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Australian Banks: Unquestionable Relief

Feature Stories | Jul 27 2017

The matter of capital requirements has finally been resolved by APRA, but do bank investors have anything to look forward to?

– APRA announcement brings sighs of relief
– Banks can meet requirements organically
– Positive earnings results expected
– Medium term challenges remain


By Greg Peel

Much Ado

The Australian Financial System Inquiry was conducted in 2014. In a nutshell, the Inquiry was conducted for the purpose of assessing what level of tier one capital Australian banks should be obliged to hold as a sufficient buffer against the risk of another Global Financial Crisis, which as we recall occurred back in 2008.

The FSI findings were announced ahead of an expected decision by the international bank regulatory committee as to the level of capital that should be held by all global “domestically systemically important banks” (D-SIB), or as they are better known, banks deemed Too Big To Fail within their own countries. The bank regulator, APRA, had previously suggested that an additional capital buffer, over and above that of the “Basel 4” international D-SIB ratio, would be needed for Australia’s banks given the relative size those banks in an otherwise relatively small developed economy.

On releasing its findings, bank regulator APRA did not provide any quantification of what that buffer should be, but merely offered that bank capital positions will need to be “unquestionably strong”.

No one was to know at the time that this vague “unquestionably strong” definition would proceed to hang over the banking sector like an ominous storm cloud all the way to July 2017. It was unlikely APRA’s intention to keep the banks guessing for such a period either, given back in 2014, a decision on Basel 4 was expected at any moment. As it stands, that decision has never come. Having postponed and postponed, the international committee finally admitted no consensus could be reached and subsequently postponed indefinitely.

This put APRA in a tough position. The starting point for an “unquestionably strong” capital ratio was always going to be the Basel 4 ratio, to which APRA would then apply its own additional buffer. Without any starting point, it fell on the regulator to actually come up with a standalone ratio of its own. Last week APRA finally announced that decision. Cutting a long story short, that ratio is 10.5%.

The sighs of relief from the banking sector, and bank investors, were audible. Australia’s banks have not been sitting on their hands all this time waiting to learn of APRA’s decision, but rather they have been building up their capital positions in anticipation. When three of the big banks reported first half results in May (and one a quarterly update), the average ratio between them stood at 10.0%, a mere 50 basis points away.

And the banks have until 2020 to meet the new requirement.

Next month Commonwealth Bank ((CBA)) will post its full-year earnings and ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) will provide quarterly updates at which the latest capital standings will be confirmed. The bottom line is, bank analysts all agree satisfying APRA’s new target will be a stroll.

There will be no need for the banks to raise fresh capital.

Going Organic

Nor will there be any need to slash dividends to retain capital and meet 10.5%. Indeed, ANZ may even now look to return some of the proceeds of its recent asset divestments to shareholders, analysts suggest. There will not otherwise be a flurry of dividend increases or specials nonetheless, and indeed one or more of the big banks may need to offer discounted dividend reinvestment plans (DRP) to pull them through.

Otherwise the new ratio can be achieved through organic capital growth. Such a result is a far cry from that which had been feared by many.

On Deutsche Bank’s forecasts, ANZ and NAB will hold 10.1% capital ratios by FY19, and CBA and Westpac 10.4%. But these numbers assume DRP buybacks. Without DRP buybacks, ANZ would hit 10.5%, NAB 10.4%, CBA 10.6% and Westpac 10.7%.

There is, nevertheless, the small matter of portfolio risk weightings. While a tier one capital ratio is a broad-brush requirement, APRA also limits the extent to which any one form of lending, for example mortgage lending, dominates a bank’s total loan book. In the current environment, lending to property investors and writing interest-only loans is deemed more risky than lending to owner-occupiers through principal-and-interest loans.

APRA has already been clamping down on riskier loans, and the banks have responded accordingly. APRA is yet to announce new risk weightings that will accompany “unquestionably strong” ratios, but last week suggested that they will not amount to an additional capital buffer, on average.

There remains a risk those banks more weighted to riskier mortgages may yet need to increase their individual capital ratio to meet the new standards. This means CBA and Westpac. Macquarie’s analysts believe all four banks will actually look to push their capital ratios beyond the 10.5% level by 2020 in order to apply a small buffer of their own. The analysts assume 10.75-11.00%. CBA and Westpac will need to be nearer the top end of the range.

Macquarie calculates such additional capital will result in -2-3% dilution to bank earnings.

All analysts agree that of there is going to be another change to risk weightings, it will again target mortgage books. If there is a clear and present danger it is in Australia’s housing market. Business lending, by contrast, remains subdued and bad debts historically low, for example. But if there is further tightening in mortgage rules it is assumed this will again be at the expense of investor and interest only loans with a likely offset being provided by an easing for owner-occupier loans.

Laughing all the way…

Remember the good old, bad old days when the RBA would cut the cash rate, the banks would not “pass on” the full extent of the cut to mortgage rates, and politicians would scream bloody blue murder, as they knew such criticism rated well with focus groups? Or in the other direction, when the banks would “reprice” their mortgage books (lift rates) “out of cycle” despite no move from the central bank, drawing the same response? Well in recent months the banks have all been lifting mortgage rates while the RBA is firmly on hold.

And not one peep out of the pollies.

This is because the banks can legitimately say “APRA made me do it”. Any politician criticising a clamp-down on risky mortgages in the face of an impending housing market collapse would look like a complete fool. Or should that be “even more like a…”. Never mind.

The banks’ repricing of investor and interest-only mortgage rates is the tool they must use to keep their risk weightings under the new APRA caps. They simply need to reduce demand. But out-of-cycle rate hikes also play straight into earnings. The risk is that were the banks to push this windfall just a little too far, the resultant drop-off in demand and a possible customer rush to the competition would actually result in lower earnings.

It’s a fine line, and APRA is yet to announce its next round of risk weightings.

Now What?

With the capital question now (all but) resolved, it’s back to business.

The first order of business is that despite pollies keeping quiet on risky mortgage repricing, they have been far from silent when it comes to the banks in general. The federal government has imposed a levy on the Big Five, dressed up as a means of helping return the budget to surplus, but also popular with the baying mob.

If only the mob realised that the levy will, indirectly, be paid out of their own compulsory super.

At the time of the levy announcement, fears were expressed that the rate will inevitably be increased over time. What no one saw coming was the attempt by the South Australian state government to impose an additional levy of its own. This led to fears of a rush to do the same by all the states.

Fortunately for the banks, the South Australian opposition blocked the bill.

That risk may have been averted for now, but the federal opposition is not going to let its cry for a Bank Royal Commission go. Now Labor wants to include the regulators themselves in the inquiry. There is little doubt Australia’s banks, and particularly the Big Four or Five, will remain at the mercy of political pressures for some time yet.

But there’s not a lot they can do about it.

Bank analysts are presently of the view the full-year and June quarter numbers about to be published by the big banks have the potential to surprise to the upside.  The repricing of mortgages will provide upside to net interest margins, and thus earnings. Credit quality is now broadly stable, with no sign of any new “pockets of weakness” or single name risk that spooked the market a year ago. Bad & doubtful debt (BDD) levels should come in at historical lows. The banks have also been trying to cut costs (while at the same time having to spend on IT upgrades) and this is one area from which surprise may emerge.

It could be a good season. But what about beyond?

The banks, as noted, will need to be careful about further mortgage repricing given the risk of demand disappearing. When BDDs are at historical lows there is only one way, cyclically, for them to go in the future (although bank analysts have been forecasting BBD increases, incorrectly, for at least three years now).

The housing market is set to cool, so everyone keeps telling us. No one expects a crash, but a “cooler” market in itself means lower demand for mortgages, and thus lower earnings growth. Business loan demand is finally on the rise in the wake of the GFC but is hardly shooting the lights out. We are also constantly being told that households are up to their eyeballs in debt, and thus unlikely to be in any rush to borrow for anything.

To quote UBS, “the medium term outlook remains challenging”.


It is, however, not as if any of this is lost on investors. Bank share prices have had quite a rollercoaster ride of late and there tends to be a swift rush to the exits at any sign of danger. But the lower the bank share price, the better the fully-franked yield. There is a limit to share price downside.

Morgan Stanley remains concerned about structural and cyclical headwinds, but believes resilient earnings can support bank share prices in the near term. Macquarie continues to see near-term relative upside for the sector, citing scope for consensus earnings expectations to be beaten on the benefit of recent mortgage repricing and improved deposit costs.

In Credit Suisse’s view, current absolute bank valuations appear to be fair and relative to the market they appear inexpensive. With the sector now likely to enjoy a little “clear air” on capital, Deutsche Bank suggests the majors look “reasonable value” despite modest growth prospects.

The equivalent table to above published in FNArena’s last bank update in May, Australian Banks: Earnings Results And The Great Big Tax, showed a net 8 Buy ratings for the Big Four among the eight FNArena database brokers, 16 Hold and 8 Sell. The above table shows subsequent upgrades now leaves us with 10/18/4.

Over that period, bank share prices have rallied on a net basis from the depths they plumbed when the federal levy was announced. Dividend yields nevertheless remain very healthy at around 5-6%. Despite the rally, bank analysts have been busy lifting target prices to reflect forecast earnings increases on mortgage repricing. These forecast increases also lift dividends.

Higher share prices reduce yield so on balance forecast yields have reduced little since May.

The increase in target prices means there is more upside to bank share prices than there was in May, with the exception of CBA which almost perennially trades above target.  Such upside reflects broker views as outlined above, that it could be a good season for bank earnings numbers next month.

In the meantime, the current yo-yo range the ASX200 is currently stuck in must be breached one day, either up or down, and that will depend a lot on the banks, given the Big Four alone account for about a quarter of the index's market cap. Bank shares prices have joined in the yo-yo-ing. Great for traders, disconcerting for investors.

It would be more advisable for investors to look through the volatility, recognise that in the medium term the banks are not offering anything in the way of exciting growth, but will continue to pay solid dividends now the whole capital ratio scare has been resolved.

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