Taking a regional (bank) tour - part 1

When you next take out a mortgage, will you be swayed by the bank's brand or the 'personal service' you receive – or will you just go for the product that saves you 0.1% per year? For most people it's likely to be the latter and the same applies if you're instead looking for a term deposit, business loan or credit card. The similarity between different banks' products means they compete primarily on price, such as offering higher rates on deposits or lower rates on loans, and this makes banking your typical commodity business.

This price competition is exacerbated by the tendency of customers to remain with their bank. This is why Commonwealth Bank has long targeted customers whilst they're still in school, encouraging youngsters to open Dollarmite accounts. Once CBA (or any bank) snags a customer, the goal is to sell them as many products as possible to increase their profitability to the bank whilst also increasing the cost and inconvenience to the customer of switching to a competitor.

The fixed costs of regulation, operating branches and ATMs, and the increasingly costly software and systems required mean economies of scale are important too: a wide variety of products sold at low cost is essential. The difference between CBA's and ANZ's cost-to-income ratios of 42% and 46% respectively may not seem like much, but it's one reason why CBA's return on equity is 3-4% higher than ANZ's.

The smaller banks such as Bendigo & Adelaide Bank, Bank of Queensland and Suncorp Bank – owned by Suncorp Group – tend to fare even worse. The economies of scale available to the larger banks will only increase as banking becomes digitised and increasingly a software business. New technology doesn't come cheap and it makes the world of difference to have more customers to spread it across.

Regulatory capital

One area where the tide might be turning in favour of the smaller banks, though, is regulation. Banking regulation is complex and most of it is pretty mundane, but the key component is the minimum capital demanded by regulators which, amongst other things, depends on a bank's operating risk, market risk and the type and amount of assets it holds.

Broadly speaking, each asset – such as a treasury bond, home loan or credit card debt – is given a specific 'risk weight' based on its potential for default. The risk weights applicable to each asset also depend on whether a bank is classified as 'standardised' or 'advanced'.

Smaller banks such as those noted above are classified as 'standardised' because they haven't satisfied the accreditation requirements to become 'advanced'. These include having the necessary technology and risk-management systems to appropriately model and manage their risk to the sophisticated level required by regulators. As such, their residential loans are given a risk weight of 40%.

However, the major banks – CBA, Westpac, NAB, ANZ and Macquarie – have satisfied the requirements and so they're allowed to use internal models to determine the appropriate risk weights for their assets. Their internal modelling has resulted in average risk weights of around 16% being applied to their mortgage assets.

At least, that was until APRA mandated average minimum risk weights of 25% from 1 July 2016. This is consistent with the recommendation from the recent Financial System Inquiry to reduce the competitive disparity between the majors and regional banks and also with APRA's goal of making the big five banks 'unquestionably strong'. 

Why is this important?

This means that two banks with the same total assets could potentially have different risk-weighted assets (RWA) depending on the type of assets they hold and these assets' applicable risk weights.

Moreover, even if they hold the same amount and type of assets, their risk-weighted assets will vary if different risk weights are applied to what are otherwise identical assets, such as residential loans. All things equal, lower risk weights result in lower capital requirements, more leverage, and hence higher returns on equity (see Table 1). This is a major reason why the big banks currently earn returns on equity in the mid-teens, while the smaller, regional banks struggle to reach double figures. 

After raising billions in extra capital as a result of APRA's increase in mortgage risk weights, the big banks' future returns on equity are likely to decline. As you can see from Table 1, though, even after the changes standardised banks are still required to hold far more capital against their mortgage assets than the major banks.

To further reduce this competitive imbalance, however, APRA has recently decided that standardised banks can obtain advanced status in stages.

Previously, standardised banks had to satisfy all of the requirements before being granted 'advanced' status. Under the new regulations, however, a standardised bank can satisfy the requirements for, say, its residential mortgage business and thereby reduce the risk weights applied to these assets to the 25% allowed for the major banks.

It could subsequently satisfy the requirements for other parts of its business, further levelling the playing field between the smaller banks and the five major banks. 

Systemically important

Due to their size, complexity and interconnectedness, amongst other things, APRA has designated the big four banks (ie excluding Macquarie) as 'domestically systemically important banks' or D-SIBs. This mouthful means they have to hold an additional 1% capital to reduce the risk that they become 'too big to fail' and hence will require direct taxpayer support in future.

There is, as they say, though, a price for everything, and in part 2 later this week we'll look at whether there is any value in Bendigo & Adelaide Bank and Bank of Queensland.