Does CBA deserve its premium?

Why, particularly since the GFC, have Commonwealth Bank of Australia’s returns outpaced ANZ’s, NAB’s and Westpac’s? For decades, macro-economic conditions have affected each of the Big Four in much the same way; and since 2017-2018, in the wake of the findings of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the reputation of each bank has suffered roughly equally.

Last year, one analyst contended that CBA’s market capitalisation explains its outsized returns. “At $145.8 billion, CommBank is significantly larger than its closest rival (Westpac at $88.8 billion) and almost twice as large as ANZ and NAB combined. This gives the bank an advantage from both scale and capital stability – the same way a building with deeper foundations can stand higher. Size means strength in banking and investors know this.” It’s true that greater size means economies of scale and lower costs of capital, etc.; but by a more relevant measure of size, the Big Four are much the same and CBA isn’t the biggest. Ranked by total assets on 30 June 2021, they comprise: ANZ ($1.04 trillion), CBA ($1.01 trillion), WBC ($993 billion) and NAB ($947 billion).

Why has CBA outperformed the others? The answer, I think, lies in its finances, focus and operations. In this article, I quantify the Big Four banks’ returns to shareholders over key intervals since 1990. I also compare CBA’s finances and operations (which have generally been the Big Four’s least conservative) and NAB’s (the most conservative) along key criteria. CBA’s liquidity and reserves have been lower than NAB’s, and its leverage higher; for these and other reasons, which for the sake of brevity I omit, CBA’s average return on equity over the past 30 years (14.9%) has been higher than NAB’s (12.6%). Does CBA deserve the premium its shares have long commanded? I doubt it; and judging by its returns since March 2020, investors are having second thoughts, too.

Long-term returns to shareholders

Investors who purchased shares of ANZ, NAB and WBC in January 1990 (and CBA when its first tranche of shares listed on the ASX in August 1991) and retained them thereafter have been well – and in CBA’s case since 2009, very well – rewarded (Figure 1). Each bank’s shares have “outperformed” the All Ordinaries Accumulation Index. Since January 1990, the investment of $100 in a portfolio of stocks that mirrored the AOAI (dividends reinvested) grew to $1,561 in June 2021; that’s a compound rate of growth of 9.1% per year. The purchase of $100 worth of CBA’s shares in August 1991, also assuming the reinvestment of all dividends, grew to $7,291 – a compound rate of growth of 14.6% per year. An investment in ANZ grew to $2,818 (11.2% per annum); NAB’s shares compounded at 11.1% and WBC’s at 10.7% per year.

 Figure 1:Investments in the Big Four Banks and the AOAI (January 1990 = $100)

Table 1 shows that over key intervals over the past three decades and until recently, it’s been CBA versus the others:

1. before GFC, CBA “outperformed” the other banks and the Index;
2. during the GFC, it fell less than the other banks (except WBC) and the AOAI;
3. after the GFC and before the Global Viral Crisis, it outpaced the others;
4. during the GVC, it fell less than the others.

Since March of last year, however, CBA hasn’t s outperformed. ANZ’s shares have risen more than CBA’s; and CBA’s rise is little more than NAB’s and WBC’s. This, I suspect, might be a preliminary and surface indication of a deeper and long-lasting change: if the 30 years to 2020 suited a relatively aggressive bank like CBA, might the times now favour – at least in relative terms – a more conservative one like NAB?  

Table 1: Big Four Banks’ Returns, Specified Periods since January 1990

Some key aspects of CBA and NAB’s finances

Liquidity Ratio

A bank’s cash and other assets that can be readily converted into cash (such as current short-term loans and high-grade bonds) comprise its liquidity. Liquidity is critical because a lack of liquidity is a bank’s fastest path to failure. In the Christmas classic, It’s a Wonderful Life, Bedford Falls Building and Loan suffers a “run” – that is, panicked depositors suddenly and en masse exercise their right to demand as cash the balances of their cheque, savings and other accounts. At the end of that frantic day, the bank escaped insolvency by the thinnest possible margin: a single dollar remained in its till. Bedford Falls B&L owned millions of dollars loans, securities, etc., but these assets availed nothing when depositors suddenly demanded cash. Without sufficient cash, banks fail. It’s really that simple. That’s why central banks “backstop” them before crises and extend lifelines to them during crises. The result, of course, is moral hazard: banks take risks that they’d never take without the support and assurances of bailouts.

 Figure 2 plots CBA’s and NAB’s liquidity ratios, i.e., the sum of their cash, liquid investment securities (primarily government bonds) and short-term loans to other banks as a percentage of total assets. On average since 1990, NAB has been the most (20%) and CBA least (14%) liquid of the Big Four; currently (2021), CBA’s ratio is lowest (16.5%) and NAB’s highest (23.1%).

Figure 2: CBA’s and NAB’s Liquidity Ratios, 1990-2021

What’s an appropriate ratio? During the 1920s, when American banks undertook the reckless lending that helped to foment the Great Depression, their ratios averaged 18%-20%. During the late-1930s, on the other hand, banks that had survived the Depression (ca. 5,000 didn’t) were among the soundest in American history. In those years their liquidity averaged 25-32%. Recently, only one of the Big Four – NAB in 2014 – briefly met that criterion’s lowest threshold. Despite the propaganda that they’re the world’s strongest, the fanfare of various “reforms” since the GFC, etc., the Big Four’s liquidity is, by global standards, nothing special In 2018, I wrote to Leithner & Company’s shareholders: “They’re not dangerously illiquid; equally, however, if another crisis occurs they’ll likely – as they did in 2007-2009 – require assistance from the RBA.” Of course, that’s exactly occurred during and since February-March 2020!

Reserve Ratio

A bank’s reserve ratio is its ratio of liquid assets to deposits. In 2011, The Evil Princes of Martin Place: the Reserve Bank of Australia, the Global Financial Crisis and the Threat to Australians' Liberty and Prosperity, I wrote:

Other things equal … the lower the the more profitable the bank. At the same time, banks’ perennial risk is that they lend too much relative to their reserves. Over the centuries, a rough pattern emerges: the lower is a … bank’s ratio, the more profitable it tends to be during a boom – and the more prone it becomes to collapse during a crisis.

Figure 3 plots CBA’s and NAB’s reserve ratios. Liquid assets comprise cash, investment securities (primarily government bonds) and short-term loans to other banks. On average since 1990, NAB’s ratio has been the Big Four’s highest (36%) and CBA’s the quartet’s lowest (24%); currently, CBA’s is below-average (22%) and NAB’s above-average (37%). Considered as a whole, the Big Four are better reserved today than they were on the eve of the GFC – but no better than they were in the early-1990s.

Figure 3: Reserve Ratios, CBA and NAB, 1990-2021

What’s an appropriate reserve ratio? During the 1920s, American banks’ ratios averaged 22-24%. During the late-1930s, on the other hand, they averaged 30-37%. Today, NAB is the only Big Four bank that meets this latter criterion. 

What Does It All Mean? Banks’ Returns on Assets and Equity

Because it’s been prepared to swap liquidity and reserves for loans, the typical bank is heavily leveraged; as a result, and as long as the economic sun shines, it’s highly profitable. This characterisation particularly describes CBA. It’s therefore important to understand that a bank’s profits derive more from leverage than managerial acumen. This assessment, too, describes CBA.

Figure 4 summarises each Big Four bank’s average return on assets and equity since 1990. The ROAs differ little – and average less than 1%. CBA’s is highest (0.95%) and NAB’s lowest (0.77%). CBA’s ROE exceeds the others’ but not greatly. Its average is 14.9%, NAB’s is lowest (12.0%). 

Figure 4: Big Four Banks’ Average Returns on Assets and Equity, 1990-2021

Historically, banks’ ROEs have risen and fallen in response to broader economic, financial and even cultural tides. Over time, culturally and otherwise, discipline has lagged, risk has waned and ROEs have risen. Since the 1950s, according to UBS, Australian banks’ ROE has averaged 12.6% and the median has been 13%. During the 1950s and 1960s, ROE averaged 8%. The average rose to 12% in the 1960s and 15% in the 1980s, fell marginally to 13% in the 1990s and zoomed to 18% in the 2000s. From 2010 to 2016 it averaged 15%; since then it’s sagged to 13%. That’s the lowest in 40 years. How long can CBA’s ROE resist this receding tide? 

Conclusions and implications

From this analysis I draw three conclusions:

1. Australia’s Big Four banks have long been – like most banks overseas, and operationally and ethically – reckless. Without implied support from central banks at all times, and massive support during crises, they risk failure. Throughout the Western world, banks are politically privileged and financially protected. Indeed, they’re “too big to fail.” In any crisis, the RBA and Commonwealth Treasury will have their backs.

2. Over the past 30 years, the Big Four’s finances haven’t changed greatly. They’re hardly rickety; nor, however, are they impregnable.

3. Also since 1990, shares of the Big Four have generated market-beating investment returns. Why the disparities among their returns? CBA has lent particularly aggressively; that is, its liquidity and reserve ratios have consistently lagged the others’. For this and other reasons, its ROE has exceeded the others’ – and market participants have valued its equity relatively highly. Does CBA deserve its premium? I don’t think so; and judging by its returns since March 2020, it’s possible that investors as a whole are having second thoughts, too.

These conclusions have an important implication. “Following the significant leveraging of Australian and New Zealand households over the past 30 years,” said UBS in 2013, the Big Four 

are now low-growth and remain heavily exposed to housing, funding markets and and unemployment … Their profits and dividends are a result of significant leverage; they are not annuities comparable to term deposits.

Shortly before the GVC, on 2 December 2019, APRA’s chief, Wayne Byres, concluded

When [banks’] returns have been very high, as they’ve been , it’s easy to … grow the business, grow the balance sheet and pay out returns to shareholders. We are entering into an environment now where that’s no longer going to be the case. There will be a much harsher choice for bank boards to make about how much of their reduced returns they need to retain to … fund balance sheet growth, and how much they can afford to return to shareholders.

My hunch is that in this respect COVID-19 has been a colossal distraction: for banks, nothing fundamental has changed over the past couple of years. In this environment, CBA no longer deserves its premium and will therefore lose it; the price of its equity, in other words, will either fall towards the others’ or the others’ will rise towards CBA’s, or some combination of the two. 

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