This week, the Australian Prudential Regulation Authority announced higher capital requirements for residential mortgages for the four major banks (ANZ, CBA, NAB, Westpac) and Macquarie, in order to offset mortgage risk.
The report follows one dated 13 July where APRA put the banks on notice that in order to be regarded as being in the top 25 per cent of global banks in terms of capital held, and thus qualify as “low risk”, they would need to hold an extra 2 per cent of capital.
Combined, the measures are going to affect bank profitability unless the banks can pass on all of the costs. Aside from the cost, they all need more capital and will be looking for the most cost effective and least disruptive way to satisfy the new rules.
This creates advantages and disadvantages for bank hybrid investors.
Before I go into more specific hybrid implications it’s worth assessing exactly how APRA defines bank “capital”.
There are many categories of capital that will qualify.
For example, retained earnings, share capital, preference shares/hybrids and subordinated bonds would all be suitable. APRA gives different weights to various types of capital and the most attractive, being the most readily available to support the bank if needed, are retained earnings and share capital.
From a bank’s point of view, retaining more earnings would mean less being available to pay dividends. I’m not saying the banks will cut dividends, but it’s an option and there’s a case for it being a one-off hiccup.
More likely they could decide not to increase dividends over those paid in 2014. Either way a change in expected dividends would result in a lower share price. As one analyst suggested in recent days the banks could satisfy the new rules simply by raising mortgage rates 0.5 per cent higher.
Another very good choice would be to increase share capital with a rights issue. This would be dilutive to existing shareholders but would increase the most attractive capital held. Again, this option would likely result in a lower share price.
Hybrids offer a less valuable form of capital to the banks as it’s not so accessible. New hybrids that comply with Basel III regulations do convert to share capital if certain capital triggers are breached or APRA deem the bank “non-viable”. But until either one of those conditions is met, the hybrids are marginally lower risk than shares. The attraction for the banks to issue hybrids will be that it is less disruptive; it won’t affect dividend payments or share prices.
If a bank opts to increase retained earnings and share capital, hybrid investors in the bank will be better off because there will be a greater buffer between them and conversion or non-viability.
The needs and actions of each bank are likely to be different. Assessing the best value hybrids won’t just be a matter of which offers the best pricing, but also consideration of the types and value of capital held, the likelihood of events destroying capital and the potential volatility, loss or conversion until the hybrid is repaid in many years to come.
As a guide to pricing, the CBA Perls VII, which matures in December 2022, is trading at a margin of around 3.9 per cent providing a yield to maturity of 6.83 per cent.
Any new hybrid with an eight year term should at least offer the same margin. If you expect all the banks to issue in the domestic listed market, then they should be offering a premium to that rate.
Undoubtedly, the risk of hybrids will change with the introduction of the new rules, but not necessarily uniformly. It will depend on the moves made at each bank. Watch this space.
