There are widespread beliefs that the Australian banking system is safer and more conservative than their overseas counterparts. Thus, it is generally assumed that the sub-prime and credit crunch problems that affected the US will not happen in Australia. But is this a reasonable assumption?

First, as we showed in Australia has no sub-prime debt? Think again!, there are real-life examples of dodgy lending by Australian banks. The question is, how widespread is such lending? Are these examples of dodgy lending indications of a systemic problem? In any case, it is obvious that it is not in the banks’ best interest to be forthright about their dubious lending practices. Perhaps you may want to do your own scuttlebutt research on this. If you have any stories about dodgy lending practices or dodgy borrowing, please feel free to share them in the comments section below.

Next, our suspicion is that Australian banks are severely underestimating their vulnerability. As Brian Johnson, a banking analyst from JP Morgan was quoted in Banks to feel more pain: analysts,

Mr Johnson believes that Australia’s banks are failing to envisage the possibility of a loan-loss cycle where asset prices [such as housing] fall, and banks struggle to recover loans from defaulters and forced sales.

…

Mr Johnson said Australian banks are actually more vulnerable to the credit crunch than many of their global counterparts because of their high levels of gearing, or loan to capital ratios.

“We’re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,” he said.

As we said before in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

In addition, the Australian banking system has a vulnerability not shared with other countries. As this news article, Fast rise of round robin lenders, reported,

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

We will give a highly simplified analogy of this problem. Imagine an economy of 3 people: Tom, Dick and Harry. Tom owes Dick $1000, Dick owes Harry $1000 and Harry owes Tom $1000. Each of them will have a balance sheet that looks something like this:

Asset: $1000
Liabilities: $1000

For each one of them, what they owe are their liabilities and what they are owed are their assets. Let’s say, for whatever reasons, Tom is unable to honour his debt repayment to Dick. In that case, Dick’s asset will go bad. As a result, he is unable to honour his debt repayment to Harry. This in turn caused Harry’s asset to go bad, which affected his ability to repay his debts to Tom. Therefore, one person’s debt problem becomes a contagion that spreads to everyone else.

In a similar way, this is the current vulnerability of the Australian banking system. It is unique to Australia because of the shortage of government debt that could be used as bank assets and collaterals, thanks to the previous government’s budget surplus. We suggest that you read our earlier article, Banking for dummies for more details about bank balance sheets.

Of course, though it may be possible that such things may happen, it does not necessarily mean that it will happen. It’s the job of the RBA and APRA to prepare the drills in anticipation of this worst case scenario. But should it happen, what can be the possible triggers? For the answer to this question, one news article, ANZ is the big local bank most at risk, caught our eye:

ANZ Bank has been singled out ahead of other big Australian banks as most at risk of further material provisions because of its long credit default swap positions, potentially running to $2.4 billion, based on international comparisons.

National Australia Bank is not far behind in the structured credit risk stakes.

As we highlighted before in How the CDS global financial time-bomb may explode?, Australia is not going to escape unscathed when this potential disaster strikes.

In view of all these, perhaps there is little wonder that, as Fast rise of round robin lenders reported,

At a recent conference held by one of the world’s largest banks, the Australian banking system was identified as one of the best investment opportunities, for going short.