For some time the team at Montgomery have been reporting on the risks to the relative competitive position of the major banks including doing so prior to the publication of David Murray’s Financial System Inquiry (FSI) report.
You can read some of our previous articles here and here.
The major recommendations of the report relevant to today’s post were the increase in the incremental CET1 (Common Equity Tier 1) capital APRA requires the four D-SIBs (Domestic Systemically Important Banks) to hold for being too big to fail, and the changes to the Mortgage Risk Weighting Ratios adopted by the big banks that ‘unfairly’ reduced the competitiveness of the regional banks.
As to the latter, the FSI recommended APRA; “Raise the average internal ratings-based (IRB) mortgage risk weight to narrow the difference between average mortgage risk weights for authorized deposit-taking institutions using IRB risk-weight models and those using standardised risk-weights.” Financial System Inquiry Report
In anticipation of the report’s well-flagged recommendations, the Montgomery analysts and Investment Committee revalued and subsequently added, respectively, Bendigo Bank to the portfolio of The Montgomery [Private] Fund.
Mortgage Risk-Weightings
The Mortgage Risk Weighting Ratio is applied by multiplying it with the amount of a loan and then by the Authorised Deposit Taking Institution’s CET1 capital. The product of the formula is the capital required by the bank to hold against the loan.
The four big banks were effectively permitted to hold less than half the amount of equity, for every $100 of mortgage loans issued, compared to the regional banks.
There are two approaches to determining mortgage risk-weightings: (i) the standardized approach – a set of rules that apply to all banks by default; and (ii) the internal-ratings based (IRB) approach –available only to those banks with sophisticated credit risk management systems that have been approved by APRA.
The major banks use the IRB approach – which allows them to hold significantly less capital against their mortgage assets than Bendigo and Adelaide Bank (ASX:BEN) for example. Until Bendigo’s heavy investment in its credit risk management systems bears fruit and it gains the Advanced Accreditation from APRA required to use the IRB approach, it is at a competitive disadvantage.
David Murray himself drew attention to the different approaches and the massive disadvantage that regional banks are at because of higher risk weightings applied to mortgages.
APRA themselves anticipated a change by Murray and prior to the release of the report suggested that any changes to the risk weightings should not be a lowering for regional banks but a raising for majors.
Today’s Announcement
Today the Australian Prudential Regulation Authority (APRA) announced an increase in the amount of capital required for Australian residential mortgage exposures by authorised deposit-taking institutions (ADIs) accredited to use the internal ratings-based (IRB) approach to credit risk.
The change will mean that, for ADIs accredited to use the IRB approach, the average risk weight on Australian residential mortgage exposures will increase from approximately 16 per cent to at least 25 per cent.
The forecast 200 basis point increase in capital ratios needed by the big banks is APRA’s current judgement of the adjustment required for the Australian major banks’ capital ratios to be comfortably positioned in the top quartile of international peers over the medium- to long-term.
The IRB risk weight for Australian residential mortgage exposures from the current average of around 16 per cent to 25 per cent is the equivalent of increasing minimum capital requirements for the major banks by approximately 80 basis points.
And here are some bank specific thoughts from our impressive and growing team of analysts (thanks Stuart) we can share with you:
ANZ – Based on ratios from 31 Mar 2015, ANZ would need to allocate approximately A$2.3bn of additional capital to the bank’s Australian mortgage book and is largely in line with its expectations.
WBC – The change increasesWBC’s RWAs by A$40.7bn based on the 31 March 2015 balance sheet. Had the change been implemented on 31 Mar 2015, it would have reduced WBC’s CET1 ratio to 8.5% – just below the company’s preferred ratio of 8.75-9.25%, requiring an incremental A$3bn of capital to lift the ratio to the top end of the range. WBC is well placed given the partial underwriting of the 2015 interim dividend DRP and partial selldown of its BTT stake.
CBA – the increase in risk weighting is expected to increase the CET1 ratio required on Australian residential mortgages by 95bpts from 1 July 2016. CBA will provide more commentary on this at its result on 12 Aug
NAB – Changes are in line with expectations and NAB has built a capital buffer in anticipation. This will increase the capital requirementets of the major banks by around 80bpts. For NAB, the impact would be around 70bpt increase in CET1 required and this is likely to rise by a further 10-20bpts when the impoact of the A$5.5bn capital raising and other potential strategic transactions are factored in.
Suffice to say we remain more than comfortable with our holding in Bendigo Bank as both its competitive position improve and opportunity for higher returns becomes more tangible.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.