The RBA's reasonable bank paranoia

Good regulators are at least slightly paranoid and the Reserve Bank is a good regulator.

It is evident from its latest Financial Stability Review that the RBA remains acutely aware of the risks to the financial system posed by two potential conduits of stress through the banking system.

The first, whose significance was largely ignored until the financial crisis made it obvious and an issue of widespread and heated debate, is the continuing, albeit reduced, reliance of the major banks on offshore wholesale funding markets.

The second is more conventional but because of the resources boom, now waning rapidly, has been generally played down in the post-crisis period. The traditional threat to the profitability and stability of the banks has been deterioration in the domestic economy.

As the RBA says, while the major banks are better positioned to manage the risks created by their offshore funding exposures, any disruption to offshore wholesale funding markets and/or a (further) deterioration in global economic activity would be channels for contagion to the Australian banks.

The Australian banks have very limited direct exposures to European sovereign debt or euro area banks – their exposure to euro area banks are to French, German and Netherlands banks and represent about 0.7 per cent of their total assets – but are still raising about $100 billion of wholesale funding each year.

While they are holding more capital (about 200 basis points more tier one capital on average than in mid-2009) more and higher-quality liquidity (10 per cent of their domestic books compared with 6 per cent in 2007, with a massive shift into government securities and away from bank paper) and there has been a shift in the mix from short-term funding to longer term borrowings they are still unusually reliant on wholesale funding relative to their peers.

The banking system which looks most like Australia's is Canada's. Where the Australian banks have a wholesale funding ratio of 34 per cent, a customer deposit funding ratio of 49 per cent, a foreign funding ratio of 24 per cent and a loan-to-deposit ratio of 135 per cent the Canadian banks have a wholesale funding ratio of 23 per cent, a customer deposit funding ratio of 67 per cent, a foreign funding ratio of 10 per cent and a loan-to-deposit ratio of 103 per cent.

In fact the Australian banks are significantly more reliant on wholesale funding than any other system except Sweden's, which has a wholesale funding ratio of 33 per cent.

As the RBA suggests, one has to be careful about some of those comparisons. The loan-to-deposit ratio comparisons, for instance, could be misleading because unlike some of their offshore peers the Australian banks have relatively small trading books and raise little non-resident deposit funding.

Nevertheless, when markets froze during the worst of the GFC it did highlight the vulnerability of the Australian banks to malfunctioning offshore wholesale debt markets and even though the banks have lifted the share of deposit funding from about 40 per cent in 2008 to about 53 per cent today and lengthened the terms of their wholesale funding those markets remains a conduit for risk while the euro area remains unstable.

The point of vulnerability within the domestic system has always been seen as the banks' disproportionate exposures to residential mortgages. With the household savings rate close to 10 per cent in the post-GFC period and house prices deflating gently (by about 6 per cent over the past year) rather than precipitously, the broad settings are more stable and less obviously vulnerable than they were and the Australian housing loan books have shown themselves to be remarkably resilient over a very long time. The banks have also wound back the risk profiles of their recent lending for housing and in any event demand for credit from households has been very subdued.

It would take a very big tick up in unemployment for home loans to constitute any kind of serious threat to the stability of the system.

The RBA appears slightly more concerned that the flow of impaired assets, after falling steadily from their GFC peak, has picked up again and that the impact on bank balance sheets and profitability (the reduction in bad and doubtful debt charges has been the key driver of improved bank profitability in the past couple of years) has troughed.

With weak demand for credit from both households and businesses and competition for deposits pushing up funding costs there will be more pressure put on profits which will force banks into cost-reduction programs. The RBA worries that overzealous cost-cutting or greater risk-taking in response to the pressure on margins and earnings could sow the seeds for future problems.

A concern, albeit not one expressed by the RBA, is that the resources boom that has supported the economy through the post-GFC period is petering out as China's growth has slowed and, with big increases in the supply of commodities, prices have tumbled.

Yet the Australian dollar remains at historically high levels, which has as much to do with the relative health of the other developed economies than the current state of the domestic economy. Historically the dollar has tracked the direction of commodity prices.

The risk is that rather than the two-speed economy that the non-resource sectors and states have been complaining about we end up with a one-speed economy where activity is stalling as the stimulus from the resources boom fades, even as the dollar remains strong, and federal and state governments pursue contractionary fiscal policies.

Any significant increase in impairments that occurred against the backdrop of a high dollar, declining resource sector activity, heavy cost-cutting by governments and the rising capital and liquidity requirements flowing from the global regulators' response to the GFC could produce quite a nasty shock, and one not confined to the banks, although they would be forced to impose a credit crunch to preserve their ratios.

The banks are in better shape than they were pre-GFC and better equipped for another offshore "event", while there is more scope for fiscal and monetary policy responses to new threats to economic and financial stability than in almost any other developed economy.

It would be preferable, however, that those settings weren't tested again until the positive trends within the composition of bank funding and household de-leveraging have had longer to run and the current round of attempted fiscal consolidation at the state and federal levels has also run its course.