There's a one in three chance that Aussie banks will need to raise more capital

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Morgan Stanley analysts say there’s around a one in three chance that the next ruling from Australia’s banking regulator will require the big Aussie banks to raise more capital and cut dividends.

The Australian Prudential Regulation Authority (APRA) is scheduled to release an information paper towards the end of this month, clarifying its definition of “unquestionably strong” for bank capital requirements.

In a research note outlining their bull Vs bear case for the APRA ruling, Morgan Stanley said that APRA would almost certainly find that further changes are needed to ensure the stability of Australia’s banking system.

They applied around a 35% chance of a “bear case”, where tougher restrictions would be enforced and the big four banks face a combined capital shortfall of $25.7 billion. Commonwealth Bank would be the worst affected, requiring an additional $9.2 billion.

Morgan Stanley

The analysts assigned an 60% probability to their “base case”, which would require banks to maintain a tier one capital ratio (CET1) of 10%, and a small increase in the risk weightings for mortgages as part of the banks’ total asset portfolio.

Morgan Stanley noted that the major banks’ collective CET1 ratio had increased from 8.9% in 2014 to around 10%.

“As a result of the improvement in capital ratios over the past year, this implies the banks could comfortably meet “unquestionably strong” capital requirements by 2019,” the analysts said.

Morgan Stanley

The current risk weighting for mortgage books is 25%, following a 2015 ruling by APRA which increased it from the mid-teen levels.

Morgan Stanley said that will likely rise to 27.5%, but that banks will then have a period of consultation and the new requirement would come into effect towards the end of 2017.

In considering a more bearish case, Morgan Stanley noted that Australian banks are face more domestic risk than their international peers due to Australia’s booming house prices.

“We believe that most investors are assuming that the minimum CET1 ratio will settle at ~10%, but there is an increasing probability that the mid-year information paper will include a higher target,” the analysts said.

They also noted that the Basel Committee “has proposed higher risk weightings where the repayment of the loan is “materially dependent” on the cash flows from the property”.

In Morgan Stanley’s view, there’s a reasonable chance that APRA may adopt that approach and put higher risk weightings on investor mortgages and interest-only loans.

The analysts conducted a scenario analysis for Westpac bank, and concluded that risk weightings on mortgages would increase to 32.7%.

In a situation where banks needed to raise their CET1 ratios above 10%, and APRA enforced a risk-weighting for mortages above 30%, Morgan Stanley said that each of the major banks would face significant capital shortfalls.

In such a scenario, Morgan Stanley said that Commonwealth Bank would be the worst impacted. They said that ANZ was best-placed to deal with more stringent capital requirements.

The analysts said that if the bearish forecast came to fruition, it would “materially increase the risk of dividend cuts”.

“We assign a probability of 35% or approximately a 1 in 3 chance to our bear case, as we believe it is likely that mortgage risk-weightings will be lifted >30% due to a revised treatment for higher-risk loans, while recent commentary from APRA and the banks also points to target CET1 ratios above current levels.”

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