Are the big four Australian banks undercapitalised? And should investors worry about their capital ratios in the long run? According to an APRA study on international banks, the answer to both questions is yes.
APRA warns the major banks will need to raise capital reserves in order to strengthen their balance sheets. That would ease concerns over their liquidity in the event of a sharp economic downturn.
That’s certainly true, considering the growing uncertainty in the economy. But rising capital ratios are a problem for several reasons.
For one, banks need to raise this capital from somewhere. It’s optimistic to think investors will come to their rescue. Investors stand to lose the most from higher capital requirements. After all, capital reserve ratios only eat into profits.
Anything that diverts money from profits alarms investors. They tend to prize dividends and share prices over capital reserves.
The big banks already pay out relatively healthy dividend returns of over 5.5%. But investors are right to worry about what this could do to the banking sector’s aggressive dividend policy over the next year.
Beyond that, the immediate effect of higher capital reserves will be on share prices. Bank shares are already trading lower today.
Commonwealth Bank [ASX:CBA] saw its shares fall by $0.54 by 2pm. ANZ [ASX:ANZ] is down $0.37 today, at $32.01 per share. Westpac [ASX:WBC] lost $0.17 in early trade.
Meanwhile, National Australia Bank [ASX:NAB] is faring better, down by only $0.06 to $33.42 per share.
Will higher capital requirements pass costs onto consumers?
Investors are unlikely to contribute the necessary capital to shore up reserves. That could leave consumers footing the bill through higher borrowing costs. At least that’s what the banks are arguing.
Sue Wright, a professor at Macquarie University, doesn’t agree with the banks. She says borrowing costs would only need to rise by 0.08% if capital reserve requirements rose.
That’s hardly a cause for concern. It’s not insignificant, but it does allow banks to pander to investors. And there’s no doubt investors would prefer to see costs passed onto consumers. It could also lessen any concerns about long term dips in share prices.
Do banks need higher capital requirements?
You may be wondering why banks would need to shore up their capital reserves. As with any business, banks need a contingency plan. As the primary issuer of capital in the economy, banking liquidity is vital in preventing economic crises.
That’s what the global financial crisis was about in the first place. Banks found themselves lacking the necessary liquidity to stay afloat.
A major economic crash in Australia would raise similar concerns over banks.
How likely is an economic crisis in Australia? It’s not as farfetched as you might think.
Australia faces significant challenges in the months and years ahead. The economy is already on shaky ground.
Government revenues will remain flat as tax revenues fall to recent lows. That’ll put severe pressure on government spending in the next few years.
That situation is made worse by a private sector which refuses to spend money. At least, not until returns on investments match up to their lofty expectations. Even amid low interest rates, business still demand high returns on investments.
At the same time, Australia is importing more — and exporting less — than we have in the past. The growing trade deficit will only lead us to take on more debt in the long run.
This will only result in higher unemployment and poorer wage growth. Household savings to debt ratio will go up as a result, leaving many Aussies worse off.
Why do I bring this up?
I do so to highlight the fact that big banks depend on the prosperity of the economy.
But the likelihood of a recession, or a larger crash, is more apparent than it has been in the past two decades. And a financial crisis could come from anywhere.
Take real estate for example.
A national housing market crash could wipe out households and banks in equal measure. That’s especially true for banks as they issue home loans. Imagine a torrent of bad loans cascading throughout the economy. It would be carnage.
Big banks would find themselves exposed to a wave of defaults and foreclosures.
That’s the reason capital reserves are so important. Whether they like it or not, banks have a responsibility to everyone to maintain high reserves.
How much liquidity is enough?
As lenders, banks have a vested interest in most day to day financial transactions. That’s something most people understand.
The problem for Aussie banks, as you’ve seen, is that they’re undercapitalised.
So what will it take to bring them up to scratch?
APRA has come out and said the big four banks will need to increase capital ratios by 2%. That would put them among the top 25% most capitalised international banks.
Again, the capital ratio is important because it signals the relative strength of a bank. It shows us how much equity banks would have in the event of an economic downturn.
What’s interesting about APRA’s conclusion is that it goes against what banks have been saying.
The banks have been vocal in assuring the market their capital ratios are sound. In fact, they maintain they’re in the top quartile of capitalised international banks.
APRA clearly doesn’t agree.
Their study shows that, while banks are certainly well capitalised, they are far from world leaders in their field. That means capital ratios will rise in the near future.
What isn’t clear is by how much it’ll need to go up by.
Yesterday the government’s Financial System Inquiry suggested capital reserves may need to go up by $30 billion.
We’ll have to wait and see what this does to bank stocks in the long run. If The Daily Reckoning’s Vern Gowdie is correct, one big bank will see its price decline sharply over the next six months.
Vern is the award-winning Founder of the Gowdie Family Wealth advisory service. He’s been ranked as one of Australia’s Top 50 financial planners.
He also believes we’re set for a catastrophic crash in stocks in the future. And he thinks the ASX could lose as much as 90% of its $1.8 trillion market cap.
Vern wants to help you avoid the coming wealth destruction. That’s why he’s written ‘Five Fatal Stocks You Must Sell Now’. In this free report, Vern will show you which bank stands to damage your portfolio this year. There’s a good chance you own it. To find out how to download the report, click here.
Contributor, The Daily Reckoning