Why can’t ASX small bank stocks beat the Big 4?

Be disappointed all you like at the performance of some of the Big 4, but ASX small bank stocks have fared even worse in the last couple of years. New floats like Pepper (ASX:PPM) have turned out to be duds and established stocks like Bank of Queensland (ASX:BOQ) and Bendigo and Adelaide Bank (ASX:BEN) have stagnated. But why? Haven’t these companies been recording solid growth in their books? And some of them have been recording ever increasing profits.

Is it just a case that the only poor performing employees these companies have are their IR (Investor Relations) people? Are investors still living as if its 12 months ago and the US regional banking crisis is still on? Or can investors see something else that executives either cannot or don’t think should be deal-breakers?

Why ASX small bank stocks are struggling

First of all let’s just recap a few realities underpinning the situation small cap bank stocks face, as do their larger peers:

• Although interest rates have increased substantially, banking margins have not due to intense competition between banks to keep customers from switching banks as well as to gain others. There was an actual term for this: The Mortgage Wars.
• Whether or not you think interest rates cuts are coming this year or next, it is all but certain the next general direction is down (even if interest rates go up one more time, it is not as if we’ll see another 6-12 straight increases).
• Banks have had to invest a lot in their technology to remain competitive.

Is the deck stacked against the small players?

Now let’s look at some of the ways small bank are disadvantages compared to their larger peers.

• One of the biggest selling point of many small banks are that they offer flexibility to customers rejected by the Big Four – we’re looking at Pepper. They have been rejected by the Big Four for specific reasons, because the banks view lending to them as too risky, not profitable, or both. You may say banks can recover money by charging them higher interest. True, but the small banks have to pay higher interest on their warehouse funding. And they are more reliant on it than larger banks that have a deposit base.
• Bad debts have gone up. Even though not as much as doomsayers may’ve thought, many smaller banks have faced substantially higher bad debts than larger banks. Why? See the previous bullet point. In mid-2023, Pepper’s arrears were 4.5%, up from 3.4% at the start of the year. Consider the highest of the Big 4 was 1.4% (it was NAB).
• In January 2021, laws were changed to make it illegal to pursue people for bankruptcy if they had less than $10,000 in debts compared with $5k before the pandemic. The Big Banks exited smaller loans like this while the small banks chose to enter this space. While the reverse, small banks exiting mortgage, hasn’t happened as fast, we have seen Bank of Queensland stand back from the market as it admitted it could not get an adequate economic return given its higher cost of capital. And, after 2 years of fighting the ACCC, ANZ won the right to take Suncorp’s retail bank operations that the latter was desperate to offload.
• Small banks find it harder to recover their cost of capital, and thus have Return on Equity in the single digits, while all the Big Four had it in the double digits (with CBA being the highest in FY23 at over 14%).

Conclusion

So are we suggesting another regional banking crisis is on the horizon? Not per se. However, we are suggesting investors avoid ASX small bank stocks given everything we mentioned above. We also think investors should watch to see more smaller banks offload mortgage operations to the bigger banks in the future (or just wind them up), similar to what BOQ and Suncorp have done.

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