Moody's: Major Australian banks' capital metrics will come under pressure

Moody's Investors Service says that the risk-weighted capital metrics of Australia's major banks will come under downward pressure, as a result of both cyclical and regulatory factors, but they will nevertheless retain considerable flexibility to preserve their strong credit profiles. 

"In this context, one of the key cyclical pressures on the Common Equity Tier 1 (CET1) ratios of the big four banks will come from an upward revision in their credit risk weights," says Ilya Serov, a Moody's Senior Vice President. "However, this development should also be seen in the context of the considerable improvements of past years," he adds. 

"Recent signs suggest that the asset cycle in Australia has peaked, leading, we expect, to an upward revision of credit risk weights, and thus credit risk-weighted assets (CRWA); and this scenario is particularly the case for the banks' corporate loan portfolios, as they are more vulnerable to any potential worsening in economic conditions and will thus see the sharpest revision in risk weights," adds Serov. 

In addition, residential mortgage risk weights will rise to an average of at least 25% for the major banks in July 2016, as they implement the regulatory change announced by the Australian Prudential Regulation Authority (APRA) in 2015. 

Moody's conclusions were contained in a just-released report on Australian banks, "Capital Metrics Will Come Under Pressure Due To Rising Risk Weights, But Impact On Credit Profile Will Be Limited". 

Moody's sensitivity analysis suggests that the potential decline in the banks' capital metrics will be limited. 

Even in a highly stressed scenario of risign risk weights, and before factoring in any potential for organic capital generation, the major banks' CET1 ratios will remain above 8.0%, a level which is the combination of the regulatory minimum CET1 plus Capital Conservation and Domestic Systemically Important Bank (D-SIB) buffers. 

The two scenarios are summarized as follows: 

1. In a highly stressed scenario, we based our analysis on a corporate loan impaired and past due ratio of 2.5% (as a percentage of exposures at default), a level commensurate to the upper end of the range recorded by Australian banks in 2009, in the immediate aftermath of the global financial crisis. This results in a corporate credit risk weight of 68%. 

2. In the second case, we took the average ratio of corporate impaired and past due loans since 2008 as our base input (1.1% as a percentage of exposure at default), and this yielded a corporate loan credit risk weight of 58%. 

In both scenarios, we also incorporated the impact of the coming upward revision in the risk weights applicable to residential mortgages to 25% to be implemented in July 2016. 

These scenarios yielded CET1 ratio declines of 1.6 percentage points in the first case and 1.1 percentage points in the second case, corresponding in turn to CET1 ratios of 8.0% and 8.5%, respectively, given the level of 9.6% as at September 2015. 

Asset quality deterioration attributable to the corporate loan book accounted for a 0.7 and 0.2 percentage point of the CET1 decline respectively, with the change in residential mortgage risk weights accounting for a remaining 0.9 percentage point. 

Notwithstanding the downward pressure on from higher rigk weight, the impact of weaker asset quality on risk-weighted capital ratios is likely to be spread over multiple reporting periods. Given the banks' strong profitability, and potential to raise additional capital via their dividend reinvestment programmes, Moody's continues to view Australia's major banks as retaining considerable flexibility to maintain their strong capital profiles. 

Australia's four major banks are: Australia and New Zealand Banking Group (ANZ), Commonwealth Bank of Australia (CBA) , National Australia Bank (NAB) and Westpac Banking Corporation (WBC) (all rated Aa2 stable, a1 stable).