Everything in finances comes down to risk verses return. Like all investors, banks chase optimal returns while maintaining safeguards against loses. This pursuit of higher and higher returns contributed to a worldwide collapse during the GFC.
Recently, the regulators have announced that the big four banks will be required to hold more capital as a buffer against the mortgages that they issue to everyday Aussies. These new regulatory requirements are designed to make the financial system safer, preventing a new GFC.
It makes sense that holding more capital will make our deposits are safer, because banks have a buffer if a large number of homeowners suddenly can’t make their repayments. But what will these regulations mean for borrowers?
Banks have a wide range of assets on their books with varying degrees of risk. Banks are required to keep a capital buffer based on the risk weight of their assets.
Cash – 0% (ie no risk) Australian Government bonds – 0% Margin Lending (with strict conditions) – 20% Retail Mortgages 25% (Up from 16%) Corporate Bonds – 20% – 100% (based on credit ratings) Business Loans – 100%
The new change to the risk weight of retail mortgages means that banks have to set more capital aside for every mortgage they issue.
Keeping extra capital costs banks money. There is the cost of raising the extra capital in the first place. Plus the profits the banks miss out on, by not being about to invest that money in higher return investments. So either shareholders have to start getting used to a smaller dividend or mortgages holders will have to get used to paying more interest on their loans. It’s probably a safe bet to assume that it will be the mortgage holders who have to stump up the funds.
Not everyone thinks this is a bad thing. For a long time the big 4 have dominated the mortgage market. This is partly because smaller institutions (regional banks, building societies and credit unions) have always had to use a 25% weight for retail mortgages, while the big 4 had an average 16% risk weight.
Now, with a more level playing field, these institutions are gearing up for an opportunity to put a bigger foot in the door. The view among the sector is that for the first time the big banks may finally have some real competition.
However, ultimately house prices are likely to face pressure as buyers baulk at the higher cost of borrowing.
The end of cheap money could be near. This joy ride is slowing down.
