Australian Banks: Will The Majors Need To Raise Capital?

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– "New World" for banks might see increased need to raise extra capital
– Westpac most exposed to investment housing mortgages
– CommBank seems to have lost its premium
– All Big Four now trading well below consensus price targets
 

By Greg Peel

This article follows on from Australian Banks: Is It All Over? published on September 10.

As at yesterday’s close, the ASX200 had fallen 5.7% from its early September high. The ASX200 Financials sector index, which is dominated in market cap by the four Big Banks, had fallen 6.1%. As mega-caps on an Australian scale and high-yield on a global scale, the Big Four have been leading targets in this past month’s Sell Australia trade, which has seen foreigners exiting Australian equities in anticipation of a Fed rate rise.

A Fed rate rise would narrow the yield gap between the US and Australia and thus render Australian stocks less attractive to foreigners, but in the case of the Big Four there are also domestic forces at work. As the above article explained, local bank analysts are no longer pre-occupied by earnings forecasts per se but by domestic regulatory issues that could force the banks to increase their capital ratios.

Indeed, local analysts are now assuming increased capital requirements to be inevitable.

The regulatory attack is on two fronts: RBA concern over the domestic investment mortgage bubble and Financial System Inquiry (FSI) concern over capital safety buffers for Australian banks deemed “too big to fail”. On both counts the Australian Prudential Regulation Authority (APRA) is clearly keen on increased regulatory measures.

In order to stop the investment mortgage bubble getting out of hand, with Sydney and Melbourne the leading offenders, a 20% risk weighted asset floor for investment (as opposed to owner-occupier) mortgages is being touted. What this means is that the banks must hold a minimum 20% capital buffer against the value of their investment mortgage books, restricting leverage to five to one.

In order to account for the “smallness” of the Australian banking sector on a global scale relative to the “largeness” of Australia’s commodity-based (and therefore subject to heightened volatility as experienced recently, for example, with falling iron ore prices) economy and subsequent reliance on offshore funding, the FSI is leaning towards Australia’s Big Four holding an additional level of tier one capital beyond that already required by the Basel III global banking requirements.

In each case, and APRA is onside with both arguments, the Big Four would be required to increase their capital ratios beyond current levels, which are already above global averages. In very simple terms, more capital on the balance sheet means less money “going to work” and thus lower earnings potential. More capital reduces the opportunity for excessive dividend hand-outs.

But there is more than one way banks can increase their capital ratios without actually going to the market with new raisings, as was the case back in 2009. As to how the banks might respond to their requirements is a matter of great discussion among bank analysts.

Credit Suisse notes that investment housing lending represented 12.2% of all Australian system lending as at August. The prospect of “macro-prudential policy” being introduced through APRA, that is minimum required capital coverage of investment lending books, has increased and that in turn would impact adversely on the momentum of such lending, the broker warns.

Within the Big Four, Westpac ((WBC)) is overweight the sector in investment housing exposure, Credit Suisse notes, Commonwealth Bank ((CBA)) is sector-weight and National Bank ((NAB)) and ANZ Bank ((ANZ)) are both underweight.

Macquarie concurs that Westpac is most at risk, given 44% of its mortgage book is exposed to investor lending and it has the dominant position in NSW. The broker is now factoring in a 15% risk weighted asset (RWA) floor, rather than the full 20% being touted to date, which for Westpac and CBA affects a 1-3% value dilution and 2-6% reduction in the broker’s target prices.

Turning to the likelihood of additional capital requirements on the separate “too big to fail” issue, Macquarie sees a low to mid case scenario of 1-7% dilution and 1-14% valuation downside. Here Macquarie sees CBA as best placed to cope with the “new world” given its higher capital starting point, superior capital generation and superior deposit base. NAB is also better placed given its “self-help” capital plan, while the regionals, Bank of Queensland ((BOQ)) and Bendigo & Adelaide Bank ((BEN)) won’t be impacted by a RWA floor.

As to how the Big Four would come up with the additional capital required, Macquarie suggests lost return on equity would be recovered through deposit repricing. It is depositors who are the beneficiaries of any capital increase on a “too big to fail” basis, as they are the losers from failure. Hence the broker suggests they will need to pay this impost through reduced interest rates paid on deposits.

Citi has run its numbers on the assumption of the full 20% RWA floor. The broker estimates the Big Four will each require between $2.1bn and $4.1bn of additional core capital to meet such a requirement. Citi is another noting the more retail oriented banks Westpac and CBA, will be most impacted while the more business banking focused banks, ANZ and NAB, will be least impacted, along with the regionals.

Citi is assuming the banks would be granted a 3-5 year window within which to meet any new requirements, and has considered the means of raising such capital from the point of view of increased mortgage rates. Given increases of 45 basis points would be needed to achieve this, on the broker’s calculation, Citi believes the banks would only resort to acquiring half the necessary capital using mortgage rates, with the other half acquired with repricing across all of retail banking from mortgages, to deposits and consumer finance.

Citi is not at this stage factoring in additional capital on the “too big to fail” issue.

Morgan Stanley is certainly acting on a “too big to fail” impost assumption and has another spin on how the banks might raise the necessary capital. The broker estimates the banks will need some $39bn of additional capital to meet new requirements and believes they will primarily use dividend reinvestment plans (DRP) to do so up to 2017.

An underwritten DRP creates new shares to satisfy those shareholders who elect to take their dividends as shares rather than cash.

However, Morgan Stanley also sees an alternative capital raising scenario – large share placements in 2015.

The broker estimates that some $25bn of new capital can be raised via DRPs, leaving the banks $24bn short come the end of FY17. Thus the broker thinks it is possible the banks could undertake large capital raisings to meet the new requirements in 2015, despite any 3-5 year window provided by APRA. NAB is best placed to lift its tier one capital through asset sales but will still look to raise the balance in the market, Morgan Stanley assumes.

Indeed, Morgan Stanley suggests, given NAB’s new leadership team, the bank could justify a capital raising as early as the FY14 result in November. The post-GFC experience of 2009 showed the first in got the best price.

CIMB is assuming the combination of both regulatory changes will see the banks having to increase their tier one capital ratios from a current 8.0-8.5% to 10.5-11.0%. This would cut bank intrinsic values by 16-20%. Indeed, CIMB’s estimates of intrinsic valuation under a “new world” regulatory scenario are some 30% below yesterday’s share prices, and the broker expects the ongoing exit of offshore yield investors as the Aussie falls and US interest rates rise.

CIMB has moved the sector to Underweight.

Macquarie is less dramatic, suggesting the correction in bank share prices to date is starting to, albeit not yet fully reflecting the potential new valuation reality – except for CBA. The perennially “overvalued” member of the Big Four has now seen its share price fall to the bottom of its historical trading range versus its peers.

This becomes evident when we look at FNArena’s Major Bank Data tables. The table below was updated for the previous article (linked above) on September 10, which was just when offshore selling started to pick up.
 

Note that ANZ’s share price was still 3% shy of the consensus target price, while NAB and Westpac were trading very near and CBA, as it almost always does, was trading above. However brokers have since adjusted their target prices to some degree but not to an extent which reflects the past month’s fall in share prices. Hence in the new table, updated to yesterday’s closing prices, we see a different picture.
 

ANZ still remains furthest short of its target, at 9%, but the other three are now lined up like ducks around 5-6%. For CBA to be on an equivalent percent-to-target level as peers is almost unheard of.

Of course, of all the speculation laid out by brokers above, little is yet to be fully factored into analyst valuations and targets given it is just that at this stage – speculation. The FSI recommendations are due from November, but could be delayed until into next year. On the matter of mortgage controls, one gets the feeling something could happen any moment, but these things usually take time.

So where does this leave Australia’s bank shareholders? Given yesterday’s solid bounce in bank share prices one would have to suggest “eyeing off those 5-6% fully-franked yields”. But the speculation from brokers above would tend to suggest bank prices may well have lower to go, and if the banks did raise capital (directly or via DRPs), those yields would be diluted.

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