How to fix the CLF


There’s been much recent discussion on MB and from contributors to this blog on the merits of the RBA’s conditional liquidity facility (“CLF”), as well as more broadly recently following a series of articles by Chris Joye at the AFR. I’d like to try and make clear the importance of the CLF and the interconnectedness of taxpayer support for Australia’s banking system.

In the aftermath of governments (including Australia) having to bail out the global financial system in 2008, the Basel committee which is a committee made up of international regulators and provides the international recommendations on how the global and regional banking systems should operate, gave rules, guidance and recommendations on increasing bank capital and liquidity requirements (Basel III).

Amongst these recommendations were rules to increase bank liquidity, which we are going to deal with here. In essence banks are required to increase the amount of liquid assets they hold to protect against a bank not being able to rollover its funding lines for a period. For this post the exact amount and period is not relevant.

For most international banks the liquidity rules meant that they needed to hold more liquid securities to meet the rules. The allowable liquid securities include government bonds and some other eligible securities, now including residential mortgage backed securities (“RMBS”). In Australia, however, the RBA and APRA had a different solution in mind.

Our regulators with bank support argued that we require a different regime and would ignore the recommended Basel rules. The main reason put forward were that there are not enough government bonds in Australia, or indeed liquid RMBS, to meet the rules and therefore Australia’s liquidity solution is for the RBA to provide a back stop facility to provide bank funding if required, Ironically, the CLF is based around the RBA taking RMBS as collateral for funding the bank.

The CLF is open to all Australian ADIs.  The amount of the required CLF by every ADI is basically both the same percentage and at the same cost (0.0015% pa). So by these measures, there is no favouritism to the larger banks ie Mega Bank.

For Australia the CLF is very important in the absence of other bank liquidity requirements. As we know a large percentage of Australian ADI  (mostly Mega Bank) wholesale borrowings is from offshore (circa $700Bn). This makes our financial system susceptible not just to events and investor attitudes that may occur in Australia but offshore as well. It’s a very real and catastrophic risk, even if some believe its low, that wholesale offshore investor will at some point and en mass want to be repaid at close to the same time. The CLF supports our financial system if this occurs. Its also what’s around the rhetoric to live with the level of the $A, an end to the basis trade  caused by lowering interest rates and the A$ could trigger the liquidity event I describe.

At this point I should point out that whilst I would argue that the whole concept of the CLF is flawed and that available bank liquidity is a direct consequence of a strongly capitalised balance sheet of each ADI with significant extra capital requirements for systemically important banks. I also consider the CLF to be a massive taxpayer subsidy to all Australian ADIs which if not properly sized for the cost and risk will lead to moral hazard risks. Nevertheless, we have the CLF and its not going away but maybe pressure can be applied to change some of the rules around the CLF.

The first issue with the CLF arises from its original premise, ie there are not enough government bonds to provide the banks liquidity requirements. Whilst this may also be an indicator of the oversized nature of the total ADI balance sheets, since the CLF was announced almost $200Bn of federal government bonds issuance has been built up, 90% of which have been purchased by offshore investors. Additionally it would appear that Australia will have deficits for a number of years to come, increasing this issuance.

Has APRA changed the rules so that the ADIs must buy government bonds so that the size of the CLF requirement decreases? No they haven’t and this suits all ADIs but especially Mega Bank. The cost of the CLF is very low ie 15bps pa, compared to the alternative. The CLF allows ADIs to originate mortgage assets and create RMBS rather than buying government bonds. The net spread on mortgage assets or RMBS compared to government bonds is much greater than 15bps pa probably now in the order of 150bps if you could pull together a direct comparison including costs. The significant comparison is with the cost of the undrawn CLF and not the cost of a drawn facility. On this point our RBA Governor would seem to be misleading.

This simple comparison demonstrates that the cost to the banks of 15bps is a direct subsidy to all ADIs. However, it’s a subsidy which is of much greater value to Mega Bank because Mega Bank is so thinly capitalised on residential mortgages than other ADIs, that the subsidy has a much greater effect on increasing Mega Bank’s return on capital and that’s a significant part of the measures that the senior managers of Mega Bank are paying themselves bonuses under.

Whilst the other two subsidies that Mega Bank receives ie the deposit back stop loss facility and the implied government guarantee of wholesale borrowing may be difficult to exactly measure in terms of return on capital, the benefit of the CLF to Mega Bank is directly measurable for each organisation on an annual basis. Does anyone actually think that this subsidy should form part of senior management bonuses awarded for performance, innovation and good management? Even shareholders should have a problem.

I have had it argued directly to me that the fees paid for the CLF are a bonus for the taxpayer as the RBA is only going to accept in the CLF what could be “riskless securities”. AAA RMBS with suitable haircuts and the RBA would not be allowing drawing on the CLF if an ADI were at risk of insolvency. This is a spurious argument at best as liquidity issues always come before solvency issues in addition to the fact that the credit rating agencies are reactive with rating revisions, so what’s AAA today may not be tomorrow although the rating remains. So the reality is that the CLF is both a back up liquidity and credit support facility.

Another unintended consequence relates directly to the availability of funds for mortgage lending. Whilst I think its somewhat academic that the CLF is primarily RMBS, but APRA does not recognise RMBS as eligible liquid securities, the focus on residential mortgages as the basis for collateral for RBA liquidity facilities provides significant credit availability for mortgages and therefore support of the housing market.

If ADIs were required to buy $200Bn of government bonds rather than creating RMBS, would this not reduce credit availability into the housing market? I doubt very much that the offshore investors now holding government bonds would simply replace them with bank debt. On the other hand if theses offshore investors were to buy direct bank debt or RMBS then at least they’d be taking the housing and funding risk that is now born by the taxpayer at a very low cost.

So the summary of my advice to the RBA and APRA on the CLF is simple.

  • Significantly increase the cost from 15bps pa to better reflect the  cost of the alternative of owning government bonds, and
  • Due the increase in government bond issuance and the likely sustainability of that issuance, ADIs should be required to hold a significant portion (maybe 50%) of those bonds as part of Basel III liquidity provisions in order to decrease the size of the CLF whilst the bonds are on issue.



  1. Top analysis, Deep T. When the liquidity train comes barreling out the tunnel – when, not if – and all those o/s lenders want their $800 billion cash back as it falls due, the RBA will write a lot of very large cheques and take on rubbish RMBS. It will cripple itself and the Australian economy.

    Steve Keen’s Modern Debt Jubilee is a much better solution. Give the $800 billion to citizens (~$40k each!), conditional on their first repaying debt, which solves the bank liquidity problem at a stroke.

    We can fail conventionally or, gulp, take a risk and make our debtors whole again. Cost is the same.

      • Agree, without addressing the structural issues its like a Beroca after a night out before another binge drinking session.

        • No, it isn’t really like that at all. The drinker is unlikely to be allowed to drink again. And the non-drinker is equally rewarded, how does that fit into your analogy? I can’t make it work, perhaps you can.

          Of course, that’s just the idea, which is a good one. The implementation of it would probably be bastardised by vested interests.

          • csfn…you haven’t wiped out the critical debt or imbalances ….the whole system is set to continue on the same path except that it has been refuelled.
            You haven’t changed anything just restored the spending power of the profligate.
            You’ve probably succedced in devastating the value of the currency with all its inflationary results and probably making our external debt that much larger.

            There is no easy way out of this other than to

  2. rob barrattMEMBER

    And in the light of this potential instability, does anybody seriously see this government or the next doing anything (re land tax, negative geqaring etc) that would threaten bank “assets” in the form of house prices?

    • Exactly, these assets are “safe” assets because…..?

      Talk about pro-cyclical hazard….. The low risk rating of MBS’s under the original Basle rules has already been fingered by some astute observers as being one of a toxic mix of factors that caused the GFC.

  3. Cognitive Dissonance

    Did we not get shown during 2008 that what was believed to be information insensitive assets (debt) turned out to be information sensitive
    after all ?…… was we just never allowed our imaginations the freedom they needed until we had to reverse engineer the outcome to arrive were the events took us anyway

    A complex nonsense.

    Who’s assets will become who’s liabilities……who cares about how you will arrive, the destination never changed

    When debt far exceeds the economy that supports it, shuffling it around won’t help much, hell it will probably be government debt that sets off the next round

    • And how much “regulation” would have made any difference? Which regulators saw anything any different to how the wide boys of Wall St saw it?

      I recall one report of a regulator at the US SEC or somewhere who wrote a strongly worded report of warning back in about 2005 or something, and was promptly sacked.

    • John Cochrane’s “Inflation and Debt” is also worth a read:

      I recently explained to a friend of mine whose intuitions I admire, that the Fed intends to keep hyperinflation under control by selling off the Treasury Bonds it has been buying with newly created money, and my friend replied without missing a beat, “who to”?

      That is Cochrane’s basic point too.

      Expect hyperinflation, guys.

      • Phil…what do you call hyper?
        I’m thinking we will get 20 to 30% inflation but surely at that point we’ll bite the bullet…then again…the unwillingness to bite even comparatively tiny bullets does not bode well.
        Once they start ‘looking through’ inflation, which they will,who knows where it will end.

        • Good reference Phil
          FWIW I disagree here “An American debt crisis and consequent stagflation do not have to happen”

          Our low inflation has depended on importing cheap goods from Asia. Any China re-balancing is going to start creating serious inflationary consequences for western nations reliant on cheap imports. So I think, again my thinking may not be worth much, but stagflation looks to be built into our future apart from all the good arguments put forward by Cochrane.

          I find it interesting that even apparently lucid articles like this do not even mention that our low inflation has been correlated and indeed resulted from, cheap imports from Asia over 50 years. It’s a cycle now coming to an end.

  4. Thanks Deep T Hopefully enough people start to read this and take note.

    “If ADIs were required to buy $200Bn of government bonds rather than creating RMBS, would this not reduce credit availability into the housing market?”

    Yes and appropriately reduce the CAD. However we could also expect a rise in market rates which tanks the housing market increasing the risk of finally triggering the crisis.
    Yes Banks could borrow privately from offshore but they cannot borrow at the same rates as the Govt without a Govt guarantee. So again increased rates…unless the RBA prints even more (even more = depending on how you define ‘printing’)
    If RBA prints would still leave a giant gap in the Current Account which must be covered.

    Round and round…a great whirlpool steadily but assuredly sucking us in.
    There is no way out.

  5. I think you have been too soft on the CLF.

    Some other issues are:
    1. If it is only 1 bank that requires the support at a particular time then it is not system liquidity. The bank ought issue shares or tier 2 equity or be taken over or fail.
    2. Use of CLF reduces collateral available to other lenders if the liquidity turns into solvency as a result of a housing crash
    3. CLF in a housing crash also increases likely amount needed for retail depositor repayment so hits either unsecured creditors or the taxpayer.
    4. CLF security ought have pre-specified Loan to security ratios which ensure no loss to RBA eg 65%. But then other banks could take the securities and provide liquidity instead so no need for CLF.
    5. If there is systemic liquidity problem then surely it is because of asset price crashes either in Australia or in the countries that lend into Australian Banks. These two situations ought be distinguished. If it is in Australia, then it will likely be a solvency problem shortly, if it is in Europe US, China or Japan, then maybe there is more argument for RBA support at a price.
    6. Covered bonds reduce the security available for banks to provide to the RBA and I assume the bonds have about 150% cover so 8% of liabilities turns into 12% of balance sheet which turns into say 40% of first mortgage assets. (I am guessing wildly here but you need to follow through the chain from the lkiabilities through the ballance sheet to the assets given and compare that to the assets that might be needed for RBA.)
    7. If it is only systemic liquidity all CLF amounts ought be repaid the moment systemic liquidity is available, not hang around for years as the covered bonds issued do.