Banking on more funding options

The reporting of Reserve Bank deputy governor Ric Battellino's address to the annual stockbrokers' conference today is generally focusing on his comments on mortgage stress, and the relatively modest nature of it. The other, equally topical, element of the address dealt with the more obvious systemic threat posed by the major banks' reliance on wholesale funding markets, where he was equally positive.

As has been discussed on many previous occasions within the commentary carried by Business Spectator during the financial crisis, during which there were moments where the wholesale debt markets were essentially shut down (banks stopped lending to each other because of concerns about bank counterparty risks), the dependence of the major banks on those markets does pose a threat to the stability of the domestic financial system.

Given that the Australian economy has had a structural balance of payments imbalance, someone had to fund that deficit by borrowing offshore to fund domestic consumption and investment. In the post-financial deregulation era it has been the banks borrowing offshore to lend for and against (in the form of equity withdrawal) housing.

As Battellino said, in the three years leading up to the crisis demand for credit had been growing at 14 per cent a year during a period where the savings rate was negative, hence the massive increase in the rates of offshore borrowings.

Last week ratings agency Moody's struck that nerve when it downgraded the major banks slightly, although the reaction to that move, and the attention it received, was grossly overdone. The downgrades merely moved Moody's into line with the other two big agencies and, in any event, had been foreshadowed by the agency. But, despite the fact that both the downgrading and the reason for it were old news, it triggered a sharp sell-off in bank shares anyway.

Battellino is relaxed about the extent of the reliance on wholesale debt markets – it represents about 40 per cent of the major banks' funding requirements, with most of that raised offshore – because he sees only moderate credit growth in prospect. He points to the sharp increase in the levels of deposits raised by banks as households and businesses have become more cautious.

Demand for credit has slowed to a mere 4 per cent and, with resources booming and consumption slumping, the current account deficit has narrowed to only 2 per cent and is still reducing. Deposit growth, he said, was now outpacing credit growth.

He also made the point that during the crisis capital inflows into Australia didn't stop, but switched to more conservative investments like government bonds.

As he said, the big question is what happens to bank funding if and when credit growth picks up, although even then he only expects credit growth in the single-digits.

He doesn't believe there will be a return to pre-crisis levels of credit growth, which he described as an extraordinary period driven by a one-off adjustment to household gearing post-deregulation and a sustained fall in inflation. He says it would be reasonable to assume modest credit growth over the next few years, characterised by solid economic growth but cautious behaviour by households and low inflation.

The majors have responded to the crisis, not only by cutting back their lending growth (a combination of lower demand and a deliberate withdrawal from lending to some sectors) but by chasing deposits to reduce their reliance on wholesale funds. There has been a dramatic increase in the levels (and cost) of their deposits.

While they still do rely on wholesale markets for nearly 40 per cent of their funding requirements, where pre-crisis a significant proportion of those funds were relatively short term (because that was the cheapest source of wholesale money) the big banks have been aggressively pursuing longer maturities.

Where once they relied on three to five-year money as the core of their funding, the banks are now raising funds with five to 10-year terms to avoid the situation they experienced during the crisis where large proportions of their funding bases were maturing each year.

That makes them less vulnerable, but not invulnerable, although the Reserve Bank's liquidity support during the crisis, and the Federal Government's guarantees, have demonstrated their worth in a crisis.

The question mark hovering over the sector is whether, in the event that credit growth is reignited, even if it isn't at the heady levels experienced in the lead-up to the crisis, is whether there is sufficient funding available elsewhere for them to avoid having to again increase the proportion of wholesale funding in their balance sheets.

In an environment of credit growth, it would appear a reasonable assumption that the household savings that are building up because of concern about the economic outlook will be running down again as they start to spend again and invest in higher-returning asset classes as their appetite for risk returns.

The banks could, of course, constrain their lending to avoid increasing the wholesale funding task, but that would damage both their profitability and the rate of economic growth. There are, thanks to the tide of new and costly regulation they will face over the next five or six years, already a lot of pressures on their profitability in the pipeline without the extra impact of voluntary credit-rationing.

There are two obvious alternatives to funding reasonable levels of growth in demand for credit without also increasing the proportion of wholesale liabilities on their books.

One is to promote a new domestic source of funds. There has never been a deep or liquid domestic corporate bond market, but the federal government has said it will facilitate the development of one by allowing the trading of Commonwealth bonds on a securities exchange, presumably the ASX. That could help create a retail market for corporate bonds, and the banks would be the most obviously attractive issuers.

That could attract longer-term savings than deposits and also bring self-managed funds into the market for bank debt.

The other obvious approach to the problem is to properly revive the securitisation markets that were discredited by the crisis. This would also help increase the level of competition within the system by providing non-banks with a source of funding and giving them the capacity to free up lending capacity without having to raise new wholesale funding.

The securitised mortgage market has reopened for business, with a number of quite large issues that haven't relied to a great degree on the Office of Financial Management's involvement for their success. It is still, however, a relatively small and still-fragile source of funds.

As discussed some time ago (Let's fix the RMBS market first, 12 Oct 2009) there are a range of measures the government and the regulators could take to redesign the securitisation markets, particularly the residential mortgage-backed securities market, to improve it as a source of bank funding and to use it as a conduit to the vast pile of savings, invested disproportionately in Australian equities, sitting within the super system.

Better architecture for those markets – not just the RMBS market but for securitised commercial and corporate loans – could make a major contribution to improving the resilience and independence of the domestic financial system regardless of what might happen in future offshore.

If better sources of domestic funding aren't developed, we might well see the others emulating ANZ with aggressive expansions into Asia, where the banks tended to be more than 100 per cent deposit-funded thanks to the high savings propensity of households in the region.

That wouldn't necessarily be a bad thing, given the growth prospects for the region, but a focused over-exposure of the Australian system to a particular region would create a new source of potential threat to the future stability of the system, this time on the asset side.