15 Dec 2015
" Three factors – market anxiety, new US reforms and reduced Australian demand for liquid paper – have cut demand for paper and pushed up short term funding costs."
Andrew Cornell, Managing Editor
Yet while the attention has focussed on longer term debt, three to five-year bonds which contribute to the stable funding base for banks, shorter-term debt, less than a year in tenor, has also been impacted.
Banks can afford to ride out – at least for a period – spikes upwards in longer term funding costs by simply not issuing. But they are largely price-takers at the shorter end of the interest rate curve with less timing discretion.
Unusually, rather than the uncertainty making the interest rate curve steeper – longer term rates rising more quickly than shorter (as happened in the financial crisis) – at the moment all rates are moving up almost in unison.
The implication of higher funding costs at the short end potentially flows on more immediately to interest rates charged to customers, notably mortgages where the product in Australia is priced off the benchmark Reserve Bank cash rate but actually funded off the bank bill swap rate.
In Australia, the key short term measure is the spread of the bill rate against the Overnight Indexed Swap rate (OIS), the market vehicle for the RBA cash rate. That spread has risen steadily since May, from around 15 basis points (0.15 percentage points) to over 40 basis points at the end of 2015 and 35 this month. A bigger spread means higher funding costs.
The reason is not straightforward: it reflects market anxiety but also a dramatic change in demand due to new US regulation and moves by the Australian Prudential Regulation Authority (APRA), the Australian supervisor.
Even during the financial crisis, when longer term funding dried up because investors in bank debt – including other banks – didn’t trust their peers, shorter-term funding, although more expensive, was available as investors were prepared to accept the risk a bank wouldn’t tip over in the next 30, 60 or 90 days.
So market anxiety doesn’t entirely account for the recent widening of short term spreads. What is thought to be more significant is supply and demand. Some key investors in bank paper have been sidelined by new regulation.
These are mainly regulated prime funds in the US which historically have bought between a third and a half of the short term debt. However reforms in this sector, designed to make it safer, have slashed the amount of such debt the funds are allowed to hold.
Holdings in that sector have dropped about 15 per cent - $US200 billion in a $US1.5 trillion market. Those in the market say that impact has been significant.
But the third factor is Australian regulation. One component of the global reforms in banking supervision since the financial crisis has been the requirement for banks to hold enough liquid assets – which can easily be turned to cash – to see them through a 30-day liquidity stress scenario. That is designed to stop short-term runs on banks causing them to fail by running out of cash even though they are solvent.
In most countries high quality liquid assets are government debt. The issue for Australia and some other countries is there is simply not enough government debt on issue. So in Australia APRA and the RBA have devised a way for banks to 'lease' liquidity at a price to make up for the shortfall.
In order to access this liquidity, called the committed liquidity facility (CLF), banks must hold certain qualifying assets they can use with the RBA for collateral.
Among these assets is the short-term debt of other banks. APRA is in regular discussions with the banks about which high quality liquid assets (HQLA) it wants them to hold.
One critical calculation APRA makes is what liquidity the banks will actually need. And, despite a number of moving parts, it has fallen.
In a December 16 speech, Some Effects of the New Liquidity Regime, RBA assistant governor Guy Debelle ran through the detail of what was happening.
“The size of a bank's CLF is determined by APRA each year as the difference between the banks' projected Australian dollar net cash outflows and the amount of HQLA that they can reasonably hold,” he said.
“Hence a bank's annually determined CLF will decline if either their projected net cash outflows decline and/or if the stock of HQLA increases. Over the course of 2015 both these developments have occurred.
“For 2016, system liquidity needs have fallen to $A440 billion, even as banks' balance sheets have expanded. This is because banks have sought to reduce their net cash outflows by the adjustments to their liabilities. At the same time, based on Commonwealth and state government budgets, we project that the stock of HQLA securities that the banks can reasonably hold will rise by $A20 billion by end 2016. As a result the size of the 2016 CLF will decline from $A275 billion to $A245 billion.”
As a result, in the run up to January 1 and since, demand for bank paper may have dropped by up to $A20 billion – although the real situation is difficult to measure as liquidity from one sector may end up in another, like ordinary deposits.
So three factors – market anxiety, new US reforms and reduced Australian demand for liquid paper – have combined to cut demand for paper and push up short term funding costs.
It’s a peculiar combination of factors but nevertheless one which plays into a broader picture of rising funding costs (credit default swaps, a proxy for longer-term funding costs, are at near two-year highs). This reverses the trend of lower-funding costs in recent years as the very high prices for debt post the financial crisis washed through the system.
And one which, if sustained, will put pressure on banks to recover their margins through pricing.
Andrew Cornell is managing editor at BlueNotes
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
15 Dec 2015
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