Peering into the Peers The G20 Financial Stability Board’s “Peer Review of Australia” is a curious critique of Australia’s financial regulators and the follow up to the IMF-World Bank Financial Sector Assessment Program which Australia underwent in 2006. I am very dubious about the FSAP since its April 2007 global report declared that there was no systemic risk in the financial system. However, this Peer Review may be worth noting. Whilst the document does not fully explain how the report was put together, my understanding is the process was something like this. The FSB sends questionnaires to the APRA and ASIC to follow up on progress since the 2006 FSAP recommendations. The information is then distributed to other global regulators who are free to make comment and recommendations. There are of course processes of face to face meetings and much international travel. However, this global input without vested interests can be quite constructive, although the report is full of rhetoric and a regurgitation of information provided by our regulators.
The guts of the review comes down to three “policy challenges for Australia” Let’s deal with them in order as recommended and perhaps importance, as the issues relate to Australia’s banking system.
First, the economy – and, by extension, the financial system – is going through a period of structural change in response to the strong demand for commodities from emerging Asian economies. As a result, Australia’s terms of trade is at historic levels and the country is experiencing a commodity-inspired private investment surge. However, the economy’s increased exposure to potentially volatile and cyclical commodity prices warrants particular focus. The use of prudential tools may be considered to manage sector-specific risks stemming from the structural changes in the economy.
In my previous posts relating to APRA’s introduction of Basel III capital reforms, I complimented APRA for proposing to introduce in the future macro-economic factors in consultation with the RBA in determining the capital requirements of the banks. However, APRA’s peers are saying that now is the time to act not 2016. If we are relying on the mining FutureBoom! to repay our external debts then that is a very high risk strategy for bankers and regulators.
We’ve borrowed heavily privately and put that money into housing, and now have the federal government stuck in a structural deficit with repayment or indeed future borrowing capacity dependent on, “potentially volatile and cyclical commodity prices”. I do think it’s strange that the Peers Report does not refer to the elephant but “manage sector-specific risks stemming from the structural changes in the economy,” refers mainly to our over inflated housing sector.
Anyway, APRA has the power now to rein in the banks reckless high risk lending to overstressed borrowers by imposing more realistic parameters in the banks internal risk models for residential mortgages, thereby significantly increasing capital. Preparing for the worst by APRA and by extension the banks will not save the housing sector or many borrowers but may save the banks.
Good advice from The Peers, will it be heeded in a timely manner? Next:
Second, Australian banks have made good progress in reducing their dependence on wholesale (particularly external) funding, and they should continue to work towards managing this funding risk. Funding structures can vary significantly depending on country circumstances, and it is both unrealistic and undesirable to eliminate wholesale external debt as a funding source. However, it is important to closely monitor and stress test banks’ overall liquidity positions; avoid over-reliance on any single (potentially volatile) source of funding; and ensure that funding is sufficiently ‘sticky’ and adequately matched to the maturity of assets.
Sounds like motherhood advice 101 but thinking like a peer and not wanting to offend, I’d say that there is a very pointed shot that Aussie banks have too much offshore borrowing and not enough matched funding. I too recommend that the banks “avoid over-reliance on any single (potentially volatile) source of funding; and ensure that funding is sufficiently ‘sticky’” However, digging a little deeper into the Review I found this graph which is meant to represent how Australian banks have improved matching of funding and the stickiness:
I don’t know about you but I’m a little skeptical about this graph. Sure long term funding is up a few percent. But have we just redefined short term borrowings as deposits? How are “Domestic Deposits” that have increased rapidly in this graph suddenly also “sticky”. These are very risk sensitive issues especially when the whole banking sector has about 42% of domestic asset exposure to long term residential mortgages. From the RBA Statistics site from Tables B3 and B 12.2 I have constructed the following graphs simply comparing domestic deposits, non-resident liabilities and domestic wholesale funding both $ amount and %s of the total bank’s liabilities ie debt. Whilst there has definitely been a an increase in domestic deposits, has this really made any significant difference to risk inherent in our bank’s balance sheets:
I think the considered opinion of any expert or peer looking at this very basic information would be that Australia’s banks remain far too exposed to offshore funding which can be very difficult to control and rely upon when you need it, and also that any increase in what may be sticky deposits is not significant enough. So there is much more work to be done by our banks according to the APRA peers anyway. Next:
Third, the presence of four domestic big banks presents important policy challenges for the authorities. Their size and nature of activities means that they could pose systemic and moral hazard risks in Australia. The authorities have a supervisory framework in place to address the risks posed by regulated entities (including SIFIs) through a graduated supervisory response. Any additional measures undertaken by the authorities in this area will depend on, and will need to be consistent with, the policy work on SIFIs that is underway at the international level by the FSB and BCBS. In addition, while a concentrated system by itself is not necessarily less competitive, it is important to proactively promote competition and contestability, as currently proposed in the various government reform initiatives.
Consumer protection measures and policies to develop market-based sources of financing are useful in that context. So clearly APRA’s peers consider that the big four banks are regional SIFIs. SIFI is the term for Too Big To Fail which is also short hand for banks that enjoy their governments implied guarantee. Perhaps APRA can get some moral fortitude to publicly acknowledge this in the context of how the big four are regulated. My previous posts addressed the issues that APRA should address in order to remove systemic risk and promote good behavior. All my recommendations are certainly consistent with The Peers that,” Their size and nature of activities means that they could pose systemic and moral hazard risks in Australia.”
Whilst I think the fluff in the detail of the review is not worth reading because of its self serving nature that APRA and the government have everything under control, I love these recommendations, “ In addition, while a concentrated system by itself is not necessarily less competitive, it is important to proactively promote competition and contestability, ……. Consumer protection measures and policies to develop market-based sources of financing are useful in that context.” Australia does not need policies or regulation that just promote competition amongst banks with implied government guarantees, we must have completion from market sources that stand on their own risk taking which are allowed to succeed or fail from that risk taking. Nothing else will create a sustainable and competitive banking system.