Why the majors are unfazed by the Murray inquiry

One of the more curious responses to the Financial System Inquiry's final report was that the share prices of the major banks rose.

All the majors' share prices were up modestly, despite panel recommendations -- almost certainly to be endorsed by the federal government -- that will lead to the banks holding a lot more capital.

The market consensus is that the combination of the panel's proposals that the banks' capital adequacy levels should be in the top quartile of banks globally and that the floor under the risk-weightings of their mortgage-backed loans should be raised from an average of 18 per cent to between 25 per cent and 30 per cent will lead to the banks needing to hold about $20 billion to $30bn of additional capital.

At face value that's not good news, even though generating that capital over a reasonable period ought to be manageable for the majors without the need for significant new equity raisings. It could, however, impact their dividends or, via underwritings of their dividend reinvestment schemes, their returns on equity.

The obvious conclusion is that the market feared something worse. It's not so obvious what that might have been.

The recommendation that the banks should hold sufficient core capital to rank within the top quartile of banks globally is quite demanding.

The international regulator, the Basel Committee on Banking Supervision, has tiered the world's banks. At the top of the tier, required to hold the most capital, are global systemically important banks (IG-SIBs). Then there are the dosmestic systemically important banks (D-SIBs), and then the rest.

The Australian majors are classified as D-SIBs. They don't have the global reach and scale, or complexity or the risk profiles of the G-SIBs, most of which have large-scale global investment banking capabilities.

The Australian Prudential Regulation Authority had assigned the majors a one percentage point capital surcharge relative to other Australian banks to reflect their domestic systemic importance. It would now appear, based on the panel's view of their current capital rankings, that they will have to add another 60 to 220 basis points of capital beyond the APRA requirement.

The international regulatory environment is a movable feast, so it is conceivable that to remain in the top quartile they may have to raise even more capital.

The change in the risk-weightings not only implies more capital will need to be held against the majors' mortgage books but that the smaller banks and non-banks will be more competitive, impacting the profitability of mortgage lending.

The market's apparent easy digestion of the FSI recommendations might be a case of the reality and certainty of the final proposals proving more palatable than some of the wilder expectations. It might also be that investors believe the majors have the capacity to offset the impact of the recommendations on their returns on equity and dividends.

There is an argument that materially higher levels of capital, by reducing the risk profile of the banks, will both lower the cost of the banks' borrowings and the expectations of its investors -- that the investors will trade a slight reduction in returns for the enhanced security of those returns.

With the banks dominating the local market for mortgage-backed lending -- they represent nearly 80 per cent of the assets of all authorised deposit-taking institutions -- they also have the market power, if they want, to simply pass on the extra costs flowing from the FSI recommendations to their customers. Bank customers tend to be sticky, so the losses of market shares and volumes to smaller institutions would probably be immaterial.

It is also conceivable that the changes to the risk weights and the requirement to hold more capital generally will lead to a change in the incentives the banks face.

It was the introduction of risk weightings (and the low risk-weightings for mortgages relative to other forms of lending) that saw the big shift in bank balance sheets towards mortgage lending in the first instance.

That trend accelerated when the regulators allowed banks with the appropriate systems to use their own internal risk ratings to determine how much capital to hold against mortgages. Risk-weightings among the majors fell from the original Basel I 50 per cent weighting to the current average of 18 per cent under the internal ratings-based system.

If returns on capital from mortgage lending become less attractive, the banks could devote more of their capital to riskier but far-higher margin business lending, where the smaller banks and non-banks don't have the skills or scale to compete effectively.

In other words, the majors have options in responding to the FSI requirements. The market's initial response appears to signal that it expects they will exercise some or all of them to blunt the apparently material impacts those recommendations might otherwise have.