A recent marketing trip revealed that the main concern portfolio managers have at present is around the banks, particularly the noise made about capital in the lead up to the final report of the Murray Inquiry. Some PMs are convinced that Murray will recommend that the majors lift their capital requirements substantially and that this will crimp their return on equity and future growth prospects, as well as curtail their ability to maintain their payout ratios.
Further stoking those concerns, Wayne Byres, the Chairman of the Australian Prudential Regulatory Authority, has recently drawn attention to the fact that rapid growth in mortgage lending in the past decade – home loans account for 65% of their loan books, up from 55% - has given the banks a tremendous free kick in terms of boosting their capital ratios. Risk weighted assets, the widely used denominator in capital ratios, has lagged growth in total assets because mortgages attract lower risk weights than business lending (see chart).
Consequently, the alternative (and more robust) leverage ratio – which uses total assets as the denominator - has lagged capital ratios based on risk weighted assets. In fact, the leverage ratio remains slightly below historical trends (see chart). The banks have likely engaged in gaming of the risk weighted assets framework to economise on shareholder equity.
The complicated politics of banking
I believe that the Abbott government is pleased that Murray is rattling the cage around banks and capital, without rattling the cage too much. After all, the methodology used by Murray suggests only a small increase is necessary for Australia’s majors to converge on Core Tier 1 capital ratios of global peers.
Despite the community backlash against the banks (and financial institutions more broadly) in the wake of the financial crisis, the politics of banking favour the major banks; they make generous contributions to both political parties, have well-funded lobby groups and paid out $20 billion in dividends to shareholders in the past year, accounting for one-third of total dividends paid by the ASX200 companies. Imagine the uproar from self-funded retirees and self-managed super funds loaded up on high yielding bank shares, if Murray recommended a substantial lift in capital which would cause the banks to cut back on dividends.
Also note the government’s decision earlier this year to not implement a key recommendation from the Senate Inquiry into the performance of ASIC, to undertake an independent inquiry into the conduct of the Commonwealth Bank’s financial planning business. Evidently, the major banks are literally too big to fail (and offend).
I am very sympathetic to the view that the majors need to finance a significantly larger share of their loan books with more common shareholders equity. The Australian system remains significantly under-capitalised and a crisis of confidence will likely expose the vulnerability that banks simply do not have adequate loss absorbing capital and rely too heavily on borrowed funds in their mix of liabilities (for more detail, see my recent blog post, An open letter to Mike Smith and Lindsay Maxsted). This represents a key longer-term, not actionable at this point in time.
Despite the noise made around capital, a number of factors should continue to support the sector in the near term. Valuations don’t look stretched (the sector is trading at a 10% discount to the market, in line with the historical median), the aggregate payout ratio of 70-75% is in the historical range and BDD charges are likely to remain low as long as business credit is weak and animal spirits remain dormant (my base case considering that Australia remains stuck in a nominal recession). For more detail, see my recent blogpost, The great complacency.
Against this backdrop, I would use any renewed price weakness of the major banks in the lead up to Murray’s final report as an opportunity to take a tactical overweight in the sector. The first key signpost to shift to a neutral to underweight position in the sector is a re-acceleration of business credit, but that remains a way off while the corporate sector’s animal spirits remain dormant and the ASX200 companies continue to face persistent revenue headwinds (see chart).
Murray Inquiry: More bark then bite
Since the financial crisis, governments and prudential regulators around the world have demonstrated an inability and unwillingness to seriously confront banks about capital and tackle the problem of too big to fail. There has been little appetite for governments to undertake an upheaval of capital regulation and to protect taxpayers from remaining on the hook for banks' excessive risk taking. As has been the case with financial sector reform across other countries since the crisis, the bite of the Murray Inquiry promises to be far less menacing than its bark. Which is a shame, because it will represent a missed opportunity to create a resilient financial system. That much will become obvious in years to come.