Could bank profitability on mortgages halve by 2017?

Proposed capital changes could have major follow-on effects for Commonwealth Bank of Australia (ASX:CBA), Westpac Banking Corp (ASX:WBC), Suncorp Group Ltd (ASX:SUN) and Mortgage Choice Limited (ASX:MOC).

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According to opinions discussed in Fairfax media yesterday morning, local and international changes to capital holding requirements could see the profit levels of big banks halve over the next few years.

Even more interesting is the fact that non-bank lenders are unaffected by the hikes and will have ample opportunity to steal market share from the majors, who will have to lift interest rates and find other sources of growth, or watch their profits dwindle.

Under the proposed changes, bank lenders like Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ), and Macquarie Group Ltd (ASX: MQG) will have to raise their risk weighted capital against a mortgage from around 2% currently to as much as 20%.

This will put pressure on the average return on equity gained from each bank mortgage, effectively dropping it from 40% to 20%, according to the analysts quoted by Fairfax.

(Readers will note that total bank Return on Equity is below 20%; ROE per mortgage is very difficult to calculate from bank annual reports as it depends on many factors).

According to Fairfax's article, the big banks will be required to raise an additional $14.5 billion capital under the changes. Westpac Banking Corp (ASX: WBC) and National Australia Bank Ltd. (ASX: NAB) are unlikely to be spared, despite the two having recently conducted their own capital raising.

Junior banks, Bank of Queensland Limited (ASX:BOQ), Suncorp Group Ltd (ASX: SUN), and Bendigo and Adelaide Bank Ltd (ASX: BEN) will have to raise an estimated $350 million combined.

In order to maintain their high returns on equity, the big four banks will have to raise interest rates on their products by an estimated 0.3%. Alternatively the banks could raise deposit rates, use strategic discounts as loan books mature, and attempt to conduct more business lending.

This is unlikely to have a major impact on bank profits as the current market shows banks can get away with charging investors a premium (more than 1%p.a. more) compared to non-bank lenders.

However price is a tricky thing and it may not take much to get customers looking elsewhere, which sets the stage for non-bank lenders like Yellow Brick Road Holdings Ltd (ASX: YBR) and Mortgage Choice Limited (ASX: MOC) to steal more market share from the big banks.

Regardless of where you stand on the issue it looks pretty much guaranteed that banks are going to have to face higher capital requirements, which isn't going to be good for profits or share prices in the short term.

Motley Fool contributor Sean O'Neill owns shares in Yellow Brick Road Holdings Ltd. 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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