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Bank capital in a post-FSI world

The Financial Services Inquiry (FSI), chaired by David Murray, is scheduled to release its final report in November 2014.

From a bank capital perspective, there are two main issues:
1. Mortgage risk-weightings, and
2. Domestically systemically important banks (D-SIB) capital for banks that are ‘too big to fail’.

Mortgage risk-weightings

The FSI has shone a light on the stark differences between the risk-weightings the big four banks apply to mortgages vis-à-vis their smaller regional competitors. The advantage arises because major banks use sophisticated internal risk models with lower capital assumptions than the smaller banks which use standardised models. As David Murray observed in his 15 July 2014 speech: “Smaller banks face some regulatory disadvantages that reduce their competitiveness, especially higher risk weights for mortgages. The report identifies a range of options to promote competitive neutrality.”

In its most recent submission to the FSI, APRA noted the distortion that these differences in risk-weightings created. Essentially, mortgage lending has been significantly more profitable for the major banks than other forms of lending.

On the notion of potentially reducing the risk-weightings for mortgages written by regional banks adopting the standardised approach, APRA went on to say: “There is no compelling reason to adopt policy changes that are weaker than the internationally agreed Basel framework in an attempt to address competitive concerns … Furthermore, it is undesirable to make changes to the prudential framework that would provide further incentives for residential mortgage finance over other forms of credit.”

Other financial commentators have supported the argument for increasing mortgage risk-weightings. In fact, Christopher Joye wrote in The Australian Financial Review in July 2014: “Investors in major bank stocks priced on current leverage and returns would arguably suffer if these reforms were implemented, but depositors and bond-holders would be better off, given lower risks of default.”

Too big to fail

The second issue relates to bank capital and moral hazard. Under the current regulations, APRA requires the major four banks to hold an incremental 1% in Common Equity Tier 1 CET1) capital (sometimes known as D-SIB capital) to reflect the implicit government guarantee the banks enjoy.

There is a view that David Murray may seek to shore up the Australian banking system once and for all by requiring an additional 1% to 2% in D-SIB capital. This would force all major banks to issue equity.

According to David Murray: “The [FSI Interim] report suggests that there may be a case for Government and regulators to do more to reduce resultant disruption and the size of the potential call on taxpayers. Options for change include higher regulatory capital requirements to further reduce the risk of failure … For this reason the committee has asked for views on the pros and cons of higher capital ratios – to reduce taxpayer exposure to failure.”

Such increased capital requirements would be dilutive, but it is the least dilutive when valuations are stretched. From this perspective, now would be an opportune time for regulators to affect such an increase in D-SIB capital requirements.

Potential implications of the FSI

The implications of these potential changes to the capital requirements of the major banks will fall into one of the following four scenarios:
1. No change to any capital rules from the FSI
2. Increase in the risk-weights for mortgages
3. Increase in D-SIB capital for the major banks
4. Both an increase in risk-weights for mortgages and an increase in D-SIB capital for the majors.

Montgomery believes that if the major Australian banks are required to adhere to the fourth scenario, for example, within a five-year time frame, this should not cause too much short-term discomfort for the sector.

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This content is provided by Cuffelinks and does not represent the views of AMP Capital.

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