Regulator says banks no safer than before financial crisis

By business reporter Michael Janda

With David Murray's Financial System Inquiry due to report this month, the major banks have used their annual profit briefings to argue against tightening rules to increase the amount of money they hold in reserve to cover loan losses.

If the inquiry does recommend increased capital requirements, banks would either have to cut back on new lending, raise more funds from shareholders or retain a lot more of their profits - all of which would reduce the dividends available to pay shareholders and/or increase the interest rate on loans.

The bank bosses have argued that their institutions not only passed through the global financial crisis intact, but have increased the capital buffers, or cash reserves, since then.

However, the Australian Prudential Regulation Authority, which governs them, does not agree.

"Today the ratio of shareholders' funds to the balance sheet assets of the Australian banking system – a simple measure of resilience – is virtually unchanged from a decade ago," said its new chairman Wayne Byres at a financial forum.

"Much of the recent build up in capital has simply reversed a decline in core equity in the pre-crisis period – as a result, on the whole we're not that far from where we started from."

Mr Byres said that the apparent increase in capital reserves has almost entirely come from a move away from higher risk business and commercial property lending towards home lending, which is considered much lower risk.

"Put simply, much of the strengthening of capital ratios relative to a decade ago is less the product of substantial growth in capital and more the product of the increasing proportion of housing loans within loan portfolios," he explained.

"In short, banks have de-risked rather than deleveraged."

Housing loans now make up about 65 per cent of Australian bank lending, up from 55 per cent a decade ago.

Mortgages have traditionally been accorded so-called 'risk weightings' which reflect the historical tendency of lower default rates.

These weights were set at 50 per cent until 2004, which meant that banks could lend twice as much in housing loans than business loans for a given amount of capital.

In 2004, those risk weights were lowered to 35 per cent, and the major banks have been allowed to set their own risk weights for residential mortgages based on internal financial modelling.

That has led to average risk weights of around 15 per cent for Australia's biggest two home lenders, CBA and Westpac, as the ABC's Stephen Letts explained in a recent analysis.

Mr Byres argued that, on APRA's analysis, the failure by Australia's major banks to actually raise more shareholder funds to underwrite their loan growth puts them barely above the world average for bank resilience.

"The largest Australian banks appear to be in the upper half of their global peers in terms of their capital strength," he said.

That supports David Murray's assertion that Australia's big four are middle of the road, rather than the banks' assertion that they around the top quarter.

All banks survive housing crash

However, the news was not all bad for the banking sector.

APRA got the banks to run various stress test scenarios that reflected their large housing exposures, and then ran the same tests itself.

Despite the preponderance of mortgages on their books, all 13 banks examined survived the stress tests where one scenario saw home prices dropping almost 40 per cent and unemployment touching 13 per cent during a deep recession triggered by a sharp Chinese slowdown, and the other flagged slightly less severe declines triggered by rising interest rates.

The banks forecast housing loan losses of $45 billion over five years on either scenario, with commercial losses a little more than double those despite being a much smaller proportion of bank lending.

When APRA ran the scenarios itself it found slightly higher home loan losses - of $49 billion under the China slowdown scenario and $57 billion under the significant rate rise scenario - with total loan losses of $170 billion under either scenario.

Mr Byres said that is a sign that banks are sound, even though they have not really increased capital buffers.

"The Australian banking industry appears reasonably resilient to the immediate impacts of a severe downturn impacting the housing market," he added.

However, he warned that "it is unlikely that Australia would have the fully-functioning banking system it would like in such an environment", with banks "severely constrained" in their ability to advance loans.