Will regulation hit the banks?

Australian banks are under a lot of pressure at the moment. The Murray financial system enquiry is widely expected to recommend lifting their capital requirements, with the interim report suggesting that our banks were ‘middle of the road’ in regards to capital adequacy. Although PwC has disputed that claim and suggested the capital adequacy of the Australian banks is in the top 25% of comparable global banks. The inquiry is due to report in November.

At the same time, in its submission to the Senate Economics References Committee, the Reserve Bank of Australia (RBA) seemed to suggest that further demands may be made on bank capital in order to stymie house price growth. It should be noted that they didn’t outline specifically what measures they or the Australian Prudential Regulation Authority (APRA) would use, but I believe they strongly hinted at it.

Firstly, the RBA seemed to rule out using loan to valuation ratios (LVRs) and instead seemed to look favourably at lifting the risk weighting attached to investor loans. The contrast is important to highlight: While one macro prudential tool appears to have been dismissed outright, another is being considered with positive commentary.

Whether or not they then attach a geographic target to the lift in the risk weighting, I’m not sure. My read of the Senate inquiry is that this is what they do actually want to do. Investor lending is really only imbalanced in Sydney and Melbourne according to the RBA. Although I can’t see how such a measure would actually work in practice. It would be very onerous for the banks to say the least and I would suggest easily avoidable.

So while we don’t at this point have a clear view of what APRA and the RBA actually plan, it does seem that adjusting risk weights or lifting capital requirements is the preferred option as doing so would make those types of loans more expensive and would of course reduce their growth.

Notionally, this is a fairly serious threat to bank earnings, given that 40% of lending is driven by investors. If regulators slow that down, then a logical argument can be mounted that bank earnings will slow in tandem. It’s perhaps a part of the reason that the big banks are down between 7% and 10% compared to the fall on the broader market of just under 7%.

Yet I’m not convinced that will actually be the case.

Lifting the risk weighting may force banks to hold more capital against investor loans, this is true - yet this doesn’t necessarily mean that the rate of loan growth in that segment will slow much.

Consider that national capital house price growth is at 9% (according to RPdata), with total returns closer to 14%. Now investors can currently fund at 4.54-4.9% variable, 4.69% fixed for three years or 4.99% fixed for five years. The after tax cost of funding is most likely lower. Against that backdrop, the banks could choose to pass on the higher costs of holding more capital to investor-borrowers and it would still be highly profitable for that segment to borrow at prevailing rates.

Recall at this point the favourable balance sheet position of your average investor. They are in a very strong position to absorb these higher costs.

1. Household savings are high; investors have higher net wealth and income than the general population (60% in the top bracket) and so have a greater claim to those savings.
2. Interest repayments as a percentage of income are low. Apart from during the GFC, they are the lowest in over a decade.
3. LVRs for investors are typically lower than for owner occupiers. For investors they are arguably higher than necessary anyway in order to maximise tax breaks and the returns to ultra-low rates.

It would be a similar issue if APRA decided to force banks to lift interest rate test on investor-borrowers – to see if they could meet a 3% rise in the lending rates. Most investors should easily be able to demonstrate this given the metrics above and the availability of very low fixed lending rates (five years at 4.99%).

To my mind, all of the above makes it very unlikely that bank earnings are under much threat. And in any case, business credit – a market that is around 1.5 times the size of the investor lending market – is on the up.

Consequently, I remain of the view that bank earnings will expand at a robust pace over the next two years and that at a fundamental level, our banks are cheap. With a grossed up dividend yield approaching 8% or so, the yield alone makes them a worthwhile investment.