Mutuals: solving the capital problem

A revamp of the Companies Act that will make it easier for mutuals to raise equity and loan capital outside of members is on the near-term horizon. 

Earlier this month, Treasurer Scott Morrison tasked Greg Hammond, the corporate governance and banking lawyer, with making recommendations on the best way for customer-owned lenders to raise capital and gave him until July 14 to report back. 

The only way to solve the whole problem is to address the concept of mutuality in the Corporations Act and further changes to the law will be much easier than making regulatory changes, according to Heritage Bank chief financial officer, Paul Williams.

The problem for credit unions, building societies and mutual banks is that capital raising outside of members is complex so they typically rely on retained profits and debt to grow. 

So will a change in the law cause a stampede into the equity capital market as mutuals look to compete with the big banks by raising equity which counts as loss-absorbing capital and allows them to pay dividends?

As things stand right now, mutuals can’t issue share capital without risking demutualisation or changing the constitution (or both); plus mutuals have difficulties issuing tier two capital and additional tier one capital because the instruments do not convert to equity - they convert to a 'mutual equity interest'.

Slow burn 

Williams is predicting a slow burn rather than a stampede to issuance.

“Rushing to issue won’t make sense for a lot of mutuals which are flush with capital," he told AB+F. “Mutual’s must be in a position where it makes sense to raise equity. These deals are expensive to put together, expensive to issue and you’ve got to achieve the right return on capital.” 

As he sees it, there are plenty of progressive mutuals, not just deposit takers and lenders, that will want to raise equity right now to fund much-needed investment programs to support growth and Heritage is one of them.

But the finance professional, and former Heritage treasurer, is adamant that going the issuance route is not as easy as it sounds. If Heritage starts raising capital this way, it really becomes a hybrid model, paying out dividends.

“This means balancing profitability with your member value proposition and this is not something every mutual is programmed to do,” he said.

He should know. Heritage has launched two Australia Securities Exchange-listed debt securities in the past and has been reporting under the continuous disclosure regime since 2009. So Williams knows the management has what it takes to balance the interests of a wholesale investor base as well as a member base. 

Like other customer-owned lenders, Heritage has been forced to intensify efforts to reassure members that mutuals have a role to play. This is partly a response to call for the fragmented sector to cull and consolidate. 

But not everyone wants to bank with the majors, he argued, some want to affiliate themselves with an entity that they can readily identify with, such as a regionally-focussed or bonded group. 

Mutual reality

In a world of increasingly homogenous lenders, Williams argues that the sector is a diverse grouping with identifiable differences even though to an outsider mutuals all look the same. 

“What frustrates the sector, is that efforts to remain relevant are being thwarted by regulatory uncertainty, inconsistency and intransigence," he said.

"The message about systemic risks may be co-ordinated, but the mutual sector is dealing with conflicting applications of the rules by the corporate watchdog, the prudential regulator and even the tax office. APRA would love us all to be one entity but that doesn’t mean that it’s the right thing for customers. 

“The systemic constraints on the mutual sector, are well known. Being forced to adhere to one set of  rules that treat mutuals differently - and hold more capital against the same loan - makes it very hard for smaller players to compete against the big lenders.” 

Mutuals are locked in fierce competition for borrowers and it is getting even tougher as the capital rules mean mutual executives are playing with one hand tied behind their backs. So for Williams the question is: can Heritage grow a bigger share in markets it has traditionally played in?

“We can go from having 0.6 per cent of the national market to 1.5 per cent and that’s an immensely good result. However, in the scheme of things Heritage is a niche player," he said.

While achieving more scale through consolidation is a common catch-cry, Williams feels scale comes with its own problems. 

“Heritage has reasonable scale at $9 billion. As you get to $15 to 20 billion with a Triple B rating, you have challenges funding yourself at a cost effective rate. That’s the reality of being a mutual or regional lender rather than a major bank.” 

Australia Prudential Regulatory Authority’s recent round of measures on riskier mortgages loans don’t affect Heritage since the mutual doesn't play in the high-risk lending space. But Williams acknowledged the riskier categories are attractive for those trying to boost market share and there are a handful of mutuals that are on APRA’s radar. 

Despite the intense competition in the home loan market, Heritage managed to achieve solid growth and a good ROE without hurting its margins. 

“We have been able to manage our deposit mix pretty well and leverage some of the infrastructure that was underperforming."

Heritage Bank clocked a first-half net profit of $20.89 million up 17.3 per cent on the year-ago same period.

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