Big bank mortgage capital needs to rise

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By Leith van Onselen

Business Spectator’s Stephen Bartholomeusz (‘Bartho’) has written a broad-ranging article today in which he questions the Big Four banks’ over-exposure to housing, and argues for an increase in capital requirements on mortgages:

The exposure of the system to housing is an increasingly topical issue as prices continue to rise, affordability continues to fall and investors continue to pour funds into a sector that has supply-side issues…

The majors have all achieved ‘advanced’ status under the Basel regime which in practice means they need to hold far less capital against a housing loan than their regional counterparts. For every dollar of capital they can lend more than twice as much as the regionals and generate returns on equity more than twice those of the smaller banks…

The regulatory settings currently in place create massive incentives for the banks to lend against housing relative to other types of assets. They generate returns on equity in the mid-30 per cent range on housing loans…

…fine-tuning the weightings could both create a more level playing field and reduce the scale of the large skew within the system towards housing…

It’s hard to disagree with Bartho’s concerns.

Under the Basel II framework, implemented in 2006, the standard risk-weight required on mortgages with loan-to-value ratios (LVRs) below 80% was dropped to 35% (from 50% previously), implying a lower capital charge of 2.8% on each dollar of mortgages written (from 4% previously).

However, 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 than under the standardised approach.

According to their pillar 3 disclosures, the amount of capital held against total credit exposures ranges from only 2.7% (Westpac) to 4.3% (NAB), with capital held against mortgages at around half that level [note: calculations are around one-year old, so are indicative only]:

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The effect of the Big Four’s under-capitalisation of mortgages are two-fold.

First, it has ensured that too much of the banks’ loans are channeled into housing. Yesterday’s private sector credit aggregates data released by the RBA revealed that the share of bank loans going to housing hit a record high 60.3% in February 2014, whereas loans to businesses hit an all-time low 33.4%:

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Second, it has skewed the competitive environment towards the Big Four and away from smaller deposit-taking institutions, who are bound to the higher capital charges under the standardised approach.

While the low level of capitalisation has dramatically boosted the Big Four’s profits by raising their return on equity, it obviously leaves creditors and potentially taxpayers exposed in the event that there is a severe downturn in the economy and asset prices, as well as sucks capital from the productive economy.

Raising capital requirements on mortgage lending would, therefore, be a wise move.

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  1. migtronixMEMBER

    Loan creates the depositor, now if asset values on the books plummet how do they make good on obligations? Bloody interesting question

      • So taking on debt is probably the prudent choice then @Op8? [not financial advice yada yada]

    • The last thing that I want right now is another discussion on whether falling house values would start a “margin call” on home loans, but that is what you are suggesting.

      Whilst loan contracts often have that clause embedded in them, banks have stated that they will not enforce those clauses as a general rule. I have confirmed that with more than one bank.

      Business and commercial loans however are another thing. They can be called in if the borrower is not meeting the loan covenants which can be security margins or even profitability – so it’s a different ballgame altogether.

      Borrowing for a business, in particular a new business has always been difficult. In fact it’s far easier now than it was 20 years ago.

      • migtronixMEMBER

        Don’t need margin calls pf all you need is people funnelling cash flow to loan repayments and defaults are guaranteed. Period.

      • Why? Cashflow is always funnelled to meet commitments including loan repayments. You need to be more specific.

        Are you then suggesting that SME profits will fall – if so why?

      • migtronixMEMBER

        if so why?

        Wow! If you don’t sell as many goods this year as last year because the cash is being retired what are going to do to maintain profits?


      • migtronixMEMBER

        Did I say they were falling Today? Sheesh.

        When values fall who in their right mind won’t pay down double quick? Especially all those boomers with worthless IPs

      • Ah so sales are NOT falling and the money supply is NOT diminishing but if they ever do we will be in trouble.

        Well I agree subject to those parameters, but if that is a prediction it’s pretty “out there”

      • @PF

        Does that sales data depend on the ABS inflation number as deflator?

        Also they are sales numbers, not profit numbers.

      • @ athalone – you’ve got me there, I didn’t look to see if they were adjusted or not.

        Yes they will be sales numbers, no one will have the profit numbers. How could they? Generally as sales rise so do profits as long as margins are not slashed, which they aren’t to the best of my knowledge.

        Have a look at the current financials of the listed retailers, that might give you some food for thought. Sorry I don’t have time at the moment.

  2. The problem with requiring more capital is that it is not needed when thnigs are having growth that merely matches growth in GDP + say 2% inflation.

    What is needed is a rules guided reserving system against certain types of loans based on the rate of increase in asset prices or unemployment because price stability and employment are the major parts of the RBA charter.

    When existing house prices are increasing, increase the interest free reserve deposit required against each loan and if unemployment is increasing and above say 3% use the profits from lending back to the market to subsidise the rate of interest on loans funding activities which increase employment eg home building and infrastructure.

    During a recession, there would be no reserve deposits, and subsidies would have to come from fiscal policy/automatic stabilisers but the banks would not be saddled with excess capital.

    • migtronixMEMBER

      employment eg home building and infrastructure.

      Great thanks can I have penury too. Is your boomer magnanimity capable of that too?

  3. Given that business loan interest rates are higher than that of a standard mortgage (& as Peter points out above there are other pitfalls to taking this type of loan), could it just be a case of more borrowers deciding to take out a standard interest only LOC & funding their business needs without advising the bank?

      • migtronixMEMBER

        Mmmm I do plenty of speculation – buy low sell high. Not buy and the and pray for central bank uselessness

    • @BB – yes a lot of small business funding is done as a standard home loan, whereas once that could not happen.

      Big business OTOH go to the markets to raise capital and bypass banks.

      Given those factors I struggle to see that overall business borrowings have fallen or that finance has become more difficult to obtain, but the avenues to obtain that finance have altered.

  4. Hugh PavletichMEMBER

    Leith … thank you for this important article.

    Clearly the capital requirments for residential lending are inadequate.

    As a matter of interest, does anyone know what they were in Ireland in 2007 ?

    Hugh Pavletich

  5. Hugh PavletichMEMBER

    “Multiple Stretch” is a huge issue. Researchers need to check carefully where Ireland was in 2007 (refer 2008 4th Edition Demographia Survey) with Australia today ( refer 2014 10th Annual Demographia Survey). Access these easily at .

    I covered this issue back early January within “China: Big Bubble Trouble” …

    The higher the lending multiples, the greater the risks involved of course.

    How did the Irish Banks cope with their capital base back in 2007, with much lower housing and lending multiples, than is the case in Australia and New Zealand today ?

    What would the capital base of the Irish Banks needed to have been to cope ?

    Hugh Pavletich