What APRA's capital call says about mortgages
13 July 2015
http://www.afr.com/brand/chanticleer/what-apras-capital-call-says-about-mortgages-20150713-gibagy
Hidden within the first authoritative regulatory analysis of Australian bank capital is a flashing red light about the risks inherent in the residential mortgage market. The Australian Prudential Regulation Authority's international capital comparison study concludes that Australia's big four banks need to bolster their overall capital by 200 basis points or $24 billion in order to be "unquestionably strong". About half of that additional capital is needed to cover changes to the risk weights for mortgages thanks to a tougher stance being taken by APRA and by the Bank for International Settlements (BIS) in Switzerland. Banking is a highly leveraged business and there are few things more leveraged than lending money on an Australian residential mortgage. It is generally accepted that the big four banks can turn $1 of capital into $70 of home lending.
That enormous leverage is possible because of the risk weighting that is applied to mortgage assets. The risk weighting of mortgages differs between the big four banks and the regional banks because of the different models for measuring and managing credit risk. The big banks have benefited from a system called the internal ratings based (IRB) approach to calculating regulatory capital. This is commonly known as the advanced approach to risk weighting. They invested millions of dollars in systems that analysed loan default histories. Australian mortgages have low default rates and that naturally led to lower risk weights. But the BIS discovered several years ago that the global risk weighting system was flawed. They were aware of a problem but confirmed it existed when they asked different banks in different jurisdictions to provide the BIS with their assessment of risk weights for the same portfolio of assets.
The responses varied between banks which showed that the IRB approach or advanced accreditation was not delivering uniform outcomes. Most importantly, the BIS work found that the IRB systems did not cope well with the unforseen risks in an asset class with a long history of low defaults. The Basel Committee is now of the view that risk models built on low default histories do not provide sufficient protection for depositors against unexpected events. APRA chairman Wayne Byres was heavily involved in the BIS work on risk weights when he was secretary general of the Basel Committee, which is the regulatory capital-setting arm of the BIS. Since taking over from John Laker as chairman of APRA, Byres has spent much of his time confronting the prudential challenges presented by a booming housing market. He moved quickly to ensure the banks tightened their rules for investment loans. He will move soon to lift risk weightings on mortgages for the big four and that will probably add about 100 basis points to their overall capital.
Many ways to raise capital
The banks will have about a year to add this $12 billion in overall additional capital. There are many ways to raise that capital including dividend reinvestment plans, selling assets and full-blown capital raisings. The big banks will have about 12 months to lift their capital following a change in risk weighting for mortgages from about, on average, 18 per cent to between 25 and 30 per cent. Regional banks, which have risk weighting for mortgages of about 36 per cent, will not be affected. But their competitive position will be enhanced. In some ways Byres had a baptism of fire because soon after taking over he was hit with recommendations for higher capital made by David Murray's financial system inquiry. Murray's finding that Australia's banks needed to be "unquestionably strong" and that they were not carrying enough capital relative to their global peers was a less-than-subtle criticism of APRA's performance. Of course, Murray's conclusions on capital were initially trashed by the banks through the Australian Banking Association. The ABA turned to accounting firm PwC to reaffirm its view that the banks had more than enough capital. They argued that APRA had imposed capital rules that were tougher than regulators in other jurisdictions.
'At or above 75 percentile'
The PwC conclusion that "on average, the Australian banks are at or above the 75 percentile of bank capital relative to the most appropriate comparator banks" was a strong riposte. However, it was out of step with the findings of the leading banking analyst and commentators such as the AFR's Christopher Joye. APRA had a distinct advantage in preparing its international capital comparison because it obtained access to information from the BIS that was not publicly available to PwC. APRA found that the its strong rules relative to capital measures in other countries meant the banks were entitled to add 300 basis points of capital to bring them into line with overseas peers. But that still left them 70 basis points short of core equity capital to qualify for the top quartile ranking. That core equity shortfall is about $8.4 billion, according to APRA. One important aspect to keep in mind is that all the numbers on capital are relative to June 2014. Banks have increased their capital since then. Most notably, National Australia Bank has raised $5.5 billion.
Custody beauty parade
There is a juicy custody contract about to hit the market thanks to the NSW government's amalgamation of the bulk of assets managed by NSW TCorp, NSW State Super, and the Safety, Return to Work and Support Division, formerly known as WorkCover. The amalgamation of $65billion in assets under the TCorp banner has been a methodical process that started in late 2012. Now that all the relevant staff have shifted to the single funds management model within the offices of NSW TCorp in Governor Phillip Tower the government can start to harvest the efficiency benefits of amalgamation. The three existing custody providers, their clients and assets under management are as follows: JPMorgan (State Super) with $35 billion, BNP Paribas (TCorp) with $15 billion and State Street (Safety, Return to Work) with $15 billion. They will be nervous about the upcoming tender because the market is extremely competitive.
All three existing providers are in the top five as measured by total assets under custody for Australian investors, according to the Australian Custodial Services Association. The other two in the top five are the leading player, NAB Asset Servicing, which has $692 billion in assets under custody and Citi, which is ranked fourth with $270 billion of assets under custody. But over the past two years the biggest mover in the industry has been Northern Trust, which won some big tenders including the Future Fund. The custody business is virtually a loss leader given that the margins earned are only 2 or 3 per cent of assets under management. Margins have been squeezed in recent years as the big global banks have used their scale to undercut competitors and use custody as a starting point for offering a range of other services including foreign exchange and equity clearing services. Details of the tender for the TCorp business will be decided over the next six months. The process itself including the tough probity requirements for government contracts will probably take more than six months and involve detailed due diligence. One advantage for the incumbents is that custody relationships are complex and therefore difficult to change. The assets under TCorp's management are one third cash and fixed interest, about half in local and international equities and the balance in alternatives, infrastructure and property.
Tony Boyd Read more: http://www.afr.com/brand/chanticleer/what-apras-capital-call-says-about-mortgages-20150713-gibagy#ixzz44trQKHwZ
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