The hidden risk in ASX bank shares
ASX bank shares have delivered enormous long-term returns, but there’s one overlooked risk income investors chasing dividends need to watch.
This video might be the only one you ever need to watch to sort out your investing journey in perpetuity. I’m going to talk about the banks. I could not believe the Australian miracle of the bank sector – with their big yields, share prices going up, and franking on top. Since they listed in the early 1990s, ANZ (ASX: ANZ), Westpac (ASX: WBC), National Australia Bank (ASX: NAB), and Commonwealth Bank (ASX: CBA) are up over 5,000%, and Commonwealth Bank is up over 15,000%. And that’s before you include dividends and franking. Can you believe it? Let’s just put all our money in there and leave it. Well, no. There are a couple of things I’ve seen over the last 26 years which tell me that this is actually a very dangerous sector. You have to be on the lookout for certain things. I’m going to tell you what those are. And at the end, I’m going to tell you one thing about the banks which could just make a massive difference to your retirement if you’re holding them. Let’s get into it.
Why the banks print so much money
ANZ, NAB, Westpac, and CBA – the big four – are turning over between them about $80 billion a year. Out of that, they make a profit of $29.3 billion. That is $1,129 of profit out of every man, woman, and child in Australia. What a fantastic business. And why do they do that? There are a few elements to the bank sector that don’t exist anywhere else in the world. In Australia, there is no competition. What international bank is going to bother to try and compete in Australia for 27 million people who are unimaginative, financially unsophisticated, and very happy to leave their money in banks that are earning $1,129 out of them every year, including their children and their babies. No one is going to compete with our banks from overseas. And until that happens, these are very reliable, solid, profitable businesses.
The other thing the Australian banks do is they don’t bother being ambitious. There was a time when all the Australian banks thought they’d try and make it overseas, particularly in the UK. Almost all those operations have now been shut down, and they pulled their necks in and are sticking to their knitting. The same sort of thing happened in the resources sector, where management realised that they are just putting themselves up against incredible global competition if they step outside of Australia – and really, they might as well just keep ploughing the furrow that has been so profitable for them forever and stick to Australia. And that’s what they do. Consequently, they have reliable earning streams.
Consequently, they are also mature. They don’t have any ambitious gambling, capital expenditure, or experimental businesses and ambition. They’ve given that away, which means they have nothing to invest in other than improving their domestic business. Their only real expenditure is keeping this profit machine going. They are some of the country’s biggest employers. They are a huge part of the economy. They are too big to fail in the eyes of government. And so they are pretty much left alone to keep making profits. It’s the price we pay for a stable financial system in Australia – to let these companies make their profits. And the only way to get even is to become a shareholder.
And because they’re mature, they don’t have anywhere to spend their money. So they pay it back to shareholders. They have huge payout ratios, and they have paid some of the most reliable dividends – if not the most reliable dividends in Australia, if not the world. They are possibly the best income stocks in the world. And in Australia, the dividends are franked. And as your financial planner will tell you, in pension phase, you can get that franking back as a cash refund. It’s almost magic.
Why the banks aren’t growth stocks
So, what is wrong with the banks? Well, let me tell you. You invest in the banks because they pay out a decent dividend. You don’t invest in the banks because they are growth companies. So if you’re trying to grow your nest egg, you probably need to be looking somewhere else. So if you’re in the accumulation phase, the banks are probably going to hold you back a little bit. There used to be a time in the 1990s where we always considered the banks to be a buy on a P/E below 10 and a sell on a P/E of 16 or more. We’re now looking at banks on P/Es of 25, even 30 times. P/Es have almost doubled in this sector. The growth stage has matured.
So whilst you are too big to fail and unlikely to lose much money, the chances are that over the next few years the banking sector is going to grow marginally. They do have a fantastic return on equity – over 10%, more for CBA. And what that means is that for every dollar you give them, they’ll earn $110 by the end of the year, and that’s compounding. So this is a good investment. It’s not really a growth stock though, but it’s underpinned by very reliable earnings. So a good investment, but in accumulation phase, there are sexier things to invest in. If you are looking to grow your super, you don’t want to be putting too much in a mature industry.
So what pushes the banks up and down? Well, they are on a cycle – the interest rate cycle. They’re certainly, especially CBA, on a housing market cycle. Share prices will reflect loan growth, which is a function of how the economy is going and whether interest rates are high or low. And as we know at the moment, the property market in Australia has been damaged by the budget. So the banks have stalled. I think as I speak, some of them are down 10 to 23% from the top. So they are in a cycle. But if you’re a long-term investor in the banks, you really don’t need to worry about that.
The banks are always a buy on weakness for the long term for income, on the understanding that they’re going to continue to plough the furrow, take low risk, pay out big dividends, get a return on equity of 10% plus, and pay it all back to their shareholders – and that the government is going to make sure they’re looked after because they are core to the economy. So low risk, decent returns, decent dividends.
The once-in-a-decade risk to watch
Once a decade, once every 20 years, something’s going to happen that is going to materially damage the bank sector. Rather than treat this as a disaster that’s got to be avoided, the incredible thing about disasters is that if you look at them the right way, they are opportunities. In the global financial crisis, you had a serious problem – not only did you lose 56%, the banks also cut their dividends, and it took 11 years for the market to get back to where it had been 18 months earlier. So these seismic events happen, and you have to be awake to them, and prepared once every ten or 20 years to protect yourself by selling a sector that you never thought you’d sell.
And you’re not selling it really to avoid losses. The amazing thing about disasters is that they are opportunities – you would sell the banks because you’re going to get an opportunity to buy them back much lower down. If you timed the bottom, you made accelerated gains for a number of years in the bank sector as it recovered its quality position in the Australian market. And if you didn’t react to the top, you missed that fantastic opportunity.
Now, I know a lot of you are going to continue to say, well, I’m going to pass them off to my kids, and they always recover. That’s absolutely fine. But there are occasional opportunities – and before those opportunities, you might have an event that will change your expectations for retirement. And that’s the really dangerous bit. If you’ve got huge holdings in the banks and not much else, you have to watch out for that once-in-a-decade event that is going to change the dividend payouts, change the share prices, and upset you.
The one thing that could upset the whole global financial sector once again and cause GFC 2 – which would actually be GFC times 10 – is if the US lost control of the bond market. We’ve talked about this before. It’s called the big one. $39 trillion worth of debt, and they need to issue a trillion dollars’ worth of bonds every year just to pay the interest. And bonds are becoming less popular as the Chinese are pulling money out and buying gold. The Japanese are pulling money out too – two of the biggest holders in the US bond market. It is becoming dangerous in the US bond market.
Because if there’s a crisis of confidence, it may well be that the whole US bond market cascades in one sudden realisation that nobody wants US bonds anymore – that no one has faith in the US paying back its $39 trillion worth of debt. The US has been raising money endlessly, printing dollars, destroying its currency. And if it happens, the banks are going to be the worst performers, not the most defensive performers, in a falling market. And goodness knows, anything could happen at any time.
You owe it to yourself, if you’re in the equity markets, not to be complacent, not to pay no attention, not to have blind faith in the long term, not to just buy and hold. It might go wrong – unlikely, but for goodness sake, don’t take it for granted that holding banks is safe.
How AI could supercharge bank profits
What is the one thing that could absolutely propel the banks? There is one. It’s a bit odd, but the banks have a cost-to-income ratio of about 34%. That’s their labour cost relative to revenue. This line has been static for years. If they could pull back their labour costs by 1%, it would pop their profits by 2.7%. Just think about that. If AI meant that they were spending 10% less on labour, then suddenly the gearing through to profit for the banks is 2.7 times. They suddenly become growth stocks.
There are certain industries thought to be vulnerable to an AI revolution in terms of how many employees are doing routine processing functions, and the financial services industry – particularly the banks and particularly the insurance companies – have the most employees doing routine processing jobs that could be done by AI. Approval times on loans have already gone down. The banks have become more efficient already. That process is ongoing, and it has always been impossible for the banks to move their cost base. But suddenly they have an opportunity to make radical difference to their cost base.
And if that came true, you’re suddenly looking at these huge banks – which have got mature, reliable, quality businesses with no major competition, huge payout ratios, huge dividends with franking – cutting their cost base because of AI. And that is going to feed through in multiples to their earnings, their dividends, and therefore their total return. AI could be the best thing ever for the financial services sector, for the Australian banks. So it’s not all bad. The cost improvement from AI is 50 times more likely than some sort of disaster.
To round it up, if income is all you’re after, we would be heavily weighted to the Australian banks. And yes, we would be fairly faithful that we don’t need to trade them. We know they’re not going to grow much. We’re going to be long-term. And if we’ve got enough money in them, we might actually have enough income and have some income go back into the nest egg every year. And if you’re rich enough with enough money in the banks, you might just find you’ve got enough income to live on, and money is still coming back into the banks and growing your nest egg. It’s a wonderful thing. And we’ve got AI on the way.
Nothing wrong with being in the banks long-term if you’re after income. Keep awake. Watch out for the seismic event. It almost happened in April 2025. It’s not impossible. It’s unlikely the US will print its way out of it. But you never ignore investments.
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