Why the enforcers need the banks' protection money

The Australian Prudential Regulation Authority and Reserve Bank arrangements for emergency liquidity support for banks in any future crisis have generated considerable controversy. In finalising those arrangements today, however, APRA underscored their necessity.

There has been a lot of discussion about the RBA's “Committed Liquidity Facility”, which is designed to make liquidity available to banks in a crisis as part of the broader Basel III regulatory requirements that require banks to hold sufficient high-quality liquidity to survive a 30-day period of acute stress.

The CLF has been caught up in the wider debate about the taxpayers' exposure to banks that are “too big to fail”, with critics charging that the RBA's support has been made available too cheaply and that it would prop up banks that, because they would be unable to meet their obligations as and when they fell due, would actually be insolvent.

There are echoes of that argument in the US, where there are some who argue banks' access to the US Federal Reserve's discount lending window should be shut down to make the threat of bankruptcy more credible -- to make it clear the banks would survive or fail on their own merits.

There is, however, a peculiar problem in Australia.

The Basel III requirements insist that the liquidity the banks hold should be high-quality, which means largely cash, government and semi-government debt and other securities that are repo-eligible for the RBA's normal market operations.

The problem is that there aren't enough of those high-quality assets within this system. APRA could have responded to that dearth of eligible liquidity by broadening (weakening the quality of) the range of eligible securities -- which has happened, for different reasons, offshore -- but instead has chosen (very sensibly) to maintain a conservative position to buttress confidence in the Australian system.

The solution to the paucity of government debt and other eligible assets within the system is the CLF, under which the RBA agrees in advance to a specified amount of liquidity it will make available to individual institutions in a crisis.

A bank that draws on the facility has to lodge security -- a repo arrangement for high-quality assets -- and pay a 25 basis point premium over the RBA's cash rate for the funds. Regardless of whether they ever draw on the facility, they have to pay a 15 basis point annual fee on the full amount of the undrawn facility they have put in place with the RBA. It isn't costless -- the annual fee for the CLF could be regarded as an insurance premium or tax.

The liquidity requirements are predicated on all authorised deposit-taking institutions holding more than 100 per cent of the liquidity required to survive the 30 days of stress.

In finalising the CLF arrangements APRA invited authorised deposit-taking institutions (ADIs) to apply for facilities. Fourteen Australian institutions applied, with the total CLF requested a staggering $288 billion.

To determine the size of the CLF the RBA estimated the amount of Australian dollar high-quality liquidity that local ADIs would appear likely to need to hold in 2015 and the amount of those assets likely to be available, after taking account of who currently holds them and the need for markets to function smoothly. APRA also assessed the likely net cash outflows for each institution ($410bn to the end of next year), with the ADIs submitting three-year funding plans.

The net outcome was that the ADIs asked for a total CLF of $288bn, the regulators concluded that the amount required to ensure 100 per cent liquidity coverage was $235bn and, with a buffer, that the total size of the CLF granted should be $275bn.

The size of the CLF underscores the reliance of the system, mainly the big banks, on offshore funding markets that proved most unreliable during the financial crisis, when those markets effectively shut down.

The size of our major banks relative to the size of the banking system and economy means that it is inconceivable that they could be allowed to fail. There has to be some form of lender-of-last-resort facility for banks that aren't insolvent in a real sense, but have through no fault of their own lost access to funding.

The CFR isn't a taxpayer subsidy -- the ADIs pay for it regardless of whether they ever use it -- and its pricing is a deterrent for its use in anything but a real emergency. The RBA also has the discretion as to whether to allow it to be drawn on -- it wouldn't allow access to an institution which had underlying and real solvency issues.

The regime actually encourages the banks to raise as much high-quality liquidity as they can outside the facility, limiting the extent of the moral hazard created by using the taxpayer as the ultimate provider of liquidity support.

When critics of the big banks argue for levies and super-profits taxes to reflect their too-big-to-fail status, they disregard the impact of the increased regulation post-crisis and the likely extra layer of regulation likely to flow from the Murray inquiry into the financial system.

There is a real cost to the capital surcharges the big banks already face (and which are likely to be increased by Murray) and there is a quite explicit and ongoing cost to the liquidity backstop, represented by the CLF, that might never be used.