Bank offshore funding coming back to bite

The risks inherent in the Australian banks’ heavily reliance on offshore funding has received a lot of attention on this blog (for example see here). Now with the European debt crisis seemingly reaching a crescendo, it looks like these borrowings might now be coming back to bite.

From the Australian:

AUSTRALIAN and South Korean banks are the most exposed in Asia to Europe’s debt crisis, because of their heavy dependence on offshore wholesale funding markets, a senior official at Fitch Ratings says.

Fitch Asia-Pacific sovereign ratings head Andrew Colquhoun said while direct exposure was low, but if the Greek debt crisis imploded and spurred a major dislocation in global credit markets, Australian and South Korean banks and economies would suffer the most.

“Among the countries in Asia I would regard as relatively more exposed are both Korea and Australia, which have an issue of short-term and long-term external debt of the banking system,” Mr Colquhoun said.

“If the banks found it more difficult to refinance that debt, then there could be repercussions for the economies,” he said, adding “quite a lot” of risk still remained in the process to firm up a second bailout package for Greece.

He said Australia also faced some domestic issues, with a housing market that looked “overstretched”.

If interest rates were to go much higher to contain a mining boom, stress would soon become evident among borrowers.

Mr Colquhoun said Australia’s four biggest banks had in recent years leaned heavily on foreign currency borrowing and were among the biggest issuers of debt in the world using their respective governments’ funding guarantees during the financial crisis.

For anyone relatively new to this blog, the banks’ increasing reliance on offshore funding is illustrated clearly by the below chart, which shows a sharp increase in external liabilities by Depository Corporations over the past 20 years [note: the below chart also includes offshore borrowings by building societies, credit unions and registered financial corporations, although the banks account for the lion’s share].

These offshore borrowings have been used predominantly to fund Australia’s housing bubble – a largely non-productive activity.

The key risk is that the banks’ ability to refinance their borrowings rests with the willingness of foreign investors to continue to lend them money. But in times of heightened risk-aversion – such as the impending European debt crisis – foreign investors can become nervous and less inclined to continue extending credit, which could leave Australia’s banks, house prices, and broader economy exposed to a sudden liquidity shock.

Indeed, the markets already appear to be re-pricing Australia’s debt upwards because of the riskiness of Australia’s housing market and the banks’ offshore funding vulnerabilities. As reported in Business Day on Wednesday:

Debt markets appear to be betting Australian banks will suffer fallout from any European debt crisis…

Analysis by Banking Day suggests that the Big Four Australian banks’ credit risk continues to be priced higher than the debt of other AA-rated banks.

Banking Day has compared five-year Australian bank CDS spreads for the year to date with those of AA-rated HSBC and BNP Paribas. These spreads, sourced from Markit, are a proxy for the major banks’ cost of wholesale debt…

When we want to assess investor perceptions of banks’ credit risk, what matters is the spread paid by the banks over the base rate.

As can be seen from the chart, the Australian banks have been at a cost-of-debt disadvantage for most of the past five months. (The chart uses ANZ spreads, but spreads for other Australian banks are virtually identical.)

CDS spreads for AA-HSBC have remained around 80bps over the period and now sit some 40bps below those of the Australian banks.

AA-rated BNP Paribas is one of the banks considered most exposed to the Greek crisis. Ratings agency Moody’s announced a week ago that it was considering cutting the bank’s rating because of its exposure to Greek debt. Yet CDS spreads for BNP Paribas are no worse than those of the Australian banks, even though they have widened since early May, as the Greek crisis re-emerged.

Out of interest, also included in the chart are the five-year CDS spreads for A+-rated JPMorgan Chase & Co. While JPMorgan is rated two notches lower than the other banks shown, its CDS spreads align more closely with those of HSBC.

Clearly, the sharp slowing of household credit growth is working in the banks’ favour as it has significantly reduced their offshore funding requirements. Even so, the market appears to be unconvinced, deeming the Aussie AA- banks riskier than their peers (hat tip AusHousingCrash for the Banking Day link).

Further, with the banks in the sights of regulators, ratings agencies and investors for their heavy reliance on wholesale money markets, it is questionable whether they would be able to ramp-up their offshore debt raisings even if the demand for credit from households was there.

And with offshore funding seemingly on the nose, and credit growth likely to remain sluggish, the banks’ ability to support further house price growth appears to be limited. A prolonged period of price stagnation, therefore, now appears to be the best case outcome for the Australian housing market.

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Unconventional Economist
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  1. Nah nah nah, some guy from BIS Shrapnel said on ABC news this morning that house prices were going to go up up UP! Nothing to worry about 😉

  2. My wife went looking at properties on the weekend. She saw one that was just listed for 475k. It last sold Dec 2003 for $415k. “They haven’t gone up much’.

    My comment was that he will be lucky to sell it for 440k.

  3. Hi Guys, normally I come on here to tell of the sad story in lending figures as I work for one of the big four banks as a lender. Well looks like the banks loosening of credit policy and drastic reduction in interest rates is now taking effect as our figures have taken a major sudden rise. We have procssed more loans in the last week then in the previous month. They are big loans and most for purchases as opposed to the refinances we we have been seeing. The banks credit policy is being wound back to 2008 I have even heard a rumour that the sub prime 100% loan may make a comeback (just a rumour at this stage). The lending figures are a big surprise, I am taking a small break from a very busy day to post this. So maybe the Brisbane market is going to stablise. I also noticed a house that has been on the market since December 2010 sold over the weekend (trying to find out what it went for). Interesting to see what the lending figures for June will be.

    • Cheers Stormboy.

      I was informed on the weekend by a friend who works as a regional loans manager for Suncorp that they are doing the same.

      The band continues to play as the titanic sinks.

      • I see this current boom bust cycle more like the Hindenburg than the Titanic, after the Titanic sunk transatlantic passenger liners continued until the advent of modern air travel. After the Hindenburg however the age of the Airship as a means of transportation was finished. Much like the current standard of lending and financial regulation will blow up in the faces of the powers that Hindenburg style. 🙂

    • What is this ‘drastic reduction in interest rates’? Rates haven’t gone down to any significant degree yet, if at all?

    • Torchwood1979

      Hi Stormboy, in QLD could this be a rush of non FHB trying to get in before the Stamp Duty increase? Also what is the “drastic reduction in interest rates”you’re talking about? Thanks for the clarification.

  4. “Debt markets appear to be betting Australian banks will suffer fallout from any European debt crisis…”

    Let’s wait and see if the Greek parliament approves austerity measures this week.

    “Investors pulled a net $5.3bn from high-yield bond funds, their biggest weekly outflow on record, according to EPFR. Investors are jittery after disappointing data from the United States, Europe and China.”

    “To achieve ‘solvency’, Greece needs to write off about 60pc of its debts,” said Piero Ghezzi, BarCap’s head of economics research.

    Once the International Monetary Fund and European Union loans are excluded, and the holdings of domestic banks taken out of the equation, foreign creditors would need to take a 70pc “haircut”.”

  5. Does this mean that the multiples that the bank share prices have risen since the early nineties is sustainable…
    I think they were around the $2.50 mark back then,and had a fall since..but looking forward they seems more thorn than rose..on PE

    Thanks UE
    cheers JR

  6. The whole thing with Greece, is a foregone conclusion, enforcing austerity is not going to grow their economy, its just ensuring the bankers can keep the growth of credit going, I am just wondering when the focus shifts to Spain and Italy. I can remember an article abouts the Spanish proerty market having the same number of distressed properties as the US with 1/6th of the population.

    • The_Mainlander

      The Spaniards have even higher unemployment (circa 20-22%) than the USA.

      Very scary and much more socialist than the US – of course!

      Interesting days coming.

  7. Ahhh, the wonderful world of Liquidity Risk and a credit crunch! I know it very very well.

    To be able to sit inside an Australian bank and see their data. What would it reveal? The term structure of wholesale unsecured liabilities (and the proportion taken from offshore) v.s. the modeled liquidation profile of their assets (assuming no fire sale, no significant impact on PnL and limited securitisation of unencumbered mortgages and other assets).

    I wonder what picture it paints? I wonder how realistic are their asset liquidation assumptions? I wonder….

    There are bank Treasury employees out there who know what really lies below their glossy monthly liquidity risk reports (Hi guys! Hang in there). I’ve seen it all before – reality is NEVER as ideal as liquidity analytics suggest, even though regulators and central banks seem to swallow the modeling assumptions. The the game actually gets played out, wholesale funding vanishes at every maturity, and gets shorter in term with every rollover. Meanwhile, assets are not nearly as liquid as you thought, and trading desks have no interest at all in pissing their bonus away by selling positions because of a liquidity crunch. And in a crunch when all major players plus off-shore branches head for the exit at once. Ouch, the first to approach failure are the small names and regionals who pretty much just bog like a helpless cork in an ocean. It is just a matter of when.

  8. “A prolonged period of price stagnation, therefore, now appears to be the best case outcome for the Australian housing market.”

    It might start out as stagnation but soon enough it will turn into a crash.

  9. Covered bonds to the rescue – I read somewhere that the plan is to roll-over the current government-guaranteed bonds (~$140 billion) that are maturing, into covered bonds.
    This basically translates into a fee-free government guarantee for wholesale funds, for which the treasury currently charges a fee.
    This implicit bailout should keep banks rolling into 2012.

    • “I read somewhere that the plan is to roll-over the current government-guaranteed bonds (~$140 billion) that are maturing, into covered bonds”

      So would that increase the govts deficit?

      • Not until one of the banks have a severe liquidity crisis for it to impact the budget – I.e. bank is unable to pay back the depositors covered under deposit guarantee or bonds guaranteed by the commonwealth treasury. So the treasury steps in and pay the depositors/bond holders
        So it’s all good for now… Until the sh!t hits the fan, maybe around 2013.
        Covered bonds are a bit of extend and pretend – extend the similar protection as the GFC era government wholesale funding guarantee, but pretend they aren’t doing it.

  10. Why are people concerned about bank liquidity? Stevens has declared that a role of the RBA is to assist with liquidity. The Treasury need not be involved. The Treasury only needs to get involved in solvency issues. Much of the banks’ overseas borrowing is in AU$. If those foreigners withdraw those funds it makes no difference to the result in the balance sheet. Similarly with foreign currencies borrowed and owed by the banks. It is almost all hedged – the RBA say so and APRA ensure so. Again, it is all fully funded – there is no solvency issue. If there’s a liquidity difficulty the RBA (or the FED) are there to provide as they always do.
    The issue of foreigners withdrawing their deposits is no different to the issue of domestic depositors withdrawing their funds in a big way. It can create liquidity problems. It’s a feature of the banking system which is dealt with by co-operation between banks and/or the central bank.
    I see that the Bank for International Settlements now rate the Aussie banks as the most profitable in the world.

  11. Suzi Wong, I don’t know where to start, you have made a number of odd statements and incorrect assumptions.

    Lets start here: “Similarly with foreign currencies borrowed and owed by the banks. It is almost all hedged”

    What is hedged? How do you hedge against an inability to roll your unsecured wholesale deposits?

    Now this one: ” If there’s a liquidity difficulty the RBA (or the FED) are there to provide as they always do.”

    Always do? A bank that is unable to meet it’s settlement commitments without the last minute emergency support of a central authority is an illiquid bank. To protect ‘the system’ the RBA will help, but the morning after, so to speak, will not be pretty. That bank is over.

    There is not necessarily an inherent liquidity problem in Australian banks save for the fact that they have a disproportionately large dependence on foreign unsecured deposits of relatively short term structure being used to fund a mortgage book. That is hot money v. illqiuid assets. And that is bad.

    • Hedging protects the amount of their liabilities and thus the balance sheet. Providing liquidity is a duty of the RBA. Risks to banks come from its loans not from the actions of its depositors. The effect of deposit withdrawals on the balance sheet, and thus solvency, is neutral. As I wrote above, the effect of foreign deposit withdrawals is no different to the effect of domestic deposit withdrawals. It can cause a liquidity problem. Suggesting as you do that a liquidity problem means “The bank is over” is simply wrong. Liquidity is quite a different matter to solvency.

      • “Hedging protects the amount of their liabilities”

        I am not sure what you mean by “amount of their liabilities”. But I can only guess that you are talking market risk? That is irrelevant in the context of balance sheet liquidity.

        “Providing liquidity is a duty of the RBA”

        !! Proving balance sheet liquidity for a commercial bank is most certainly not the duty of the RBA nor any other modern central bank. I disagree with you, so do the officers of the central banks I have met with over the years in previous employment (about 6 different CB’s)

        ” Risks to banks come from its loans not from the actions of its depositors.”

        You have never worked in a bank, have you? At least not in Treasury, balance sheet management or funding.

        “As I wrote above, the effect of foreign deposit withdrawals is no different to the effect of domestic deposit withdrawals”

        Obviously. However the sensitivity of offshore lenders and the dependency domestic banks have in them is a concern.

        “Suggesting as you do that a liquidity problem means “The bank is over” is simply wrong.”

        The bank is over means the bank is no longer a viable participant in the system without the emergency aid of the CB. Once they come to rescue you, your days as a credible bank, in the opinion of the CB, are shot, sone, over. The day after you call a CB for aid, you are a different bank. It obviously is not insolvent, however the liquidity gap in it’s balance sheet that leads to real settlement failure is an unacceptable position for a bank to be in. If the market ever found out that you took ‘lender of last resort’ funding from the CB, you are over. The only exception to this was when the Fed offered emergency funding as Lehman was failing and almost forced some banks to take it. No one wanted it, as to take it is to say to the virtual Dod of the system “I am unable to run my bank in a liquid manner, I have failed”. Trust me, I was there and it was the climax of a very deep career in the field.

        • So true db!

          Liquidity mis-managment is what leads to ultimate solvency issues.

          If one looks up into lehmans books going back in the days, repos of tens of billions every quarter were normal practice. And when this could no longer be placed as collateral at face value it culminated over a brief period into a solvency issue.

          At least that’s how I interpreted it.

          • Groan. With all due respect you have already made statement so absurd that I don’t think this is worth my effort, but for the last time I will reply:

            “In the face of a sudden flight to liquidity like this, it is the central bank’s job to supply the necessary cash to meet the demand.” Glen Stevens.

            Yes, in general across the settlement system they will do so on a daily basis. If commercial banks will not lend to each other due to fear induced by a passing liquidity squeeze – if they horde their cash in the CB accounts – then the CB has no choice but to inject liquidity into the system to keep it flowing. In credit crunches they may do this towards the end of the day, or even in the middle of the day by announcing another round of repo transactions. They are comfortable taking these steps as liquidity squeezes are usually passing in nature (except the last GFC meg credit crunch, which I watched start in March 2007. As cash spread spiked incredibly EU and NA banks all said “it will pass”. Wrong.)

            Anyhow, after a certain amount of purposeful calculation, at the CB on any given day there is just enough cash in the game to meet settlement requirements and to allow small commercial bank overnight deposits at the CB. The CB discourages these deposits by paying below market rates on them, in turn ensuring that in normal market conditions, cash is circulated, not horded and thus tightening liquidity. But if the banks do not lend that cash, if they accumulate much larger deposits at the CB than they need, the system doesn’t work and the CB has to step in.

            This is entirely different to the CB protecting the liquidity of an individual commercial bank or propping up the system as a necessity.

            If you argue that they will need to assist the market as a whole, on a going concern basis, then the system is illiquid. Eventually foreign lenders and rating agencies will slam the aggregate credit perception of our banking sector as a whole, and it is game over as far at the status quo is concerned. Funding costs through the roof, and an inability to issue the required volume of CP offshore to fund mortgage books (which unfortunately at the same time may be having their collateral devalued).

            And so then the banks turn to their asset liquidation stress tests and try to enact them in real markets… and… whoops, not so liquid now.

        • Good to see Guy Debelle today endorsing what I have written in this thread with the emphasis on the loans/assets rather than deposits/liabilities being of concern.
          It is also worth noting that for the system as a whole it is always fully funded. Loans create deposits.
          With any foreign liabilities of the banks the same principle applies. The almost 100% hedging ensures that the foreign liabilities on the banks remain at their original sourced level in AU$ regardless of exchange movements and thus those liabilities, in the total system, are matched by the resultant deposits from the lending. All fully funded on a system wide basis and in normal times banks help each other. Occasionally they need more help – as Stevens says – that’s the RBA “job”.

          • Good Grief. I sincerely hope that you are not employed in this field.

            This is an absurd statement.

            “It is also worth noting that for the system as a whole it is always fully funded. Loans create deposits.
            With any foreign liabilities of the banks the same principle applies. The almost 100% hedging ensures that the foreign liabilities on the banks remain at their original sourced level in AU$ regardless of exchange movements and thus those liabilities, in the total system, are matched by the resultant deposits from the lending.”

            In the discipline of bank liquidity management, you genuinely appear to not understand what you are talking about.

            All the best to you and who ever is paying for your advice.

  12. Exclusive: The Fed’s $600 Billion Stealth Bailout Of Foreign Banks Continues At The Expense Of The Domestic Economy, Or Explaining Where All The QE2 Money Went.

    From same: QE2 was nothing more (or less) than another European bank rescue operation!
    In fact, it is the need to expand the Fed’s liabilities that is and has always been a driver of monetary stimulus, not the need to boost Fed assets. The latter is, counterintuitively, merely a mathematical aftereffect of matching an asset-for-liability expansion. This means that as banks are about to face yet another risk flaring episode in the next several months, the Fed will need to release another $500-$1000 billion in excess reserves. As to what asset will be used to match this balance sheet expansion, why take your picK; the Fed could buy MBS, Muni bonds, Treasurys, or go Japanese, and purchase ETFs, REITs, or just go ahead and outright buy up every underwater mortgage in the US.

    Also read in conjuction:

    Bernanke Channels Benchley
    by Gary North

    China’s European Bailout (And TBTF) Bid Hits Overdrive, As Wen Jiabao Is Now In The Market For Hungarian Bonds.

    Remember, contagion is THE terror of terrors. A rose by any other name is QE(n)-morphed.

    • As a Toronto banker mate says. Contagion is easy to define…

      “I know what dodgy shit I do at my firm so I ain’t lending to yours in case you are doing the same”

  13. The fractional reserve banking system which allows the banking system to create approximately 10 times customer deposits in loans should be enough! What is astounding is that even with this huge multiplier effect, they could not satisfy historical demand for credit resulting in them becoming hugely reliant on off shore borrowings which can’t be fixed overnight.

    This is clearly the result of the bank induced bubble in the property market. The public have taken the bait, not saved and borrowed like hell to “get on the property ladder” ignoring fundamental and long proven methods of accumulating wealth – save more than you spend. In the meant time bank CEOs who lend to property like building societies rip 10’s of millions of dollars out of the economy. Who is getting rich here?

  14. Hi Guys, the drastic reduction in interest rates I am talking about is most people when they borrow $250,000 or more (most loans for purchases these days and not surprisingly refinances) they are eligible for loan packages that reduce their loan interest rates by between 0.40% and 1% of the standard variable rate for the life of the loan. For example if someone where to borrow $500,000 for a new home they would be eligible with my bank a discount on the variable rate of 0.85% for the life of the loan. Before April this was only 0.70%. The banks do not charge the standard application fee and no monthly loan fees. This accounts for 80% of new loans with my bank. This is just an example but it seems to have dramatically increased enquiries and seemingly new lending. I will keep you up to date on how this goes over the next few months with winter usually the quite period.

    • Torchwood1979

      Thanks Stormboy. do you think another factor contributing to the current uptick in applications could also be due to a rush of people in QLD trying to get in before the Stamp Duty increase?