By Leith van Onselen
From a reader comes the below extract from Citi arguing that the profitability of mortgages on the banks’ books has risen strongly since the introduction of Basel II in 2006.
For background, Basel II is the capital adequacy regime pertaining to Australia’s banks, building societies and credit unions (collectively known as Authorised Deposit-Taking Institutions or ADIs). Regulated by the Australian Prudential Regulatory Authority (APRA), Basel II defines how much capital (essentially shareholder’s funds and some other items) must be put aside to cover potential losses on credit exposures (e.g. loans) and trading exposures.
The capital charge under Basel II is 8% of risk-weighted assets, whereby the risk weight is dependent on the underlying riskiness of the exposure. Under the previous Basel I framework, the standard risk-weight required to be held against mortgages was 50% (implying a 4% capital charge) provided the mortgage had a loan-to-value (LTV) ratio below 80%.
However, upon the introduction of Basel II in 2006, the standard risk-weight required on mortgages with LTV ratios below 80% was dropped to only 35%, implying a lower capital charge of 2.8% on each dollar of mortgages written. There are some other provisions relating to lenders’ mortgage insurance, but these can be ignored for now.
Importantly, Basel II also permitted the larger banks to use their own Advanced Internal Ratings-Based (IRB) models to determine their capital charge based on “probability of default” and “loss given default” metrics. Under their IRB models, the big four banks were able lower their capital requirements on mortgages even further to between 1.2% and 2.1% (see below charts).
This brings me to Citi’s analysis, which argues that the Commonwealth Bank of Australia’s (CBA) return on equity (ROE) on mortgages has ballooned since the introduction of Basel II in 2006, from 15% to 43%. Much of this improvement in mortgage ROE is due to a sharp reduction in the average risk-weight calculated on CBA’s mortgages, from 50% to 20%, which increased the amount of mortgages that could be held against CBA’s capital (see below Citi extract). Essentially, a very low capital allocation against mortgages necessarily means a much higher return on capital (equity). 
Of course, the Citi analysis does not examine the main risk for an equity investor in CBA, which is as house prices decline, capital requirements will increase well before defaults occur. Let me explain.
The Basel II Capital Adequacy Framework is inherently pro‑cyclical because of the positive feedback loop created by mortgage rehypothecation – the process of increasing (decreasing) home values resulting in decreasing (increasing) bank capital adequacy requirements, leading to increasing (decreasing) mortgage lending.
As alluded to above, under the Advanced IRB approach adopted by Australia’s big four banks, they are effectively required to hold capital in-line with the LTV ratios applying across their mortgage book.
In times of rising home prices, the banks’ LTV ratios on their pre-existing mortgage book, as calculated under their IRB models, falls resulting in lower capital requirements and permitting higher levels of lending (other things being equal). These lower capital requirements can then drive extra lending, facilitating higher house price growth. By contrast, when homes prices are falling, the banks’ LTV ratios across their mortgage book rise, which can necessitate higher capital requirements and facilitate lower lending growth and house price declines.
While the implementation of Basel II was a big boon for the banks – enabling them to grow their mortgage books (and profits) substantially on a given level of capital – it also risks downward internal ratings migration in a falling market, which pushes up risk-weighted assets and, hence, capital requirements.
