Proposed revisions to APRA's capital framework could see returns on the major banks' mortgages drop unless there is a further back book re-pricing on higher risk loans or a reduction in all front book discounting.
The APRA changes - released last month - could prompt a relentless fall in returns from 21 per cent to between 16 per cent and 18 per cent - if the country’s banks don't act soon.
This comes from Morgan Stanley’s Richard Wiles who reckons that mortgage risk weights could jump to 30 per cent, from 25 per cent in September 2017.
“All else equal, this would cause return on core equity tier one capital ratio to fall from 21 per cent to 16 per cent using a CET1 target of 10.5 per cent or to 18 per cent using a target of 9.5 per cent,” he said in a client note.
“Our analysis suggests that the current return of 21 per cent is broadly in line with the early2015 level, but there has been a significant change in returns for different types of loans."
Generally speaking, rising capital intensity has been offset by mortgage re-pricing.
Rates are up 20 basis points on owner-occupier loans - where borrowers also pay down principal - and 110 basis points for both owner-occupier interest-only mortgages and investor principal-and-interest loans.
Interst rates have risen 130 basis points on interest-only investor loans.
On WIles' analysis, while returns on owner-occupier principal-and-interest loans should improve under the proposed APRA rules,major banks will need to reprice higher risk mortgages by 40 to 65 basis points to maintain an average 21 per cent RoCET1 under the scenarios he has outlined.
“While we think this will be a challenge - given increased scrutiny of conduct and competition from current bank sector inquiries - over time banks could protect returns by reducing front book discounting by 15 to 25 basis points on all home loans.”
Risk weights recalibrated
APRA's proposed revisions will take effect in January 2021.
Under the proposed new capital framework, mortgage risks weights have been recalibrated to distinguish between owner-occupier and investors.
Given the industry is on track to meet the ‘unquestionably strong’ benchmarks set out by APRA last year, the impost of the Basel accords is largely over and lenders will not be asked to add significant capital from here.
Total capital has risen from 2 per cent of risk weighted assets in 2002 to over 12 per cent in 2017, this has coincided with return on equity from almost 20 per cent to approximately 16 per cent.