Australia’s banks emerge from crisis in credit

Australia’s banks are the envy of the world, at least from a funding perspective. They have weathered the financial crisis better than most, emerging stronger than before on a relative basis. But their funding models are being scrutinised, with their dependence on wholesale markets a concern, while observers warn of the dangers of the battle for deposits among Australia’s banks escalating into a war that would push their aggregate cost of funds even higher they are today.

  • 01 Aug 2012
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If there was such a thing as a good global financial crisis, Australia’s big four banks have had one. As Ken Henry, Secretary to the Treasury, said in a speech in December 2010: "The Australian banking system emerged from the crisis in a stronger position, relative to banking systems in other countries."

This is not to suggest that Australia’s banking sector was untouched by the crisis. Quite the reverse. Broadly, the global financial crisis has hit the Australian banking industry in three ways, each of which appears likely to be permanent. It led Australian banks to address the thorny issue of their historical dependence on international wholesale funding; it increased the dominance of the quartet of ANZ, CBA, NAB and Westpac; and it focused the attention of the local regulators on Basel III.

There are several reasons explaining why Australia’s big four banks have traditionally been highly reliant on offshore borrowing. In the simplest terms, Australia’s domestic investment has perennially outpaced domestic savings. The current account deficit created as a result has historically been plugged by banks’ offshore wholesale funding, which meant that relative to their assets, the big four Australian banks were among the most insatiable issuers in the global capital market. According to research published recently by Citi, in 2009 Westpac and CBA were the two biggest issuers in the world by this measure, issuing 11.7% and 9.6% of their assets respectively. ANZ was fifth on the Citi list, and NAB eighth.

There are other structural reasons explaining Australian banks’ prolific wholesale funding. "The asset side of our balance sheets is highly intermediated, with limited scope for taking home loans off-balance sheet," explains Simon Maidment, head of group funding and execution at CBA’s Sydney headquarters. "There is no secondary loans market and only a small securitisation market, which makes Australia very different from the US, Canada or the UK."

"Additionally, most corporate lending is intermediated, with only a limited number of Australian corporate borrowers having access to the capital market," says Maidment. "This is one reason why Australian banks have historically had high loan to deposit ratios."

Although these ratios have fallen sharply from their peak of about 180%, they are still high by international standards, with Fitch data putting them at 161% at Westpac in September 2011, 154% at NAB, 140% at CBA and 135% at ANZ.

Before 2007, the banks’ dependence on wholesale markets was seldom identified as a potential weakness. After all, Australia’s big four have for many years been among the world’s best rated financial institutions, as a result of which their funding spreads for three year bonds were around 50bp over Commonwealth Government Securities (CGS) in 2006 and 2007. Those spreads, according to the RBA, shot to a peak of about 220bp in the domestic market and 280bp offshore at the height of the crisis.

Funding models scrutinised

Those spreads have since narrowed to more manageable levels. But as KPMG notes in a recent report on the future of Australian bank funding, "the aftermath of the shock on the viability and implications of [the banks’] current funding model is now increasingly the subject of public debate and inquiry."

It also leaves Fitch, for one, jittery about the perceived dependence of Australia’s banks on wholesale markets, which is the main reason it gave for downgrading three of the four to AA- in February.

"We’re not so crude as to say that all wholesale funding is bad, and we recognise that the banks have reduced their short term debt since the Lehman crisis," says Tim Roche, director at Fitch Ratings in Sydney. "But given how susceptible wholesale funding can be in a downturn we feel more comfortable with the banks at AA- than at AA."

Some local bankers say the Fitch rating action amounted to a bizarre exercise in slamming the stable door long after the horse had bolted. Certainly, the Fitch move looked odd, given how much the banks’ funding profiles have changed in the last four years. "Before the crisis, foreign investors held around 29% of total bank funding," says Gus Medeiros, director of credit research and strategy at Deutsche Bank in Sydney. "Today, that share has fallen to 23%."

"It would take a significant shock to the global banking system for Australian banks to lose their access to the market," says Sean Henderson, head of debt capital markets at HSBC in Sydney. The relative strength of the big four was strikingly re-emphasised in June, when none of them were among the 15 global players downgraded by Moody’s. As ANZ commented soon after Moody’s confirmed the downgrades, "this leaves the four major Australian banks in a group of only 16 banks rated AA (or higher) by all three major credit rating agencies."

Those ratings are of pivotal importance for the broader Australian economy. S&P says that the "most identifiable risk" to Australia’s AAA rating is "an unlikely, significant weakening in the credit quality of the country’s banking sector, given its role in funding Australia’s current account deficits."

That may be, but there are plenty of other reasons why analysts are relaxed about the outlook for the banks’ access to ample, competitively-priced local and offshore liquidity. Foremost among these is that a number of factors are combining to make the funding challenge facing the leading banks today far less daunting than it might have been. The most obvious of these is that their aggregate funding requirements are well down from the peaks they reached in 2009 and 2010.

"For us and Westpac, the global financial crisis created a once-in-a-lifetime opportunity to make important acquisitions," says Maidment. "The acquisition of BankWest meant that CBA had a wholesale funding requirement in FY2010 of $54bn. We were able to issue some of that with a government guarantee, but I suspect it was the largest amount ever issued in a single calendar year by any Australian borrower. It was a one-off and our annual funding requirement has now come back down to around $25bn."

Declining funding needs

That is broadly in line with the funding needs of the other big Australian banks, which are declining. In a note published in March, NAB forecast that the big four would have an aggregate requirement of between $80bn and $85bn rather than the $100bn originally expected.

At Deutsche in Sydney, Medeiros says that based on deposits growing at about 8% and lending at 6%, banks’ aggregate funding requirement in 2013 will reach around $125bn. "The banks’ funding need will rise next year, mainly because refinancing requirements will rise," he says. "But that is still a very manageable total."

In part, banks’ refinancing requirements in 2013 are the product of maturing government-guaranteed bonds, of which some $130bn were due to mature between 2010 and 2014. Bankers’ views are mixed on how much of a challenge this may pose for the big four. "The question about refinancing government-guaranteed bonds is a bit of a red herring," says Duncan Beattie, managing director of debt capital markets at JP Morgan in Sydney. "Most jurisdictions limited government-guaranteed debt to three years, whereas in Australia issuance stretched out to five years, so there is a much wider dispersal of maturities than in many other markets. Besides, the banks have been very proactive in buying back their government-guaranteed bonds, or in switching it into other forms, such as RMBS, as well as accessing the triple-A investor base through the covered bond market. So I think it would be misleading to focus too heavily on the need to roll over government bonds."

In the meantime, overall pressure on the banks’ wholesale funding requirements is expected to continue to be relieved by the resilience of deposits flowing into the Australian banking system.

Depositors have been drawn to banks by the very high rates that they are now being offered for term deposits (TDs), which over the last five years have become something of a must-have in Australia. "You only have to walk down the street and look at the rates banks are offering on TDs to understand how attractive these have become," says James Waddell, director of debt market origination at NAB in Sydney. "Rates are typically around 5%, while the cash rate is 3.5%, so we’re talking about a margin of 150bp over the cash rate for retail deposits."

This pick-up, says Waddell, is a relatively new phenomenon. "When I started my banking career in 1988, term deposits paid 2% below the cash rate," he says. "There has been a huge turnaround over the last 20 years, although the most dramatic change has been since 2007."

Waddell attributes this change principally to a combination of two factors. The first is the so-called Irish solution to the global banking crisis which provided savers with the comfort of government guarantees on their term deposits. The second is the rising popularity of self-managed superannuation funds (SMSF) in Australia, which are cheaper and more flexible than other forms of retirement savings schemes.

"All of a sudden, investors in managed funds found they could earn a pick-up over the base rate in government-guaranteed term deposits," says Waddell. "So after many years in which asset growth had been stronger than deposit growth, we began to see a surge in inflows into TDs. In 2007, there was something like $188 of loans for every $100 of deposits in the banking system. Today, it is more like $144."

Battle for deposits

How long banks will be able to maintain these robust inflows is open to question at a number of levels. One challenge is to ensure that the battle for deposits among Australia’s banks doesn’t escalate into a war that would push their aggregate cost of funds even higher they are today.

To date, say analysts, there has been little to suggest that this is a danger, although there are signs that competition for deposits is intensifying. "I wouldn’t say we’re seeing a deposit war," says Fitch’s Roche. "But there has been some of what the banks call irrational pricing on the deposit side — teaser rates on deposits that are above lending rates and are therefore unsustainable, for example."

Looking to the longer term, there may be pressures on the demand side if depositors sense that the prices of riskier assets have fallen too far. "The challenge for the banks will be how they can sustain these high deposit levels if and when confidence returns to property and stock markets," says Andrew Dickinson, partner, financial services, at KPMG in Sydney.

For now, however, there is little sign that Australian savers are losing their appetite for deposits, which account for 52% of banks’ overall funding, compared with less than 40% five years ago.

Several other influences have eased the pressure on Australian banks’ funding. One of these is that with support of Australia’s legislators, the country’s banking industry has been quick to exploit other funding options, most notably in the covered bond market. They owe that opportunity to a dramatic change of heart by the powers-that-be over depositor protection, which as recently as 2007 led bankers to believe that APRA would allow banks to issue covered bonds only over its dead body.

Bankers view the volte-face from Australia’s government on covered bonds as testament to its pragmatism and adaptability in the wake of the global financial crisis. "The notion of government-guaranteed bonds would have been equally abhorrent to the authorities prior to 2007," says Andrew Macgonigal, head of debt origination at Nomura in Sydney. "With banks that were used to funding at 50bp over Treasuries suddenly facing funding spreads of 250bp, there was a recognition that they would have to look at every pool of capital available to them."

Aside from maximising the new opportunities opened up in the covered bond market, Australian bank issuers have been very nimble in exploring other funding sources. No other group of issuers, for example, has been more active in the Samurai market, although bankers say that it is a mistake to imagine that Australian banks’ focus on Japan has been a knee-jerk response to the global financial crisis. "Before the market turned in mid-2007, all the banks recognised that Japan was going to be an increasingly important source of capital," says Macgonigal. "They all established Samurai documentation and fostered good relations with the Japanese investor base well before the European crisis, and they have been rewarded with well priced and broadly placed transactions in good size."

The big four get bigger

The second way in which the global financial crisis changed the Australian banking sector is in the added power it shifted into the hands of the big four banks.

According to Moody’s, the big four accounted for 83% of total loans and 78% of deposits in the banking system in August 2011, up from 70% and 63% respectively when the crisis began in August 2007. "These market share gains are partly a result of market consolidation in recent years, but also testify to the major banks’ superior access to funding," notes Moody’s.

Their capacity to issue covered bonds clearly improves that access to funding and strengthens the stranglehold that the major banks already had on the Australian mortgage market, in which they now command a market share of almost 87%.

This concentration in the balance of power among the big banks has a number of important implications for the industry and for the capital market. In a paper published at the start of the year, the IMF warned that as they account for 180% of GDP, any distress among the big four could have a "sizeable impact" on the financial sector and on the real economy in Australia and New Zealand. "Moreover," the paper cautioned, "they may be perceived by the markets as too big to fail, which implies they could pose a potential fiscal liability."

Against that backdrop, it is unsurprising that the well-being of smaller banks is such a political hot potato in Australia. Nor is it a surprise that the government has supported smaller mortgage lenders via the AOFM’s RMBS purchase programme, launched in September 2008 "to support competition in Australia’s mortgage market".

"It is a struggle for some of the smaller ADIs and non-bank lenders to compete with the majors in the prime space, because RMBS has been a significant source of funding, and is relatively expensive at the moment," says Andrew Chick, country executive and head of international banking at RBS in Sydney. "That is why the AOFM programme is so important to those institutions as it increases demand for the paper."

The jury seems to be out, however, on how the arrival of covered bonds in Australia will compromise the overall credit quality of RMBS. Issuance rose to $22bn in 2011, which was the highest total since 2007, although volumes slowed notably in the second half, with the RBA commenting that "for the major banks, covered bond issuance could have crowded out RMBS to some extent".

This bears out a warning sounded by Moody’s late last year that covered bonds would have credit negative implications for RMBS collateral in Australia, with lower-rated banks increasing their share of the market. This, said Moody’s, would lead to the RMBS market becoming "less diversified and [exhibiting] higher arrears".

Others are more relaxed on this score, especially given the limits on the use of covered bonds imposed by the cap on issuance at 8% of total assets. "Covered bonds will not entirely supersede RMBS," says Rupert Daly, a managing director in capital markets and treasury solutions at Deutsche Bank in Australia. "RMBS will continue to be an important part of banks’ funding toolkits, and appeal to a different investor base."

LCR focus

The intensification of regulators’ focus on Basel III, meanwhile, has been principally on the liquidity coverage ratio (LCR). "All the leading Australian banks have FSA-equivalent capital ratios of 13% plus, so none will have any problem complying with the Basel III capital rules," says KPMG’s Dickinson. "The bigger challenge is liquidity, because there is such a shortage of high quality liquid assets in the domestic market."

There is virtually unanimous agreement that this particular concern was decisively addressed last November with the announcement by the RBA of the establishment of its Committed Liquidity Facility (CLF). All securities eligible for repoing under the RBA’s normal market operations (including most SSA Kangaroo bonds) are eligible for the CLF, as are self-securitised RMBS.

It is easy to see why the RBA viewed the CLF as an essential component of Australia’s implementation of the Basel III liquidity reforms. As Guy Debelle, the RBA’s Assistant Governor (Financial Markets), explained when the facility was launched, the gross stock of Australian Commonwealth debt on issue amounts to 15% of GDP, while outstanding semi-government debt equates to around 12%.

"These amounts fall well short of the liquidity needs of the banking system," Debelle explained. "To give you some sense of the magnitudes, the banking system in Australia is around 185% of nominal GDP. If we assume that banks’ liquidity needs under the LCR may be in the order of 20% of their balance sheet, then they need to hold liquid assets of nearly 40% of GDP." In other words, this means that the entire stock of government and state government debt would fall well short of the total amount of liquid assets Australian banks would need to hold to be LCR-compliant.

The creation of the CLF has been warmly welcomed by the Australian banks. "Twelve to 18 months ago there were some big question marks over how we were going to meet the LCR requirements," says Maidment at CBA. "Those doubts have been addressed by the CLF, and the extension of the facility to include internal RMBS is very pragmatic and sensible."
  • 01 Aug 2012

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