Anyone who invests in bank deposits, bank bonds, and/or bank equities should read my AFR column today, which is partially excerpted for your benefit below (Apologies for the brevity, I am currently on a study tour overseas.) Free here:
"One of this column's firmest convictions has been that the major banks must continue deleveraging their balance sheets, which in respect of their biggest asset exposure (home loans) remain more than 40 times their equity capital base. This did not jive with the prevailing zeitgeist, with many bank investors, analysts and executives crowing that the capital raising debate was "over". Yet arguably Australia's finest regulator, Wayne Byres, once again "shocked" complacent stakeholders during the week with a hard-hitting message that materially more equity capital was coming. This will likely result in the majors targeting core risk-weighted common equity tier one (CET1) capital ratios above 10 per cent, which CLSA's Brian Johnson estimates leaves them pro-forma short about $20 billion assuming no further rises in the risk weights applied to investment property loans, which account for 35 per cent of their housing books. If they do climb, which is probable, then the shortfall expands by $10 billion for every 10 percentage point increase in risk weights. The characteristically independent Byres did not pull his punches, noting that for all the banker talk of better risk-weighted capital ratios since the global financial crisis, real leverage had not, in fact, shrunk much. "Overall leverage has not materially declined," Byres cautioned. "The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6.5 per cent ." So notwithstanding "the extra capital that new regulation has required, banking remains a highly-leveraged business". Our big banks currently hold less equity capital than a first-time buyer with a 10 per cent deposit. The mirage of soaring post-GFC capital ratios was a function of Byres' predecessors' willingness to allow banks to slash their home loan risk weights, and hence artificially disappear assets, from 50 per cent before 2007 to 16 per cent in 2014, which meant the majors could leverage their equity when lending against bricks and mortar by more than 65 times. Because house prices never decline…Every dollar of extra equity capital banks source is a dollar of future funding they no longer need, which means they will likely pull back on issuance of expensive wholesale bonds, as they did during the first capital raising phase in 2015. Combined with lower risks of default and loss as leverage atrophies, these favourable supply "technicals" should ensure debt costs dissipate... While the RBA may have relentlessly talked down housing risks since 2013 (only this week governor Lowe made the absurd claim that the Council of Financial Regulators was not concerned that the "ongoing increases in indebtedness and rising housing prices…posed a risk to the stability of our financial system"), APRA and Treasury have long harboured worries about the bubble. After Martin Place dismissed this newspaper's 2013 warning that its rate cuts could precipitate a bubble as "alarmist", and erroneously alleged the market was cooling in 2014 (and again in 2016), the Treasury Secretary, John Fraser, had no compunction describing Sydney and Melbourne property as "unequivocally" in a bubble in 2015. On Tuesday Lowe amazingly tried to sheet home blame for double-digit house price growth on supply-side rigidities, an observation that the RBA rejected when I first tendered it in 2003. But supply has been (belatedly) soaring in recent years, which is negative for prices. There has been only one positive demand-side shock: the 11 rate cuts the RBA has bequeathed borrowers since May 2012. Treasurer Scott Morrison delivered a much more authentic speech on Wednesday stressing that he "endorses the steps…APRA is taking on capital requirements to ensure that our banks are unquestionably strong" while warning that "there is more to do to ensure Australian banks maintain their strong positioning compared to the rest of the world". In unusually frank remarks, Morrison argued that world-beating capital buffers were "especially important" because "our banks source a considerable share of their funding offshore, reflecting Australia's position as a net importer of capital, and our banks provide the bulk of the domestic credit that local firms and households receive"... Morrison will likely deliver a healthy budget in May with an earlier-than-expected return to surplus, additional housing reforms and an improved structural deficit driven by prudent savings and superior revenues, which should save the AAA rating and ameliorate threats to the banks. With so many dramatic policy shifts being introduced to bolster the resilience of our financial system, Standard & Poor's will presumably wait until the dust settles to determine the magnitude of risk mitigation. It is entirely possible that APRA's reforms secure the majors an upgrade to their stand-alone credit profiles as their S&P risk-adjusted capital (RAC) ratios, which APRA reiterated this week it will be watching closely, punch through 10 per cent. This will burnish their prized AA- ratings on senior bonds while also boosting ratings on subordinated debt and hybrids one notch. As Byres implored, "Fortune favours the strong". And smart bankers should make haste and grab equity capital quickly while it stays cheap."
Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.