Australian banks’ capital conundrum

Market insights

James Freeman – Analyst, Macquarie Fundamental Equities
Tuesday 22 September 2015

The Australian banks have been solid performers over the last couple of years, but recently they have lagged the market amid concerns around earnings growth and capital requirements.

This article looks at the impact of recent changes by the Australian Prudential Regulation Authority (APRA) on the large Australian banks and looks at how regulation can have unintended consequences.

In the past month APRA has released its long awaited rules on capital.  APRA’s platform for capital going forward will now include;

  • Increase in the risk weighting of mortgages for Advanced accredited banks from an average of approximately 16% to an average of 25%;
  • Global benchmarking in order to determine if Australian banks are “unquestionably strong” when it comes to capital. 

The change around mortgage risk weighting is relatively straightforward and somewhat expected given global changes. The use of a global benchmark, however does increase complexity into the Australian capital ratios. Many countries use national discretion when it comes to which Basel III rules they implement and with most banks internal models having different risk weighting for the same type of loan, setting a global benchmark is near impossible to achieve.

APRA’s busy agenda has not stopped at just capital ratios. In addition to the changes in capital APRA has also strengthened its resolve around lending to investment housing with a 10% cap on investor housing loan growth to be more vigorously implemented.

In our view, these changes will see a significant reduction in banks returns and hence value over the time, if the banks do not take action to offset the risk.

Impact on the banks

The combined impact of these changes to capital and investor lending growth is likely to see bank’s Return on Equity (ROE) fall by 2-3% from an average of 15% to an average of 12-13% and impact dividend growth if they do nothing about it.

Capital raisings have commenced

Whilst APRA has provided some clarity around specific items such as Risk Weighting on housing, the absolute level of capital required by the major banks to meet all regulatory requirements is still a little bit of a mystery with APRA still vague around a range factors. Given the uncertainty it is impossible to come up with an exact dollar increase in capital for each bank, however as shown in the chart below we are able to come up with a range based on our analysis of the worst case outcome.


Source: Macquarie Investment Management

Based on this analysis we believe that the capital requirement from regulation could be as much as $39bn in total. With a range between banks of $13bn for ANZ to only $7bn for WBC.  This is the worst case outcome and assumes APRA implements all the potential known changes. The best case outcome is that APRA enforce only the Risk Weighting changes for mortgages in which case the capital headwind is approximately $13bn for the sector or $2.5bn - $4bn per bank. In our view we are likely to settle somewhere between the high and low case at around $15-20bn for the sector.

Whilst there is still substantial uncertainty around the amount of capital that will ultimately be needed by banks and the time frame in which they will need to generate that capital, we would expect (and are seeing) the banks beginning to increase capital ratios ahead of a final capital number coming from APRA.

In a normal cycle banks would look to build capital through organic methods such as retained earnings, normal dividend reinvestment plans (DRP’s) and underwritten DRP’s, asset sales and RWA optimisation.  As shown in the table below banks should be able to organically generate approximately $44bn over the next 3yrs from organic measures if APRA gave them the time. 

However this is not an ordinary cycle.

With APRA giving the banks only 12 months to adopt the changes in RW on mortgages we can understand why banks have been undertaking recent equity raisings to try and bridge the capital gap and to address any additional capital changes that might occur.

Whilst we believe that we are at the end of the capital build in the near term, we do expect capital to remain a hot topic of conversation and is likely to drag on the sector from time to time as the market awaits key announcements from APRA over the next 12 to 24 months.

It’s not all bad news…

Whilst the headline return on equity (ROE) impact from APRA’s changes appear significant, the banks are unlikely to sit quietly and absorb the impact of higher capital and slowing growth.

As in previous cycles when either regulatory or market pressures have threatened returns, banks have looked to offset these impacts through increasing lending rates or reduce deposit rates. The below chart depicts the experience in the global financial crisis (GFC) where banks repriced loans to offset higher capital and funding costs.

Source: Company data

Already in the past few months we have seen banks reprice investor loans by 27bps which we estimate will have a positive kick to earnings and returns. As such we believe a lot of the return impact from APRA’s changes can be offset over time.

The “Capital Conundrum”

Whilst APRA’s idea of increasing capital and slowing lending growth to help protect has merit, it can lead to significant downward spiral in economic growth and ultimately bank security i.e. A regulator can cause the exact problem it is trying to avoid if it is not careful.  We call this the Capital Conundrum.

Source: Macquarie Investment Management

As such regulators need to be careful to not call for too much capital to be raised or slow growth too aggressively in the current environment as it could lead to banks rising rates, reducing lending appetite which in turn leads to slower economic growth and if bad enough, can lead to rising bad debt. Ultimately this places more pressure on banks’ capital and around and around we go. Europe is a great example of how regulators can materially impede economic growth and cause greater instability in the banking system.

At present, it appears that APRA are attuned to this risk, however as we have seen globally, sometimes regulators can get over excited about system security and miss the woods for the trees. 


We do appear to be moving closer to some conclusion of how much capital is required by the banking system and by when.  That said, there are still some significant issues that need to be addressed by APRA before banks and investors can have absolute certainty around equity levels and future bank returns.

Banks will offset the majority of the return drag caused by higher capital and slower lending volumes from asset repricing over time. However both the banks and the regulators need to be careful not to push too hard on capital as this could end up in a negative spiral that sees poor economic growth lead to poor bank’s profits which in turn leads to the requirement for more capital and so it goes.

Share this

If you enjoyed reading this article, why not share it?

Simply copy and paste the text and include a link to the article. Please read the Expertise Articles Terms of Use before sharing.

Related articles


Find out how we can help

If you'd like to speak to a specialist about how we can help build your business, get in touch.

This information has been prepared by Macquarie Investment Management Limited ABN 66 002 867 003, AFSL 237492 ("MIML") and is current as at September 2015.The information is provided for general information purposes only and does not take into account the investment objectives, financial situation or needs of any person. It should not be relied upon in determining whether to invest in a fund. In deciding whether to acquire or continue to hold an investment in a Fund, investors should consider the product disclosure statement. The product disclosure statement is available from MIML by phoning 1800 814 523.

Future results are impossible to predict. This report includes opinions, estimates and other forward-looking statements, which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements. Forward-looking statements constitute our judgement as at the date of preparation of this report and are subject to change without notice.

Investments in a Fund are not deposits with or other liabilities of Macquarie Bank Limited or of any other Macquarie Group entity and are subject to investment risk, including possible delays in repayment and loss of income and capital invested. None of Macquarie Bank Limited or any other member of the Macquarie Group guarantees any particular rate of return or the performance of a Fund, nor do they guarantee the repayment of capital from a Fund.

Except for Macquarie Bank Limited ABN 46 008 583 542 AFSL and Australian Credit Licence 237502 (MBL), any Macquarie entity referred to on this page is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Cth). That entity's obligations do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of that entity, unless noted otherwise.