What price bank liquidity?

ScreenHunter_15 Apr. 02 11.07

By Leith van Onselen

Early last month, the AFR’s Chris Joye wrote a timely article questioning the merits of, and processes around, the RBA’s Committed Liquidity Facility (CLF) for Australia’s banks:

The Reserve Bank of Australia’s unique Committed Liquidity Facility – a little-known, taxpayer-backed “line of credit” to help banks overcome solvency crises – creates as many problems as it is intended to address.

The RBA claims there is a difference between an “illiquid” and an “insolvent” bank, and the new facility, which could be as large as $380 billion, will be made available only to “solvent” institutions.

…The Committed Liquidity Facility opens a Pandora’s box of problems. The most obvious concern is that it inverts the logic of the Basel Committee’s post-GFC policy remedies by entrenching taxpayer loans as a first, rather than last, line of defence against bank collapses.

A second class of concerns relates to who actually controls, and is responsible for, the CLF and the manner in which it is deployed.

The facility was designed and announced by APRA and RBA staff with no public debate or oversight. The bureaucrats’ view is that it was within their mandate to do so…

Joye’s criticism of the CLF prompted the RBA Governor, Glenn Stevens, last week to deny emphatically that the CLF was a ‘bail-out’ fund for insolvent institutions:

It is not a ‘bail-out’ fund for banks. ‘Bail-outs’ usually mean stumping up public funds to inject capital to an institution whose solvency is in question. The CLF does no such thing. It is a facility, for which the institutions concerned will pay a fee, which would provide cash against quality collateral pledged by institutions that the Bank and APRA judge to be solvent. The fee structure is designed to replicate the cost the institutions would incur if there were sufficient ordinary high quality collateral – i.e. government debt – for them to hold to meet the Basel liquidity requirements – which, of course, there is not. If we are to meet the global standards, we either have to have a facility like this, or have the government issue a few hundred billion dollars in extra gross debt so the banks can hold it. The relevant ADIs will pay a fee of 15 basis points per annum for the facility whether they use it or not. If they do use it, any funding will be at an interest rate that is 25 basis points above the market rate. This has been developed openly, and under the scrutiny of the international regulatory community. It was approved by the Reserve Bank Board in November 2010.

Over the weekend, Chris Joye stepped-up the pressure on the RBA over the CLF, questioning its definition of insolvency and warning of the moral hazards inherent in the scheme:

The RBA has been using a profoundly erroneous interpretation of “insolvency” to allege that the CLF is not furnishing banks with solvency support.

In the RBA’s alternative reality, “solvency” means that a bank has assets that are worth more than its liabilities, or “positive net worth”.

While that might sound reasonable, the value of a bank’s assets relative to its liabilities has little bearing on whether it is insolvent under the Banking and Corporations Acts. These definitions are clear, tight, and applied by private company boards and lawyers every day.

The bottom line is that if you cannot find the cash to repay every single one of your debts when they mature, you are insolvent. It does not matter whether you have high quality assets, as the RBA suggests. Allco and Babcock & Brown had positive net worth before they were placed into administration. They went bust because they did not have the money to pay their debts, which suddenly fell due.

According to the Banking Act, “insolvent means that the body corporate is not able to pay all its debts as and when they become due and payable”. This is an exacting standard: if one small fraction of one deposit cannot be repaid when a saver demands it, the bank is insolvent…

In the RBA’s words, the CLF was “designed to ensure that [banks] have enough access to liquidity to respond to an acute stress scenario.” So banks can tap the RBA for cheap cash for an undefined term whenever they face a run on deposits or when wholesale creditors refuse to provide them with new loans.

This is unambiguously a solvency problem. In the absence of the CLF, or the RBA’s other funding facilities, the banks would be promptly placed into administration by their boards…

The most significant risk is manifest moral hazard.

On the whole, I agree with Chris Joye’s assessment of the CLF. It indeed appears to have been devised under a cloak of darkness without public debate or oversight. It also risks furthering moral hazards within the banking system, whereby a bank is incentivised to take on excessive risks (or not undertake sufficient risk management) in the full knowledge that the taxpayer will bail it out in the event that it cannot repay its debts as they fall due.

To be fair, moral hazard has been an ongoing issue for the Australian banking system ever since the Government guaranteed the banks’ wholesale borrowings and deposits in the wake of the GFC, and the RBA stepped-up its repurchase agreement operations, providing the banks with substantial liquidity support. The wholesale borrowings and deposit guarantee, in particular, also went against the recommendations of the 1997 Financial System (‘Wallis’) Inquiry, which explicitly stipulated that the Government should never provide a guarantee over the banking system.

Without the Government’s/RBA’s support, the the banks’ cost of capital would have risen dramatically in the months following the GFC and some might even have faced insolvency. Of greater concern, however, the measures heightened the expectation that the authorities would support the banks as required going forward, which the ratings agencies have acknowledged provides the banks with a two-notch ratings upgrade.

Ultimately, the Australian banking system, as it currently stands, has departed in a fundamental way from the recommendations of the Wallis Inquiry. Moral hazard is now entrenched, transparency and accountability is lacking, and there has been little to no public debate or consultation about what system is appropriate going forward, or the long-term implications of using the Government’s balance sheet as role of guarantor of last resort.

The next Australian Government should immediately undertake a new Financial System Inquiry to examine these and other financial stability issues. At the very least, it will place all the issues on the table, facilitate public discussion and scrutiny, and provide greater accountability of Australia’s regulators and financial system policy.

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Leith van Onselen


  1. Deus Forex Machina

    Guys – Chris’s definition is bunkum.

    “The bottom line is that if you cannot find the cash to repay every single one of your debts when they mature, you are insolvent.”

    Banks perform maturity and liquidity transformation. They borrow short and lend long.

    Yesterday there was a debate about the value of deposits over RMBS. With APRA and others arguing that deposits are the gold standard for liquidity and funding.

    But deposits are either at call – that is they can be called now, tomorrow or the next day. Perhaps they are term deposits but these generally don’t go past 12 months.

    Yet most ADI’s, banks but also Credit Unions and Building Societies have the vast bulk of their assets as home loans which by there very nature are long term.

    Thus is all my depositors come to me and say can I have my money back but my assets are unliquifiable home loans then I can’t repay the cash.

    Accordingly every bank on the planet – even ones which have a surplus of deposits over loans are technically insolvent under the above definition.

    This is the exact reason the CLF exists – the RBA recognises that and they are right.

    All this ranting about the CLF fails to go back to Banking 101 – liquidity and maturity transformation.



    • All valid comments. But doesn’t change the fact that the CLF and other interventions (e.g. deposit/wholesale guarantees) have been developed on the fly and raises moral hazard. The CLF’s pricing is also ambiguous. How did the RBA arrive at the figure? Why is it appropriate and does it adequately compensate the taxpayer for their support? And does it ensure competitive neutrality? And so on.

      The financial architecture has changed so much since Wallis that we need another open and transparent financial system inquiry to debate these issues. Australia’s regulators and financial sector policy suffers from severe hubris and needs to be kept in line.

      • Deus Forex Machina

        I disagree that the CLF has been done on the fly given I know its genesis and thought process but I agree 100% about the pricing and the deposit guarantees.

        I think this is where the debate needs to be – if the Australian taxpayer is underwriting the big 4 then the Australian taxpayer should get some compensation for the guarantee.

        Perhaps we can differentiate the guarantee for smaller institutions which are essentially less risky as well for the most part to give them a competitive leg up.



        • If I am squeezed the Banks would typically charge me 12% plus fees. That’s what they are hitting small business for.
          If Banks are squeezed why shouldn’t they be charged at the same rate?

          • P.S. That’s why its genesis smells. Gail et al take their $10M bonuses while we all subsidise them at unrealistic negative RAT rates.

  2. Banking is always going to be a high risk industry. The benefits of having a banking industry are clear, but the risks are much harder to quantify when the economy can swing wildly suddenly putting the banks assets at risk. We also saw in the USA how banks can hide the poor quality of their lending decisions until it is too late to save the situation.

    I’m with Greg, I think we need this facility, but only when it’s balanced by sensible lending decisions by banks and that’s where it gets tricky.

      • In many respects they do, it’s just that they don’t have LVR restrictions, which is what most people focus on. There are certainly restrictions on servicability.

        Most banks will lend to 90% and some will in some circumstances lend to 95% but under much tighter conditions. I can only assume that they are OK with those LVR’s.

        • Crocodile Chuck

          “Most banks will lend to 90% and some will in some circumstances lend to 95% but under much tighter conditions.”

          And they, and we, have learned nothing from the US. A 95% LVR is renting, with an option to purchase. One could not invoke a worse example of moral hazard.

          “I can only assume that they are OK with those LVR’s.”

          Why wouldn’t they be OK with these? Guess who’s backstopping them? I have just pipped my example above of ‘worst moral hazard’.

      • Deus Forex Machina

        The “sensible lending decisions” thing is partly why (or entirely why perhaps) the RBA is asking for standardised loan level data so it can see what it might ultimately take via the CLF…

        This transparency to the RBA will give them a good window on what is going on

        • I find it amazing that the RBA or investors can’t drill down to individual loan level to perform audits or due diligence in the case of an investor.

          We wouldn’t buy a car without a roadworthy certificate.

      • Jargon. Tell me how it is possible to generate a meaningful enough probability distribution to generate a meaningful 6 sigma event. Its really only valid for absolutely normal distributions and absolutely normal distributions only exist in coin tosses (and maybe the level of the Nile in the 1800s)

  3. This tax payer stand by facility of $360b and the guarantee on deposits. Tells me that fractional banking is a real concern. You need real discipline with this leveraged Banking system and I don’t see any Bank standing out as one that has a policy that is anti shoveling mountains of debt into a property bubble.
    If this facility is drawn it needs to redirect Banks profits back to the tax payers, from what I can gather I see that the funding of such a facility provides Banks with a cheaper source of funding. Surely it has to be at commercial rates of interest so tax payers get a return. Forget shareholders they can’t benefit from the nations joint and several guarantee .

    • I agree. The CLF appears to resemble a new sandpit that the banks will be able to play in whenever it takes their fancy. The sand is nice and golden, very soft and there are plenty of the latest toys in there as well. Whenever you feel like having a play, just go on in, as long as you’ve got your 15 cents. It’s loose change. They’ll be taking advantage of the sandpit on a regular basis.

      Such a sandpit ought to be more akin to a snakepit. It ought to have a very high entry fee, very coarse black sand that stinks, and plenty of nasties that’ll bite you on the behind if you hand around too long. It ought to be an expensive, unpleasant experience that is only used when there are no other alternatives.

  4. Fact the RBA is happy to re-blow the housing bubble is a pretty good indicator on their judgments about moral hazards.

  5. If the assets to be pledged are so good, they can be sold on the open market to avoid any cash flow crisis.

    Why is the RBA a better judge of market value of a bank’s assets than the national and international finance and investment community?

    Banks manage their liquidity by buying and selling assets and borrowing and lending on the short term money market every day.

    If the RBA is to lend against assets, even Australian sovereign debt, it ought only lend when markets freeze and then only 80%. It ought not lend to individual banks when the markets are working freely. If the markets are working freely then no individual bank ought need liquidity support.

    I would dearly love the Australian government and RBA to clarify the support for depositors and in particular whether it will give the government a first charge over all bank assets to rank in front of covered bonds, or does it come out of consolidated revenue with ordinary unsecured creditor claim on the relevant bank.

  6. I agree that, given the policy parameters outlined, there probably does need to be a CLF in place. However, my issue is that it should be a last resort mechanism. At the moment, it appears to be a pot of money for banks to access almost at will. If they are a bit short of cash on any given day, they can raid the CLF for a modest fee. I’m sure the banks would come to treat this as just another (modest) cost of doing business.

    The CLF should be very expensive to access with very strict conditions applied to ensure it truly is a last resort mechanism.

    I’m not sure how these things ought to be priced, but 15 basis points seems very low to me. Perhaps something in the order of 100 basis points or more would be enough of a deterrent. And the interest rate on the funds obtained ought to be 100 basis points above the current market rate. Make it truly unappealing to tap the CLF unless they absolutely have to. And perhaps the banks should be made to make a submission to the RBA that is subsequently published on the RBA website, much like the AOFM publishes which banks it has purchased RMBS from. The public should be able to clearly see when banks have used the facility, how much they have obtained, the fee paid and which criteria were met to allow them access to the funds. The moral hazard would still be there, but it would be very expensive and much less likely to be an integral part of the banks’ business model.

    • I thought the 15 points was a line fee, not the interest rate on drawings which is a different thing.

      The whole debate no bank capital adequacy and support is a tussle between borrowers, who want bank costs kept as low as possible so they can have low rates while the banks still get a good return on equity and lenders to banks who want to be sure they will get a real rate of interest after inflation and tax of say 1% and get all their money back.

      Politicians tend to favour increasingly tilting things in borrowers favour to keep credit growing and promoting growth because it is much easier to have a happy population when there is growth rather than contraction.

  7. Standard & Poor’s, Fitch and Moody’s to put a rating on the size of the CLF.
    The larger the amount used of the $380 billion the lower the rating.