Australia is lucky that it avoided the worst excesses of the pre-GFC years and that consequently we’ve been able to skirt the edges of the GFC. Mining booms Mark I and II have in no small way contributed to this, as has the 4 pillars policy, as well as timely funding and liquidity support from the Federal government, but Australian banking has mostly been hit by the domestic landscape not the blight that is global finance.
In a speech Friday titled “Life in the Slow Lane” the Australian Prudential Regulatory Authority’s (APRA) Chairman John Laker made it obvious that he wants this to remain the case, but equally, the challenges ahead for Australian Deposit Taking Institution’s (ADI’s) boards and managers is no small task:
In an environment of lacklustre credit demand, ADIs will have to look elsewhere and work harder to maintain profitability. This is not a simple proposition. There is also pressure on profitability from other angles. Net interest rate margins, for example, have been dampened by more expensive deposit funding costs and higher bank risk premia in global funding markets. And the boost to profitability in recent years from lower bad and doubtful debt charges is going to wane. Looking ahead, ADIs will also be required to operate with larger capital bases, maintain increased holdings of lower yielding but higher quality liquid assets and adopt more prudent funding profiles as they make the transition to the Basel III reforms.
In summary, Laker is saying that banking is now and in the future a lower return business than it was in the past. Thus there is a regulatory challenge as APRA seeks to empower boards and managers to make the transition to this realisation at a time of increasing costs and in a manner that serves the macro-stability goals of the regulator, not the short term share price or half yearly performance goals of management and shareholders:
In the face of these challenges, strategic ambitions will be crucial in determining how ADIs negotiate the slow lane and maintain their financial strength and profitability in a durable way. For this reason, APRA is placing high priority on the oversight of ADI strategies as part of its supervisory efforts, including in its regular discussions with boards and senior management. Before the crisis, strategic ambitions were often couched in terms of ‘above system’ rates of growth and the achievement of such rates was a commonly used metric of success. It is a metric, however, that may have no regard for the quality of assets going onto the balance sheet.
These days, we see little unbridled ambition expressed in this form. Where we do, we will challenge the board and senior management on whether growth targets can be realistically achieved through superior products or services or whether the institution is at risk, in colloquial terms, of ‘taking in others’ washing’.
But even the more common strategic response from the ADI community is, according to Laker, still potentially problematic and he sets out what is happening, what the banks are doing and what APRA is guarding against. The full speech is worth a read and can be found here but today I want to concentrate on funding and liquidity.
As a former Treasurer of and ADI, liquidity and funding are close to my heart. It is what you do all day every day. Sure the balance sheet stuff like interest rate risk management is important and a bit of fun and there are lots of other meetings you dragged into but at its core the job of Treasurer is to make sure the money is always there – funding and liquidity – and if you can do it in a manner where no one has to think about it then you have done your job.
In his speech, Laker says that credit risk is the most important inherent risk to an ADI. But I reckon that for a well-diversified lending portfolio credit risk is secondary to liquidity and funding in terms of how quickly it can bring a financial institution to its knees. Even if the problem starts with credit, it manifests in the confidence of your lenders (depositors or wholesale counterparties or both) which quickly and ultimately flows through to funding and liquidity.
So, in the wake of JP Morgan’s debacle last week, and the revelation that the models didn’t take liquidity into account, it is appropriate for me to deal with this part of Laker’s speech first. He starts this section by saying:
The acute dislocation in global funding markets in late 2011 has been a reminder, yet again, of the importance of ADIs having strong liquidity and funding positions.
The next few months might just reinforce it once more if this recent escalation in Europe and slowdown in China gets any worse.
But the key point is one I think many people are yet to grasp. When it comes to funding and liquidity, the Australian banking system got lucky in the GFC. The Australian government loaned its AAA ratings to the deposits and bonds of the banks. Then China came back with a vengeance, which masked for a time the deleveraging of Australian households and the impact this had on growth. But even the deleveraging process has so far worked, fortunately, in the banks favour. Household retrenchment and a material and structural return to savings has enabled all major banks to grow deposit funding by 25% since 2007. Laker knows it:
Lower credit growth and high rates of saving are positive dynamics for ADI balance sheets: weaker asset growth reduces overall funding demands while the high rates of saving have reflected in strong deposit inflows. ADIs have taken advantage of these conditions to put themselves on a stronger balance sheet footing. In the case of banks, domestic deposits now account for over 50 per cent of funding, up from 40 per cent in 2007 and the highest share since 1998. The share of short-term wholesale funding has shrunk by a similar proportion since 2007 and the duration of wholesale funding has been pushed out. ADIs have also been building up their holdings of cash and liquid assets.
APRA knows that risks remain – what happens when the economic sunshine comes out again, which it eventually will, and some or a large swathe of these deposits get redeployed to equities or simply consumed? Where will the money come from then to replace these deposits?
So Laker expressly says that APRA is heavily involved with ADI Treasurers both day to day and in preparation for Basel III implementation. He reckons that boards:
…should be asking questions of their treasurers such as ‘How long could the ADI operate profitably without access to offshore wholesale funding or securitisation markets?’ ‘How long could we operate without the ability to issue short-term debt?’ ‘What is the risk/return trade-off in lengthening the maturity profile of wholesale funding by one month? One year?’ ‘What is our tolerance for relaxing our risk appetite and what are the consequences?’ Increasingly, boards are asking ‘Do we want to rely on short-term funding markets to fund loan growth at all?’ This focus on risk appetite is leading to a change in mind-set among retail and business bankers, where the garnering of sticky deposit funding counts and is being built into business targets.
Make no mistake, even MLH ADI’s will be effected by the changes coming down the line from APS 210 and the changes it will cause in the Australian funding and liquidity landscape. The last bit, bolded, highlights the risks that accrue to the smaller players in the Australian banking landscape, such as credit unions and building societies whose member bases represent the very sticky deposits that Laker wants the major banks to chase.
That raises the question, of course, who will fund the smaller ADI’s?