Originally published by UBS Asset Management
APRA recently released its much anticipated ‘Unquestionably Strong’ benchmarks. The overriding objective is to have the major banks’ Common Equity Tier 1 (CET1) capital ratios rank in the top quartile of international peer banks and APRA has determined that increasing the minimum CET1 ratios to 10.5% in CET1 capital should achieve this ranking over the medium to long term. The banks need to comply by January 2020, but are encouraged achieve it much faster. Equity markets rallied on the back of the announcement as the view was the new rules were less punitive than initially expected and because the banks should have little trouble meeting the new requirements (primarily from DRPs and retained earnings). For us as investors this is positive as it adds resilience to an already strong banking system, and is supportive to our investments in senior unsecured and covered bank debt.
Mortgage risk weights are also expected to increase from the current 25% major bank minimum, but there’s uncertainty as to quantum, timing and whether the burden will be greater for ‘higher risk’ mortgages (e.g., high LVR, investor mortgages). The uncertainty derives primarily from the finalisation of Basel III, which potentially has wider ranging risk weight changes applying to a wider range of banks globally. We expect further announcements on this front possibly by the end of the year. It is also uncertain at this stage what buffer the major banks will build on top of the 10.5%, and this point is key in determining whether S&P upgrades the major banks’ stand-alone credit profiles. Whilst we do not expect an upgrade to senior unsecured ratings, the buffer has the potential to see upgrades on subordinated AT1 and Tier 2 instruments.
APRA referenced current and ongoing work around liquidity and funding, governance and risk culture, recovery planning and crisis management powers under severe financial stress scenarios, viable resolution plans. APRA also detailed the results of their recent severe stress test scenario, which resulted in a relatively manageable effect on capital.
Additional Loss Absorbing Capacity (‘ALAC’, the Financial System Inquiry’s third recommendation) was also mentioned as an agenda item, although down the priority list. Australia will be late to the ALAC party as global systemically important banks from the US, EU and Japan are already in full-fledged ALAC raising mode, with Canada recently joining the party. APRA has been deliberately cautious in adopting the full scope of global standards, given the nuances of the structure of our banking system. APRA has consistently signalled its intention to ‘draw lessons from, and not move ahead of, the rest of the world.’ The solution Australia will eventually adopt will inform our views about which part of the bank capital structure is most attractive on a risk-adjusted basis, but we expect at this stage it will favour senior debt.