Bulked up banks ready for a second storm

The implications of the breaking down of the austerity consensus in Europe at the weekend has created a question mark about the stability of the eurozone that won't be answered until the nature of any new policy directions in France and Greece, and how they are to be funded, becomes clearer.

There is, however, clearly some potential for another outbreak of global financial instability, even a new financial crisis, if Europe can't satisfy international investors that it has a path towards longer term fiscal stability.

While the austerity program hasn't worked in the most distressed and indebted economies, indeed has worsened their condition and debt-servicing capacity, it isn't clear why markets would fund continuing deficits and maturing sovereign borrowings if there isn't a clear path towards debt and deficit reduction.

That means the eurozone remains and will remain on a knife-edge for some time, with the potential for another implosion that would reverberate through global financial markets.

It is unlikely, however, that another severe financial crisis would have quite the same impact as the original global financial crisis that exploded after Lehman Brothers collapsed in 2008. The condition of the financial system in Europe and elsewhere is different to 2008, although Europe remains the weakest link in the system.

Europe, and the global banking system, would probably still be vulnerable to the shutting down of wholesale debt markets if bond investors decide to flee the eurozone. Despite the relative inaction of European regulators and their banks, however, the eurozone banks have raised some capital, albeit not enough, and more particularly they have been doused with liquidity by the European Central Bank.

The two long-term refinancing operations conducted by the ECB, one late last year and the other earlier this year, injected more than a trillion euros (about $A1.3 trillion) of three-year funds into the European banking system at a cost to the banks of 1 per cent a year. That ought to tide them through even a significant freeze in markets.

Outside Europe, the more decisive action by the US government to recapitalise and rigorously stress-test its institutions means its system is far better positioned for shocks than it was in 2008 while the Australian system, which weathered the original financial crisis in better shape than most, is vastly different and stronger than it was in 2008.

The 2008-09 period did expose the major banks' vulnerability; their reliance on offshore wholesale debt markets. Since that scare they have worked assiduously to reduce those exposures, particularly to short-term debt. As a system the Australians banks are now funded more than 50 per cent by customer deposits and the majors' net loans and advances are about 60 per cent funded by deposits.

Last week's interim results from Westpac and ANZ provide a useful snapshot of how different the Australian banks balance sheets now are.

In 2008 Westpac had tier one capital that amounted to 7.8 per cent of its risk-weighted assets and ANZ's tier one capital adequacy ratio was 7.7 per cent. Today Westpac has a tier one ratio of 9.8 per cent and ANZ 11.3 per cent, using an Australian Prudential Regulation Authority approach that is conservative by global standards.

In 2008 Westpac had liquid assets of $45 billion and ANZ $54 billion. Today Westpac has $101 billion of liquidity, ANZ $99 billion and the Australian banks also have access to Reserve Bank emergency liquidity arrangements that were put in place post-crisis.

Significantly, all the major Australian banks have reduced their exposure to short term wholesale debt to immaterial levels and are holding liquidity that would cover several years of maturing wholesale debt – the majors' annual funding task runs at between about $25 billion to $30 billion each.

With the help of the federal government – with encouragement from APRA and the RBA – the banks can now also issue covered bonds, which give investors security over dedicated cash flows and which are therefore more likely to find investors, even in a crisis.

The resilience of the Australian banks and Australian economy during the crisis also means there is a much greater awareness of them among global investors. There is also a recognition that there is an implicit government guarantee of the four big banks because they are too big to be allowed to fail with the relatively low public sector debt levels providing confidence the Australian government would have the capacity to support them.

However, their far stronger condition relative to their state entering the crisis in 2008 doesn't guarantee the banks would be unaffected by a fresh crisis.

Their funding costs would spike – although there is a view that the reduction of risk in the US system and the ECB-generated liquidity within the eurozone would mean the size of any spike would be considerably less than in 2008-09 and the likelihood of a prolonged freezing of debt markets would be considerably lower.

In any event, they could maintain a slightly subdued business-as-usual approach if they chose for quite some time without resorting to emergency measures.

Had the Europeans properly tackled the issues within their banking system during the window of opportunity that opened in mid-2009 and remained opened until well into last year, as the US did and the Australian system has, the entire eurozone crisis would be far more manageable. Europe has a daunting sovereign debt challenge inextricably linked into an under-capitalised banking system with massive exposures to those sovereign debts.

It is that incestuous relationship between the faltering fiscal regimes and the extremely vulnerable eurozone financial system that has created the threat of another global financial crisis, albeit one far more threatening to Europe this time than to the rest of the world.