Troubles in the Australian banking sector have been a major factor in the sharp decline we’ve seen in Australia’s broad market index, the ASX, which recently closed at a four-month low. The ASX bank index has fallen by 15% since hitting its one-year high back in March, dragging the entire index down as investors worry that the banks will have trouble maintain their profit margins.

Australia is known as relatively prudent and fiscally sound country. If we were to play a word association game and I said, “Machiavellian,” the first thing to come to mind wouldn’t be “Australian bankers.”  But that’s exactly how a recently study from Macquarie University (based in Sydney) described some of them, saying that chief executives of many Australian banks are ignorant of scheming and ethical breaches in their organizations.

That academic judgement follows on the heels of several scandals in the country, with wealth managers selling shady products and manipulating the country’s benchmark interbank borrowing rate.

The Australian Securities and Investments Commission says it is working to rein in that behavior, and the Australian Prudential Regulatory Authority (APRA) is cracking down on investor loans in real estate, which now make up about a third of the country’s mortgage market.

There are fears in Australia of a U.S.-style housing bubble. While Australia dodged our real estate bullet in 2008, largely thanks to conservative lending standards and an effective regulatory regime, home prices in the country’s biggest cities have soared 40% or more over the past three years.

Earlier this week, Treasury Secretary John Fraser said that Sydney was “unequivocally” in a housing bubble, a clear sign things are overheating. A housing crisis would be particularly dire today, given major banks’ reserves against potential loan-losses have plunged since 2008.

However, most Australian banks are working on stricter criteria for investor loans. They are cutting interest rate discounts and raising down payments from as little as 5% just a month ago to as much as 20% today. APRA is also pushing banks to raise more capital to buffer themselves against losses, with the “Big Four”  banks alone expected to raise between $17 billion and $31 billion.

Good News

So the good news is that Australia has benefited from proactive regulators in the past and is continuing to do so. While investors are clearly disappointed in the banking sectors performance, regulators are protecting both the Australian economy and investor returns by slowing deflating the mortgage bubble. And Australian banks are still quite strong relative to many other global banks.

The average loan-loss ratio, a measure of soured loans versus performing ones, at Australian banks remains at cyclical lows, though they are picking up in the major cities. As a result, Australian banks on the whole aren’t suffering from a capital crisis yet.

And the Big Four banks have already been tightening lending standards for a couple of months.

The best news is that while Australian bank shares are off, the banks themselves are still quite strong. That means they should get a boost down the road as the markets realize that a real estate bust isn’t going to trigger a banking crisis, so the banks will continue to turn in steady-if-somewhat-slower growth. That also means that their dividends still have room for growth along with earnings.

The takeaway here is don’t bailout on Australian banks, since there doesn’t appear to be a government bailout necessary in their future. They’ve simply hit a cyclical turning point in their business which, thanks to on-the-ball regulators, shouldn’t turn into a crisis. And if you focus on the strongest and healthiest banks, you can pick them up at extremely attractive yields right now.

Portfolio Update

Shares of Westpac Banking Corp have fallen by nearly 20% since the end of March, for all the reasons discussed in the article. While loans were up by 7% in the first half of the bank’s fiscal year back in May, with deposits up 8%, net interest margin had declined slightly to 2.05% thanks to several one-time adjustments. Add in the increased regulatory intervention in the banking sector and you ended up with jittery investors.

Westpak (NYSE: WBK) hasn’t been ensnared in most of the scandals which have impacted the Australian banks recently, though it is being included in the government’s investigation of rate rigging thanks to its position as one of the Big Four banks. While it’s too early to know its degree of participation in the scheme, regardless of the outcome of the investigation shouldn’t be particularly dire. It has also been tightening its lending criteria for the past two months, so APRA’s directives won’t come as a great shock to the bank’s lending business.

At the same time, the bank is quite well capitalized already with its tier-1 ratio at 8.8%. A common measure of bank strength based on its equity capital and reserves, it is well above the APRA’s required minimum. Still, the bank will be raising about $1.6 billion in additional capital by offering its shares at a 1.5% discount through its dividend reinvestment plan, taking its tier-1 ratio to above 9%.

Given Westpac’s limited capital raise, it’s clearly one of the strongest of the Big Four.

With shares of Westpac Banking Corp now yielding nearly 6%, we continue to rate it as a buy under $34.