Brokers Ponder Regulatory Curbs On Major Banks

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-Cap on debt servicing ratios possible
-Raising of mortgage risk weights likely
-Majors will need to raise more capital
 

By Eva Brocklehurst

The Reserve Bank of Australia has made its concerns known regarding the investor mortgage market in its semi-annual Financial Stability Review (FSR). What is the most likely course of action the central bank could take to address those concerns? The RBA is looking at whether bank mortgage lending practices are sufficiently conservative in the current environment of low interest rates, strong house price inflation and higher household indebtedness. The issue for central banks in such an environment is how to curb asset price inflation but avoid shutting down a broader economic recovery by raising official interest rates.

Credit Suisse suspects the most likely tool in the RBA's arsenal is a cap on Debt Servicing Ratios (DSR). That is, tightening the income requirement needed to service mortgage interest payments. The RBA appears to view a DSR cap as a relatively well targeted measure, as it allows lower cash rates to feed into lower mortgage servicing costs but not into increases in the size of the mortgage. That would constrain lenders with regard to domestic borrowers but what about foreign investors? The central bank appears to consider a solution regarding foreign investors lies outside its powers, such as with tax, foreign investment and housing supply policies. The RBA has stated that, over time, it should be within Australia's capacity to meet demand from both foreign investors as well as Australian citizens for new housing.

The RBA is discussing options with other regulators including the Australian Prudential Regulation Authority (APRA), which released a draft prudential practice guide on residential mortgage lending back in May. The guide elaborates on APRA's expectations for lenders with regards to risk management, loan origination and security valuation. This suggests two things to Citi: firstly that some targeted macro prudential type of instrument for the investor segment cannot be ruled out and secondly, that a cash rate increase (RBA's responsibility) is not one of the options being considered.

UBS concurs, regarding the conclusions about the consultation with APRA, noting the RBA's FSR was a warning shot across the bows. What is not exactly clear to the broker is whether the RBA is warning that if the market does not slow more action will be taken, or whether steps are required immediately. The RBA does not specify measures, but UBS believes it would tend towards traditional macro prudential tools, such as interest rate tests or counter cyclical capital buffers, rather than New Zealand-style loan-to-volume ratio rules. What is important is that the central bank has revealed some preference for targeted measures against "unbalanced' housing activity rather than broader cash rate hikes. The broker acknowledges this creates some risks for its forecasts for a rate hike in mid 2015, suggesting the timing might be too early.

In parallel with the growing concerns raised by the RBA over the housing market there is the Financial System Inquiry being conducted into capital requirements for the major banks. The Murray Inquiry is due to deliver its final recommendations in November. Credit Suisse believes introducing mortgage risk weights for the big banks could constrain, at the margin, the participation in mortgage finance by the major banks but implementation could take some time. This brings the broker back to the DSR cap as the RBA's most likely option.

Morgan Stanley believes the Murray Inquiry will recommend that capital requirements be revised to enhance financial stability and help restore competitive neutrality in the mortgage market. The broker expects higher minimum capital ratios and an increase in mortgage risk weights. APRA is expected to require major banks to meet more onerous capital requirements over the next few years.

How do the major banks line up in regard to the implications from the regulators' mortgage market concerns? Morgan Stanley assumes the major banks will use their dividend reinvestment plans (DRPs) to meet the new targets by the end of 2017. The alternative is large share placements in 2015. Furthermore, the broker believes National Australia Bank's ((NAB)) new leadership may justify a capital raising at the bank's FY14 result, irrespective of the Murray Inquiry's potential outcome. The majors may not want to pre-empt the conclusions, but recent comments from the inquiry panel and APRA suggests the banks will ultimately need to hold more capital.

Credit Suisse believes the majors, ex Commonwealth Bank ((CBA)), will need to raise capital to meet prospective capital requirements, with NAB the more vulnerable. Any requirement for more weighting on mortgage risk – such as that envisaged above, results in additional capital requirements for each major bank. Credit Suisse does not believe organic capital generation, or DRPs, will be enough. Only CBA is able to accumulate sufficient additional capital over three years merely by using nil discount DRPs, while the other three will face shortfalls.

Other options for the banks include immediate sale of non-core assets, such as NAB's Great Western, Clydesdale or UK CRE and, to a lesser extent, ANZ Bank's ((ANZ)) Panin Bank investment. Raising capital up front to immediately enhance flexibility could be particularly effective for both NAB and ANZ. In fact, Credit Suisse argues such an initiative from these two could leave CBA sidelined and vulnerable to share price underperformance as it organically accumulates capital.

Where does the fourth major, Westpac ((WBC)) fit into the scenario? Well, if the Murray Inquiry's recommendations skew more towards mortgage risk weighting then Westpac is the most affected major bank, although it would result in additional capital requirements for each of the majors. The other in the likely spectrum of recommendations is based on the framework established in Basel III for dealing with Domestic Systemically Important Banks (D-SIBs). If the recommendations skew more to additional charges on this basis then the scenario is relatively more burdensome for ANZ and NAB. Brokers suspect the recommendations will involve a combination of both mortgage risk weighting and D-SIBs measures.
 

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