The Financial System Inquiry is Bad News for Banks — and You

The Australian government has issued a long overdue response to the Financial System Inquiry (FSI). The government is throwing its full weight behind the report’s recommendations.

The inquest, led by David Murray, was a broad overview of the financial system. Its aim was simple: figure out ways of improving efficiency, and return with a plan of action. That plan was presented earlier in the year. But it’s taken a leadership change for a white paper to turn into policy.

Prime Minister Malcolm Turnbull has made the FSI his first major policy change. So much so the government is adopting most of Murray’s recommendations. It amounts to the biggest overhaul in the financial system in decades.

What does it all mean for you then? It’s a bit of a mixed bag.

For the most part, households are the major winners from these new policies. Take retailers for starters.

New rules will prevent merchants from slugging you with excessive credit card fees. You’ll only be charged what it costs retailers to receive your credit card payment. It’s an overdue change, but at least it’s coming.

Superannuation is another industry set for change. The FSI found many Aussies felt they were overpaying when it came to super fees. The government is tasking the Productivity Commission to look into this. The Commission will look at new ways of allocating savings for those who don’t choose their own funds. Lower super fees can only be a good thing. And the government should be applauded for following through on this.

Advisory bodies will come under the microscope under new rules. No longer will you receive counsel from unqualified advisers. Public registers will be shored up too. This means you’ll know exactly which advisors meets industry standards.

These are some of the key takeaways from the government’s new policy. By no means is it a comprehensive list of changes. Yet it shows you a few ways in which consumers will benefit directly.

Yet there are also losers to be had as well. Banks in particular stand out as one.

Anything we mention banks, we can’t separate them from their consumers either. Which is a roundabout way of saying that changes could affect every household.

A key FSI recommendation centred on boosting banking balance sheets. In practice, it will require banks to raise more capital. Which is exactly what is set to take place in the coming years.

Safer banks might be good news at face value. But they punish shareholders and customers indirectly. For investors, it means lower potential returns. For customers, it’s higher fees.

At the same time, it could spell trouble for home owners. Banks are likely to make up for capital raising by lifting home loan rates.

Capital ratios on the rise

High capital ratios do benefit banking balance sheets. But they hurt lending practices too. The more money banks set aside as future funds, the less they have to lend out.

That’s bad for business. However banks have little choice in this matter. When regulators demand change, banks have no choice but to obey.

How bad are Aussie bank capital reserves ratios? Compared to global peers, Aussie banks are slipping according to industry experts.

A recent APRA study into Australian banks found they face a $30 billion capital shortfall.

In fairness, banks have already been active on this front.

Westpac announced plan to raise $3.5 billion last month. That would take its tally to $5.5 billion for the year. Commonwealth and NAB have each raised $5.5 billion. ANZ, meanwhile, outlined plans to raise $3 billion in August.

Banks are working on shoring up balance sheets. But with regulators demanding more, they’ll need to keep that up. Which means days of capital raising aren’t over by any stretch.

Unfortunately, as these things have a habit of doing, the costs don’t fall merely on banks. Customers and shareholders shoulder many of these burdens.

Typically, banks request shareholders stump up this cash. Yet this also has adverse effects. You might see fees, or rates, rise for instance. It’s exactly what we saw last week when Westpac raised home loan rates by 0.2%.

Meanwhile, shareholders know all too well how such schemes put equity returns at risk.

Unless profits rise to match capital raised, investors see weaker returns. Why? Because banking earnings get spread over a larger number of shares.

Then there’s the question of dividend yields. There’s no suggestion dividends are heading down across the sector. But it does put pressure on banks to meet ongoing commitments.

At the same time, capital raising has its upsides. It lowers a bank’s leverage, leaving shares with less risk attached. Any reduction in leverage lowers the risk of default among bank issued debts and deposits. That in turn lowers a bank’s interest funding costs, improving profits.

Nonetheless few investors see capital raising in a positive light. Again this all comes back to returns. With capital raising schemes, investors expect their returns to decline. Which is all that really matters in their eyes.

Why is capital raising so important now for banks?

Higher capital reserves are all part of a plan to protect banks. It’s a safety net in the event of a financial meltdown. The bigger the rainy day fund, the less likelier a big bank meets the same fate as Lehmann Brothers…

What the government doesn’t want is what the US went through in 2008. Taxpayers were forced to bail out banks in the aftermath of the GFC. Back then, banking capital levels were dangerously low. It’s the reason why the costs of bailing out banks fell on taxpayers.

That’s where banking regulations come in.

Strengthening balance sheets is a way of lowering potential risks. And for Australia, that’s critical. Why? Because our banking sector is overexposed to the housing market.

That explains why APRA have focused banks on limiting home loan lending. Net interest margins on home loans are lower than business or personal loans. Coupled with an overheated housing market, it makes sense that banks target home loans.

That applies to owner occupiers as much as it does investors.

Investor lending isn’t the only concern for banks anymore. Owner occupiers are increasingly facing rising loan rates. Westpac’s 0.2% rate hike for owner occupiers was the first sign of this. This will help banks carry the burden of requiring more equity.

However you look at it, the health of Aussie banks is tied into both housing and stocks. The sector accounts for almost half of the entire ASX index. Which makes any banking crash a scenario worth avoiding at all costs.

None of this is hard to imagine. Entering a prolonged economic downturn is as likely as it’s been in decades. Anything that strains household budgets is a cause for worry.

If households can’t meet loan repayments, the entire banking system risks unwinding.

The same is true in the event of rising interest rates. Many mortgage loans were calculated at low interest rates. If mortgage rates rise, households may find repaying loans a struggle.

All of which makes capital raising an important fact of life for banks. But it’s also one that damages their core business of lending.

Anything that crimps business can’t help but affect investors and consumers either.

Mat Spasic,

Contributor, Markets and Money

PS: Bank stocks are down across the board since April. Share prices are down on the back of this year’s capital raising. Some banks, like CBA, are down by as much as $20 a share. With capital raising an ongoing priority, the banking sector is in line for more pain.

The sector is a big reason why the ASX lost $90 billion since June. But none of this comes as any surprise to Markets and Money’s Vern Gowdie. He predicted the current market correction at the beginning of the year. Yet Vern reckons we haven’t seen the worst of it yet.

He’s convinced the ASX will lose as much as 90% of its market cap in the future. As China’s economic slowdown picks up pace, market volatility will follow.

Vern is the award-winning Founder of the Gowdie Family Wealth and The Gowdie Letter advisory services. He’s ranked as one of Australia’s Top 50 financial planners.

Vern wants to help you avoid this coming wealth destruction. That’s why he’s written this free report ‘Five Fatal Stocks You Must Sell Now’. As a bonus, Vern will show you which five blue chip Aussie companies could destroy your portfolio. You’ll be surprised to learn which banks make Vern’s list…

To find out how to download the report, click here.

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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