Big banks face a halving of mortgage profitability

Australia's big banks may have to raise variable mortgage rates by around 30 basis points to compensate for proposed changes to mortgage risk weights used for capital purposes, according to JP Morgan analysis.

However, JP Morgan banking analyst Scott Manning said he doubted that raising interest rates would be the best strategic response to the Basel Committee on Banking Supervision's changes to capital requirements.

While the Basel Committee is still working on its revision to the measurement of risk weighted assets, Manning said there was enough material in the Financial System Inquiry report, the Basel Committee working papers and comments from the Australian Prudential Regulation Authority to make valid assumptions.

The big banks' average mortgage risk weight will rise from 17 per cent to around 30 per cent. Under the new rules the increase in risk weights will be greater for loans with higher loan-to-valuation ratios.

Manning estimates that the "front book" profitability of the major banks' mortgage portfolios would fall from a return on equity of 40 per cent to a return of 20 per cent.

"Re-pricing the mortgage portfolio is a lazy response, and not only that, arguably quite detrimental to longer run return prospects for the mortgage portfolio - to the benefit of non-banks and regional lenders," Manning said.

He said alternative measures to mitigate the impact of the new risk weights included re-pricing business loans instead (where there is less competition) and shifting the funding base to low-cost wholesale funding.

One feature of the proposed rule changes is that the value of the property being financed will be kept constant at the value at origination when assessing LVR, as opposed to the "dynamic" LVRs currently reported by banks.

For example, ANZ dynamic LVR, which is currently 51 per cent, would increase to 61 per cent, with a consequent increase in risk weights.

This feature and the segmentation of LVR bands for the purposes of calculating risk weights could lead to much greater segmentation in the market, with higher discounts for borrowers in lower LVR brackets and a strong focus on the refinancing market.