S&P strikes back

It appears yesterday’s speech by RBA Assistant Governor (Financial Markets), Guy Debelle, has done little to allay the fears of the ratings agencies about the Australian banks’ heavy reliance on offshore wholesale funding.

In today’s Australian Financial Review (AFR), Standard & Poors (S&P) issued its second warning in as many months on the banks funding risks. From S&P warns of big four’s offshore risk (AFR, 29 June 2011):

The AA rating of Australia’s major banks is under a cloud after a global credit agency warned they borrow too much money on unstable international markets.

S&P also said the prospect of soft property prices, a dour outlook for business investments and the high Australian dollar were worrying signs for the banks…

Releasing a report card into banks across Asia, S&P credit analyst Gavin Gunning said Australia’s banks stood out in the region because of their heavy dependence on offshore funding.

“Because Australian… banks are large borrowers on international markets, dislocation in those markets [due to Europe’s debt problems] would lead to higher costs of funds for the banks”, Mr Gunning said.

He predicted that property prices would be flat but warned banks would take a hit if the market turned for the worse.

“The emergence of a less likely scenario, such as a major correction in property prices … clearly would affect major banks’ asset quality”, he said.

“As well as the potential for a softer property market, other risks we are monitoring in the context of the major banks sector include … a caution outlook for business investment and managing the effect of a high Australian dollar on some industries”…

The cost for banks to borrow on [international] markets, which soared during the financial crisis, has increased in recent weeks as a result of the debt crisis in Greece…

…any move by S&P to cut the banks down from AA would likely have major implications, pushing up the cost of funds they borrow on global markets and putting upward pressure on home loan interest rates.

S&P is considering changes to its ratings criteria to place a greater emphasis on funding issues…

Mr Gunning said: “We have the Australian major banks on ‘stable’, so that would indicate that the most likely direction for the four ratings is to continue to enjoy that AA status under our current rating criteria.

“Unambiguously, however, funding and liquidity is the relative soft spot for the major banks”.

Back in May, Moody’s ratings agency stated that the Government’s implicit guarantee of the banks’ wholesale funding and well as the explicit deposit guarantee is worth two ratings notches. When added to the explicit liquidity support provided by the RBA (articulated in yesterday’s speech by Guy Debelle), there can be no mistaking that the Australian banking system is being directly underpinned by Australian taxpayers, and that moral hazard is endemic.

Yet despite the Government and RBA backing, the ratings agencies remain unconvinced about the Australian banks’ outlook and their underlying strength. Further, the agencies have put the Australian Government on notice that it must continue to support our banks, or risk sharp downgrades and a surge in bank funding costs.

Although Guy Debelle was at pains to argue that it is overwhelmingly the quality of bank assets that warrants most scrutiny, the ratings agencies seem to view liability management and liquidity as equally important. And given the major role played by ratings agencies in determining wholesale funding costs, their warnings need to be taken seriously.

As a side note, I highly recommend that readers check out Chris Joye’s brilliant dissection of Guy Debelle’s speech in Business Spectator today, where he questions the RBA’s policy of distinguishing between ‘illiquid’ and ‘insolvent’ institutions, and highlights the risks posed to the financial  system as a whole. Here are the closing extracts:

Debelle, the RBA and other central bankers would do well to drop the historical fiction that a central bank can distinguish between “illiquid” and “insolvent” institutions. Under the law by which all corporations and the RBA must abide, there is, in fact, no such distinction.

The Corporations Act is crystal clear in this respect: you are an insolvent institution if you cannot pay your debts “as and when they become due and payable”. Put more bluntly, if you cannot pay them without recourse to the RBA’s liquidity facilities, you are insolvent.

The RBA would have us believe that even if a bank cannot repay all of its depositors, or all of its short-term creditors, the bank may not be insolvent if the RBA (an unelected independent statutory authority) deems that the bank has sound assets, and could, potentially, meet its obligations if the RBA supplies that bank with taxpayer-underwritten bridging finance.

Let’s call a spade a spade. Banks have business models encumbered by asset-liability mismatches that during liquidity shocks may require taxpayer subsidies. That is one key reason why we have a central bank in the first place: to bail private banks out of financial crises.

Legally and factually flawed central banking spin is only likely to encourage private bankers to believe that they are indeed government guaranteed, and able to tap the RBA’s liquidity facilities so long as they remain too big to fail.

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Unconventional Economist
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  1. I read Christopher Joye’s piece earlier and thought it fairly and correctly direct on the issue. ‘Insolvent’ is such a big word!

    Do you think it coincidence that Debelle’s speech so closely precedents Standard & Poors – or am I a little to conspiracy-like. Possibly, or not.

  2. Flip the equation. When the RBA is willing to lend money based on the assets held by a bank, then by its very definition the bank is not insolvent. The RBA can PRINT MONEY, so while the currency make suffer from debasement, it will not end up on the balance sheet of the taxpayer.

    • Sorry, I couldn’t disagree more…

      The insidious effects of true inflation (debasing currency aka. reducing the purchasing power of money) is probably the greatest thievery ever perpetrated on us.

      Here’s why…

      1) Money printing by its very nature has a very uneven distribution of effect. Not everything loses value by the same amount. Recently asset prices have become inflated to a much higher degree… effectively making rich people richer and poor people poorer. Incomes haven’t been rising nowhere as fast as asset prices.

      2) Pricing signals get messed up — resulting in massive malinvestments — the Aust property market being a good example — so much money wasted on an unproductive asset class. If you think our own RBA hasn’t been printing… look at the M1, M2, M# figures over the last 10 yrs. Some years RBA has debased our currency by about 15-20%.

      This also results in a high variability in the boom/bust cycle – both much bigger.

      3) Higher unemployment because of 2… malinvestments and speculative behaviour — No point saving money which creates more problems. Savings are the foundation of growth.

      Side Note: If money printing was so effective, we would be encouraged to counterfeit as much as we can.

      As long as we have a committee of over-educated individuals deciding the price of money, the natural function of a free market that limits speculation will never occur, i.e. the volatility of interest rates is natural deterrent to speculation.

      • Let there be a government owned bank that provides liquidity to the economy,this way we have a system by the people for the people. I can see that even when these private banks will go begging to the government , they will be paying themselves huge bonuses.

      • You do realise that CJ raises the topic of Moral hazard for big banks, just so that he can get the same treatment for non-bank lenders. It is a case of “They get moral hazard, so should we” .
        He tried getting that via,the shadow treasurer Joe Hockey’s 9-point demand – one of which was extending government guarantee to private RMBS issues – clearly, a moral hazard. Then there is his idea of AOFM buying up $20billion worth of private RMBS with taxpayer’s money.
        So he clearly does not want moral hazard to go away. I am surprised that people cannot see the faux outrage he displays over moral hazard.

        • CJ on the RBA, RMBS and ‘price discovery’ (read paying bubble prices for RE):
          In short, these interventions are needed because the production of sufficient liquidity and accurate price discovery are not forthcoming in a pure market environment that is gripped for considerable periods of time by irrational investor behaviour—that is, by the complete closure of otherwise incredibly low-risk markets, such as the market for primary AAA Australian mortgage-backed securities. http://christopherjoye.blogspot.com/2011/06/joye-vs-mccrann-round-xxxvi-does-rba.html

          I take “gripped for considerable periods of time by irrational investor behaviour” to mean the current trend of investors fleeing, like rats, the sinking ship of RE market before they find themselves up to their necks in negative equity.
          Long live the irrational investor.

          • “irrational investor behaviour—that is, by the complete closure of otherwise incredibly low-risk markets, such as the market for primary AAA Australian mortgage-backed securities.”
            Wow, Did this guy just sleep through the GFC?? You know, even the US sub-prime RMBS were rated AAA. Does that mean they were/are super low-risk and investors are just crazy panic-stricken sissies?
            I understand He is a bullhawk for a reason – so full of contradiction. On one hand, he accuses the establishment of moral hazard and on the other hand, he is on the side of the establishment, telling everyone who would listen that they should not question the wisdom of the establishment.

      • There is no moral hazard! Moral hazards only exist because of Govt regulations.

        The implicit put given by Govts to the banking sector creates a moral hazard. A banking funding costs would start moving up much faster than has been happening.

        In the event of a collapse, bond holders take the hit (obviously the shareholders). Depositors are easily covered by bondholders (i.e. deposits make a smallish percentage of funding).

        In a true free market, depositors can also purchase insurance (such a accepting a lower yield on deposits). Those comfortable with higher risks are free to do so, i.e. become a unsecured creditor.

        Taxpayers have no business holding the bag.

        Companies have been collapsing from the dawn of time… any business with assets will be bought by someone else. Why should banks be any different? They’re not!

    • Nah, CJ has been consistent on this matter and the need for another Financial System (‘Wallis’) Inquiry for years now. I might disagree with CJ on housing-related issues, but I agree with him on these points.

    • Same old same old from Bill. My concern about the RBA’s liquidity support first and foremost is moral hazard. The banks will continue to lower lending standards and borrow heavily offshore as long as they know the Government and RBA are there to bail them out.

      • Torchwood1979

        We need to start a NZ style raft of reforms to wean our banks off government and central bank support and protect the taxpayer. NZ leading the way for us, it makes me want to weep.

      • Moral hazard certainly is a concern, however I think this is a case of “mechanism” not “function”. I do think it is valid that the government should be providing “lender of last resort” function to the economy, especially given we are a sovereign FIAT nation.

        The problem is not that it does this, it is HOW it does it.

        We already have moral hazard in this country because of the implicit/explicit guarantee provided to the banks by the government. The reason it is a “hazard” is because there is no REAL cost or using the function.

        What is needed is a mechanism that provides financial stability yet addresses the moral hazard issue. For that we can turn to our SON of Wallis winner


        The main issue is that under the current framework banks do not have enough self-effecting risk (http://macrobusiness.com.au/2010/11/why-perceived-self-effecting-risk-matters/).

        I am fairly sure no one would be worried about moral hazard if the loans of “last resort” used the equity of Bank CEOs and Board members as security on default.

        • I only speak for myself as a single tax-payer, but I would most certainly not be worried about moral hazard if “…the loans of “last resort” used the equity of Bank CEOs and Board members as security on default.”

      • I share your concern. Aus govt, by global standards, has little debt. They could really ramp it up if they want to. Setting up the NBN is an example – not even a cost benefit analysis – just go the debt. Who advises these clowns?
        I would image banks & RE lobbies have even more leverage than Telco lobby.

  3. JJ and Ronin seem to be in fundamental agreement RE: the results of printing money (QE) is that you move your problems off your balance sheet and on to somebody else’s (or further into the future, whichever way you want to look at it).

    The fundamental problem with focusing so much private investment into housing is that many people have put all their investment eggs into one basket at the expense of (say) industrial or rural production – once the bread and butter of our economny. Housing isn’t like other investments in that it doesn’t have potential to produce export income; it only really employs people in the contstruction of new dwellings; it isn’t regulated like other financial products and as an investor you can’t cash out as easily as other investments.

    We’re really only now seeing the effects of this highly skewed investment now in that we have almost no manufacturing left (except for the companies on the dole like Holden and Ford) and what’s left of rural production is also bleeding offshore. My concern is about the sustainability of this situation in the longer term… banks borrowing offshore to finance jumbo mortgages in big cities where nobody actually makes anything.

    • Daft isn’t it? Whiteant local industries via reduced tariffs and sales to foriegn interests and at the same time pave the way for a society of debt slaves (with most debt ie. 92%, being used to bid up the price of 2nd hand homes) to pad out the pockets of banksters and RE industry.

  4. RBA: if you have good assets, we will always prop you up, you will never be illiquid/insolvent.

    If the banking system were prime time tv, the RBA just used the c-word and thinks that now they have done so, it’s no longer a bad word.

    Whilst the rest of the world is making progress in banking liquidity, and Chris Joye seems to have a handle on that, the RBA has now all but forced domestic participants to abandon liquidity management global best practice for a one sentence liquidity policy of “the RBA said my assets are good enough, they will always support me”.

    Australia – it really is different here. What a pathetic and sad turn of events. It boarders on surreal. I guess anything is possible when one talks one’s book through fear and misplaced arrogance.

  5. Is it also a case of Bullhawk biting the hand that feeds him – Maq Bank owns Rismark and boy, did they utilize truck-loads of Moral hazard to stay afloat during the GFC.
    Maq bank is an ADI, entitled to same level of liquidity support from the RBA, just like the big 4 banks.

  6. Basically the RBA’s function is to talk ‘Blue Sky’ around the Australian economy. There is a lot at stake.
    They didn’t make any rumblings that remotely sounded like a GFC was coming in 2007, they made no mention of the Greece collapse until it was upon us, they constantly talk about the absurdity of China providing Australia with endless revenue through buying “our” resources and other manner of Tulip Bubble talk.
    They are as predictable as they are wrong.
    The RBA is a very good contrarian indicator as well!

    • Svetlana, they wouldn’t even tell you if a bus was about to hit – they merely echo policy goals of whoever’s in power. Johnnie Howard and Peter Costello made it really clear that THEY decided interest rates, not some wishy-washy public servant heading the Reserve (I recall Peter Costello making vague threats to the Reserve RE interest rates some years ago when they decided to increase rates). The Reserve’s job is to smile and agree with everything and keep talking up the economy. Anything else would be what Jeff Kennett called “un-Victorian”.

      • No Europe is all sorted out now…didnt you hear -the Greeks signed up for a 10 year recession.

        I guess Adam Carr was right in 2010 when he said Europe concerns were overstated ; )

      • Didn’t you see the EURUSD? Everything is sorted. The Carr-Koolaid kings were right. “Shaft a country 102” (101 was Ireland). As long as the execs at BNP Paribas don’t get a twitch its all cool.

        Risk on. 48 hours of riots to secure a 12B loan with 18B owed next month.

        Its all good.

  7. If I was working at Fitch or S&P, Debelle’s speech would just further cement my view that the big 4’s credit rating needs downgrading. What sort of message is this: “Keep funding long-term illiquid assets through short term offshore borrowings because the RBA will not only provide temporary liquidity should you need it, it will risk its inflation fighting credibility & capital to bail you out”. I don’t reckon any other central bank around the world would say that.

    Why can’t they admit that if the banks lost access to offshore borrowing it wouldn’t be a liquidity problem. It would mean the banks business model was broken and would quickly lead to insolvency.

    Debelle should read Mervyn Kings speech he made last year here:


    Key points were:
    – The solvency of a bank isn’t just determined by the quality of their assets, but the overall balance sheet risk (especially the riskiness of the funding structure) – see Northern Rock
    – Central bank liquidity can only be temporary (eg. used in a panic). It won’t work when a banks business model is exposed as no longer viable .
    – “The distinction between illiquidity and solvency can be difficult in practice – the difference in timing might be just a few days”

    And this King quote is a direct rebuttal of Debelles “asset quality only matters” argument: “If a business model is based around a particular funding model that suddenly becomes unviable, then the
    business model becomes unviable too, as events in 2007 showed”

  8. “the agencies have put the Australian Government on notice that it must continue to support our banks, or risk sharp downgrades and a surge in bank funding costs.” Great. Support the banks; all good, don’t; turns to sh1t. The tax payer is officially now on the hook to support our irresponsible banks. What’s the RBA going to do? Why nothing, it’s all good!