- Increased capital requirements expected
- Banks need to raise capital
- DRPs sufficient?
- Earnings growth potentially zero
By Greg Peel
The recent Financial System Inquiry made a number of recommendations regarding Australia’s banks and their capital positions.
Importantly, bank capital ratios – basically the level of equity held against their loan books – should be “unquestionably strong”. The risk weighting of mortgages – the ratio of mortgages a bank believes to be “at risk” of default – should be within a more “appropriate range” of 25-30% (they have been around 15% recently) and should be more representative of a standardized model than internally determined models, which see different banks arriving at different calculations of “risk”.
The Australian Prudential & Regulatory Authority agrees with the broad conclusions of the FSI. APRA also believes the Big Four, by their concentration, represent a greater systemic risk in Australia from another GFC-style episode than the largest of global banks, considered to be “domestically systemically important banks” (D-SIBs) by the international regulators, in an international context. This greater risk implies the need for an additional capital buffer above the capital ratio requirement set out by the international regulator.
APRA has also taken issue with risks inherent in Australia’s runaway housing market (in Sydney, and to a lesser extent Melbourne, to be precise) and believes the banks’ internal measures of mortgage risk weightings are inconsistent and need to be reviewed. And there is no need to wait for international regulators to decide on a framework, APRA has suggested. Risk weightings need to be reviewed now.
What does all this mean? Well it means that sooner or later, Australia’s banks are going to have to raise more capital, by one means or another. Increased capital requirement implies lower leverage in their businesses, which, all things being equal, means lower earnings per share. Given the banks pay dividends based on a payout ratio of earnings, this means lower dividends per share. Both imply lower share price valuations.
Bank analysts at major broking houses all agree that ultimately the banks will need to come up with more capital. But there is some difference of opinion on just what new requirements may be forced on the banks, how they will be implemented and just what impact they might have.
Morgan Stanley is assuming the Big Four will be required to hold a capital buffer of an additional 1% (100 basis points) above the international D-SIB capital ratio requirement to be set by the Basel IV agreement. On the subject of mortgage risk weightings nevertheless, MS offers four different possible scenarios.
The broker’s base case is a 20% mortgage risk weighting. This implies (inclusive of the 1% capital ratio buffer) the banks would need to raise around $15.5bn in additional capital. Another scenario sees Basel IV applying a standardised weighting of an average 40% for different mortgages, implying $22bn in additional capital.
The broker believes the second scenario is looking increasingly likely.
A third scenario would see the 40% average adopted but an additional 10% increase would be applied for investment mortgages. This implies $26.5bn and is consistent with new rules recently applied by the Reserve Bank of New Zealand, specifically in the Auckland housing market. Investment mortgages are considered at higher risk of default in the case of a severe market downturn.
A fourth scenario suggests APRA simply applies a risk weighting of 25%, which is the bottom end of the FSI’s 25-30% recommended range. This would mean only $12.5bn would need to be raised, but Morgan Stanley does not believe APRA will apply this simple “one size fits all” weighting given it does not recognise any differentiation of mortgage risk.
Whatever APRA eventually comes up with, and all we know is that the regulator intends to say more “shortly”, Morgan Stanley is forecasting more capital raisings (National Bank ((NAB)) has already jumped the gun) – from the banks this year.
Citi is expecting risk weighting reforms will be delivered in the September quarter, followed by Basel IV global capital ratio changes later in the year.
Citi believes average internal mortgage risk weightings could move closer to 30% to be more in line with changes globally. But the broker also believes the banks will be offered a three-year implementation period to bring their weightings into line. On Citi’s analysis of the banks’ potential three-year capital plans, the Big Four may not need to actually issue new shares but could meet new requirements through two fully underwritten dividend reinvestment plans (DRP) implemented within the three-year period.
NAB has already, of course, issued new shares, but this was also to cover the cost of exiting from its UK business.
Note that a DRP provides the shareholder with a choice of taking their dividend in the form of cash or as new shares. “New shares” implies a capital raising paid for by the bank itself in lieu of cash not handed out from earnings. If a DRP is not underwritten, then new capital will be raised only to a level based on the number of shareholders who choose shares over cash. In a fully underwritten DRP, a broker or brokers agree to take up any capital shortfall in the form of discounted new shares.
Given the banks have often offered DRPs anyway, this “backdoor” means of capital raising is seen as having less of a negative impact on market sentiment than a straight-up capital raising via the announced issue of new shares.
But on Citi’s calculations, these DRPs would equate to a 5% increase to the banks’ share counts and imply, over the three-year period, the banks’ earnings per share growth could potentially fall to zero.
Zero EPS growth could be avoided if the banks choose to “reprice” their mortgage books over the period, Citi notes. “Repricing” implies the banks increase their mortgage rates outside of the cycle of RBA policy meetings, or despite the RBA leaving its cash rate on hold at a meeting, or implies not reducing their mortgage rates by as much as a 25 basis point rate cut.
But Citi also notes the banks are already enjoying high mortgage lending returns thanks to the housing boom and that strong competition amongst the banks and other lenders has once again resurfaced. This makes individual mortgage repricing less of an option.
UBS notes mortgages represent the largest asset class on the Big Fours’ balance sheets, making up 66% of all Australian loans. Given the Basel IV committee has recently met to discuss the topic of risk weightings, the broker is expecting an imminent announcement from APRA with regard increased risk weights.
While the market is also anticipating an announcement, UBS believes investors have been too focused on mortgages and may be underestimating the potential impact of increases to non-mortgage risk weights in line with the need for “unquestionably strong” capital ratios, as the FSI recommended, to be finalised later this year.
UBS nevertheless believes increased mortgage risk weights will lead the banks to begin repricing their loan books as they attempt to rebuild their respective returns on equity. Thus the broker suggests that any sell-off in the banks sparked by the aforementioned underestimation of capital requirements would provide an opportunity for investors to increase their exposures, and thus benefit from repricing and ROE rebuilding.
Credit Suisse speaks for all brokers in suggesting, unknown capital increase requirements notwithstanding, that the recent sell-off in the banks has brought valuations back to more attractive levels, at least by some measures. Those measures include price/earnings (PE) relative to the non-bank market and price to book values.
On standalone PE, dividend yield and underlying profit multiples, the banks still look less than compelling, Credit Suisse suggests. But as least those numbers are not as “overcooked” as they were previously. That said, the sector earnings growth is back to a modest 2-3% and earnings momentum has recently been negative.
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