- Bank capital positions already improved
- Mortgage weightings uncertain
- Plenty of time to comply
- More of a win than a loss
By Greg Peel
The two main factors to come out of last year’s Financial System Inquiry recommendations involved overall capital requirements for Australia’s deposit taking institutions – let’s call them “banks” – and a specific capital weighting to be held against mortgages. While it now seems like a lifetime ago, bank capital considerations are part of a global response to the Global Financial Crisis. Specific mortgage considerations are an element of such capital considerations but have become more of a focus in Australia of late given the investment property boom.
The FSI recommended Australian bank capital ratios should be “unquestionably strong”, which was defined as being in the top quartile of global bank ratios. The responsibility falls on the Australian Prudential Regulatory Authority to actually define and implement ratio requirements, and also to address mortgage risk weightings in particular. The RBA has also been leaning on APRA to get moving on mortgage risks.
After conducting international comparisons, yesterday APRA released a set of conclusions which it will use to “inform” but not necessarily determine a final decision on bank capital requirements. There are two capital benchmarks under consideration – tier one and total.
Common equity tier one capital (CET1) is a primary benchmark, reflecting the value of equity capital (ordinary shares) held by the banks as a ratio of the total value of what the bank has on its loan books. It is a measure of leverage, such that, for example, a 10% ratio implies leverage of ten to one, a 20% ratio five to one and so on.
To provide the funds for the balance of loan value, banks raise capital by other means. These include deposits, issues of debt securities locally and offshore, and issues of “hybrid” securities which begin life as debt but may be converted into equity at some stage. These are all effectively loans to the bank which the bank has the obligation to repay, unlike equity, which is provided at risk to the shareholder. Together they make up “total” capital, on varying degrees of repayment risk.
Having conducted its analysis, APRA found that the level of Australian bank sector capital compares favourably on a global basis. However in order for Australian banks to be “unquestionably strong”, another 70 basis points of tier one capital would be required to take the sector into the top quartile globally, and “at least” another 200bps of total capital would be required (noting tier one is included in total). APRA’s numbers are based on Australian bank capital as reported at end-June, 2014.
An important caveat to the “top quartile” goal, and one providing relief to banks and bank analysts alike, is that it is not a hard and fast benchmark. Given banks around the world are addressing their own capital positions, the top quartile is indeed a moveable feast, and thus remaining clearly in that bracket would require constant monitoring and adjustment. Thus APRA suggests top quartile positioning is a “useful sense check” and not a regulatory obligation.
It is also important to note that as at June last year, three of the four majors had just paid their interim dividends out of capital, which reduced their capital starting point for APRA’s comparison. All four have organically generated capital in the meantime, and at the end of their second halves, ANZ Bank ((ANZ)) had implemented a dividend reinvestment plan (which increases tier one capital on shareholder reinvestment, dependent on the number of shareholders who choose to do so), and sold out of its Esanda finance business (cash is, of course, also tier one capital), Westpac ((WBC)) had implemented a partially underwritten DRP (guaranteeing a minimum level of new capital generated), and National Bank ((NAB)) had raised new capital via a rights issue.
NAB’s raising was predominantly intended to cover its UK business spin-off but included an additional amount to pre-empt new APRA requirements.
In other words, the banks have already been raising capital, one way or another, in the meantime. Then we come to the matter of mortgage weightings.
Earlier this year APRA addressed the issue of mortgage risk by setting an initial 10% risk weight average, which in simple terms means a bank must hold 10% of the risk value of its mortgage book as capital, forming part of the overall capital requirement for all loans. But 10% was always going to be just a first step, with an increase expected later this year.
From day one, the bank analysts at various broking houses all had different expectations of just what the increased ratio might be. And that is still the case today. Suffice to say, the weighting could be anything between 20% and 35% depending on which broker’s analysis one chooses.
Clearly the level that APRA decides upon will impact on the overall capital increases the banks may need to undertake. And that’s before any risk weighting limits are set by the regulator on other loans, besides mortgages, if that is to be the case. The higher the ratio(s), the more capital the banks will need. However, such increases form part of, and are not additional to, overall tier one and total capital requirements.
APRA has promised to announce its new risk weighing ratios shortly. With regard overall capital requirements, APRA has to wait until the latest round of global deliberations on the matter are concluded and a new Basel agreement is announced. Hence the regulator’s analysis to date will, at this stage, “inform” rather than determine ultimate changes. Given the FSI recommended Australian banks hold an additional capital buffer above and beyond Basel rules for systemically important global banks, because Australia is a small fish playing in a big pond, final requirements for Australian banks will still be at APRA’s discretion.
Which is why yesterday’s announcement by APRA answers some questions but raises others. For starters, the regulator has decided that Australian banks will need “at least” another 200bps of total capital, which leaves a final figure open for debate. Given brokers are divided on their mortgage risk weighting expectations, tier one and total capital expectations also vary. And it is not yet known what numbers will emerge from Basel.
Offsetting this uncertainty is comfort in the fact that APRA will not issue new requirements one day and expect the banks to have complied by day two. Indeed, the period of grace allowed by APRA for the banks to comply will be measured in years. APRA has stated that it wants to ensure “any strengthening in capital requirements is done in an orderly manner, such that Australian [banks] can manage the impacts of any changes” to be “well placed to accommodate any strengthening of capital…in the next few years”.
To that end, brokers agree that such breathing space may allow for the banks to avoid the outright tier one capital raisings (such as NAB has already conducted, but also for other NAB-specific purposes), the threat of which has cast a pall over bank share valuations in recent months. There is already talk Commonwealth Bank ((CBA)), which reports its FY15 result next month (the other three big banks report in November), will take the opportunity to announce a raising. But brokers are not so sure.
Most agree that given the allowable time, and the growth in tier one bank capital already achieved since APRA’s June 2014 benchmark, new tier one and total requirements could be met through DRPs and the issue of non-tier one capital, as well as through asset sales if desired. In the latter case, ANZ has already flagged the possible sale of Asian minority interests, albeit ANZ has the lowest capital ratio of the big banks at present.
NAB has already raised capital, very successfully, it must be noted, which leaves CBA and Westpac. The two bigger banks of the Big Four have the greatest exposure to mortgages, so the first step for these banks will be determined by just what APRA’s mortgage risk weighting ratio is going to be. Thereafter, Westpac has already shown it is willing to undertake underwritten DRPs, and CBA was in the best capital position of all four to begin with.
The bottom line is, and irrespective of the variation in specific assumptions amongst brokers, yesterday’s announcement from APRA can be seen as a win for the banks. Bank analysts agree it could have been much worse, the banks are already a lot of the way there in capital terms, and time will be very much on their side. Even if one or more banks do decide to directly raise fresh capital, and here brokers disagree on whether they will or not, the amount of raising will not be enormous and thus share price dilution will be kept to a reasonable level.
Again we note that NAB’s recent raising was quickly swallowed up by thirsty investors.
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