18 Aug 2015
What has happened?
Australia’s banking regulator, APRA, recently confirmed that the four major banks are well capitalised and need to be “unquestionably strong”. Despite this conclusion, APRA acknowledged the major banks’ adjusted capital adequacy ratios are not in the top quartile of global peers and will need to increase.
APRA’s best estimate is the major banks are likely to need to increase their Tier 1 capital ratios by at least 2% relative to their positions at June 2014 to be “unquestionably strong” and to achieve top quartile status in the medium to long term. At present, estimates put the 2% additional capital at circa $20-24bn, but may be as high as $40bn, depending on the movement in bank balance sheets and upcoming changes to global banking regulations.
Whilst Basel IV (new set of global banking regulations) is yet to be completed and agreed upon, the current moves to raise capital are aimed at ensuring the Australian banks are in a prime position once Basel IV is handed down.
The major banks are well placed to meet higher capital adequacy requirements during the next few years given their shares are trading above historical valuations (big discounts on equity raisings aren’t required), the demand for yield (i.e. captive investors) and large shareholder bases (less dilution). They will be able to meet the new standards using a combination of underwriting dividend reinvestment plans, asset sales, better capital management, equity raisings, and the issuance of hybrid securities.
NAB and Westpac (WBC) have already instigated dividend reinvestment plans which they have underwritten. NAB has sold assets (US and UK subsidiaries) and is rumoured to be looking for a buyer for their life insurance business. Westpac has partially sold down their stake in BT Investment Management, and ANZ may look to sell their Asian business (though, this looks to have been postponed). NAB ($5.5bn) has already raised equity, and ANZ ($3bn) and CBA ($5bn) have just announced equity raisings. WBC has issued $1.25bn of hybrids, and the rest are likely to follow with their own hybrids in the short to medium term.
They may even need to lower dividend payout ratios, but this will depend on the amount of capital that needs to be raised. If they need to raise more capital ($40-45bn) than currently expected (circa $20-24bn), further equity raisings may also be required.
What are mortgage risk weights and why the sudden change?
Banks are required by APRA to hold capital to protect bank deposit holders. The amount of capital they are required to hold is based on a percentage of risk-weighted assets. Essentially, the higher the risk of an asset, such as a mortgage, the more capital a bank is required to hold.
The change from APRA sets a minimum required mortgage risk weight of 25% (banks previously self-assessed as low as 16%). The higher minimum capital requirement applies to both new and existing mortgages, but excludes small business lending secured by residential mortgages.
APRA had previously indicated that they were committed to the higher capital being raised in an orderly manner over a reasonable transition period (three years). However, this all changed a few weeks ago when they announced that implementation would be required by 1 July 2016.
Based on estimates from Morningstar, and following ANZ’s $3bn and CBA’s $5bn capital raisings, CBA will have the highest Tier 1 capital ratio, followed by NAB, ANZ and WBC. CBA could also do a couple of fully underwritten dividend reinvestment plans if needed. It seems WBC will have to lift their efforts, but they have committed to underwriting their dividend reinvestment plan. ANZ could’ve sold some or all of their Asian assets, but chose to delay and instead raise capital through a share purchase plan.
Absent pricing and fee adjustments (we’ve already seen rate rises on new and existing investor property loans), a higher capital base can reduce returns on equity, earnings per share and dividends per share. Historically, the banks have generally succeeded in passing additional regulatory costs onto their customers (e.g. higher fees; lifting rates out of cycle; not passing on the full RBA rate cut/increasing more than an RBA rate rise; etc.). This time, shareholders will also be hit with lower returns going forward and some share dilution due to equity raisings (if not taken up).
The holding of additional capital strengthens their balance sheets. As such, it is a positive for bond holders and hybrid holders, as well as taxpayers in terms of less reliance on government funding in case a bail-out is required. It also improves the robustness of the Australian financial system.
Specifically in relation to hybrid securities, the increasing focus on capital stability acts to support hybrid pricing by decreasing two key risks within the Basel III style hybrids: ‘capital trigger risk’ and ‘non-viability risk’. These clauses are included in all Basel III compliant hybrids.
However, hybrids will continue to remain an important and cheap funding avenue for the major banks. If supply outweighs redemptions over the medium term, as is likely, hybrid prices would most likely fall. As such, pricing pressure will require higher margins on new hybrids to continue to attract investors, especially when interest rates begin to rise. In addition, there is a small risk that the banks don’t redeem on the first or second call dates if the outstanding issue represents cheaper funding when compared with replacement issues.
In relation to ordinary shares, equity raisings will be completed at various discounts to the trading price of shares, resulting in downward pressure on share prices until the equity raisings are completed. Lifting capital requirements and the issue of more shares will lower potential returns whilst increasing the amount of shares on issue.
It remains to be seen whether the banks can maintain current margins and earnings growth in light of this, but we definitely know they’ll be passing a fair chunk of the burden back on to customers.
If you would like to discuss this further with your Financial Adviser, please call us on (02) 9324 8888 or click here.