It's official. Australia's largest banks will be forced to carry more capital against mortgages as a safeguard against a potential economic downturn.
On Monday, the Australian Prudential Regulation Authority, or APRA, announced an increase in the amount of capital required to be held against residential mortgages which will see the average risk weighting increase from 16 per cent to "at least 25 per cent".
At this point, only authorised deposit-taking institutions (ADIs) accredited to use the internal ratings-based (IRB) approach to credit risk will be impacted by the changes, given that they hold the material share of exposure to Australia's residential mortgage portfolio.
That includes each of Australia's big four banks, namely Westpac Banking Corp (ASX: WBC), Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ) and National Australia Bank Ltd. (ASX: NAB), together with Macquarie Group Ltd (ASX: MQG), which should help even out the playing field for the nation's smaller, regional banks (more on that in a moment).
Indeed, the market has been expecting such a change after it was highlighted in the financial system inquiry chaired by David Murray in 2014 where a risk weighting of between 25 per cent and 30 per cent was recommended. As highlighted by APRA, the decision to target the lower end of the range reflects the interim nature of the measure with further restrictions possible in the future.
APRA said: "The increase in IRB mortgage risk weights announced today is an interim measure. It is not possible to settle on the final calibration between the IRB and standardised mortgage risk weights until changes arising from the Basel Committee's broader review of this framework are complete. Further changes to IRB mortgage risk weights will be considered over the medium term in the context of these broader international developments."
The initial changes will come into effect on 1 July, 2016, while greater clarity on the outcome of the Basel Committee's review is unlikely to be provided before the end of 2015.
What this means for the banks, and their shareholders…
Banks play a crucial role in any economy and thus, it is vital that they remain "unquestionably strong". Given the recent surge in Australian house prices, particularly in Sydney and Melbourne, mortgage loans have become a significant risk for the banks which is why they are being targeted by APRA.
As it stands, the change announced by APRA today will increase the minimum capital requirements for the major banks by approximately 80 basis points which, as highlighted by the Fairfax press, will equal roughly $11 billion across the big four banks.
Each bank will be forced to raise a different amount and this will be dependent on their size and risk weightings. The banks that are accredited to use their own risk models are the ones that use the "internal ratings-based" approach to credit risk that APRA is specifically targeting. Notably, the smaller banks are not IRB accredited and are thus forced to hold more capital against mortgages, making it difficult to compete with the bigger players in the past.
The banks have been expecting such a change to be announced and have been gradually responding to ensure they are well placed to meet the new requirements. Indeed, National Australia Bank and Westpac have already raised capital earlier in the year which will go towards strengthening their capital reserves. It is unclear how ANZ or Commonwealth Bank intend to raise their capital levels.
For investors, APRA's latest action could certainly reduce the banks' return on equity if the costs are not passed onto borrowers or savers, while it could also restrict their dividend payments to shareholders. With each of the banks trading at high valuations, investors would be wise to give the sector a miss in favour of some of the market's more appealing opportunities.
Forget the banks! Get our top dividend stock for 2015-2016 instead
