Mark Fowler: Aussie downgrades could hit NZ banks

Pedestrians walk past a National Australia Bank Ltd. Photo / File

Opinion

Earlier this month, Standard & Poor's (S&P) issued ratings downgrades for 23 of Australia's financial institutions - representing the vast majority of such organisations in Australia.

It's a move S&P has attributed to rising "economic imbalances". It's also something that many people have seen as, among other things, a warning about the overheated domestic property market (particularly in Sydney and Melbourne), and the overall risk this poses to national financial stability.

Elevated levels of household debt and subdued economic growth are not new themes, and questions are now being asked as to whether this latest downgrade from the ratings agency is likely to put further pressure on investor sentiment.

Considered within the wider context of uncertainties around the regulatory landscape (ie, with Australia's newly imposed bank levy), and the impact these measures will have on bank profitability, we can expect these developments to increase the risk premiums of Australian banks, and their New Zealand subsidiaries.

Impact

It's worth noting that the ratings of Australia's Big Four (ANZ, Commonwealth Bank, National Australia Bank, and Westpac) were left unchanged, with S&P citing expectations of Government support in the face of a housing crash. However, the ratings for Australian and NZ subordinated (unsecured) debt and debt-equity hybrids were lowered, which is likely to have a direct impact on their cost of funding in both wholesale and retail markets.

We estimate the direct impact of higher funding costs will take approximately 2 per cent off earnings over a three- to five-year period. We can also expect to see a further indirect impact from reduced availability of wholesale funding, which will likely restrict the regional banks' ability to grow and put more pressure on deposit costs.

Uncertainty remains

The Australian Government announced it would be introducing a bank levy as part of its 2017 Budget, with some describing it as a bank "super tax", similar to the proposed resource company super profit tax back in 2012.

Based on Treasury estimates, the bank levy will raise approximately A$1.6 billion ($1.68b) net of tax per annum. Each of the major banks has provided their estimate of the impact on earnings, however, and their preliminary calculations put the value at between A$220m and A$265m. If correct, this would mean - on an aggregated basis across the four majors - the implied bank levy is approximately A$1b - which falls well short of the A$1.5b-A$1.6b earmarked in the Budget.

With this discrepancy in mind, there's a risk that the levy will be changed to bring the total amount raised closer to the Federal Budget estimates and current forecasts (which don't take tax deductibility into account ).

Furthermore, the Australian Treasurer has launched an Australian Competition and Consumer Commission inquiry into residential mortgage pricing, suggesting that there will be greater scrutiny in this area.

Domestic impact

At first glance, this activity may appear to be well contained across the Tasman, but we believe it may have an impact for domestic investors also.

In New Zealand, some investment mandates prevent fund managers from holding non-investment grade securities - most notably, in respect of corporate bond funds, which are responsible for investing KiwiSaver flows.

So, as regulatory capital instruments are notched down from the stand-alone credit profile, some of these securities may become ineligible for investment.

In addition, the local banks are likely to feel the higher cost of regulatory capital, as any widening in credit spread or cost of funding will be reflected through both markets, as institutions will demand comparable pricing.

Outlook

The New Zealand economy remains relatively robust, notwithstanding increasing risks associated with an over-geared household sector.

However, with uncertainties relating to the regulatory landscape and the ultimate impact these will have on banks' profitability, we can expect these measures to weigh on the risk premium of the Australian banks, and ultimately, therefore, their NZ subsidiaries.

Mark Fowler is Head of Fixed Income at Hobson Wealth Partners. This article does not consider the objectives or situation of any particular investor. It should not be construed as a solicitation to buy or sell any security or product.