Market vs RBA on bank stability

The RBA released its quarterly Financial Stability Review today. It is a fine document with some incredible research and, I’m happy to say, strikes a more cautious tone about bank stability than recent speeches by RBA boffins have suggested. The document tells an upbeat story of the steady cleansing of Australian bank reliance on wholesale funding:

Overall, Australian banks have faced a favourable funding environment for much of the past year, though the latest bout of global market uncertainty has caused some tightening of wholesale funding conditions since July. Growth in deposits has remained strong over the past six months, averaging over 10 per cent on an annual basis, and continuing to exceed credit growth by a significant margin (Graph 2.15).

Within this, there has been strong growth in deposits from both households and businesses, and across most types of ADIs.

Underlying this growth in deposits has been an increase in the rate of household saving in recent years, some of which has flowed to the ADI sector, and robust growth in business sector profits, particularly in the resources sector. Competition in
the deposit market has abated somewhat recently, especially for wholesale deposits, partly because banks are becoming more discriminating as they take into account the liquidity implications of these deposits under the Basel III liquidity rules.

As a result of the rapid growth of deposits and subdued growth in credit over a number of years now, the difference between ADIs’ loans and deposits – a measure of the funding that needs to be filled from wholesale and other sources – has declined by about one-sixth since 2008, to around $700 billion in June (Graph 2.16).

Consistent with this, domestic deposits now account for about one-half of banks’ funding liabilities, up from two fifths in 2008 (Graph 2.17).

As well as increasing the share of their funding from deposits, banks have also sought to lengthen the maturity of their wholesale funding over recent years in response to market and regulatory pressure. Short-term wholesale funding has fallen from about one-third of total bank funding in 2007 to around one-fifth during the past year, while the long-term wholesale funding share has risen from about one-sixth to more than one-fifth over the same period.

So much for the good news. Now we turn to what matters, bank’s access to wholesale markets. Here the news was good much of the year but recently turned more worrying:

Banks maintained good access to domestic and offshore wholesale bond markets during the past year. Their reduced wholesale funding requirement has allowed them to take a more opportunistic approach to their bond issuance, issuing when pricing has been most attractive. Over the eight months to end August, the value of bonds issued was slightly less than matured, so the value of bonds outstanding fell (Graph 2.18). Banks also raised less wholesale funding from offshore than matured in the past year meaning that, in net terms, they have been repaying some of their foreign liabilities. While Australian banks have had limited bond issuance since July, discussions with the banks indicate that many of them are already ahead on their wholesale funding plans for the year, allowing them to hold back from issuing bonds during periods of heightened market volatility.

While there has been some tightening in wholesale funding conditions due to the recent global market turbulence, the overall effect has been modest compared with some other countries, and to conditions globally in 2008. Domestic secondary market spreads on the major banks’ three-year debt, for instance, have traded within a range of about 110 to 150 basis points over Commonwealth Government securities (CGS) over the past six months compared with around 200 basis points for most of 2008.

Some banks have repurchased their government guaranteed bonds that have around one year or less left before maturity and replaced them with unsecured debt. In total, banks bought back around $13 billion of their guaranteed bonds over the past year. Many of these repurchases were securities that mature in the first quarter of 2012, a period of larger-than-average maturities of guaranteed bonds. Together with the $23 billion of guaranteed bonds that matured over the past year, repurchases have helped reduce banks’ guaranteed wholesale liabilities outstanding, to around $120 billion in August, down from around $155 billion in mid 2010.

Conditions in the residential mortgage-backed securities (RMBS) market have generally improved this year. Issuance in the first half of 2011 was the strongest since 2007, with the major banks accounting for around one-half (Graph 2.20). A tightening of spreads in the secondary market has supported primary transactions and reduced the extent of support by the Australian Office of Financial Management, which only participated in around one-half of the number of transactions this year (7 per cent of the value). While there has been some issuance of commercial mortgage-backed securities this year, it remains very low compared with pre-crisis levels.

From what I’m hearing this is old news. The market for Australian RMBS has effectively shut, with purchasers only willing to buy at prices that issuers won’t meet. And although the tightness in wholesale markets certainly hasn’t reached 2008 levels, CDS prices (the cost to insure wholesale debts) has climbed all year and has jumped in the past two days:

Moreover, as you can see on the next chart, CDS prices have reached 2008 levels of stress:

So, what exactly is this signaling? First, we should note that CDS are liquid and can be used to punt. So we can assume a speculative dimension is at work here. Second, note that the spread between the four big banks is virtually non existent. That might also suggest the market is driven by a simple punting mentality, rather than being carefully differentiated.

But, there is an alternative explanation. And that is that none of the four banks is trading simply on their own credit merits. Rather, all four are trading in some measure on the basis of the implicit Federal guarantee that stands behind all four. In short, the lack of spread may be an indication of being too-big-to-fail.

Also a concern is that these levels of CDS pricing weren’t reached until some time after the Lehman event. This time, we haven’t even had an event, yet here we are.

It’s important to remember that the Federal government can step back in with a guarantee if needed, but in the mean time, markets are not as sanguine as the RBA.