The year will see the potential implementation of the Murray report as the main focus for the banking sector. The two major areas to impact the banks are the recommendations to hold top quartile levels of capital internationally and higher risk weightings on residential mortgages
Key points:
- The year will see the potential implementation of the Murray report as the main focus for the banking sector. The two major areas to impact the banks are the recommendations to hold top quartile levels of capital internationally and higher risk weightings on residential mortgages.
If implemented as Murray intends, this will see
- increased ordinary equity as Core Equity Tier 1 (CET1) capital, and
- residential mortgages become more capital intensive for the major banks, levelling the playing field for regional banks and over the longer term a likely rebalancing towards commercial mortgages.
- For income investors, the impact will vary across the capital structure with senior bonds, subordinated debt (Tier 2) and hybrids (Alternate Tier 1) the likely winners while equity returns will diminish.
- With the Australian economy facing headwinds, the other risk factor for the banks is the high levels of exposure to the residential mortgage market so you can expect the market to keep a close eye out for any weakness. However, with rates predicted to remain low for longer and two rate cuts forecast, the housing market is likely to be supported through 2015.
- FIIG continues to prefer the old style subordinated debt and hybrids as they offer a good source of income with lower expected volatility.
Bank outlook
The banking sector’s focus in 2015 will be on the Murray reforms and the political willingness to implement them. For the four major banks, the reform has the potential to increase capital requirements and change risk weightings which could change the longer term focus of the banks’ business. The reform is now in the hands of the Treasurer who has in turn stated that it is APRA’s call as the regulator of banks.
Further submissions will be gathered by Treasury through to March 2015 which will then be provided to APRA. APRA will also take into account changes in global banking regulation on risk weightings and bank capital levels before implementing any changes. All of this indicates that there are unlikely to be any changes until late 2015/2016 and given the importance of these reforms to the banks’ businesses you can be sure the banks are lobbying APRA and the government to tone down the recommendations.
To the reform, the FSI has made the following three key recommendations relating to the banks to reduce the probability and cost of failure:
- Increase capital levels so capital ratios are unquestionably strong; this requires the major banks to raise capital so they are in the top quartile globally. This has been estimated to require around 2.2% or $20bn1 primarily common equity capital T1 (CET1)2.
- Increase the risk weightings of housing mortgages for the major banks from 18% to 25-30%. This will remove the advantage enjoyed by the major banks and will increase capital requirements for residential mortgages.
- Implement a loss absorbing and recapitalisation capacity framework in line with the emerging global framework. This is a minimum capital base that can absorb losses in times of financial distress. Currently this includes equity (CET1) and subordinated debt (T2) and hybrids (AT1) that contain capital triggers or bail in clauses3. The inquiry raised the potential for another layer of debt above T2 and below senior debt that could also have bail in clauses.
Income investors are attracted to the banking sector as it provides high levels of income particularly in the equities and hybrids.
For income focussed investors it is very important to understand the potential price volatility of the investments across the capital structure. Assessing an investment based on income alone could lead to capital losses if investors are required to realise their investments. The chart below depicts the price performance of the major banks’ capital structure over the 2014 year.
Source: Bloomberg, FIIG Securities
Clearly the equity is the most volatile followed by the hybrids (bail in), sub debt (bail in) and then the senior debt4. FIIG has a preference for the old style subordinated debt and hybrids that do not contain the “bail-in” clauses as they:
- offer investors income of up 5.7% for 2-3 years,
- should experience lower volatility as they do not have “bail-in” clauses and are expected to be redeemed at the first call date5
There is a catch as the number available investments is shrinking as banks’ call at the first opportunity.
1FSI states the plausible range for CET1 is 10-11.6% versus the 75th percentile cut off of 12.2% and analysts estimate this at $20bn of additional capital (AFR 8 December) 2 FSI has recommended APRA determine the mix between CET1 which is ordinary equity and total capital which also includes T2 and AT1
3Securities convert into equity or get written off where APRA determines the bank is non-viable
4If we included the TD it would be a straight line at $100 although note that there is virtually no liquidity in a term deposit.
5as they will no longer qualify as capital for regulatory purposes