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Thursday, May 17, 2012

Rethinking Australian bank business models (column)

Today I want to put to you an idea that the prevailing attitude to, and analysis of, Australia’s banking system is profoundly misguided.

The forever-recycled, conventional wisdom is that the Australian banks’ reliance on “wholesale funding”—that is, credit supplied to banks via domestic and international institutions investing in bank “bonds”—is a tremendous source of weakness and instability. One frequently sees analysts, strategists, hedge fund managers, and even bodies like the OECD, quote Australia’s woefully high “loan-to-deposit ratio”.

With the misplaced preference (post-GFC) for retail deposits, Australia’s banks have managed to reduce their loan-to-deposit ratios from a high of circa 180% in 2008 to closer to 140-150% today.

This simply tells us that, on average, the total value of bank loans is roughly 1.4 to 1.5 times the value of their deposits. Another way of saying the same thing is that retail deposits only make up about 60% the value of loans. The missing 40% is provided by wholesale funding and shareholder cash.

Whereas in numerous research reports and media articles the low level of “more stable” retail deposit funding is the basis of claims that Australian banks suffer from inherent financial flaws, I would contend the opposite. So long as a bank can secure committed, long-dated wholesale funding (typically “bonds” that are like tradeable term deposits) with diverse maturities, and ideally from a balanced mix of domestic and offshore investors, it is actually higher levels of short-term retail deposits, which have an average duration of less than six months, that expose Australian banks and taxpayers to systemic risk.

I would further argue that the logic around bank funding has got so twisted that taxpayers have had to provide a band-aid and underwrite the dependability of short-term retail money via the government’s deposit guarantee. Crucially, the banks pay nothing for this insurance, which Glenn Stevens recently told parliament would be worth hundreds of millions of dollars annually (as I have long suggested).

By compelling banks to bulk up on short-term retail deposits, and reducing their reliance on committed wholesale funding of far longer maturities, regulators are actually shifting more and more of the catastrophe risk onto taxpayers. The fact is more retail deposits mean more deposit insurance doled out by government. And more taxpayer insurance means more moral hazard (ie, incentives for bankers to take silly risks). This thinking is seriously messed up.

One of the most important lessons from the GFC is that taxpayers should insist that banks minimise the normally acute mismatches between the committed life of their liabilities (ie, the savings individuals and institutions entrust to them via bank deposits and bonds) and the life of their assets (such as the home loans they create with that money).

You can see how the domestic banking regulator, APRA, seems to have fallen for the lazy logic that says retail deposits are good and wholesale funding bad in one of its responses to the new banking rules. In particular, APRA has decided to “exempt ADIs with simple, retail based business models” from the two new “liquidity shock” tests that global banking regulators have developed under what is known as “BASEL III”.

This is both perverse and ironic because the banks with the most acute asset-liability mismatches are precisely those that rely mostly on retail deposit funding. And we had proof positive of this during the GFC: the stealth bank runs that threatened Australian institutions were found not in the major banks, but in smaller deposit-takers like Bank of Queensland.

If you are wholly reliant on retail deposits, and your depositors decide to withdraw that money, you risk trading insolvent. If, on the other hand, you were funded, at an illustrative extreme, with 90% long-term wholesale loans over maturities ranging from 3 to 10 years, you are in a demonstrably superior position to withstand a liquidity and solvency crisis.

A related point is that in a genuine catastrophe, it is asinine and irresponsible to assume that the retail deposits supplied by mums and dads will somehow be more sticky and reliable than a diverse mix of term wholesale funding. If any cohort of bank creditor is likely to be skittish and susceptible to herd-like behaviour, it is mums and dads. Retail deposits are, to be sure, stable during the good times, but, as the history of banking over the last two centuries shows, they are awfully unreliable when confidence in a bank’s solvency evaporates.

If we were building a bank from scratch, we would want it to have access to funding with a weighted-average life of, say, at least five to 10 years, to get as close as possible to the average duration of the loans the bank was making with that money (noting that 60% of Australian bank loans are 25-30 year residential home loans).

The good news is that the new BASEL III banking rules are very much focussed on maximising a bank’s “liquidity”. These rules work out the worst-case outflows of funding a bank may suffer during a crisis. In order to meet this flight of funding, and thus not trade insolvent, banks are being forced to hold more “liquid assets”. Although that is not exactly true here in Australia.

The RBA and APRA have decided that because Australia has little government debt (and, accordingly, few truly liquid domestic assets), it would be better to give all banks a “tab” or “line-of-credit” from the RBA that they can draw-on if they get into strife.

It literally works like this: the bank figures out how much retail deposit funding--notably not committed wholesale funding--will likely fly out the door if its creditors think there is a risk the bank won’t repay them.

The bank then rocks over to the RBA and says, “We will need to borrow this many billions of dollars from you in a run on our deposits.” When they borrow from the RBA, they pledge assets as security for the loan. The RBA then gives them very cheap cash to repay their creditors. While the line-of-credit is undrawn, Aussie banks will pay a fairly trivial fee of 0.15% per annum to have it accessible. Of course, the more short-term retail deposits a bank has, the more money that can run out the door in a shock. And so the larger the line-of-credit they require from the RBA. And thus the bigger the taxpayer subsidy becomes.

By the end of this article, some smarty pants will be saying, “But our banks cannot access enough term wholesale funding.” This is partly true.

So, as I argued many years ago, the solution to both bank funding and improving bank competition comes back to the $1.4 trillion of savings locked-up in superannuation. More specifically, the solution is about fixing the parlous asset-allocation decisions made by Australian super funds, which I have been harping on about here since 2008.

Despite repeated requests for them to engage, the asset-allocation problems in super have been willfully neglected by APRA and its boss Treasury, and were mostly ignored by the Cooper Review.

If you want to understand the magnitude of the issue today, have a think about this. One of the nation’s most well-known super funds, Australian Super, which manages over $42 billion, structures is standard “balanced fund” option as follows.

Just 2% of the portfolio is invested in cash. Only 9% is allocated to bonds. An incredible 50% is invested in extraordinarily volatile Australian and global shares. A further 11% is allocated to risky commercial property equity. And another 18% goes into the equity of infrastructure assets and private companies.

All up, Australian Super’s balanced fund has about 80% of its money in equity risk while only 11% is allocated to cash and bonds. And yet Aussie government bonds have outperformed global shares for the last 30 years while cash is your single best inflation hedge (with an inflation-targeting central bank). Is it any surprise that Aussie Super has given members just a 1.71% per annum return over the last 3 years?