Three recent announcements by the Australian Prudential Regulation Authority (APRA) will have material implications for investors and customers of Australian banks and to a lesser extent credit unions and building societies
The three announcements and changes to regulation are summarised as well as their possible impacts on mortgage rates, bank shares, hybrids and bonds.
- The first announcement was back in December 2014 when APRA wrote to Australia’s Authorised Deposit-taking Institutions (ADIs) in a letter entitled “reinforcing sound residential mortgage lending practices” and warned of their concern with the level of residential investment lending growth. In that letter, APRA stated they would like to see each ADI keep investment lending growth under 10% per annum.
It appears that many of the banks gave this directive little attention in early 2015 as investment lending growth continued to exceed 10% in many cases. APRA has seemingly stepped up the force of this message and we have witnessed a quite remarkable change in the lending rules and margins for residential investment loans in the past month. Both variable and fixed rates on investment lending have been hiked between 20bps and 30bps by most of the major and regional banks as well as maximum loan-to-value rations (LVRs) lowed to around 80% from in many cases the high 90%s.
Interestingly, while APRA are focusing on new loan growth, the banks have taken the opportunity to up interest rates on both new and existing investment loans, a measure that is sure address some of the pressures of addition capital that is required (as detailed below).
The significant increase in cost of investment loans and lower LVRs should impact housing investment.
Recent press has also speculated that some banks are considering increasing owner occupied interest rates but as yet this has not been seen. In fact, some banks have reduced fixed rates for owner occupiers at the same time as raising the fixed rates for investment loans.
- The second major announcement was on 13 July 2015 when APRA released its “International Capital Comparison Study”. APRA has made it clear it wants our major banks to be in the top quartile of global banks in terms of capitalisation, and thus considered as “low risk”. As such the regulator put the banks on notice that in order to be regarded that way they would need to hold an extra 2% of capital.
- The third announcement came just a week later when APRA stated the risk weighting for residential mortgages under the internal ratings-based approach to credit risk (i.e. the system used by the four major banks plus Macquarie) would be amended from July 2016. APRA estimates the changes to result in the average risk weighting for residential mortgages increasing from approximately 16% to at least 25%. This is a significant change and will require a significant increase in capital. In fact, APRA has estimated that this one change will account for around 80bps of the required 200bps (or 2%) increase in capital highlighted just a week earlier.
Together, the latter two measures will require banks hold a material amount of additional capital which will affect bank profitability unless they pass on some of the costs. To this end the recent increase in investment lending interest rates, for both new and old loans, seems to be “killing two birds with one stone”. Firstly, it is finally addressing the December 2014 directive from APRA to reduce investment loan growth but secondly, it appears the banks are getting in early to protect profitability as they commence holding more (expensive) capital.
Conclusion
and key implications
The more capital a bank/ADI has to hold against a particular asset, be it a residential mortgage or any other asset, the higher the return (or margin) they must change to keep the same return on equity for shareholders.
However, for depositors and debt holders, the higher the capital buffer, the stronger their position. In fact, should the banks increase their capital ratios by 200bps, we would expect the rating agencies to upgrade the deposit, senior debt, subordinated debt and possibly hybrid ratings while equity retains its first loss position.
Some of the key implications from these three APRA announcements include the following:
- Higher capital levels will be required which improves depositor and debt holder protections
- Likely rating increases as capital ratios improve
- Significant risk of dilutive equity raisings over the coming years
- Likely continued issuance of bank hybrids (additional tier 1 capital) which could see hybrid credit margins continue to widen as supply increases
- Possible reduction in dividends or at least limitation in dividend growth as a way to partially meet new capital requirements. Also the possibility of incentives to participate in dividend re-investment plans, for example via larger discounts
- Risk of increased margins on all lending products. This has clearly been the case for residential investment loans but could be extended to owner occupiers or other lending, especially on the back on the increased risk weightings being applied from 1 July 2016 for all mortgage loans for the big four and Macquarie
- Somewhat levelling of the playing field between the majors (and Macquarie) and the smaller ADIs in terms of mortgage risk weightings which could see increased competition from smaller ADIs, especially for investment loans