Australian banking is one of the global economy’s last cash cows. It has been more than two decades since the nation last tipped into recession, which accompanied Westpac’s near-death experience. As the Australian economy skirted the very edges of the global financial crisis, banks have been able to build strong franchises generating substantial profits and an almost unassailable position within the domestic economy.
In recent years, fuelled by RBA rate cuts and a surge in demand for housing credit, Australia’s banking sector – especially the four major players CBA, NAB, ANZ and Westpac – has ridden a wave of profits and high stock prices. To look at them in isolation camouflaged the overall disappointing performance of the domestic economy.
Perhaps nowhere is this more in evidence than the performance of the financial index (ex-REITS) and the ASX “Small Ordinaries” which, given the constituent companies, represent a broader Australia when you take out the weight of the big banks in the ASX 20, 50, 100 and 200 indices. Here’s the chart:
Earlier this year that strength of lending growth and expectations of profitability at the banks helped propel the ASX 200 index to 6,000. Just four months ago the stock prices of the big four banks hit all-time highs.
The Commonwealth Bank’s share price was trading at $96.50 and the bank was widely expected to be Australia’s first big $100 stock. The NAB was above $39, the ANZ over 37 and Westpac touched $40 a share.
Look at where we are now, though, just over 12 weeks later.
Changes swift and meaningful
Australia’s major banks sold off heavily as it became clear Australia’s banking regulator, APRA, would demand they hold more capital. Investors questioned what kind of impact this would have on bank earnings.
Last week APRA confirmed it would force the major banks to hold 2% more capital. Depending on who you speak to, this amount appears to be in the low $30-billion-plus-range of new capital to be raised, either in debt or loss-absorbing equity.
This was quickly followed up by a related edict which said the banks needed to increase the risk weights on the home loans they have on their balance sheet from around 16% to an average of 25%.
APRA said this change to the risk weightings would be around 0.8% of the 2% extra capital it wants the majors to hold.
Increasing the risk weightings APRA applies to assets on a bank balance sheet means that the bank has to hold more capital against that asset. That means that the bank has more reserves, and less leverage, if something goes wrong with that asset or that asset class.
While that doesn’t mean the bank can’t get into trouble, what it does mean is that bank has more of its own resources to survive any issues that arise before a rescue by APRA, the RBA or the government is necessary.
It is fundamentally an effort to de-risk the Australian banking sector.
Today Westpac announced it was bolstering its capital reserves with a $750 million corporate note issue. This comes on the heels of recent issues from the ANZ, which raised $970 million, and the NAB $1.4 billion.
During May NAB, under new CEO Andrew Thorburn, raised $5.5 billion in equity, even before the latest APRA changes. It was a move Thorburn, who famously called out New Zealand’s love affair with housing when he was running the NAB’s New Zealand operations, said was prudent and appropriate.
Thorburn’s approach to get ahead of the regulator, along with the Westpac issue announced today under new CEO Brain Hartzer, is emblematic of a changing of the landscape of Australian banking.
APRA is reducing the risk profile of the sector while at the same time dealing with possible speculative excess in the residential investment property market.
By putting a hard limit of 10% on residential investment lending, and crucially enforcing the new limits, APRA is forcing – well, has forced – the banks to change their behaviour.
Last week the Commonwealth Bank announced it was following the ANZ in lifting rates to dampen investment property loans. At the same time both banks lowered the rates they would offer on some loans for owner-occupiers in an attempt to rebalance their books.
NAB has announced a similar measure this afternoon, increasing the variable interest rate on interest-only home loans by 29 basis points.
All of these measures are a clear sign of a changing environment in Australian banking. There are material implications for competition and for the returns investors will receive from the banks in the years ahead.
While investors won’t be overly bothered by the increase in borrowing costs from the CBA or ANZ moves given the Government, via negative gearing deductions, will pay a substantial part of the extra cost, it is clear APRA has ushered in a new credit rationing regime in Australian finance. That takes away a massive source of revenue for the Australian banking operations of all four majors. And it makes it harder for new investors to access finance.
As APRA enforces the 10% rule across the industry, and to the extent that many lenders have been over this threshold recently, some will need to shut the gate and rebalance their books.
The implications of this are less credit to investors and in time this implies less upward pressure on house prices, all other things equal because the the marginal buyer is being taken out of the market.
That would mean mean prices stop rising, reducing demand for new loans and taking away an area of growth and profitability for the banks.
Equally more capital for any given level of assets impacts the banks’ return on equity. It lowers it. APRA’s push for the banks to raise this additional capital impacts overall costs of doing business to the banks.
Of course, the banks have a choice. They can choose to be less competitive and cede ground to their smaller rivals, some of who will have room to increase lending for investment and all of whom probably want a bigger slice of the owner-occupier home loan market. Which is good for competition in Australian banking.
But, as unpalatable as it may be for shareholders, APRA is pushing the banks toward a lower risk and lower return regime.
That’s good for the economy and economic and financial stability over time. It’s also a recognition that however much Australian banks and Australian shareholders want to think the good times will roll on, APRA has a long memory and recalls what times were like the last time one of the big four faced an existential crisis.
It has happened quietly, but it is a seismic shift to the status quo.