Banks set for slower profit growth, share price pressure: analysts

Over the past three years Australia's big four banks have outperformed the broader share market by about 50 per cent, but that stellar run is coming to an end according the US broking house Morgan Stanley.

Morgan Stanley says investors have underestimated the impact of the Federal Government's Financial Systems Inquiry and argues that the cycle of earnings upgrades is about to turn.

The upshot may be more expensive home loans, less generous deposit rates and share prices under pressure.

In a note to clients, the Morgan Stanley bank analysts say they have taken a "negative stance" on the big four that "now face a period of underperformance."

"Australian banks' share prices have been supported by a period of earnings upgrades and solid EPS (earnings per share) and dividend growth," he said.

Morgan Stanley notes that their view is not based the risk of an economic downturn or house price correction but the fact that there are few earnings drivers left for the banks.

"We believe the EPS upgrade cycle is coming to an end," the analysts forecast.

"We expect that margin tailwinds will ease in financial year 2015 and loan losses are at bottom-of-the-cycle levels.

"At the same time, we believe that a modest pick-up in volume growth and good cost discipline are already factored into consensus forecasts and investors' expectations."

*'*Murray Inquiry biggest driver of share prices'

"In our view, the Financial System Inquiry (or Murray Inquiry) will be the single biggest driver of Australian bank share prices in the next two years," Morgan Stanley argued.

On Morgan Stanley's figures, the banks between them will need to hold an extra $24.3 billion in the highest quality 'tier 1' capital.

"An extra $24 billion capital requirement in our base case will lead to dilutive equity issues and lower sustainable ROE (return on equity)," the analysts concluded.

The move to higher minimum capital ratios is designed to reduce the risk of taxpayer support in the event of a financial crisis and align Australia's bank regulations with emerging international standards.

Despite protestations to the contrary from the big four, FSI chairman David Murray argues Australia's banks are globally "in the middle of the pack" on capital ratios.

Morgan Stanley says there are a number of reasons why the banks will be forced to hold capital at the top end of their international peer group, not the least of which being their regulator's (APRA) desire to protect its reputation for conservatism.

There is also the issue of Australia's highly concentrated bank sector and it sizable exposure to the mortgage market that creates significant systemic risks in the event of a severe downturn.

Morgan Stanley says the Murray Inquiry and APRA are also likely to force the big four banks to raise the risk weightings of their mortgages and move them more into line with other smaller lenders.

On the analysts' modelling that could require additional capital of between $8.5 billion and $27.5 billion.

Morgan Stanley argues this would allow smaller lenders to become more competitive in the mortgage market while addressing risks to financial stability arising from the major banks' high exposure to residential property.

The banks are in a position to raise fresh capital by boosting their dividend reinvestment programs and selling non-core assets, such as NAB's Great Western Bank in the US or some of ANZ's smaller joint-venture operations in Asia.

More expensive loans, lower deposit rates

The banks also have other levers they can pull to mitigate the forecast falls in their earnings per share and return on equity ratios.

None are particularly heart warming for borrowers or depositors.

"We would expect the banks to use their oligopoly pricing power to raise Australian mortgage standard variable rates (SVR) and lower term deposit rates," Morgan Stanley noted.

Don’t raise so much capital, cut risk: JP Morgan

However another big broker, JP Morgan, says the solution to shifting the burden of systemic risk away from the tax payer may not lie with increasing the level of top tier capital banks must hold, but reducing the risk relative to existing capital levels.

In its latest survey of the Australian mortgage industry, JP Morgan banking analyst Scott Manning argues that adopting a broader view of different types of capital, as is being introduced in the United Kingdom, would keep the banks' costs down, while increasing stability and greater competition in home loans.

Mr Manning says increasing total capital relative to risk weighted assets from 12 per cent to 17 per cent and increasing the housing risk weighting from 20 to 30 per cent would require the banks to hold an extra $12 billion in capital, about half Morgan Stanley's forecast.

On the JP Morgan figures, this would increase banks funding costs by about $2 billion annually.

Mr Manning says greater consideration should be given to reducing the probability of default and simple day-to-day risk management at individual banks, such as by requiring more stringent tests on borrowers' debt servicing abilities in the face of higher rates before issuing loans.

The Final Report of the Murray Committee is expected to be tabled in November.