Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 510

Why Aussie bank hybrids are rock solid

In 2008, a combination of Rio Tinto management mistakes and the GFC saw the RIO share price fall from a May 2008 high of $124 to $41. The Chinese sensed an opportunity and lobbed a cheeky bid for some of the assets and a 18% stake at a premium to the market's valuation. Apparently, the Chairman of RIO finally said:

“There’s only one Pilbara, it only gets sold once and it never gets sold cheap.”

The Pilbara and RIO’s mines were easily the lowest cost in the world, closest to the end-user market and an honest government. They were the premier resource assets in the world and irreplaceable. The RIO price has increased fourfold since then.

In the same way, the major Australian banks (along with the big 5-6 Canadian banks) are the Pilbaras of the global financial system. Rock solid. The banks have high returns, low volatility and enormous moats which have been, and will remain, structurally impenetrable.

This first chart shows average Returns on Equity (RoE) since 2000 (vertical axis) and the volatility of those returns (horizontal axis) for 90 banks on both sides of the Atlantic (and Australia). We’ve split them by domicile and highlighted the Australian (large blue dots) and Canadian banks (large grey dots). It’s apparent which banking groups to invest in.

Banking 101 and bank strength

Successful banks do three things: be in a position to borrow enough money, at the right price, and lend to customers at the right price. Muck one of the three up and you don’t make enough profit. The big four Australian banks can make supernormal profits because they control deposits in a manner which is largely unparalleled.

In 2002, the big four gathered 66% of all deposits with the fifth-largest (St George) having an 8% market share. In 2023. it’s 78% with Macquarie the next largest at 5%. Is that 20 years of progress? More like 20 years of banks using the occasional crisis to strengthen monopoly positions and a lazy or ineffective competition regulator.

The next chart shows the deposit dominance of Australian and Canadian banks compared with the US and UK banks (note UK data is market share of mortgage lending, not deposits, so not exactly the same thing). The cumulative market share (vertical axis) is shown by the number of banks (horizontal axis). So, In Australia and Canada, we pretty much all dump our money in the top four banks. No other bank can get a foothold.

Deposit control leads to margin pricing power

The link between controlling the deposit market and monopoly profits is net interest income and the key short-term driver of that is the Net Interest Margin (NIM). The chart shows NIMs of the major banks since the early 1990s. NIMs have been in a structural decline since the 1970s, but there are two significant periods when NIMs were increased, which are circled. The first was in the early 1990s when all but NAB and to a lesser extent CBA (both lost less money on commercial property in that period than the other two banks) put their margins up. Post GFC losses, they all increased margins.

So, banks will gently compete against each other, and margins slowly fall. If there are general, or bank specific, speedbumps, banks put their margins up for a few years to play profit catch up. It’s not long enough for smaller banks to gain market share, so we’re then back to the status quo of the ‘four-opoly’ earning supernormal profits. Once profit is restored, banks resume normal business of lots of smoke and not much bang about competition to see if they can gain a few more percent of market share without hurting profits too much.

What does this mean for hybrids?

The big risk for hybrids is that APRA declares non-viability and hybrids get converted to equity. For the past decade since ‘non-viability’ was introduced, we’ve never seen anything but super-viability.

If the probability of non-viability increases from the current near-zero to a higher number, we would expect hybrid prices to decrease. Both are not good outcomes. However, we think the excess profitability makes non-viability risk extremely remote. Price-to-Book (P/B) is a good metric for what the market thinks of the prospects of banks. If it is well below one, markets are assuming ongoing low profitability, hidden bad losses, problems with deposit funding or big upcoming equity issues. All these factors would indicate warnings about non-viability. The chart shows the P/B ratios for the big four since the 1990s and it’s a pretty picture for hybrid owners.

In the early 1990s which was probably the worst general banking crisis since the 1930s (maybe the 1970s?), system average P/B fell to 0.8 for a year (with WBC at around 0.6). Since then, system P/B fell to 1.2 during the GFC and Covid. No major bank has had a P/B below one since the 1990s.

As a contrast, the P/B of Credit Suisse was below 0.5 for the last three years and many of the big European banks have been below 0.6 for most of the last decade. The previous last big Euro bank resolution was the Banco Popular Espanol, which had a P/B of less than 0.1 for 2-3 years. That’s what non-viability looks like.

Can the big four become non-viable? Not from assets

We can’t see how the big banks can become non-viable from developments on the asset side. There is a massive virtuous circle of guaranteed profitability which means they can raise equity capital at a reasonable price, in addition to the natural accrual via profits.

In contrast, Euro banks haven’t been able issue capital because their P/B ratios are so low that equity raising is prohibitively dilutionary. They have had to zombie themselves to life by slowly reducing the balance sheet and retaining what profits they made, thus raising equity levels.

Deposit non-viability

As we have seen with Silicon Valley Bank and Credit Suisse, a deposit run kills banks quickly. This is where a disaster becomes intriguing. What if Australian depositors started a run on one bank? Where do they put their money? In one of the other big four? Given they all do pretty much the same thing they should all be suffering the same stresses, so that’s not a solution.

We think that a severe enough systemic problem would see the government guaranteeing all deposits. Is that a non-viability event and what does APRA do? Do they convert hybrids and Tier 2 and write equity off and let the government own the entire banking system? That doesn’t look like a good idea, but anything less than that should leave equity relatively unaffected and hybrids untouched.

Are remote risks already priced in?

Clearly there are fat tail risks for hybrids in times of severe banking stress, but we think they are priced in. Trading margins of 2.5% - 3% imply a situation where hybrids suffer 50% loss every 25 years. We think that is grossly pessimistic given the industry structure. In a practical sense, hybrid prices will fall well before we start getting into the theoretical universe of non-viability.

 

Campbell Dawson is Managing Director of Elstree Investment Management, a boutique fixed income fund manager. This article is general information and does not consider the circumstances of any individual investor. Financial advice should be sought before acting on any opinion in this article. Elstree's listed hybrid fund trades under ticker EHF1.

 

4 Comments
Lisa
May 28, 2023

Hybrids are the only sector in my portfolio that has been less volatile in recent years. Compared to the hit my bonds values have taken and the recent drops in local equity prices, they have remained relatively stable. Like anything else, diversification helps to stabilise returns.

Campbell Dawson
May 26, 2023

Hi Frankly and Jean Paul. In the GFC, the Elstree Hybrid Bank index had a maximum drawdown of19%. That was for a period of 3 weeks in Feb/Mar 09. Most of the GFC it suffered a 10% drawdown. Bank Equities had a maximum 52% drawdown. If margins went to GFC levels tomorrow, the drawdown would be c12% (margins rising from c3% to 5.5% compared to rising from 1% to 5.5% during the GFC).
We agree that hybrids will not trade at par if there is banking or recession stress. Recent catastrophes (Covid, 2016 etc) have seen a 20%-30% delta to the equity market, but it was followed by a quick recovery. Post GFC the longest drawdown period we have seen is 3 months. Equities can stay below previous highs for more than a year

Jean-Paul
May 25, 2023

Great article on the 'moats' of the Aussie banks. I have two concerns with the hybrids: 1) everyone is bullish on them which is never a good sign 2) will they act more like equity than debt in a bad downturn?

Frankly
May 25, 2023

I also like hybrids but I cannot forget what happened in the GFC, Sure, they did not fall as much as bank share prices but they took a big hit, my recollection is about half the fall in bank shares. If bank shares fall in a recession of depression, hybrids will not trade at par.

 

Leave a Comment:

RELATED ARTICLES

Ian Macfarlane on emerging markets, banks and property prices

The sorry tale of our big banks

Why 'boring' Big Four banks remain attractive

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.