BMI View: We believe that the Australian financial sector is about to see another wave of regulation, on top of higher capital charges for funding mismatches and domestic systemically important banks that is slated to kick in 2016. Greater linkages between households, the housing market and banks, together with growing signs complacency have spurred the authorities (APRA) to issue warnings, and we believe that increased concerns over financial stability heightens the possibility of greater regulation. We examine the implications of a number of measures that could be implemented over the next few quarters, and we believe Australian banking equities have not adequately priced in these risks.
Another round of regulatory change is set to descend on the Australian financial sector, even as the sector has progressed much quicker than many of its peers in other developed countries in terms of the implementation of the Basel III requirements. Apart from the commitments Australia made at the 2010 G20 meeting (with regards to improving the stability of domestic financial systems), the unraveling of the banking crisis and ongoing resolution process in peripheral Europe (mainly Spain) have further spurred the Australian authorities to relook at linkages within the financial system. An examination of the current measures in place and capabilities of institutions to deal with similar problems have also been proposed (and is underway in some instances).
|Increasingly Lax Management?|
|Australia - Dividends Distributed (AUD, LHS) & Loan Loss Reserves (% Of Total Loans, RHS) For Australia's Big Four Banks|
Increasing Bank Complacency Worries Regulators
Although we have previously noted that Australian regulators may be keen to relax implementation timelines as regulators in other markets have increasingly done so, we see domestic authorities increasingly prioritising the stability of the financial system over its global competitiveness (to a certain extent). With rumours of low-equity, low-documentation mortgages becoming more prevalent and self-managed superannuation funds increasing their investments in the property sector, the linkages between households, banks and the housing market are on the rise. On top of this, households are further exposed to Australian bank, who themselves have a large exposure to the domestic housing market as banks lend their deposits to property investors.
Greater Regulation Looms
Given the growing size of the assets at stake, the Australian authorities such as the Australian Prudential Regulatory Authority have since issued several warnings to banks against excessive dividend increases, poorly documented loans and the declining levels of loss provisions. With a wave of inquiries and reviews either in progress or on the cards, such as the ongoing Senate-directed review of the performance of the Australian Securities and Investments Commission (ASIC), we believe that more measures will be implemented over the course of the next few quarters. While we note that these could help improve the resilience of the banking sector, we believe that these subsequent rules are unlikely to be sufficient to prevent any fall-out from property price declines.
Below, we review a number of the measures suggested so far, and highlight that we believe that current equity prices do not seem to account for the risks that these rules will be implemented, which could increase funding costs, grow compliance burdens and even possibly result in the dilution of equity stakes. Indeed, we believe these risks will become more apparent to the market in the coming months and, thus, see room for Australian banking equities to head lower.
Doubling Of Bank Levy: In line with our previous analysis ('Bank Levy A Good Start To Address Potential Bailout Costs', August 7), the newly-elected coalition government has indicated that there may be plans to double the proposed levy amounts for the Financial Stability Fund, given that the size of fund based on initial proposal may be too small to cope in the event of multiple defaults. Although this is a step in the right direction to address this problem, we note that doubling of the flat rate tax would exacerbate the adverse impact on funding costs for smaller financial institutions.
Macroprudential Rules: With other developed Asia central banks such as New Zealand, Hong Kong and Singapore adopting macroprudential rules to rein in rising property prices, we believe that this option will be increasingly attractive, especially since the RBA is unlikely to risk choking off business lending. Apart from the restriction of low equity loans via capping the maximum loan-to-value ratio, we believe Australian regulators may look instead to tweak the provisioned amounts banks current set aside for its loans. Examples include raising the capital charges that mortgages are levied (like in New Zealand), or requiring banks to stress test their loan book under a more extreme scenario (like in Hong Kong). Implementation of such rules would weigh on banking profits, thereby reducing the likelihood that banks would continue to break their profits records. Indeed, in light of the steps that regional regulators have taken, the government-sanctioned review of the financial system (which will be completed by November 2014) to presents a unique opportunity for Australian regulators to do the same.
A More Powerful APRA: On top of doubling the size of the financial stability fund, the government is considering to grant the APRA additional powers in the event any institution is declared insolvent. Should the regulator be granted the full range of powers, which would include the ability to force senior creditors to absorb some level of losses, whether by means of haircuts, exchange of debt for equity or restructuring the terms of the original loan unilaterally, we see scope for credit default swaps (CDS) on senior debt issued from Australian banks to reverse their downtrend and trade at higher levels. Moreover, the possibility of further dilution of equity stakes owned by current shareholders suggests that a higher risk premium should be demanded. Together with the possible implementation of macroprudential rules and doubling of the levy, we maintain a downbeat outlook for Australian financials.