The financial system inquiry has tendered two profoundly important issues that have the potential to radically change the balance of power between banks and the returns you should expect on their deposits, equities and bonds.
The first challenge is ensuring Australia’s too-big-to-fail major banks, which are worth, on average, $100 billion a pop, are not “free-riding” off artificially cheap money given to them by investors assuming they will be bailed out in a crisis.
UBS research suggests that a reasonable increase in the major banks’ Tier 1 capital ratio would require them to source another $23.5 billion, which would shave their returns on equity from 15.4 per cent to 14.3 per cent.
A second, equally important, policy problem the inquiry canvassed, which has been previously targeted by this column, is the remarkable disconnect between the capital and leverage the major banks apply to their home loans compared with all their peers (save Macquarie Bank).
New analysis prepared by The Australian Financial Review shows this enables the majors to generate returns on equity that are more than double their competitors’. This is crucial because home loans represent the bulk of Australian bank assets.
To properly understand this research it is essential to first explain how the numbers are calculated.
Before 2004, regulators allowed banks to assume that only 50¢ in every dollar of standard home loans they advanced was ever at risk of loss. This is called a 50 per cent “risk weighting”. All other “non-residential” loans ordinarily attract a 100 per cent risk weighting, which means banks have to assume every single cent is at risk.
By pretending only half the value of residential mortgages is at risk (heaven forbid what would happen in a war), banks can hold half their normal core Tier 1 capital and thus twice the leverage vis-a-vis other non-residential loans.
Finally, regulators allowed “advanced” banks, which in Australia includes only the four majors and Macquarie, to set their own risk weightings because they are believed to have superior risk management capabilities. Forget the fact that home loans are homogeneous products.
To get a feel for the risk this induces, imagine in a severe recession that 90-day default rates on home loans pop up to 3 per cent (around the UK experience in 2009 and less than half US levels).
And suppose these bad loans incur losses of 50 per cent, which is a common rating agency assumption.
This implies that the total loss realised on major bank home loans is a seemingly small 1.5 per cent.
The worry is that this is almost identical to the total value of the (tiny) equity capital the majors hold against these loans, which would be wiped out. Spare a thought for investors in listed hybrids, which would be converted into equity at this time.
Our analysis indicates that adopting a minimum 30 per cent (35 per cent) risk weighting on residential mortgages would require the majors to raise $15.1 billion ($21.5 billion) of extra equity capital, lower average leverage to 39 times (33 times), and reduce average returns on equity to 25 per cent (22 per cent).
Even with the tougher 35 per cent risk weighting, the majors would still earn superior returns to all other banks (22 per cent versus 19 per cent) and retain loftier leverage (33 times versus 30 times).
Westpac's profits have jumped 8 per cent to a record $7.6 billion, as record low interest rates fuel a bounce in credit growth and drag down bad debts among borrowers.
Capping off another year of bumper profits for the banking industry, the country's second largest bank on Monday delivered a result driven by a strong performance in its flagship retail banking business.
The growth comes after Westpac has been seeking to lift its rate of new lending aggressively over the last year in response to the recovery in mortgage lending and an anticipated bounce-back in business lending.
Profits were also enhanced by a further decline in the charge for bad debts, which fell 23 per cent to $197 million.
Chief executive Gail Kelly was positive about the outlook for the lender, predicting a sustained level of credit credit and highlighting an improvement in the building industry.
"Housing credit growth has increased over 2014 and we expect growth at similar levels to continue through 2015, driven by strong demand and continued low interest rates. An upswing in home building is also underway," Mrs Kelly said.
"We believe we will continue to deliver strong outcomes for our customers and our shareholders in full year 2015," she said in a statement.
Shareholders will receive a fully franked final dividend of 92c a share, up from 88c a share last year. Unlike last year it will not pay a special dividend.
Before 2004, regulators allowed banks to assume that only 50¢ in every dollar of standard home loans they advanced was ever at risk of loss. This is called a 50 per cent “risk weighting”. All other “non-residential” loans ordinarily attract a 100 per cent risk weighting, which means banks have to assume every single cent is at risk.
By pretending only half the value of residential mortgages is at risk (heaven forbid what would happen in a war), banks can hold half their normal core Tier 1 capital and thus twice the leverage vis-a-vis other non-residential loans.
The regulation is not saying that only half the value of residential mortgages is at risk. It is saying that, if you take the risk on a commercial loan to be 100, then the risk on a residential loan is 50. This is a completely rational evaluation and possibly being kind to commercial loans. To work out how much of the loans the regulator is implying to be at risk, you need to take into account the required capital ratio, and it is a heck of a lot less than 100% for commercial loans and even less for resi loans.
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The worry is that this is almost identical to the total value of the (tiny) equity capital the majors hold against these loans, which would be wiped out. Spare a thought for investors in listed hybrids, which would be converted into equity at this time.
Good point. Equity is the first thing that gets wiped out, which is as it should be. CJ takes a well-deserved potshot at convertible hybrids which have upside like preferred shares and downside like equity - the worst of all worlds. The extra 50-100 basis points over preferreds is not worth the extra risk.
The truth will set you free. But first, it will piss you off. --Gloria Steinem AREPS™
The regulation is not saying that only half the value of residential mortgages is at risk. It is saying that, if you take the risk on a commercial loan to be 100, then the risk on a residential loan is 50. This is a completely rational evaluation and possibly being kind to commercial loans. To work out how much of the loans the regulator is implying to be at risk, you need to take into account the required capital ratio, and it is a heck of a lot less than 100% for commercial loans and even less for resi loans.
Good point. Equity is the first thing that gets wiped out, which is as it should be. CJ takes a well-deserved potshot at convertible hybrids which have upside like preferred shares and downside like equity - the worst of all worlds. The extra 50-100 basis points over preferreds is not worth the extra risk.
+1
So many errors in this post by CJ.
Not all other commercial loans attract 100% risk weighting. Lending to a company which has a credit rating of BBB+ or better (upper investment grade) attracts a lower weighting than 100% (as it should). Below investment grade attracts a capital rating of +100%.
Finally, increasing the risk capital to banks will not reduce their ROE, it will simply increase the spread. Meaning any fall in OCR of below 2.0-2.5% probably will not get passed on, and deposit rates will fall to zero. In other words, these changes will make monetary policy ineffective for future stimulus.
Not all other commercial loans attract 100% risk weighting. Lending to a company which has a credit rating of BBB+ or better (upper investment grade) attracts a lower weighting than 100% (as it should). Below investment grade attracts a capital rating of +100%.
Finally, increasing the risk capital to banks will not reduce their ROE, it will simply increase the spread. Meaning any fall in OCR of below 2.0-2.5% probably will not get passed on, and deposit rates will fall to zero. In other words, these changes will make monetary policy ineffective for future stimulus.
Sure. Cutting through it all, we need to all keep it in perspective: parameters of bank risk is neatly designed for all our benefit. So if you don't have the vision and energy for business, stick with the houses. And it should be all good: for you and the bank.
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