Australian Banks: Is It All Over?

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By Greg Peel

For a couple of years up until last year, the story for Australia’s major banks has been one of replacing expensive offshore funding with domestic deposit funding and driving earnings in a low credit rate environment through the retirement of provisions taken at the height of the GFC against bad debts and general global risk. This combination has allowed the majors to increase their tier one capital ratios while at the same time handing out capital rewards to shareholders.

As is well documented, bank share prices have done nothing but rally over the period on the lure of dividend riches in a low yield world. For a long time the rally continued despite constant “overvalued” calls from bank analysts, until those bank analysts finally woke up to the fact the punters couldn’t care less about low non-provision earnings growth as long as the candy kept being handed out. The analysts then added a premium to their valuation models to account for the global demand for yield, and decided Australia’s banks weren’t so overvalued after all.

The story began to change however, as we headed into 2014. When three of the Big Four published their full-year earnings reports last November – Westpac ((WBC)), ANZ Bank ((ANZ)) and National Bank ((NAB)) — analysts warned that the end to ongoing dividend increases and/or special dividends was likely nigh. On the one hand, GFC provisions were all but exhausted and would no longer provide earnings growth, leaving the banks once more at the whim of domestic credit growth. While credit growth had been quietly improving from very low GFC depths, it was still low by historical standards and would take a long time to fully recover in Australia’s imbalanced economy. The other issue was not one of profit and loss, but of balance sheets.

Australia’s big bank stocks have not just been favoured by domestic investors chasing yield but by offshore investors as well who, despite not enjoying the bonus gross-up of franking, have still been attracted to the Big Four’s AA credit ratings and world-leading capital adequacy ratios in the face of soon to be implemented global regulatory tightening. It had appeared that Australian bank capital ratios were already safely above new requirements, and at the same time the RBA was able to negotiate concessions on liquidity coverage ratios given Australia’s relatively small government bond market.

Then along came APRA. The prudential controller weighed into the argument and suggested that while Australian capital ratios might exceed those around the globe, Australia’s smaller domestic economy and reliance on offshore funding implied Australian banks should hold more tier one capital than their global peers. The global regulators introduced a category for banks called the domestic, systemically important bank, or D-SIB. Those familiar with the year 2008 would recognise D-SIBs as those banks deemed “too big to fail”. D-SIBs, it was decided, would be required to hold additional capital.

Australian banks, APRA suggested, should probably be required to hold further buffer on top of that additional capital.

By the time three of the Big Four had come around to releasing their interim profit reports last May, bank analysts had started talking less and less about earnings and more and more about capital. By the time Commonwealth Bank ((CBA)) reported its full-year result last month, earnings forecasts hardly scored a mention. Instead, all the attention was grabbed by the Financial System Inquiry (FSI) underway and talk was not just of additional capital buffers but of other regulatory restrictions to boot, all of which would weigh on bank share prices.

We recall that back in the GFC, the US government was forced to “bail out” America’s major banks and financial institutions by injecting equity capital using taxpayer funds. Europe pretty quickly followed suit, as did the UK, and indeed the eurozone reached the point at which the entire economies of the peripheral members were being bailed out by German taxpayers.

Greece was the poster child. It was bailed out and bailed out again. Then a sensation was caused when neighbouring Cyprus went down a different route. Cypriote banks weren’t bailed out, they were “bailed in”.

There were two major issues arising from the initial TARP rescue of US banks by the government. One was the simple “moral hazard” of using innocent taxpayer money to cover the backsides of greedy, and arguably fraudulent, bankers. The other was more technical. Had the US banks not been bailed out then they would have probably gone to the wall and all their creditors would have lost the lot. But they didn’t go to the wall, so the creditors argued they should be paid back in full. The government argued, from a moral standpoint, that it is only fair creditors should take “haircuts” on their loans (being paid back less than face value). The creditors argued, from a legal point of view, that you can’t change the rules mid-game.

The same tune played out across the globe until Cyprus, with eurozone support, introduced the statutory bail-in. This involved Cypriote banks being saved using forced haircuts for creditors and, most controversially, a proportion of excess funds held on deposit.  

In 2008 the Rudd government avoided having to use taxpayer money overtly to bail out Australian banks but it did implicitly use taxpayer money to provide a temporary deposit guarantee. Australia avoided the worst of the GFC fall-out, it can be said with the confidence of hindsight, but that doesn’t mean the same “moral hazard” arguments weren’t raised.

Returning to 2014, and last month’s second round of submissions to the aforementioned FSI, and we find not only are additional capital buffers still on the table for the Australian banking industry, but so are statutory bail-ins. And given the exorable link between bank risk and mortgage risk (which was what the GFC was all about after all), so too are mortgage risk weight considerations on the table.

Bank analysts are coming to the conclusion that whatever the FSI eventually decides when it hands down its recommendations in November, Australian banks are going to be required to hold more capital. And if the banks have to hold more capital, say goodbye to any further dividend increases.

APRA argues that Big Four’s capital levels are still inadequate on consideration of global relativities. The Big Four are arguing strenuously otherwise. They believe their tier one capital levels are above the global average on an “internationally harmonised” basis. They are also generally opposed to bail-ins, arguing they are unproven. It has also been pointed out the US taxpayer ultimately turned a profit on their 2008 bail-out funding for all bar General Motors (which means the investment banks, AIG, Fannie Mae and Freddie Mac).

The banks can argue till they’re blue in the face, but analysts largely agree FSI chairman David Murray is likely to push for more strenuous protection. Says UBS:

“We continue to believe that given Australia's unique situation as a small, commodity based economy, heavily reliant on foreign capital, with a very concentrated banking system, David Murray is likely to err on the side of caution. We believe this means both higher mortgage risk weights and D-SIB buffers despite the Majors' vehement objections.”

“Our view is that the main uncertainty is the extent of the higher capital and ‘bail-in’ that will eventually be imposed,” says CIMB.

“In our view,” says Morgan Stanley, “major banks will be required to hold more capital, despite the fact that they currently look well-positioned vs international peers. Our revised forecasts assume a 2% D-SIB buffer (vs 1% currently) and an increase in mortgage risk weightings (via a 20% risk weight floor).”

The bottom line is David Murray has not been given the task of deciding whether or not Australia’s banks can afford to pay out more dividends and thus attract share price support. His job is to ensure the safety of the Australian financial system into the future, lest another GFC situation were to arise. The last one scared the bejesus out of everyone.

Morgan Stanley goes on to sum up the mood:

“We sense that the Murray Inquiry wants to enhance financial stability and help restore competitive neutrality in the mortgage market. In addition, we think it needs to ensure that major Australian banks’ capital ratios stay at the top end of the global peer group, given Australia’s reliance on offshore wholesale funding. Accordingly, the trend towards higher capital levels around the world will lead to more onerous capital requirements in Australia.”

Morgan Stanley has moved to Underweight banks, suggesting the bank earnings upgrade cycle is coming to an end (as aforementioned here with regard GFC provision returns), and investors are underestimating the downside risk to bank returns on equity as a result of the Murray Inquiry.

But don’t panic! There are some caveats. Firstly, APRA is likely to allow a transition period, more than one broker suggests. Given the Big Four oligopoly, downside to earnings and returns on equity should be mitigated. Morgan Stanley, for one, is not assuming an Australian economic downturn as a base case and does not see a material housing correction ahead.

There is also another potential caveat with regard Australia’s unique position and, perhaps we might say, “smallness”. As was the case with regard global liquidity requirements vis a vis Australia’s small bond market, brokers suggest “bail in” rules may not be appropriate for Australia without some concession.

This might mean even higher tier one capital ratios to offset bail-in rules, UBS suggests, but the banks themselves argue higher ranking capital could replace additional tier one buffers, such as hybrid issues and senior debt that could be “bail-inable”. Credit Suisse is slightly at odds with other brokers in not assuming an additional tier one buffer is inevitable, suggesting APRA may yet accept the banks’ increased non-equity proposal.

Last month Citi pulled CBA back to a Neutral rating from Buy, such that the broker no longer has a Buy on any of the majors. This was not, however, a response to specific FSI risk with regard capital.

Citi believes the bull run of outperformance for Australian bank stocks over the past two years is likely to be coming to an end. Since the GFC, the majors have actively increased their returns on risk weighted assets to offset a decline in leverage (caused by having to hold more capital) in order to maintain their returns on equity. Subsequently, return on risk weighted assets is currently at a 25-year high.

But the glory days of the post-GFC era are over. Provisioning is returning to normal and pricing for risk is being re-established, Citi notes. Competition is re-emerging. The gradual reduction in the cost of bank funds since the GFC has run its course. Banks now face “significant” challenges in maintaining their returns on risk weighted assets, and hence Citi expects the average Big Four return on equity to decline to 12% from a current 16%.

As the cost of capital is presently around 10%, there is nothing to fear. But things are simply going back to “normal”, and in a “normal” economic environment, banks do not enjoy long-run share price outperformance as they return more and more capital to drooling shareholders.

The following table outlines current FNArena database broker forecasts for the Big Four based on yesterday’s closing prices:
 

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