- A material lift in bank capital is on the cards.
- If implemented it is likely to result in a combination of higher lending rates, lower deposit rates and potentially lower returns on equity.
- The landscape of lending markets is also likely to change, with Australian banks becoming more discerning about the volume of lending to low return sectors and we may see the emergence of non-bank lenders.
The proposal by the Reserve Bank of New Zealand (RBNZ) to lift capital held in New Zealand by banks has significant implications for the economy.
New Zealand’s banking system is effectively managed by the four Australian-listed trading banks. These banks have a dual regulatory reporting requirement. Australia’s banking regulator Australian Prudential Regulation Authority (APRA) and the RBNZ determine between them rules regarding capital held to limit the risks around bank failure. Globally, the rules around the amount of capital required by banks, particularly systemically-important banks, have continued to tighten. In Australia, APRA introduced the concept of unquestionably strong in 2014 and defined this principle in terms of a capital ratio last year. In Australia, the major banks need to attain and maintain a 10.5% CET1[1] level of capital by 2020 while also adjusting their models for calculating risk-weighted assets (RWA)[2].
In New Zealand, the RBNZ announced a capital review in 2016, and recently released a Capital Review Paper outlining a proposal for increased minimum capital requirements to be reached over the next few years. The proposal provided a shock to the banks and capital market participants. Effectively the RBNZ recommends a 40% lift in the capital backing the New Zealand banking system, with CET1 ratios increasing from around 11.5% to 14.5% for the major banks by 2023, with the addition of a further 1.5% additional tier. The media have reported a new 16% capital target. However, banks themselves are likely to hold a buffer over and above that 16% requirement. The capital lift comes in terms of both a higher CET1 ratio and higher risk weightings for specific lending, together with a restriction on how much capital can come in the form of additional tier 1 capital. Banks will need to apply a much higher metric to the risk-weighted assets for mortgages taking, for instance, the scalar factor for their capital floor from 1.06x to 1.20x. In talking to the banks over the last week, we also expect them to hold an additional buffer over and above the RBNZ requirements. In aggregate this is a major proposed change in New Zealand’s banking system.
Overall, analysts have estimated additional common equity capital of between NZ$14bn to NZ$20bn may be required. ANZ alone said their requirements would be between A$6bn and A$8bn which seems at the high end of analyst estimates. The RBNZ has made a case that higher capital ought to lower the required rate of return on capital, reflecting lower risks. With an unlikely assumption of no growth in RWA[3], the following table outlines one scenario for capital requirements, although changes to individual bank risk models places a large range around estimates.
There are large direct and indirect costs from increasing bank capital and these need to be weighed against the potential benefits (averting bank failure, and system failure). A key cost not touched on is the impact of scarce equity being allocated away from other sectors in the economy as instead it is raised and invested as bank equity.
There is no free lunch in setting capital limits within the banking system; and rather than say this is a net good or bad approach, there are numerous judgements to be made. That is why there is likely to be a long tail of discussion following submissions to the RBNZ proposals. Furthermore, the impact of additional changes in response by both APRA and the banks themselves needs to be considered to evaluate the costs and benefits, and the possible investment implications. Unfortunately, from a public policy debate perspective, deep knowledge of the banking system is largely confined to the participants in the banking system and the terminology alone seems enough to put off a deep analysis by the more casual market participant, investor, saver or public policy analyst.
From an investor’s perspective, equity investors have the downside risk to earnings growth (per unit of capital) to weigh against potentially lower risk from bank earnings; while bondholders may assess that the potentially lower risk could provide lower returns to holding bank debt.
Transition costs and uncertainty may also impact returns, while the potential for large capital market transactions seems greater (e.g. financial sector IPOs, divestments and new equity and debt structures).
Economic impacts from higher bank capital
Economists have already started to assess interest rate, credit growth and economic impacts of the transition to a higher bank capital world. There are wide differences, and Harbour has already canvassed some of these issues in an earlier note to clients
(see Harbour Investment Horizon 31 January 2019 - RBNZ banking rules shaping credit markets).
To further explore these issues, we visited all four trading banks in Australia this week together with analysts and investors. Our trip coincided with the release of the RBNZ’s Deputy Governor’s speech –Safer banks for greater well-being, which itself attempted to assess the economic and capital market impacts.
For instance, we expect that the banks may constrain lending to more marginal sectors and risk categories where return on equity is already low. Higher capital will diminish returns to lending where it is difficult to re-price risk. Sectors mentioned by the banks included agriculture, small
business lending and unsecured consumer loans. As a result, we may see other participants move into providing lending to these sectors – combinations of non-bank financials, perhaps smaller banks and even, over time, a deepening of the non-investment grade debt capital market.
Mortgage re-pricing could be expected[4], and if banks hold lower risk-weighted assets bank demand for funding from bank term deposits may decline which in turn could lower interest rates for savers using, say, term deposits. Australian analysts and investors anticipate higher mortgage rate re-pricing over time, whilst noting that the supply of credit is possibly a larger factor. Both responses are hard to consider to model, nevertheless, the feedback we have received suggests upside risks to mortgage interest rates and downside risks to lending and perhaps economic growth as estimated by the RBNZ. This, in turn, may see a policy response by the RBNZ or Government in terms of the Official Cash Rate or taxation and spending. Forecasting second round policy impacts is almost impossible given the moving parts.
Impact on financial service industries
The non-bank sector could see a significant revival and, to the extent that higher bank capital drives saving and borrowing into the non-bank sector, policy-makers may need to consider both systemic and implied risk elsewhere in the financial system. Typically, the non-bank sector has not coped well with defaults, recessions, interest rate volatility and liquidity risk. Capital in the non-bank sector has typically proven to be inadequate at times of economic stress.
In addition, while developing rapidly, New Zealand’s corporate bond market is not as deep as in some offshore markets. Lending facilities (often called warehousing facilities) from the banks to the non-banks may be subject to greater scrutiny, limiting lending indirectly sourced from the banks. We could expect a rise in bond issuance from the non-banks. Already many corporates are sounding out the capacity of the debt capital markets to diversify sources of finance. More corporate bond issuance will require a deeper analytical requirement by investors.
In summary, an implication of potentially higher capital applied to the banking system and perhaps a lower return on equity for the banks could be the transfer of financial system obligations to the debt markets and other non-bank institutions. A large element of look-through to these developments by policy-makers ought to be a consideration for all financial institutions, not just the systemically-important banks. Averting a banking crisis through higher capital for the banks may be of significant benefit for society, but if it only encourages higher risk-taking by less capitalised institutions and in unrated corporate debt markets, the policy change could lift off-balance sheet leverage and result in higher leverage in non-bank financial institutions. A shift to higher bank capital will require vigilance to stem the transference of systemic risks elsewhere.
A consequence of effective restrictions on bank mortgage lending in earlier decades was the rise of mortgage trusts, finance companies and other pooled income vehicles. While these may diversify savings options and offer choice for borrowers, a stable financial system also needs deep pools of liquidity and sources of both equity and debt. The NZX, KiwiSaver Funds and fund managers more generally could have a much larger role to play in the financial system. A key stress point could be that larger financial institutions (such as the four core trading banks) typically have efficient access to foreign capital sources and to more effectively term-out and match interest rate risk. To the extent these sources of finance are less open to smaller institutions, we could see a more general rise in interest rate risk premiums, which may tend to partially offset the objective of lowering risk in the financial system.
Implications for Banks: a large range of outcomes
The earlier table highlighted the latest capital structures for banks in New Zealand. ANZ is the largest bank in NZ with NZ$82bn of RWA, followed by BNZ with $64bn, and both ASB and WBC with around $55bn.
In terms of the relevance to the overall parent, ANZ’s total RWA is 19% of group lending (measured by RWA), it’s about 15% for NAB (BNZ), 13% for WBC and only 11% for CBA (ASB). The latest data on return on equity for the New Zealand banks shows a healthy run rate of about 13-15%. These levels are significantly lower than historical averages, in part reflecting competition, already higher levels of capital and higher costs of regulation and investment in technology.
We should note that the banking industry is in the consultation phase and there is likely to be a wide range of responses and discussion in the coming months. The reaction function of the banks will be interesting to monitor as competitive forces, decisions on capital allocations and the response of the Australian regulator, ARPA all enter the mix.
An implication from the RBNZ paper is that return on equity levels may decline further to circa 12% or even lower; whether shareholders accept a further drop remains to be seen, as currently the appetite for returning capital to shareholders is high with a share buyback in process for ANZ and one anticipated by CBA.
Both NAB and WBC also have high dividend payout ratios, highlighting the strong shareholder push for returning cash. The banking industry currently has moderate growth and hence the need for organic capital has reduced significantly. Leverage, or capital per unit of lending, has risen sharply over the last decade.
Our feedback from the banks, analysts and institutions is that, if the path of yet lower return on equity occurs in New Zealand, banks are likely to:
- Continue to diminish RWA in NZ (with particular sectors highlighted),
- Push for a combination of higher mortgage rates and lower term deposit rates, and
- Potentially look to sell down equity exposures over the long term (albeit the banks were obviously silent on this aspect).
We sense that the desire to allocate fresh capital to New Zealand was not a preferred option, with retained earnings (perhaps repatriated then repackaged as equity at a group level to satisfy APRA) seen as a potential option. Lower dividends, that is a cut in dividends from 70% to 30% as proposed in the RBNZ paper, did not seem to be a likely course of action. However, pending submissions, discussion and the response from APRA, all options are open. One striking issue for the banks is that management teams remain very stretched working on remediation, Royal Commission out-takes, restructuring, selling wealth management businesses, taking costs out of their core operating functions and generally moving back to core banking.
[1] Common Equity Tier 1 (CET1) is a component of Tier 1 capital that consists mostly of common stock.
[2] Risk-weighted assets (RWA) are a measure of the lending made by banks weighted by their perceived riskiness.
[3] Growth in RWA would obviously increase capital requirements and vice versa.
[4] UBS estimate: "mortgagors and SMEs will again bear the brunt of this repricing. Even using the RBNZ's lower implied ROE targets for the banks, NZ mortgage rates will need to rise between 38bp to 75bp. However, our analysis continues to estimate the banks will reprice mortgage books between 86bp (12% through-the-cycle ROE) and 122bp (ROEs at current 13.1%)."
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