Regulatory burdens stifle the big four banks
Investors following the results of the major Australian banks will have noticed that all of them cite an increased regulatory burden as one of the reasons for their lacklustre results at the moment. What exactly are these increased regulatory requirements any why do they affect the profitability of the bank?
The answer to these questions lies in the so-called Basel III reforms that global banks are in the process of adopting and implementing. The Australian bank regulator, Australian Prudential Regulatory Authority (APRA), isn't adopting the Basel III reforms word for word but it is adopting the majority of the recommendations. One of these recommendations is that banks increase the amount of Tier 1 capital that they hold. Banks make money by lending out the majority of the money they receive and earn more in the interest they charge for loans than they pay as interest to depositors. Banks also obtain funding from other sources, such as from overseas markets and issuing hybrid securities. Obviously, banks can't lend out all of the money they receive because they need to be able to satisfy the demands of people who want to withdraw their money. Regulations actually state the minimum amount of 'money' (Tier 1 capital) that the bank must hold as a percentage of its assets. Banking crises have been exacerbated in the past when the public lose confidence in a bank and everyone wants to withdraw their money at once. Because the bank can't recall the loans they have made (at least not in a short timeframe) the bank can potentially run out of money to pay depositors and therefore become insolvent. This is known as a 'run on the bank'.
As a result of the Global Financial Crisis, which particularly affected banks, regulatory agencies are aiming to implement reforms that will reduce the likelihood of such a crisis in the future. Increasing the Tier 1 capital ratio is one way to achieve this. As the amount of this capital is increased, it reduces the risk associated with a run on the bank because the bank has more money immediately available in the event of an economic crisis. This all sounds great as no one wants banks failing and losing depositors money however the additional security comes at a cost.
The problem for banks is that they make money by loaning out funds. The more money they are required to keep in the bank, the less they can loan out and the lower their profitability. This is the situation faced by the Australian banks at the moment as APRA is implementing the minimum Tier 1 capital requirements. In order to comply with these regulations, the banks must raise new capital through whatever sources the can. All four of the major banks have been issuing hybrid securities recently as one way to raise some of this Tier 1 capital that they need. Deposits are the main source of Tier 1 capital however competition for customer deposits between banks is as fierce as ever. This competition is keeping interest rates on deposit accounts relatively high (compared to the cash rate) and squeezing the margin that banks make between the interest charged on loans and interest paid on deposits (known as the net interest margin).
Westpac bank (WBC) yesterday reported its full year 2016 results with both revenue and profit down from the prior year. One of the reasons for this, cited by the bank, is that regulatory costs are increasing and low interest rates are putting pressure on net interest margins. Furthermore, the returns on equity are decreasing as the amount of equity capital that must be held by the bank is higher as a result of the new reforms.
While the banks are likely to successfully adapt to the new regulations in the short term it is causing some pain. While the reported results for FY16 of each of the major banks is generally down on the prior year, they are nevertheless very profitable companies and the returns on equity are still very healthy at levels above 10%. Rivkin holds banks as part of certain portfolios and we are currently enjoying the very high dividend yields they are paying.
This article was written by William O'Loughlin – Local Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via email@example.com or by phoning +612 8302 3600.