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Australian Banks – What’s all the fuss?
Australia and New Zealand Banking Group announced last week a $3 billion capital raising to prepare for the Australian Prudential Regulation Authority’s new capital rules. News of ANZ’s capital raising, with an outlook downgrade on Thursday, weighed heavily on the share market late last week and the banking sector in particular.Westpac and NAB had already raised new capital in recent months and it is now expected that Commonwealth Bank of Australia will also raise when it reports its full-year earnings on Wednesday.
With banks making up a core component of many Australian investors portfolios, and depressing headlines over the weekend papers, we thought we would share our view if we see trouble ahead in the banking sector, or consider the capital raisings as an opportunity.
Background, why are the banks raising capital?
In July APRA announced an increase in the capital requirements for residential mortgages under the IRB approach (involving ANZ, CBA, NAB, WBC and MQG). This will lead to the average risk weight rising from 17% to at least 25%. The move addresses a FSI recommendation and is also consistent with the International Basel Committee’s current thinking on global capital adequacy. The higher risk weight will apply to all residential mortgages other than SME lending secured by residential mortgage and will come into effect on 1 July 2016. The move should not have come as a surprise to Investors with the major banks already having extensively gamed a 25-30% mortgage risk weight scenario.
The other recent development in the banking sector is that the banks raised interest rates for property investors and introduced tougher loan-to-value standards in response to a move by regulators to rein in the riskier corners of the nation’s housing market. With interest rates stuck at record lows due to the slowdown in the wider economy, the central bank and the Australian banking regulator have been grappling with ways to prevent a property price bubble. Last year, the Reserve Bank of Australia called the housing market unbalanced, and the Australian Prudential Regulation Authority urged banks to limit the growth in investor home loans, which make up a record 53 percent of all mortgages, according to latest government figures.
The banks have recently introduced a number of steps to curb borrowing for investment including:
- reducing the maximum loan amount they will lend relative to the value of a home,
- increased the interest rate used to assess borrowers’ ability to repay,
- reduced the sources of income they would accept in investor borrowing applications,
- CBA, ANZ and WBC have increased home-loan rates for landlords by as much as 30 basis points. For the first time since 1997, investors pay more than owner-occupiers on mortgages from those banks,
- ANZ and NAB have capped the loan-to-value ratio at 90 percent, down from 95 percent.
While the banks could have chosen to only impose the rate rises on new customers, they have gone ahead and charged it on both pre-existing and new loans. This has instantly improved their margins across a significant portion of their lending portfolios.
Last week Moody’s gave Australia’s banking system a stable outlook despite “an increasingly challenging operating environment”. Moody’s predicts economic growth will slow as investment in the resources sector falls and the terms of trade worsens, and notes the outlook for broader business capex is subdued. Rising imbalances in the housing market are a key downside risk for banks over the coming year and beyond, it says.
Still, Australian banks “should retain their strong credit profiles against these potential challenges, as they continue to benefit from their entrenched market power and healthy balance sheets,” said Moody’s Vice President and Senior Credit Officer Ilya Serov.
Moody’s “expects the banks’ financial metrics to remain broadly healthy” even as loan impairment charges rise moderately. Any increase in net credit costs will be contained at a level that is well below the long-run average, it says.
Australian banks’ capital levels will strengthen and remain strong relative to their global peers, and their liquidity and funding profiles — which have materially improved since the GFC with a sharp reduction in the reliance on short-term wholesale funding — will remain stable.
So what should Investors do?
There are indisputable threats to earnings with a slowing economy and frothy housing market, but these are also offset by the increased capital buffer and dividend streams that are unanimously expected continue to provide a competitive yield in a low rate environment. Forward dividend yields on the big 4 banks all forecast to remain above 5 per cent, before accounting for franking credits that have become so valuable to retirement income streams in particular.
The protected nature of Australian banking is also supportive, with the big four acting in unison on pricing which stifles any undesirable customer retaliation over increases.
We believe the banks will look to reprice their mortgage books and/or their household deposit books, in order to protect their ROEs. Given credit growth is still positive, funding costs remain low and the banks have been masters at improving their productivity, it is unlikely bank earnings will come under pressure, particularly while auction clearance rates in Sydney and Melbourne remain close to 80% each week.
If the housing market were to commence a solid correction or unemployment begin to rise, that would likely change our view. Housing prices can’t rise forever, and a downturn will arrive eventually- but in the meantime we remain relaxed about the banks medium term prospects.
The answer to what to do about banks in your portfolio is likely to be different for each individual, and answering it specifically for your personal circumstances is beyond the scope of an opinion piece such as this. I would make the following general observations though:
- If your portfolio is underweight banks- now may be a good time to add some exposure. The recent share price weakness of the banks is a logical outcome given institutions have had the opportunity to buy discounted shares in the capital raisings. Given they already hold large positions in the banks, selling existing shares on market to fund the discounted purchases has been a rational move for them and does create a temporary stock overhang.
- If your portfolio has enough banks or is already slightly overweight banks- you may consider using the upcoming Share Purchase plans to reduce your cost base and sell as many shares on market as you subscribe for at a profit above the subscription price.
- If you think you may have too much bank exposure- I would consider being patient. While we are certainly closer to the end of the current housing cycle than the beginning, you are likely to get an opportunity to reduce your exposure to the banks at higher prices once all the activity around the capital raisings settles down in 6 months’ time.
The table below highlights the current share prices of the major banks in comparison to Bell Potters valuation:
* Until CBA announce details of their impending capital raising the stock will be under review
As always, should you wish to discuss the impact of your bank exposure to your portfolio please contact your advisor.