Notice the expanding number of banks turning bearish on house prices lately? Damien Boey today argues that that is springing from a much deeper problem.
Interbank funding market is redundant and therefore relevant
It is well documented that interbank credit spreads are elevated by historical standards. But it is far less well understood why this is the case, especially when wide spreads should theoretically be impossible in normal times. Banks should never need to borrow reserves from each other if they have access to the RBA as the lender of last resort. In this context, bank bill swaps are largely redundant, and any spread in pricing over the risk free rate should technically be negligible. But the reality is that spreads are high, and this requires explanation.
In our recent article “The interbank funding market is redundant, and therefore relevant” dated 23 May 2018, we canvass three possible explanations for wide spreads:
1. The RBA’s willingness to provide liquidity may have changed in the wake of Basel III implementation in early 2018.
2. Somehow, rising USD funding costs are filtering through to higher AUD funding costs.
3. Banks’ perceptions of each other’s credit risk is rising.
But we believe that the last explanation is the most compelling. The mechanics of bank funding and liquidity provision rule out the first two options.
We sense that RBA officials are mystified by wide spreads, and this is a concern to us. In a recent speech, Deputy Governor Debelle reiterated the Bank’s optimistic growth outlook – but shortly afterwards, entered into a detailed discussion of interbank funding conditions, and why they may, or may not matter. Debelle believes that tighter USD funding conditions are having an impact on Australia, even though we do not. But regardless, Debelle seems to have suggested that sustained, wide funding spreads are the “one thing” that could re-shape the Bank’s outlook. After all, history suggests that loan growth and interbank spreads are very negatively correlated…
Reasons to be sceptical of popular opinion and narratives
If the RBA is serious about targeting the cash rate (which it is), it technically must provide any and all liquidity demanded by the banks at the Bank’s target price. Failure to do so would result in loss of control over the cash rate.
Recently, the RBA has reiterated its commitment to being the backstop liquidity provider to the system. Since early April, it has been conducting frequent long-term open market operations to provide liquidity to banks who need it. If the underlying problem in the system was a shortage of liquidity (or reserves), technically, the Bank should have fixed this by now. But the liquidity injections do not seem to be working, as the interbank spread is still very wide by historical standards.
There is some suggestion in the market place that in the wake of Basel III implementation in early 2018, that the RBA will only provide liquidity to compliant banks. This may be putting more pressure on individual banks to increase their liquidity by borrowing from other banks, if need be, or hoarding reserves. Either way, the claim is that Basel III is putting upward pressure on interbank funding spreads.
But our problem is this. To be compliant with Basel III, banks need to be liquid, and only illiquid banks would ever come to the RBA for more liquidity. The RBA cannot not provide liquidity to banks in need – otherwise it would lose control of the cash rate.
As for the USD funding cost argument for wider AUD funding spreads – the issue is that Australian banks look like they need USD funding, but do not need it in reality. After all, Australian households cannot use USDs to buy property. And bank loans create deposits.
To be sure, Australian banks may feel that they need USD funding because they are seeking to duration match their assets and liabilities through term funding that is easier to obtain in offshore markets than it is domestically. But if foreigners were to become less willing to provide USDs to Australian banks, this would be more of a currency event than a funding event. Banks would resort back to deposit funding, and forego duration matching. They would sell AUDs to buy USDs to pay off their USD term funding obligations.
If the change in liquidity regime, nor USD funding can explain what is happening in the AUD interbank market, the only logical conclusion, by process of elimination, is that perceptions of counterparty credit risk are rising.
Investment implications
We think that investors should be worried that interbank credit spreads are wide, despite the design of the monetary system, and a series of RBA liquidity injections. Wide spreads impair the monetary transmission mechanism, and increase de-leveraging risks in the economy. In turn, de-leveraging creates greater uncertainty.
To hedge against these developments within the equity market, we think that investors ought to avoid value, and turn to quality. Value fails during de-leveraging episodes, because asset prices drive fundamentals, rather than the other way around. But quality offers investors the certainty they need in uncertain times.
Hello counter-party risk…
