Why David Murray Wants Australian Banks To Hold More Capital

One of the key recommendations out of David Murray’s report into financial services, released today, is that Australia’s Big Four banks up their capital ratio between 1.7% and 2.3% from the current level of 8.3%.

It won’t be popular, but reason Murray is so particularly worried is because the Big Four essentially have the same business plan. They’ve done very well out of the booming Australian housing market, but if the boom does end and housing gets hit hard, it doesn’t leave them much room to move.

And while they all view it as their individual risk, their problem is that offshore investors view Australia’s Big Four as a single entity.

It’s one in, all in, as far as the rest of the world is concerned.

Murray says in the report “Given Australia’s concentrated financial system, high household leverage and relatively high house prices, the Inquiry is particularly concerned about the banking system’s exposure to housing. Despite housing risk being generally well understood by both regulators and the financial industry, the Inquiry has specifically considered this risk when making its recommendations.”

APRA chairman Wayne Byers touched on the issue a few weeks back, pointing out that while the banks passed the stress test, they each regard their exposure as a single entity, rather than a combined one.

So Murray wants the banks hold more capital. His key phrase is that the banking sector needs to be “unquestionably strong” – and that means higher reserves to prove it to the rest of the world.

Here’s how the Murray report outlines the problem when discussing resilience and concerns over systemic and housing risk in Australia.

A number of characteristics of the Australian economy and financial system present sources of potential systemic risk:

• As a large capital importer, Australia is susceptible to the dislocation of international funding markets or a sudden change in international sentiment towards Australia, which would reduce access to, and increase the cost of, foreign funding.

• As an open economy, Australia is exposed to shocks in the economies of our major trading partners and subject to volatility in commodity prices.

• Australia’s banking system is highly concentrated, with the four major banks using broadly similar business models and having large offshore funding exposures.

This concentration exposes each individual bank to similar risks, such that all the major Australian banks may come under financial stress in similar economic and financial circumstances.

• Australia’s banks are heavily exposed to developments in the housing market. Since 1997, banks have allocated a greater proportion of their loan books to mortgages, and households’ mortgage indebtedness has risen.

A sharp fall in dwelling prices would damage household balance sheets and weigh on consumption and broader economic growth. It would also reduce the quality of the banking sector’s balance sheets and the capacity of banks to extend new credit, which would compromise the speed of a subsequent economic recovery.

A severe disruption via one of these channels would have broad economic and financial consequences for Australia. Indeed, interconnectedness within the financial system and the economy would be likely to propagate distress and heighten other risks and vulnerabilities

Murray says that while it can’t be “bullet proof”, Australia needs to prepare further to withstand “plausible shocks” via capital levels with a safety buffer, which ultimately, would reduce the cost if and when a crisis occurs.

Murrray’s price on this insurance policy for banks is capital ratio of between 10% and 11.6%.

The report says it proposals aim to minimise the cost to taxpayers, Government and the broader economy from risks in the financial system.

The banks will argue that these additional costs will see consumers pay, but it’s worth noting that in Westpac’s annual report, it managed to increase its net interest margin on the retail sustomer side of the business to which this recommendation specifically relates.

That should go some way to covering extra burden following a year in which profit jumped 8% to nearly $7.63 billion.

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