The big banks prepare for diminishing returns

As the deadline for the Financial System Inquiry looms, the banks are bracing for changes to their prudential framework that will decrease their profits and increase the costs passed on to consumers.

With David Murray’s Financial System Inquiry’s November deadline now looming, it is obvious that the major banks are anticipating (albeit not yet accepting) that the panel is going to recommend a range of profit and returns-diminishing changes to their prudential framework.

It would appear apparent from the inquiry’s interim report and Murray’s subsequent public musings that the panel hasn’t been convinced that the majors hold sufficient capital, even with the additional one per cent capital surcharge they will face in 2016 because of their domestic systemically important (too big to fail) status.

It also appears that the panel is interested in the concept of  'bail-in' capital. The general concern about the majors’ exposures to residential mortgages against the backdrop of a 'hot' property market could see an elevated floor introduced for their mortgage risk-weightings.

Any and all of those potential changes to the frameworks within which the banks operate would obviously have implications for their earnings and their returns on capital.

As they stand today, the major banks have a combined equity base of about $190 billion, combined cash earnings of just over $30bn and an average annual return on equity of about 16 per cent.

By itself (and assuming they did nothing to offset it), the 1 per cent capital surcharge would probably shave only high single-digit points off their returns. If the Murray committee were to recommend increasing the surcharge – say, to 2 per cent -- the impact would obviously be more material.

It isn’t a question of their ability to raise more capital. The amounts involved are almost inconsequential in the context of their earnings and their ability to generate and retain capital. Rather, it's about the impact of increased capital requirements on their returns and ultimately their share prices and cost of equity.

While in theory the sharemarket impact of lower returns on equity ought to be offset by the lower risk profile created by holding the extra capital, in practice that hasn’t necessarily been the case.

If the committee plays around with the floor under the majors’ mortgage risk-weightings, both to reduce the risk in their balance sheets and to level the playing field with their smaller competitors (who currently have significantly higher risk-weightings on mortgages), that would also effectively require more capital.

There have been a wide range of estimates about the amounts of new capital the majors might have to raise if they were hit with the double-whammy of higher capital surcharges and higher risk-weightings.

The latest from Goldman Sachs says that the combination of an extra 1 per cent capital surcharge and a 20 per cent mortgage risk-weighting floor would require and extra $16bn of capital. A 1 per cent surcharge and a 25 per cent risk-weighting floor would see them holding an extra $25bn of capital.

That would imply a reduction in their returns on capital of just over one percentage point to nearly two percentage points.

Then, of course, there’s the issue of 'bail-in' or first-loss capital that both the global and domestic prudential regulators are considering.

There are some questions about how effective that kind of capital might be in a crisis, and the potential for unintended consequences if there were a crisis within a major bank. If it were introduced, a requirement to hold bail-in capital would obviously come at an additional cost to reflect the risk to the lenders.

Thus the banks would be holding more capital, potential quite a lot more, but paying more for their funding. All other things being equal, their earnings and returns on capital would fall relative to a no-change scenario.

The banks would, of course, try to offset the impacts by passing through as much of the increased costs of equity and debt to their customers. Given their dominance of the system post-crisis and the ability to finesse lending rates and deposit rates and their near-complete dominance of lending to small and medium-sized enterprises, one would assume they would be reasonably successful.

Tougher prudential requirements for the majors would, of course, improve the competitiveness of smaller banks and non-banks. But one wonders whether they have a significant enough presence to discipline the majors.

In any event, more intense competition wouldn’t produce a lowering of today’s costs of intermediation but would instead result, at best, in a reduction in the size of the pass-through of increase in those costs to the majors. Intermediation costs would still rise.

There’s a delicate balance between dialing down the risk in the system by a few degrees by imposing extra capital requirements on the majors, which would still be highly-leveraged institutions, and the extra costs of intermediation that would inevitably flow through in part to the wider economy. The inquiry appears inclined to err on the side of caution.

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