AUSTRALIAN and international investors have heavily bought the idea that our 'Big Four' banks have bullet proof balance sheets and, should a chink appear in their amour, there is always the national balance sheet to back them up. Further, that they so dominate the lending market in this country that their profits and dividends are equally resilient.
As an investment strategy, this has proved remarkably successful in recent years.
The Big Four banks' return on equity is currently in the high teens, with fully franked yields over 5%.
However, like all investment strategies, it requires a sober and ongoing review of the risks. So let's look at some of those risks.
The Big Four banks' shares, it seems, are being treated by many as an alternative to cash deposits.
This is evident from the flood of capital out of term deposits into bank shares in recent years, as investors (particularly retirees) chased yield as interest rates came down.
The problem is: shares are equity, not preferred debt capital, like deposits.
In short, banks are in the business of selling debt
Which means shareholders stand at the end of the queue, behind deposit-holders, creditors and employees, in the event of insolvency.
Many scoff at this suggestion on the basis that our banks are "too big to fail".
While that may be the case, another way of looking at this is to say that shareholders stand at the front of the queue in the event of losses.
Anyone around in the early 1990s will recall that bank profits are by no means assured.
Indeed, a number of banks were under such financial stress that they were forced to sell assets (loans) at fire-sale prices to sure up their balance sheets.
This history was front of mind when the Financial System Inquiry made recommendations regarding changes to bank capital requirements last year.
In short, banks are in the business of selling debt.
While the price of one of their most popular products, home loans, has fallen, there are many other products (e.g credit cards and personal finance) which have proved incredibly resilient.
More importantly, revenue is a function of price and volumes, and housing lending growth is nearing double digits while default rates remain low.
As we all know, to make profits, your inputs need to cost less than your outputs. Inputs for banks consist of a mix of equity and debt capital.
The latter comes from domestic deposits and bonds and borrowing from international capital markets, all of which have been very cheap recently thanks to post-GFC pump priming.
Not surprisingly, banks have relied heavily on debt for their rapidly increasing profit margins. What may surprise you is how much - over 40 times equity capital.
You don't need to be Warren Buffet to work out that if the property market, unemployment rates and/or offshore borrowing terms become less favourable, the Big Four banks profits may look less bullet-proof; with shareholders at the front of the queue to absorb losses.
As always, obtain professional advice to develop a diversified investment strategy that matches your financial goals and review it regularly.
* CAMPBELL KORFF is the principal of Yellow Brick Road Wealth Management, Northern Rivers.
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