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UPDATE 2-Big Australian banks told to hold more capital, on notice over mortgages

mortgages@

* Four major banks need to have Tier 1 ratio of 10.5 pct

* Will meet "unquestionably strong" benchmark - APRA

* Other banks to raise capital by 50 basis points

* New capital requirements to be met by January 2020 (Recasts, adds fund manager comment, industry context, shares)

SYDNEY, July 19 (Reuters) - Australia on Wednesday ordered the country's biggest banks to raise capital for the second time in two years and signalled further action to shore up their burgeoning mortgage books, potentially squeezing shareholder returns.

The banking regulator said it would release a discussion paper later this year to include risk weights on mortgages among other changes, in-line with expected rules due to be finalised by global regulators.

The warning on mortgages came as it raised the target for the four major banks' common equity Tier 1 ratio - a key gauge of a lender's strength - to at least 10.5 percent.

That translates into an average increase of 100 basis points above the banks' December 2016 levels. They are expected to meet the new benchmarks by January 2020.

The Australian Prudential Regulation Authority (APRA) has now ordered the big banks to boost capital twice since 2015 as it seeks to make the sector impregnable to global shocks.

Australia's major lenders - Commonwealth Bank of Australia , Westpac Banking Corp, ANZ Banking Group Ltd and National Australia Bank Ltd - hold combined market share of more than 80 percent, raising fears their failure could fatally weaken the broader economy.

"Capital levels that are unquestionably strong will undoubtedly equip the Australian banking sector to better handle adversity in the future and reduce the need for public sector support," APRA Chairman Wayne Byres said in a statement.

Every 50 basis point adjustment in the Tier 1 target above 10 percent equates to nearly A$2.2 billion in additional capital, Morgan Stanley analyst Richard Wiles said in a CBA-focussed note on Monday.

Non-major banks would be required to increase capital by about 50 basis points, APRA said.

Together the so-called Big Four raised A$20 billion ($15.59 billion) in 2015, the last time regulators announced stricter capital rules. That triggered a slowdown in dividend payouts as net interest margins slipped to record lows of about 2 percent.

Shares in the Big Four jumped 2.5-3 percent in early Wednesday trading, after each of the lenders said they were well positioned to meet the new benchmarks.

ON NOTICE

While the banks should have no trouble raising the additional capital over the next two years, analysts said the main risk now was potential changes to mortgage risk weights amid persistent concerns about the frothy property market.

The discussion paper due by the end of this year would reveal measures to address the banks' "structural concentration of exposures to residential mortgages", the regulator said.

APRA would issue draft prudential standards in 2018 leading to a final release in 2019.

"We'll be watching for the risk weights on mortgages. The real question is how much will that go up to. If it rises to 30 percent from 25 now it is probably okay, but any more than that would be significant," said Omkar Joshi, portfolio manager at Regal Funds Management.

Australian banks survived the global financial crisis that began in 2008 relatively unscathed - backed by an explicit government guarantee - and have been highly profitable largely due to their mortgage businesses.

But the banks' massive home loan books are exposed to debt-fuelled spikes in property prices, and there have been growing expectations APRA will ask banks to set aside more capital against mortgages, particularly interest-only loans.

Earlier this year, it asked banks to limit new interest-only loans to 30 percent of total new mortgages, from 40 percent now.

It also demanded that banks cap annual growth in investor credit to "comfortably remain below" a previously set limit of 10 percent. ($1 = 1.2825 Australian dollars) (Reporting by Swati Pandey and Jamie Freed; Editing by Stephen Coates)