Explainer: banks are raising capital, but should we be worried?

Last week’s A$3 billion capital raising by ANZ Bank was seen as bad news by equity investors, even though there has been no significant information released which might suggest poorer future performance of Australian banks. Any such concerns would also be somewhat offset by robust quarterly figures from NAB. Media reports have suggested the Commonwealth Bank will follow with a capital raising of its own when it presents its annual results this week.

The straightforward answer to why ANZ (and other banks) would undertake such a large capital raising, and risk adverse market reaction, is that regulatory developments mean they have little choice.

The prudential regulator, APRA, has stated a need for large Australian banks to have significantly higher levels of equity capital, and has indicated an increase in capital ratios of 200 basis points as an indicative amount.

The regulatory timetable involved rules out the possibility of generating all those funds internally by retention of earnings (although banks are likely to try to lure more investors into dividend reinvestment schemes rather than taking cash, by increasing the share discounts offered to them under such schemes. (Dividend reinvestment schemes are a popular way for some companies to retain capital, but have a relative low take up rate (20%) among investors.)

The regulator is seeking higher capital as part of its objective of ensuring Australian banks are seen to be well capitalised and thus not at risk of failure. This was recommended by the Murray Inquiry, and higher capital requirements is a common theme globally – with even some bankers acknowledging capital levels had got too low for comfort prior to the financial crisis.

Minimum capital required is linked to a concept known as risk weighted assets (RWA) – more capital is required for higher risk assets and weights are applied to various asset categories to reflect risk in the calculation of RWA. For the ANZ, RWA are around A$400 billion compared to total assets of around A$900 billion.

For the Australian banks there are two forces prompting higher capital amounts. One is increases in the minimum expected capital/RWA ratio. APRA has signalled it agrees with the Murray Inquiry recommendation that Australian banks should be, but are not currently, in the top quartile internationally. The second is the increase in risk weights to be applied to mortgage loans of the major banks, which will increase measured RWA.

Why should the market react so negatively? Higher capital will, after all, make banks safer. The answer lies in the potential effect of a higher capital ratio on bank return on equity. If there is no change in return on assets and bank total profit, earnings will be spread over a larger number of shares, implying a reduced return on equity. A reduction in bank share prices can be seen as reflecting a downgrading of market expectations of the future yield on bank shares.

But here there can be much debate about the eventual outcome. With lower leverage, bank shares have less risk. The required rate of return of investors could thus be expected to decline – although whether sufficient to offset the projected decline in the actual return on equity, is contentious.

There is also another offsetting factor. With reduced leverage, bank issued debt and deposits have less default risk, and (together with less such funding needed to support their balance sheet) this should reduce interest funding costs and improve bank profits.

But given perceptions of “too big to fail” and explicit and implicit government guarantees, the magnitude of this effect can be questioned. So, some negative share price effect is to be expected, but whether investors over-reacted remains to be seen.

Why $3 billion? Some back-of-the-envelope calculations provide insight. An increase of 200 basis points (2 percentage points) in the capital ratio as suggested by APRA would mean an extra amount of capital required of around $8 billion (given by 2% of $400 billion RWA). Over the course of a year, ANZ could expect to retain (or obtain via reinvested dividends) around half of annual profits of around $7-8 billion, giving another, say, $4 billion capital.

So, together, these give around $7 billion of the required $8 billion within a one year horizon, with the possibility of raising further regulatory capital via issue of hybrid preference shares (and earnings retention) over a longer time frame. Of course, these informal calculations do not take into account the effect of the increase in mortgage risk weights, or general growth in business, which will increase RWA and thus create a need for yet further capital.

In this environment, it is not surprising to see banks like ANZ and NAB looking to sell off non-core businesses to reduce RWA and achieving increased regulatory capital from the proceeds.

Kevin Davis was a member of the Australian Financial System (Murray) Inquiry whose recommendations on bank capital are reflected in the APRA decisions referred to in this article