RBA dials up the bank support

The RBA is pouring it on in favour of the banks just now. That makes sense given the ructions in rippling through global banking. But it’s still interesting to examine the arguments. In a speech today, Malcolm Edey, Assistant Governor (Financial System) doesn’t bother with many, he simply repeats the refrain:

In Australia meanwhile the financial system is continuing to perform relatively well. The broad outlines of that story are, I think, well known. During the GFC Australia avoided a recession and a banking crisis. Our banks are profitable and well capitalised, and their overall asset quality remains good.

We can’t of course expect the Australian system to be entirely immune from the unfolding events in Europe, but a couple of points are worth emphasising. The first is that the Australian banks have only limited direct exposures to sovereign debt in the countries that are most at risk. So potential effects on Australian banks’ overall asset quality are not an issue. The second point is that, since the height of the GFC, the Australian banks have done a lot to strengthen their funding positions. They have increased their use of domestic deposits as a funding source, lengthened the average term of their wholesale funding, and correspondingly reduced their reliance on short-term wholesale debt. These things will help to make them more resilient to the uncertainties that are now affecting international credit markets.

It’s certainly true that the banks have limited exposure on the asset side of their balance sheets. It’s not true, however, on the liability side. As the IMF recently noted:

While financial institutions (mainly banks) have reduced their external borrowing, disruptions in global capital markets could still put pressure on their funding. Financial institutions external borrowing has fallen from a peak of 70 percent of GDP in 2008, to less than 60 percent of GDP in mid-2011 (Tables 6 and 7). Short-term debt (mostly issued by banks) has also declined, but remains sizable at 42 percent of GDP (on a residual maturity basis). Funding from European banks was just over US$300 billion at end 2010, about ¼ of gross external debt. If offshore funding markets were disrupted, the cost of bank funding would likely rise.

Nor is it true that Australia had no banking crisis in 2008. The global freeze led to the following, from my co-authored book with Ross Garnaut, The Great Crash of 2008:

In the early days of October 2008, money poured into the big four Australian banks from other financial institutions. But life was becoming increasingly anxious for them as well. One by one they advised the government that they were having difficulty rolling over their foreign debts. Several sought and received meetings with Prime Minister Rudd. The banks told him that, if the government did not guarantee their foreign debts, they would not be able to roll over the debt as it became due. Some was due immediately, so they would have to begin withdrawing credit from Australian borrowers. They would be insolvent sooner rather than later.

The banks got their guarantee and rewrote our financial architecture in the process. Just because the resolution was cheap doesn’t mean it wasn’t a crisis.

Anyways, Edey is right that there is good news here too. From Banking Day today comes this note suggesting that US investors are increasing their exposure to Australia:

Data compiled by Fitch Ratings, and republished last week by Citigroup Global Markets, puts the percentage of holdings of prime US money market funds invested in the debt of Australian banks at around nine per cent. This is up from around seven per cent in late 2010.

Around the time of the 2007 credit crunch (which morphed into the financial crisis) the percentage of Australian bank debt in money market funds was around four per cent. Earlier in the 2000s these funds held little local bank debt.

Sean Keane, author of a daily credit commentary for Credit Suisse, yesterday cited “various market estimates of a pick-up in Australian bank US dollar commercial paper issuance over the past four months, with some suggesting that volumes have increased by three to five per cent.”

A similar good news story was told on Tuesday by Guy Debelle, Assistant Governor (Finanical Markets), in a finely crafted speech that addressed liabilities in detail. It was perhaps the most honest look into how Australian banks are faring versus international peers in terms of funding vulnerability yet offered by out central bank.

First up Debelle illustrated how much better Australian bank equity prices have been faring:

The share prices of the Australian banks have not fallen as far as those in the major countries, although it is interesting to note that the share prices of Canadian banks have been even stronger. Over the period since June 2007, banks have actually outperformed the rest of the Australian market.

Very nice and true. He might have added that the banks required an enormous amount opf public support to achieve this but so did the other banking systems cited so it’s a fair enough comparison. And kudos for telling us about Canada. We then move to debt funding:

By way of contrast, the equivalent spread in the Australian market (the spread between the bank bill rate and the expected cash rate), while higher than earlier in the year, has remained markedly lower than that in Europe. There have been spikes in this spread on occasion in the past few months, but they have reflected sharp downward movements in the expected cash rate, rather than upward movements in the bank bill rate.

That’s fair enough too but I wrote about this some weeks ago and noted that Australia and Europe were the only two banking systems that were behaving in this way:

It’s possible that once the majors get quarter and year end out of the way on September 30^th that they’ll embrace the rally in the OIS, longer term swaps and futures markets and that BBSW rates will drop. But, when we add in what’s happened to Australian major bank CDS over the past few months my sense is that there is a creeping concern in Australian money markets which is being reflected in increased bank funding margins.

So, although I accept Debelle’s explanation, there are other less sanguine interpretations, especially when you include broader comparisons than just Europe.

Debelle then favourably compares Australian banks to European banks in terms of liquidity, which is fine, except given we haven’t actually had a credit event yet, just anxiety about the possibility of one, that doesn’t reassure that much, before he moves on to bond issuance:

Bond issuance by banks globally has fallen sharply in recent months. A partial, but not complete, explanation for the low level of issuance is that bank balance sheet growth globally has been very low and even negative in some cases. Graph 5 shows that unsecured bond issuance by euro area banks has been at very low levels, but until recently, secured issuance in the form of covered bonds had been relatively robust. This is indicative of a general trend for investors to take greater comfort in secured rather than unsecured exposures.

As market volatility has increased in recent months, issuance by the Australian banks has also declined. As the Reserve Bank has noted on a number of occasions, the Australian banks are much better placed to ride out these periods of volatility than in the past. This is for a number of reasons, including that deposit growth has outstripped credit growth for more than two years now, thereby reducing the banks’ need to access wholesale debt markets, and that banks have increased their use of longer-term funding.

Sure, if you compare the last year with 2009, there’s a reduced “need to access wholesale debt”. But compared with 2007? It’s clearly true that Australian banks have been forced to do exactly what Debelle describes. And kudos to regulators (and China’s economy) for making it happen. But to me it’s equally obvious that the banks have an ongoing and very serious need for offshore wholesale funding, just as the IMF (and RBNZ) keep saying, even if that need is not growing. And if there is a disruption in supply of that credit they will be vulnerable, again. To me that makes them not an exception to the unstable global banking system but one hundred per cent a part of it.

Of course, as we did in 2008, if it happens again, you and I will step in and guarantee the banks. The ratings agencies have already stated that this a part of a two notch upgrade to bank ratings. But if that’s the case, then why don’t we formalise things somehow?

This ongoing ‘in the closet’ public risk, private profit offends the rights of tax payers, as well as the principles of capitalism and transparent public policy.