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.