Dear Mr Hartzer, Please Explain

Dear Mr Hartzer,

In the press release accompanying the announcement on October 14th, that Westpac would be undertaking a $3.5 billion rights issue, you state that “capital raised responds to changes in mortgage risk weights that will increase the amount of capital required to be held against mortgages by more than be applied from 1 July 2016As a result, Westpac has also announced an increase in its variable home loan (owner occupied) and residential investment property loan rates by 20 basis points.”

Demystifying the myth that capital sits idle in bank vaults

There are two parts of this statement that I do not understand.  The first is a myth that is commonly propagated by bankers; the notion that a bank must ‘hold’ capital, the implication being that it sets capital aside that burns a hole in a bank’s balance sheet while it sits idly in a vault.

This is far from reality.  Let’s start by quantifying the incremental capital requirement.  You’re correct in stating that the capital requirement for mortgages will be 50% higher from 1 July 2016.  At present, the Internal Ratings Based (IRB) risk weights assigned to residential mortgages is around 17% on average for the major banks.  In July 2015, APRA announced that for banks accredited to use the IRB approach, the average risk weight on Australian residential mortgage exposures would increase to at least 25% by mid-2016.  This is designed to narrow the competitive advantage that the IRB accredited institutions (notably the major banks and Macquarie Bank) have over authorised deposit-taking institutions (ADIs) that must use standardised weights.

For ADIs using the standardised approach, risk weights are prescribed by APRA.  The average risk weight for residential mortgage exposures under the standardised approach is around 40 per cent (see chart).

The current IRB accredited risk weight of 17% on a $600,000 home loan equates to a risk-adjusted exposure of $102,000, so a bank would need to allocate $10,200 in additional equity finance to achieve a capital ratio of 10% of risk-weighted assets.  Under APRA’s new guidelines from mid-2016, the new capital requirement increases to $15,000 for the same size mortgage, but remains well below the $24,000 that applies to non-IRB ADIs (see chart).

The nonsense that banks need to ‘hold’ or set aside capital stems from the misconception that bank capital is an asset like reserve requirements.  Bank capital is a liability, which together with customer deposits and wholesale debt, is used to finance a bank's loans.

As you would well be aware Mr Hartzer, the key function that a bank performs is maturity transformation.  It carefully manages its liabilities which are liquid with a short duration, and its loans which are illiquid and typically have long duration.  If a bank uses more shareholders equity in its liability mix, in no way is it forced to cut back on loans or dividends.  On the contrary, it can use those additional funds to lend.  Unfortunately, the terminology is confusing; capital regulation is a regulation of a bank's liabilities, not its loans or assets.

The folly of linking lending rates to capital structure

Which brings me to the second part of your statement that puzzles me; that Westpac has lifted its variable home loan rates in response to the new capital requirements.  This might not be unprecedented but it is highly unusual for a company to link price hikes to the need to use more loss absorbing capital in its liability mix. 

In recent months, a number of ASX listed companies have undertaken rights issues to shore up their balance sheets, including Myer and Origin Energy.  Yet despite the rights issues, Myer did not announce its intention to lift profit margins to fund the incremental capital raised and Grant King has not flagged that he will lift electricity prices that Origin Energy charges customers. 

The technology giant Google uses very little debt in its funding mix and certainly cannot draw on funding from government guaranteed customer deposits.  Despite this, it doesn’t charge users for an array of incredibly useful and valuable services.  Sure, the company benefits from a network effect of attracting a critical mass of users to its services and to that end, offer such services for free or well below marginal cost.  Nonetheless, to my knowledge, outside of the banking sector, CEOs do not propagate a narrative linking their capital structure to prices they charge customers for their products and services.

So Mr Hartzer, why are you seeking to confuse politicians, policymakers and the public by linking the composition of Westpac’s liabilities with the assets or loans that the company writes?  Of course, citing the lift in mortgage risk weights for higher variable home loan rates helps to deflect blame to the prudential regulator.  It might even encourage other major banks to lift their home loan rates and adopt a similar approach in managing their own reputational risk by shifting the onus to APRA.

Nonetheless, I believe that Westpac will need to carefully manage the longer term brand damage if it continues to link further movements in lending rates to the amount of loss absorbing capital in its capital structure.

What’s capital structure got to do with it?

Finally, a number of media reports have suggested that despite APRA's additional capital requirements, Westpac has maintained its target ROE of 15%.  To the extent that these media reports are accurate, their thrust is inconsistent with Miller and Modigliani’s Irrelevance Theorem; that a firm’s capital structure doesn’t matter for firm value.  Increases in leverage leave the weighted average cost of capital unchanged because the expected cost of equity rises, commensurate with the company’s higher risk profile.  Conversely, lower leverage is associated with a lower expected cost of equity, other things being equal.

So the additional loss absorbing capital in Westpac’s capital structure should lower its expected ROE by making the bank safer and more resilient.  The chart below confirms that the largest global banks which are heavily dependent on equity finance in their capital structure tend to have lower volatility of stock returns.