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Bank capital a focus but what about liquidity?

The focus during the Australian bank profit reporting season was, not unexpectedly, on capital. The amount needed, by when and for what.

Both global regulators and the Australian Financial System Inquiry have focussed on the need for capital levels to be “unquestionably" strong to protect taxpayers during a crisis.

"Like capital, liquidity has a cost, particularly when global interest rates are very low."
Andrew Cornell, Managing Editor

Fair enough. But the history of crises, including the latest biggie, tells us banks fail due to a lack of liquidity, not a lack of capital. They suffer runs, they can't roll over their debt or access funding.

Liquidity though was barely mentioned in the reporting season and there's a very interesting story in what's happening to balance sheets and earnings on that front.

Liquidity is a crucial element of a safer financial system. The regulators have recognised this, instituting a “liquidity coverage ratio", requiring banks to have liquid assets – that is cash in the form of equity or assets which can be quickly and reliably turned into cash – sufficient to fund the bank for 30 days.

In Australia, the Australian Prudential Regulation Authority moved promptly with this new rule and while elsewhere in the world – and in Asia – banks are still at around 60 per cent on the ratio, banks ruled by APRA have had to have the full 100 per cent since January.

For example, the bank I work for, ANZ, reported an LCR of 119 per cent as at March 30, representing an extra $A28 billion of liquid assets over APRA's minimum. The other Australian majors are also compliant.

(There's an added twist in the Australian liquidity picture because the nature of Australia's balance sheet means there is insufficient qualifying liquid assets for the banks to hold, largely because Australia has very low levels of government debt and government bonds are the usual liquid assets held.

(To address that issue, the Reserve Bank makes available a committed liquidity facility, for which the banks pay. Of ANZ's liquid assets, $A54 billion are from the CLF.)

Like capital, liquidity has a cost, particularly when global interest rates are very low. Around the world, the yields – the interest paid – on the most secure debt like government bonds is historically low. Low returns means lower net interest margins for banks – the difference between the price of funding and the price of lending, between money earned and money paid.

The accounting firms, in their reviews of the reporting season, all used words to the affect that a decline in funding costs for banks (lower interest rates, lower deposit costs) was “offset" by the margin cost of managing liquidity.

Net interest margin (NIM) though is what the boffins like to call a “dumb" number, it tells you about quantity and not quality and in the case of the growing holdings of liquidity, it fails to recognise the quality of the debt in the LCR portfolio can cut margins while actually lifting returns on equity (ROE).

That's because assets like government bonds have the lowest risk weightings, not captured in the NIM. So while the earnings from the low yields are down, the risk weights on the assets are down more and so ROE is up. ROE is measured against risk-weighted assets.

There's even the opportunity for arbitrage. Raising deposits and putting them in the high quality liquid assets (HQLA) portfolio reduces NIM but can be ROE accretive if the HQLA (for example, a deposit with the US Federal Reserve) has minimal capital requirements. This reduces return on assets (ROA) but through higher leverage improves ROE.

And, for the moment at least, the Australian banks don't have a regulatory issue with higher leverage. The current rates on the so-called Fed “window" are 25 basis points while the overnight rate is 7 to 8 basis points. In Australia, the RBA cash rate is 2 per cent while the international rate as measured by LIBOR is around 0.2 per cent.

So banks can borrow at the lower rate and lend back at the higher.

The impact of these numbers hasn't been broken down in the bank reporting season but with global rates so low, the liquidity play has been a significant contributor.

Interestingly, in a new piece of research “Unearthing Performance Gains to Boost Bank Value", McKinsey and Co noted one powerful factor driving bank valuations is the ratio of risk-weighted assets to total assets.

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“A reduction in this ratio generates large and consistent benefits. What banks achieve here will have a much bigger impact on their valuation than any other action," McKinsey found. “The clear implication is that banks should work continually to improve these ratios and periodically relaunch programs that deliver ongoing incremental improvements."

In the new world of the LCR, not all deposits are equal. The regulators like deposits which can't disappear quickly, such as long term deposits or transactional type accounts, and not ones which can disappear quickly such as on-line, at call accounts.

As this story in BlueNotes last week explained, banks are pricing deposits differently to reflect their regulatory value. Against that though is the need to look after some customers who may want to deposit funds with banks that don't satisfy the rules to be high ranking. The banks may well carry extra, offsetting high quality deposits to allow them to satisfy the customer.

Unlike the growing, and open ended, debate on the right levels of regulatory capital, the right levels of regulatory liquidity are now largely settled – although Australia has implemented them faster. If these liquidity rules had come in before the crisis, they would have been extremely challenging for banks but since the crisis the banks have considerably strengthened the liquidity profiles of their balance sheets e.g. by reducing reliance of short-term wholesale funding and increasing the duration of liabilities.

But as the current liquidity arbitrage shows, even when regulation is set, the impact on earnings can be dynamic.

This particular scenario where banks can satisfy a higher regulatory requirement and make money doing it is unusual and unlikely to last. It should unwind as US rates, in particular, rise.

But despite the impact on NIM, at the moment on the liquidity front banks are safer. And there has even been some opportunity to make some money to offset the broader costs of the LCR.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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