Banks dodge one bullet, another yet to come

Updated

July 19, 2017 20:40:12

The rebound in bank share prices after APRA’s definitive statement on “unquestionably strong” capital levels was telling.

Key points:

  • APRA says banks won’t need to raise fresh capital or interest rates, or cut dividends
  • APRA’s next target is further raising risk weights for mortgage lending
  • Banks may need to raise another $18b and investor mortgages likely to be targeted

Shares in the major banks jumped between 3-4 per cent after the regulator’s announcement.

The banks dodged a bullet.

APRA’s language was benign, its target not onerous and the timetable to achieve the goals far from tight.

Lifting minimum capital requirements around 150 basis points by 2020 should be a cinch.

As Clime Capital’s David Walker points out, many in the market thought APRA would want its “unquestionably strong” banks all lined up a year earlier.

“The APRA timetable would require banks on average to grow their capital base by 20-to-30 basis points a year, they’re doing that every half [year] at the moment,” Mr Walker says.

Indeed the banks have been on a steady trajectory towards the target for the best part of a decade.

ANZ is pretty well at the 10.5 per cent Common Equity Tier 1 capital ratio level already, after its shrinking-to-grow strategy has seen it flog-off a whole lot of unwanted assets in Asia and New Zealand, squirrelling the proceeds away into its capital base.

On Morgan Stanley estimates, the CBA has the most ground to make up, needing another $2.6 billion, NAB is around $1.9 billion short and Westpac $1.2 billion in deficit.

APRA itself emphasised that the banks should be able to take this in their stride, without hitting either customers or investors.

“The major banks should be able to generate this level of additional capital from retained earnings, without significant change to business growth plans or dividend policies, and without consideration of other capital management initiatives such as asset sales or equity raisings,” it noted pointedly in the report.

By way of illustration, APRA calculated that if banks wanted to maintain their returns-on-equity at the current lofty levels and immediately boost their tier one capital ratios by 100 basis points, that would mean lending rates would go up by 10 basis points as quickly as it takes to fire out a media release.

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That is not going to happen. The banks simply don’t have the political capital for that one.

APRA far from finished

However, the relief rally that saw banks share prices jump around 3 per cent may be a bit premature. APRA still has another bullet in the breech.

It has yet to tell the banks what it plans to do with mortgage risk-weightings.

All that is known is that they are going up and that is important as risk weightings – a complicated number that basically is a measure of asset’s likelihood of default – are the denominator in the equation of a capital equity ratio.

Thus, if risk weightings are raised, then tier one capital – the numerator – needs to go up as well to keep the capital ratio stable.

The big four have had the luxury – although it is fair to point out, the expense as well – of calculating their own risk weightings on their mortgage portfolios.

Needless to say, the banks didn’t think they were very risky at all.

Before 2004, it was a one-size-fits-all 50 per cent of home loans considered at risk.

When the big four (plus Macquarie) were given licence to calculate risk weightings themselves, they managed to chisel it down to around 15 per cent over the next decade.

Obviously that meant they could lend more – a lot more – their gearing went up, customers’ indebtedness went up, house prices went up and, not surprisingly, risk shot up, as did APRA’s blood pressure.

APRA is waiting on the final benchmark from global regulators via the Basel III standards, probably later this year.

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Nonetheless, the regulator has made it clear that residential mortgages are not that low risk and the heavy exposure of them on a bank’s balance sheet is not a grand idea.

It has tinkered with things – such as narrowing the gap between big banks and their regional counterparts by effectively reintroducing standardised risk weightings and lifting the requirement for the amount of capital that needs to held against home loans.

“However, they do not address the fundamental concentration in mortgage lending that has built up within the banking system,” APRA said of its own efforts to date.

In other words, APRA still hasn’t achieved its “unquestionably strong” goal and it is still got some bad news in store for the banks.

“The design of these measures will seek to target higher risk lending, balanced against avoiding undue complexity in the prudential framework,” APRA coldly stated in a line buried towards the end of its report.

Banks may need an extra $18bn to fund higher risks: UBS

Higher-risk lending is a euphemism for investor mortgages and interest-only loans.

The “measures” APRA is talking about are likely to be higher risk-weights for higher loan-to-valuation ratio (LVR) loans and separate, again higher, risk-weights for investor lending.

All of which means banks will need to hold even more capital and investors will fund that through more targeted repricing and higher interest rates.

UBS banking analyst Jonathon Mott has put some numbers on the likely outcome of higher risk weightings and said the required tier one capital ratios will effectively expand to between 10.75 per cent and 11 per cent as banks seek to be safely above the bare minimum.

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“Our initial calculations suggest the sector’s capital shortfall to reach 10.75 per cent CET1 is around $7.9 billion,” Mr Mott wrote in a note to clients.

“However, this rises to $17.7 billion assuming mortgage risk weights rise from an average of 25 per cent to 30 per cent.”

Additional capital needed

with a 10.75pc CET1 ratio

Additional capital needed

if risk weighting moved to 30pc

CBA $4.2 billion $6.5 billion
Westpac $1.5 billion $$5.4 billion
NAB $1.7 billion $3.5 billion
ANZ $490 million $2.3 billion

Source: UBS

High household debt mean rates will go up slowly

APRA’s plan will be to hasten slowly.

It has a view that the elevated Sydney and Melbourne property markets will have a soft landing, but is wary about just how vulnerable the debt-engorged sector is.

“No one wants mortgage interest rates rising suddenly,” Clime Capital’s David Walker said.

“They [APRA] are worried that if rates go up quickly, it will put already stressed households under even more pressure.

“If rates do go up suddenly, everyone knows what will happen.”

A sudden surge in debt turning bad and a mass of mortgage defaults is not really on the path to an “unquestionably strong” banking system.

Topics:

banking,

regulation,

australia

First posted

July 19, 2017 14:12:33

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