How the Aussie banks dodged a bullet

For anyone who forgot to mark their calendar, the Basel III Liquidity Coverage Ratio came into force on January 1^st.

These new rules are designed to improve the global banking system's resilience during financial crises. Lenders such as Westpac (ASX:WBC), ANZ (ASX:ANZ), NAB (ASX:NAB) and Commonwealth Bank (ASX:CBA) are now required to hold enough easy-to-sell and safe assets to ensure they can fund their short-term obligations for at least one month should credit markets seize up, as they did in 2009.

The simplest way for a bank to satisfy the new regulations is to stash away reserves at the Reserve Bank of Australia (RBA) and hold lots of government bonds. But that's easier said than done.

The total stock of Commonwealth and State Government bonds amount to around $600bn, which needs to be shared with other entities that are also required to hold government bonds, such as insurers.

The predicament Australian banks are in under the new rules was made clear in a speech by Guy Debelle, the RBA's assistant governor for financial markets.

He notes that APRA estimates Aussie banks would distort the market for government bonds if they held more than $175bn of the securities. However, under the new rules, they would need around $450bn. Even if the banks wanted to, they probably couldn't buy that much.

By forcing banks to hold more Australian liquid assets, demand would skyrocket and the market for those securities would quickly dry up – making them illiquid assets. The whole exercise would be self-defeating.

The RBA's solution was to create the Committed Liquidity Facility, whereby the banks pay an annual fee for the right to use risky illiquid assets, such as residential mortgage backed securities (RMBS), as collateral to borrow money from the RBA during a financial crisis.  

Valuing these securities is hard enough in normal times, but doing so during a crisis is next to impossible because, being illiquid, the RBA's usual valuation indicators, such as market price and trading margin, won't be present if the securities aren't trading actively.

But, fear not, there's a solution for this uncomfortable circumstance too.

“While the Reserve Bank follows the approach outlined above in valuing RMBS without a market price when conditions in the Australian securitisation market are deemed to be normal, the Reserve Bank will follow an alternative process that does not rely on estimating the appropriate trading margin … if the Reserve Bank forms the opinion that observed trading margins are not representative of the fair value for such securities.”

That's RBA speak for 'here are the rules, but when things get dicey we'll make up new ones.' Problem solved.

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