It’s unusual to see a major Aussie bank with a broker’s Sell recommendation on it – but it has happened with Citigroup placing a Sell on Commonwealth Bank following the company’s quarterly trading update.

To make matters worse, Australia’s big four banks have just had their credit ratings downgraded by Standard & Poor’s by one notch from AA to AA minus.

Just like the rest of us, Australia’s largest bank is finding this market volatility tough going – so tough in fact that it has closed its proprietary trading desk that employed seven full-time traders. The bank’s trading business suffered a $60 million fall in first-quarter profits. “The operating environment remains a challenge because of the sovereign debt concerns that I think will take some time to play out,” noted outgoing chief executive Ralph Norris who is preparing to resign at the end of December.

However, by global standards Australian banks are performing exceptionally well, and who’d think otherwise; like China, Australia’s four major banks own almost the entire market – in stark contrast to the US and Europe where prior to the GFC hundreds of banks battled for a share of the lucrative mortgage and investing market.

Indeed, the past 20 years couldn’t have been better for Aussie banks as Australians took out chunkier loans, racked up credit cards, and poured money into the bank’s investment products from insurance to super.

But when banks rely on consumer and business credit to grow, what happens when most Aussie households, businesses and miners are already geared up? Then again we could hypothise about a whole range of risks to every stock in the ASX. We’d be here all day.

On a good note, banks offer tremendous yields – some of the best yields in the market. During the September FY11 reporting season the banks displayed a commitment to paying out dividends to loyal shareholders; in fact, dividends were higher than the market hoped.

Today, you can get yields of between 7% and 7.7% on major bank stocks, and all majors offer 100% franking credits. Therefore grossed up, yields come in at the 10% to 11% mark. You can’t complain about that.

The banks are cashed up too as NAB reports a 19% increase in cash earnings, and a 13% rise in its dividend. ANZ lifted its cash earnings by 12.5% and boosted its dividend by 11%. Westpac’s cash earnings rose by 7% and its dividend was up 12%.

The bright spot for banks in the face of declining loan growth is the rise of consumer deposits. Europe’s well-broadcast financial crisis is causing Aussies to pile away cash faster than ever before – evident by a sharp uptick in bank deposits. The good news for banks is that it alleviates some of the need for banks to access the offshore wholesale funding market, which can get scarily expensive in times of crisis.

Deposit growth actually outstripped lending growth at Westpac by $11 billion and ANZ by $12 billion. NAB bucked the trend with lending growth, at $34 billion, beating customer deposit growth of $32 billion. The boost in deposits couldn’t have come at a better time since it means that all banks have dropped their reliance on wholesale funding.

The worry for banks, of course, is if this trend to stash away cash continues unabated. Banks make money from lending money not holding people’s cash. That’s why banks are so keen to test the public’s mettle via regular sentiment surveys.

The NAB Quarterly Business Survey fell to -4 in the September quarter from 10 at the start of this year – with declines in all industries and states.

NAB chief economist Alan Oster noted: “The consumer and business community are scared. They don’t really understand what’s happening in Europe, they don’t really understand what’s happening in America, but they know it’s not good. So they’re pulling in their demand for credit; they’re pulling back in terms of discretionary spend.”

Most affected by a fall in confidence were the retail, manufacturing and construction sectors. “The weaker (companies) are basically still continuing to get very poor conditions and they’re shedding labour,” said Oster.

Meanwhile mining related sectors such as transport, utilities as well as recreation, finance and property were holding firm.

So how have bank shares held up?

The table below compares the share prices of the majors. Over the last two years, Commonwealth Bank has dropped 8%, ANZ is down 5%, NAB is off 13% and Westpac is 10% lower. The S&P/ASX 200 is similarly down 9% over the same period.

But as we’ve discussed, if you’re buying for yield, short-term blips in the share price are pretty well irrelevant.

The only danger for bank stocks is if cataclysmic shifts shatter the foundations of the Australian economy at once; for instance, if the housing market implodes and/or if the mining boom takes a hit then bank stocks will be hit hard. Both of these doomsday scenarios are not out of the question, with Australia’s property market recently taking out the inauspicious title that was recently held by Ireland: the most overpriced property market in the world.

According to The Economist, the ratio of prices to rents in Australia are 56% above its long-run average, making it the most expensive property market on the planet. It goes on to say that charts for Ireland before the crisis looked very similar. For those who don’t know what happened there, Ireland’s most expensive house was bought for 58 million euro in 2005 and is now up for sale for just 15 million. And there are no buyers in sight.

“There may be good reasons for Australian prices to have risen so far, but people made similar, and ultimately incorrect, arguments for the run-up in prices in the West,” author of the The Economist’s property report, Andrew Palmer, said from Hong Kong. “I smile when I read about land scarcity in Australia…If Australia were as densely populated as Hong Kong, it could accommodate all of the world’s people seven times over.”

Whether or not you buy into The Economist’s report, the sell recommendation from Citi should make you sit up and take notice – particularly if you regard yourself as a conservative investor. After all, bank stocks are not risk free. Cash in the bank is.

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