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Why Australia & New Zealand Banking Group’s capital adequacy is weakening

The Australia & New Zealand Banking Group (ASX: ANZ) this morning acknowledged that its capital adequacy position had weakened by a quarter of a percent as a result of the prudential regulator forcing it to change how it risk weights residential mortgages.

Ever since the GFC and its liquidity crisis banks have faced tougher requirements to keep sufficient amounts of liquid capital in reserve as a proportion of their total loan books on a risk weighted basis.

Home loans being fully collateralised were generally considered low risk under the regulations and this was good news for the banks like ANZ and Westpac Banking Corp (ASX: WBC) where property lending makes up a large part of their asset base.

The banks naturally wanted the home loans categorised as low risk because they would have to carry less capital in reserve against them. The more capital banks are forced to carry in reserve the lower their returns on equity as the largely-idle capital is unable to generate more profitable returns by being lent out and reduces the banks’ leverage ratios.

Other assets the banks create or lend to clients are far more complex and not fully collateralised such as derivatives including credit default swaps (often on sub-prime debt), institutional lending activities, and other riskier capital-markets facing activities.

As a consequence the banks are forced to assign these potentially more profitable, but higher risk assets greater risk weightings and carry more capital in reserve against them.

However, given home loan lending is still the core business of the big banks even a minor adjustment to what risk weighting different home loans should be allocated can have the effect of knocking a quarter percentage point of their capital reserve ratios as demonstrated by today’s news.

Calculating appropriate risk weightings for different banks is a difficult (if not impossible) task due to the complexity of banks’ asset bases, with the ever-changing regulatory environment a symptom of this alongside the global regulators’ determination to avoid the humiliation of a GFC-like event again.

Australian bank investors then can expect investment returns to continue to be hampered by the regulatory environment, including the new levy on the big banks’ liabilities as a quid pro quo for the RBA acting as a lender of last resort. The provision of liquidity insurance by the RBA involves fiscal risks and in effect the central bank can only fulfill this role if markets believe in total faith that the government is solvent.

Over May, the big banks have been heavily sold off in response to the regulatory cycle and probably trade around fair value for now given their market dominance, profitability and appealing dividends.

As a long-term investor I would probably look to the Commonwealth Bank of Australia (ASX: CBA) as the best-quality pick of the bunch.

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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