Good times for the banks roll on

• Unemployment is currently at record lows.
• The RBA is raising rates very quickly relative to the past.
• A robust customer credit quality position due to high employment and higher margins are painting a rosy picture for the financial sector.

The big four

The Australian finance sector is denominated by the ‘big four’ banks: the Commonwealth Bank, ANZ, NAB and Westpac.

There are a number of exchange-traded funds (ETF) that enable the investor to access a weighted interest in a sector and avoid individual stock transaction fees and costly portfolio rebalancing costs.

One such ETF for the finance sector is the BetaShares S&P/ASX 200 Financials Sector ETF ASX:QFN (QFN). QFN’s holdings are the largest Australian bank names plus a number of other smaller financial service providers.

Profiting from rate rises

The majority of bank funding that it uses to lend to customers for loans and mortgages comes from savers. The balance will come from borrowings and issuing shares in the bank. In times of stress to the markets, banks are also able to access the RBA funding mechanism as a backstop.

Bank loans and mortgage rates extended to customers are then set at a generally stable gross margin percentage higher than the cost of the funding.

As baseline funding rates set by the RBA rise, the same percentage in the gross margin on a higher baseline equals a higher dollar return on the bottom line.

With the bottom line improving without the need to increase loan loss reserves as the majority of customers are experiencing a tight labour market, QFN has marginally outperformed the broader ASX 200 index ASX:STW (STW) over the last month.

With the value of residential dwellings surpassing AUD$8tn in 2021 and a large proportion either on a floating rate or soon rolling into a floating rate mortgage, the financial sector has its eyes set on a swelling revenue stream.

Hurdles

In its recent earnings announcement, JP Morgan Chase Bank NYSE:JPM (JPM) set aside more funds to cover potential future loan losses. This is not a uniform view held by all international banks as not all markets are at the same end of the supply chain. Australian banks do not carry the same level of international exposure that the US banking behemoths do.

Certainly, Europe has struggled under higher energy prices in recent months and is looking more vulnerable in its industrial sector, which may present itself in the coming months in weaker employment figures. Other nations and industries, particularly raw material exporters, have fared rather well.

Australia’s trade surplus from its positioning as a large resource supplier to an international customer base has resulted in high employment both directly and indirectly in downstream services.

A robust labour market will alleviate many of the worries that banks may have when allocating funds to borrowers. While employment remains high, despite record house prices and aggregate mortgage values, additional loan loss provisioning requirements are mitigated, further boosting the banks’ bottom line.

Outlook

Some international banks are beginning to sound alarm bells over the near-future economic conditions. While the labour market remains tight in Australia, the big four will find rich pastures and QFN holdings are likely to find easy sailing.