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Morningstar | APRA’s Proposed Changes to Capital Framework a Positive Development for Banks

The Australian Prudential Regulation Authority’s, or APRA’s, new capital guidelines released on June 12, 2019 contained no major surprises. A key highlight was the proposal to hold slightly more capital for high-risk loans (interest-only and investment property loans) relative to low-risk loans (owner occupied, principal and interest loans). Currently, all mortgages have the same capital requirements irrespective of their levels of risk. While due to come into effect until Jan. 1, 2022, we think the proposals: (1) help strengthen capital levels, which provide a greater buffer to manage a potential increase in loan losses; and (2) help encourage responsible lending, which improves the quality of the banks’ residential property exposures. For shareholders, the changes were only incremental and importantly there were no nasty surprises. Further, we do not see the need for dilutive capital raising because the banks can generate sufficient organic capital from future profits, dividend reinvestment plans and asset sales.

The proposed changes do not materially change the banks’ capital requirements nor do they significantly alter the competitive landscape. To this end, our fair value estimates and moat ratings for Westpac Banking Corporation, National Australia Bank, Australia and New Zealand Banking Group, Commonwealth Bank of Australia, Bendigo and Adelaide Bank and Bank of Queensland are intact.

APRA’s proposals include increases to the mortgage risk weights (especially for high-risk loans) that the big four banks apply when calculating credit risk for capital adequacy purposes. We expect the big four banks to comfortably meet these guidelines by 2022, owing to organic capital generation and sound asset quality with lower risk loans to make a larger proportion of assets. Macroprudential initiatives, such as the now defunct 10% benchmark for investor loan growth and 30% threshold in interest-only lending, tight underwriting standards, lenders' mortgage insurance and full-recourse lending, stemmed the flow of higher-risk loans, and preceded a series of interest-only conversions to principal and interest. Based on the banks’ latest earnings releases, we estimate interest-only loans average about one quarter of the big four’s mortgage portfolios, while investor loans make up about one third of the book. There’s some overlap between the two groups. Both are down, notably from 12 months ago, at about 30% and 35% respectively. Encouragingly, new-flow statistics continue to point toward a growing portion of owner-occupied, principal and interest, and lower loan-to-valuation, or LVR, ratio loans.

Westpac appears an outlier of the majors at first glance, with a comparably larger portion of interest-only and investment property loans. Nonetheless, the bank’s high-risk loans have been declining, with about 31% of interest-only loans in the Australian mortgage portfolio by March 2019 (versus 35% six months ago and 40% a year ago). Investment property loans are down by about 1% to 39% from a year ago. Westpac’s composition of high-risk loans will progressively shrink, with close to 60% of all interest-only loans due to expire within three years, and likely to roll over to principal and interest. Westpac’s Australian mortgage portfolio’s weighted average dynamic LVR is below 60%, while mortgage loan losses remain at low levels of about 0.2% of the mortgage portfolio.

The common equity Tier 1, or CET1, ratios of the four majors continue to trend upwards and are well on their way to satisfy APRA’s "unquestionably strong" benchmark of 10.5% by Jan. 1, 2020. Westpac and ANZ Bank’s CET1 ratios (currently at 10.6% and 11.5% respectively) comfortably meet the regulator’s benchmark ahead of time. The absence of additional customer remediation costs and announced asset sales should lift the CBA’s CET1 ratio (currently 10.3%) well above the benchmark by 2020, while the cut in dividend and partial underwriting of the dividend reinvestment plan will also ensure an orderly transition for NAB (currently 10.4%) to satisfy this capital requirement in time.

The regulator’s new proposals to hold more capital against high-risk loans also extend to the smaller banks we cover, Bendigo Bank and Bank of Queensland. We think the two regional players are well positioned to meet these requirements organically, thanks to comfortable regulatory capital levels and nonperforming loans, which are tracking well. Both banks have a low portion (below 30%) of interest-only loans, although the Bank of Queensland appears to be more at risk, with about 41% of investor loans and a weighted average LVR of 66%. Nevertheless, the Bank of Queensland’s underlying capital generation is strong. The bank flagged increased near-term capital expenditure, which could trim 7 basis points in the CET1 ratio. However, this is immaterial given its CET1 ratio of 9.26% by February 2019, well ahead of APRA’s January 2020 benchmark of 8.5%. Bendigo Bank’s CET1 ratio is 8.76%, also above APRA’s benchmark.

What do the new capital guidelines mean for the banks’ profitability? While the proposals might further disincentivise the writing of riskier, high-margin loans; slower growth in volumes and a greater focus on high-quality loans should result in less risk and lower credit losses in future. Our major bank valuations currently assume relatively staid credit growth of about 3.5% per year to end 2023, flat net interest margins, or NIMs, at about 2.00%, and modestly increasing loan losses, averaging 0.17%. Our base case fair value estimates already incorporate a considerable slowdown in loan growth compared with recently.

There is potential upside to our earnings forecasts. The coalition’s electoral victory, the new first homebuyer deposit scheme, APRA’s proposed changes to the mortgage serviceability benchmark and potential further RBA rate cuts, suggest property prices should at least stabilise. The rate of decline in Sydney and Melbourne house prices reached its lowest point in 12 months and auction clearance rates have rebounded, with Sydney experiencing a 66% clearance rate for the first weekend in June. CoreLogic estimates national dwelling values fell just 0.4% in May. It is still too early to adjust our home loan credit growth forecasts upwards, but early signs of a housing market recovery could prompt higher credit growth projections and potentially modest fair value estimate increases.