Australian banks rally on Murray Report

The ASX 200 Financial sector (ex-REITs) responded well to release of David Murray’s report into the financial services industry. As the largest constituent of the ASX 200 index, comprising more than one-third of market capitalization, sector performance is critical in determining future direction of the broader index. Breach of resistance at 7220 suggests that the correction is over. Follow-through above 7400 would confirm a fresh primary advance.

ASX 200 Financial ex Property

David Murray’s Financial System Inquiry

The Final Report of the Financial System Inquiry, led by ex-Commonwealth Bank CEO David Murray, calls on Australian banks to become “unquestionably strong” to prevent another financial crisis. The FSI calls for increased bank capital in the form of common equity, with capital ratios increasing from an average of 9.1% to the 12.2% threshold for the top quartile of international banks. The FSI also proposes that banks increase their average risk-weighting for home mortgages to 25-30% compared to current weightings as low as 15%.

Chris Joye from the AFR estimates that the first proposal would require about $21 billion in new capital, while increased risk-weighting would require an additional $15 billion. There may be some overlap between the two, but the combined requirement is likely to be more that $30 billion.

Impact on consumers is likely to be negligible. The FSI projects that a 1% increase in bank capital ratios would increase the weighted cost of capital by 6 basis points (0.06%) because of the higher cost of equity capital.

Bank Funding Costs with Increased Capital

But this does not take account of lower risk premiums required, for debt and equity, when capital is increased. A reduction of debt funding costs to 3.65% and equity to 14.75% would offset the increase in equity capital; so the actual cost increase may be considerably smaller.

A resilient banking system would not only avoid significant losses of GDP (as high as 158 percent) in the event of a financial crisis, but would save up to 900,000 jobs according to the FSI. In addition, reduced risk of a government bailout would minimize the threat to government debt levels and Australia’s AAA credit rating. Banks would also benefit through improved profitability and stronger growth prospects.

My concerns with FSI are mainly long-term. Raising capital ratios to the top quartile of international banks would certainly improve the resilience of Australian banks, but this is a moving target. We can expect average capital held by international banks to increase as other countries conduct their own reviews into the adequacy of bank funding. Also, leverage ratios (ignoring risk-weighting) remain low and should be progressively lifted towards a long-term goal of 6 to 8 percent. Reliance solely on risk-weighted capital ratios can encourage industry-wide concentration in low-risk-weighted assets which in turn will elevate risk. Lastly, bail-in bonds are dangerous — any attempt at conversion would destroy creditor confidence in the banking system with far-reaching repercussions — and should be discouraged.

I believe that stronger capital ratios are a win for both Australian taxpayers and bank shareholders. Implementation of the FSI recommendations would be a major advance towards building a resilient and sustainable banking sector.

Bank chiefs in last-ditch plea to David Murray on tougher rules | The Australian

From Richard Gluyas at The Australian:

THE four major-bank chief executives have each made an eleventh-hour appeal to members of the Murray financial system inquiry ahead of Tuesday’s closing date for final submissions, as concerns mount that the sector could be forced to hold even higher ­levels of bank capital due to the ­inquiry’s emphasis on resilience. The closed-door meetings with the inquiry panel members come as Steven Munchenberg, chief executive of peak lobby group the Australian Bankers’ Association, said the industry was “jittery” about the inquiry’s focus on ­balance-sheet resilience because more onerous capital requirements would affect the banks’ ability to lend and serve the ­economy.

I disagree. Banks with strong balance sheets are better able to serve the needs of the economy. Highly leveraged banks leave the economy vulnerable to a financial crisis and are more likely to contract lending during periods of economic stress.

The shrill outcry may have something to do with the impact on bankers bonuses. Incentives based on capital employed would shrink if shareholder’s capital is increased.

Bank shareholders on the other hand are likely to benefit from stronger balance sheets. Reduced default risk is likely to enhance market valuation metrics like price-earnings multiples. Reduced risk premiums will also lower cost of funding and enhance lending margins. And shareholders are also likely to benefit from enhanced growth prospects. Analysis by the Bank for International Settlements in the post crisis period shows banks with higher capital ratios experience higher asset and loan growth.

Australia: UBS eyes $23b capital hit to big banks

Chris Joye at AFR reports on a recent study by UBS banking analysts Jonathon Mott and Adam Lee. The two believe that David Murray’s financial system inquiry is likely to recommend an increase of 2 to 3% in major banks tier 1 capital ratios.

Based on an extra 3 per cent capital buffer for too-big-to-fail banks, UBS finds that the major banks would have to “increase common equity tier one capital by circa $23 billion above current forecasts by the 2016 financial year end”.

…This automatically lowers the major banks’ average return on equity at the end of the 2016 financial year from 15.4 per cent to 14.3 per cent, or by about 116 basis points across the sector. Commonwealth Bank and Westpac come off best according to the analysis, with ANZ and National Australia Bank hit much harder.

Readers should bear in mind that capital ratios are calculated on risk-weighted assets and not all banks employ the same risk-weightings, with CBA more highly leveraged than ANZ. As I pointed out earlier this week, regulators need to monitor both risk-weighted capital ratios and un-weighted leverage ratios to prevent abuse of the system.

Bear in mind, also, that a fall in return on equity does not necessarily mean shareholders will be worse off. Strengthening bank balance sheets will lower their relative risk, improve their cost of funding, and enhance valuations.

Read more at UBS eyes $23b capital hit to big banks.