Australian banks are breaking primary support levels. There are two major reasons for this. One is the precarious level of household debt as a result of the housing bubble. The first graph below shows how housing prices have more than doubled compared to disposable incomes (after tax but before interest payments) over the past 30 years. And how household debt has risen, not as a result of, but as the underlying cause of, the housing bubble. Without rising debt there would be no bubble.
Growth in Australian housing prices is now slowing, prompting fears of a correction.
The second reason is falling returns on equity. Banking regulators have increased pressure on major banks to improve lending standards and increase capital backing for their lending exposure. For decades banks were given free rein to increase lending without commensurate increases in capital, to the extent that the majors hold only $4 to $5 of common equity for every $100 of lending exposure. Low interest rates, increases in capital and slowing credit growth have all contributed to the decline in bank equity returns to the low teens.
Chris Joye at AFR reports on a recent study by UBS banking analysts Jonathon Mott and Adam Lee. The two believe that David Murray’s financial system inquiry is likely to recommend an increase of 2 to 3% in major banks tier 1 capital ratios.
Based on an extra 3 per cent capital buffer for too-big-to-fail banks, UBS finds that the major banks would have to “increase common equity tier one capital by circa $23 billion above current forecasts by the 2016 financial year end”.
…This automatically lowers the major banks’ average return on equity at the end of the 2016 financial year from 15.4 per cent to 14.3 per cent, or by about 116 basis points across the sector. Commonwealth Bank and Westpac come off best according to the analysis, with ANZ and National Australia Bank hit much harder.
Readers should bear in mind that capital ratios are calculated on risk-weighted assets and not all banks employ the same risk-weightings, with CBA more highly leveraged than ANZ. As I pointed out earlier this week, regulators need to monitor both risk-weighted capital ratios and un-weighted leverage ratios to prevent abuse of the system.
Bear in mind, also, that a fall in return on equity does not necessarily mean shareholders will be worse off. Strengthening bank balance sheets will lower their relative risk, improve their cost of funding, and enhance valuations.