred in 2009. It can be observed that our major banks saw profit declines by 40% in the GFC and this was the direct result of bad debt charges. Figure 5. Bank Profits Source. APRA; Banks' Annual and Interim Reports; Credit Suisse; Deutsche Bank; Nomura Equity Research; RBA; UBS Securities Australia Recently bank share prices have been driven by much media coverage concerning the increase in bad debt charges and exposures. As we mentioned above, there seems no doubt that bad debts charges and provisioning will increase in coming few years. However, the recent prices moves seem well ahead of any real evidence of bad debt exposure. Whilst market prices for banks will always be pre-emptive, we believe that recent declines in the price of ANZ and NAB are excessive. The prices of these banks have been driven down towards 1.2 times NTA (or equity). These are starkly different to CBA’s multiple of 2 times NTA. Therefore we suggest that the market is being driven by excessive speculation regarding ANZ. Whilst we perceive some unique problems for ANZ as it withdraws from its Asian expansion, we also perceive that 80% of banking issues, if they occur, will be common to all banks. Finally, we reiterate that listed companies are perpetual entities. The oldest listed company in Australia is Westpac which was formerly the Bank of NSW. It is interesting and indeed sometimes profitable (for a few) to speculate on bank share price movements, but history suggests that well run banks are profitable long term investments. Whilst we have adjusted our forecasts for bank profitability to below current consensus market forecasts, we find that banks in general are looking like reasonable value. Indeed we have even cut our dividend forecasts and they still filter as value. So it would only be a severe recession that could justify lower bank prices for NAB and ANZ at this point – but a recession would hit the share price of CBA harder. Disclosure: Clime Asset Management owns shares in ANZ, CBA, NAB and WBC on behalf of various mandates where it acts as an investment manager.

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