APRA announced moves to make Australian banks safer. The announcement was greeted warmly by the market. But what do the new capital requirements mean for the banks in the short to medium term? And should investors really be so sanguine about the prospects for the banks?
Two and half years after the release of the final report from the Financial System Inquiry (FSI), APRA has released its conclusions regarding the amount of additional capital that might be ‘reasonably expected to be required’ for the Australian Banking sector to have capital ratios that can be considered ‘unquestionably strong’.
Uncertainty regarding this issue had been an overhanging black cloud for the major bank stocks over the last couple of years. The range of expectations in the market was wide, with some expecting a benign outcome given the increase in common equity tier 1 (CET1) ratios over the last two years, and others expecting another significant step up in capital and other requirements which would negatively impact margins and sustainable return on equity.
APRA announced the CET1 capital ratio required for the major banks to be regarded as unquestionably strong is at least 10.5%. While this was in line with most analyst expectations, there were a couple of other positives that came from the announcement.
The first was regarding when the banks would be required to comply with the higher target CET1 capital ratio. APRA announced that the banks would be required to meet this higher level of equity capital by 1 January 2020. This is later than the market had been expecting, providing the banks with more time to raise the incremental capital internally through retention of profits. As such, it reduced the risk of large scale capital raisings for the banks in the short to medium term.
APRA actually made the comment that “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”. This does not mean that all four banks are in an equivalent position in this regard, but it does significantly reduce the risk of a major call on the market for additional capital.
The second, and more significant positive was the comment that “APRA expects that any changes to the capital framework that may eventuate from the finalisation of the international reforms will be able to be accommodated within the calibration set out in this paper, and will not necessitate further increases to requirements at a later date”.
APRA made note in its information paper of the increase in risk from lending in the residential mortgage market, as well as the risks to the banking system created through the concentration of loan books in mortgage lending that has built up within the banking system in recent years. APRA has introduced prudential measures over the last couple of years that were designed to reduce the risks to banks in residential lending markets.
However, these do not address the issue of loan book concentration in residential mortgages. APRA will strengthen capital requirements for residential mortgage lending as part of its implementation of ‘unquestionably strong’ and final Basel III reforms. These measures will target higher risk loans with higher risk weights. This will require the banks to hold proportionally more capital against these higher risk mortgages, diluting their return on equity generated from these loans in the absence of any moves by the banks to further differentiate interest rates offered by borrower quality by lifting interest rates on higher risk types of mortgages (eg investment, high loan to valuation and interest only mortgages).
The market has been concerned that a higher minimum CET1 capital ratio would represent only part of the changes that would require the banks to hold more capital. Further increases in mortgage risk weights were expected to dilute the CET1 capital ratio, requiring further capital top ups from the banks to return the ratio to levels above the new ‘above 10.5%’ target.
APRA determined the new target CET1 capital ratio by comparing the Australian banks with global peers. To do this, it needed to adjust its more conservative definitions of both CET1 capital and the risk weights applied to bank assets to make the ratios of the Australian banks comparable with those of international banks. If APRA increases risk weights on certain types of mortgages and other higher risk assets, while it would reduce the banks CET1 capital ratio under APRA’s definition, it would not affect the internationally comparable ratio calculated for the Australian banks. This merely makes APRA’s definition even more conservative than that used for international peers, requiring a larger adjustment for comparison.
This effectively removes the risk that there will be an additional round of capital increases required for the banks.
The reduction in regulatory and prudential risk saw the major bank stocks jump by between 4% and 7% in the two days following APRA’s announcement. Admittedly this partially represented a reversal of the almost 2% fall in major bank share prices the day before, but the share prices have still seen a sizeable boost on a net basis over the three day period as a result of the resolution of one of the key risks to the sector.
Despite the removal of this risk, the outcome still sees capital requirements acting as a headwind to return on equity over the next few years. Dilution of bank return on equity from higher capital requirements means that a unit of future earnings growth is less valuable to shareholders than it was historically. This means that the banks should trade on lower earnings multiples than they did five years ago.
The ability of the banks to reprice their products to pass on the increased capital requirements will test their pricing power, particularly given the increase in political bank bashing in recent months.
Slowing loan book growth, FY18 earnings that cycle a period of favourable trading and markets conditions, and ongoing fee pressure will continue to create a challenging environment for bank earnings growth in the coming year. Then of course there is the risk the increased pressure on household budgets from weak wages growth, rising utilities prices and higher mortgage rates leads to increasing delinquencies and asset quality.
So while the regulatory cloud has lifted to some degree, there remain a number of reasons to stay cautious on the banks.
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Stuart is the Portfolio Manager of The Montgomery [Private] Fund – a concentrated, All-cap Australian equity fund that aims to achieve absolute returns from a portfolio of long only Australian shares and cash. Capital preservation is paramount.