The Aussie dollar funding crisis squeezing the banks
The LIBOR-OIS spread indicated how much the banks would have to pay to borrow money for a month, over and above the overnight rate they could access from the central bank.
The higher it went, the more it reflected the anxiety of lenders about the solvency of the too-big-to-fail banks.
Australia had its own equivalent spread based on the local money market benchmark – the bank bill swap rate – and in 2008 transmitted its own panic signals as the faith of conservative cash investors in our major institutions wavered.
Funding pipes in Australia's money markets are clogging up as billions of dollars shift in and out of the financial system. Phil Carrick
Now, as the 10-year anniversary of the financial crisis approaches, traders are reflecting on the near death experience with the fears having well and truly abated.
But something very strange is happening, again.
Those measures of panic are flashing amber. The LIBOR-OIS spread reached levels not seen since the crisis and the Australian equivalent rate not only followed it, but spectacularly overshot.
What is more perplexing is that even as the US spread has settled down, the Australian "Bills/OIS" continued to surge to levels not seen since the crisis.
Significant potential impact
Given the high reliance and sensitivity of Australia's banks on the wholesale funding markets, the potential impact for bank profits, monetary policy and the currency from the spread spike is significant.
As it has done so, other Australian dollar "funding rates" have been dragged up.
Implied foreign exchange forward rates and "repo" rates in which safe assets such as government bonds can be pledged to a lender in exchange for short-term financing are all at inexplicably high settings.
What became a knock-on effect based on developments in US money markets has become a decidedly Australian issue.
Given the high reliance and sensitivity of Australia's banks on the wholesale funding markets, the potential impact for bank profits, monetary policy and the currency is significant.
While rules aimed at making the banks safer slowed the flow of capital around the world, the actions of central banks, through low interest rates and quantitative easing have flooded the system with money. AP
Since two thirds of the funding sourced by Australian banks is tied to the BBSW, which has gone up by about 30 basis points in the past year, there is an undeniable and significant margin squeeze for loans, such as mortgages, that do not move in tandem with BBSW (most corporate loans are directly tied BBSW)
The non-major banks have already responded to the pressure by lifting home loan rates by as much as 17 basis points. As for the larger lenders, the prevailing view is they would have nudged their lending rates up too were they not under such political and regulatory scrutiny.
What is strange about the spike in short rates is that there's no hint of a panic.
During the financial crisis, the spike in short-term rates was a reflection of concerns that if an investor lent money to a bank – such as Lehman Brothers, Citigroup, Macquarie or Westpac – there was a real chance they might not get it back in 30 or 90 days.
The Reserve Bank is also an active participant in repo market and will provide funding to counterparties that pledge eligible assets such as government, state government or bank bonds. Louie Douvis
In fact, the US banks were accused of lying about the true rates they could borrow at, partly to prevent spreading further panic.
That is clearly not the case today.
The banks are well capitalised and new rules have forced them to hold billions of dollars of safe assets that be sold in an instant, should a threat of a bank run emerge. In fact, measures of concern about bank solvency, such as major bank credit spreads and credit default swaps are as low as they have been since the global financial crisis.
So what on earth is going on? Why are Australian dollar funding rates misbehaving to the point where local lenders are paying punitive costs to borrow money?
The tough question
Put the question to traders, analysts, bankers and policymakers the same response emerges – it's complicated!
Understanding what's going on and why it matters requires a strong knowledge of recent financial history and a grasp of the esoteric workings of global money markets and derivatives such as the "repos", the "yen basis" and FRAs.
In an increasingly siloed financial system few are in a position to see the workings of the money market in their entirety, but based on several conversations a picture emerges.
In the decade that followed the GFC, the global banking system was been redesigned. The banks scaled back their market-making activities and new Basel guidelines were drafted, debated and enforced. This changed the economics of many banking activities and effectively reduced private sector funding.
While rules aimed at making the banks safer slowed the flow of capital around the world, the actions of central banks, through low interest rates and quantitative easing have flooded the system with money.
To use a plumbing analogy, the taps were turned on, but the pipes were following increasingly convoluted paths.
Now the taps are being tightened a little – and the true extent to which the plumbing has changed, and the flow has slowed, has become evident.
Experts in money markets have been warning for years that changes brought about by post-crisis regulation were being masked by the age of easy money. The spike in short-term spreads has vindicated them.
Other factors relating to US fiscal policy have compounded the strains and further altered the supply and demand dynamics in money markets, at least in the short term.
To fund its growing deficit, the US government ramped up its issuance of treasury bills, crowding out private sector borrowers.
Meanwhile the tax agreement that has allowed US corporate giants to repatriate an estimated $1 trillion dollars of cash has reduced an enormous pool of funding.
Another tax change was equally profound. Global banks and multinational corporations could no longer transfer money between their operations as needed, without attracting a tax hit. So they've been turning to money markets to finance their assets, increasing the supply of issuance, forcing rates up.
For Australian banks that raise billions in the US money markets, including from the vast cash piles of the tech companies, this has had adverse consequences.
Their assets may be simple, made up largely of mortgages and loans to local businesses. But their liabilities are complicated, given there are only enough deposits to fund two thirds of their loans.
That has forced them into the international capital markets to fund a $450 billion funding gap, making them among the most prolific and sophisticated borrowers in the global credit markets.
The banks are constantly demanding derivatives to hedge the currency risk of large foreign borrowings, which makes it relatively cheaper to borrow money in Australian dollars.
So when US money market rates spiked up, it became even more expensive to borrow short-term money in US dollars, the Aussie banks turned increasingly to local money markets.
The consequence was a spike in the BBSW as the major banks crowded the local borrowers.
When US rates began to settle down, however, Australian rates went the other way – a sign that funding pressures were very specific to the local Australian dollar funding markets.
This, several analysts have speculated, has been aggravated by a noticeable slowdown in deposit growth relative to loan growth, increasing the marginal funding demand of the Australian banks.
While the US factors explain the spike in the BBSW to a large extent, traders are debating whether it explains a blow-out in other funding rates.
The grim repo
The most acute pressure has emerged in the repo (repurchase) market in which participants can gain access to funding by effectively selling eligible high-quality assets and agreeing to buy them back at a slightly higher price at a later date, therefore implying a rate.
The repo market is used by banks (which tend to borrow about as much as they lend), institutional investors and brokers.
The Reserve Bank is also an active participant in repo market and will provide funding to counterparties that pledge eligible assets such as government, state government or bank bonds.
The most plausible explanation is that the increase in repo rates has been driven by demand from foreign investors, mainly Japanese institutions seeking to escape zero rates.
The current setting in currency derivative markets has made it particularly enticing for Japanese funds to seek out higher yields in the US and Australian bond markets.
But recently, fears of a trade war and a rising US deficit, has made Australian dollars a marginally better bet.
These institutions are likely to finance their investments in the repo market, pushing up demand and hence funding costs.
There have since been calls on the Reserve Bank to intervene in the repo market by making more cash available in this format.
But the central bank is understood to be reluctant for several reasons. One is that the banks, and others, can still get ample funding, even if they don't like the price, and the repo market is not one that is relied upon to fund the real economy.
Also if they were to intervene and lower costs, it may discourage the creation of new financiers. If attractive returns can be earned through the virtually risk-free activity of lending against high-quality assets, other pools of capital such as superannuation funds could be enticed set up repo desks, creating a new source of funding for the system.
In a broader sense, the belief is that the anomalies created by these funding rate blow outs had historically been arbitraged by traders at the banks.
But for a multitude of reasons, mainly regulatory, this is no longer occurring.
In time, the hope is that the opportunities will mobilise new entrants as the financial system reinvents itself.
As for the consequences of the funding spike, they are manageable, but real.
The most acute pressure is being felt on the net interest margins of the banks. About two thirds of their funding is tied to the bank bill rate, although so too are most corporate loans, acting as an offset, which means their net interest margins are being squeezed.
For the smaller banks the pain was too much to bear and they jacked up rates, while the majors are left to agonise as to whether they will be crucified by politicians should they follow suit.
Should the banks enact an out-of-cycle rate hike of 10 to 15 basis points, it would be in the context of generally falling mortgage rates over the past year, so is unlikely to have a significant impact on the economy.
The market has anticipated that if real rates in the economy are at the very least no longer falling, the RBA is on hold for longer than previously assumed.
Such is the nature of markets that the currency has weakened as a result, and in a self-fulfilling fashion, financial conditions have loosened.
So these are far from the crisis times. But the first strains on the money market are a stark reminder that Australia's economy remains reliant on a complex and opaque global financial system.
That's no different to the dark days we saw a decade ago, when money market spreads spiralled disturbingly out of control.
Firstmac Limited is Australia’s largest non-bank lender, with more than 35 years’ experience in home and investment loans. Firstmac has written in excess of 100,000 home loans and manages approximately $8 billion in mortgages and $250 million in cash investments. Firstmac is a premier sponsor of the Brisbane Broncos.
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