The Australian Prudential Regulation Authority (APRA) has set the minimum capital level required for banks to meet the ‘unquestionably strong’ benchmark recommended by the 2014 Financial System Inquiry at 10.5%, versus a common equity tier-one (CET1) capital ratio of around 9.5% for the major banks as at December 2016. The deadline to meet the new benchmark is January 2020.
The increase in the CET1 baseline to 10.5% was as expected, and the performance of the banks post the APRA release highlighted this view. The changes mean the minimum regulatory capital requirement under Basel III increases 150 basis points – to 9.5% from 8.0% – although this will be offset partially by a reduction in the banks’ capital surplus. Based on our understanding, the 10.5% mark is only a ‘soft target’, meaning the banks can fall below it following dividend payments.
What remains unclear at this stage, however, is what changes, if any, will be made to risk weights. The APRA announcement included the line that changes to the capital baseline were “reflective of future changes in risk-weights and other framework changes”, which could be viewed as confirmation that they are unlikely to increase much above current levels. We expect this to be viewed very positively, given many (including Ord Minnett) had assumed there would be a material increase in risk weights.
We would, however, caution against adopting overly optimistic assumptions. Given the recent focus on higher-risk lending, such as investor interest-only loans, we believe APRA may look to increase the risk weights on certain types of loans, e.g. interest-only loans and high loan-to-valuation ratio loans, while providing offsets in other areas, such as owner-occupier principal and interest loans.
Based on Ord Minnett’s initial estimates, which assume average domestic mortgage risk weights remain at 25%, we expect the sector will need to raise an additional $5.2 billion in capital, which will see the banks more inclined to use their dividend reinvestment plans over coming periods.
We have updated our models for the major banks to account for the APRA changes and the effect of greater DRP use, but see the effect on our cash EPS forecasts being less than 1%. Our stock recommendations and price targets remain unchanged post these model updates.
In our view, the new capital rules will likely trigger a pricing response from the banks, although deciphering exactly what form this may take remains far less obvious. Investor-loan repricing would seem the simplest method, but further reliance on this channel could open the banks up to competition, which may see them shift their attention back onto depositors.