RBA gives Australian banking a BIG tick.

In 332 BC Alexander the Great besieged the impregnable city of Tyre off what is now the coast of Lebanon and what was then an important strategic island fortress. He managed to take the city with initiative and aggression and almost 2500 years and the topography of the area have caused the island to join the mainland.

Why am I relating a fallen fortress to an article on the Australian Banking system (please note here I am referring to my beloved Mutuals such as Building Societies and Credit Unions as well as the listed ADI’s – Banks)? Two reasons, firstly I do not want to tempt fate on a topic, such as the strength of Australian ADI’s, that I believe is as impregnable as the old fortress island had been before Alexander. Secondly it is important to remain vigilant even when you think you are impregnable in a way the Tyrians perhaps did not but that I trust the RBA, APRA and ADI management will both now and in the future.

So to the main point.

RBA Assistant Governor Guy Debelle gave a speech today titled “Collateral, Funding and Liquidity” where he effectively made the very same tw0 points I have just made above in relation to Tyre about the Australian Banking Sector. That is, it is strong but vigilance remains high.

The Australian summarised Debelle’s speech quite nicely when it said

THERE is no clear sign of stress for Australia’s banks from the ongoing debt crisis in Greece, a senior central bank official said today.

“At this stage at least, there is no sign of any of those stresses materialising,” said Guy Debelle, Assistant Governor (financial markets) at the Reserve Bank of Australia, in a question-and-answer session following a speech in Sydney.

Mr Debelle noted that Australia’s banks have all issued a fair bit of debt in the last few weeks, while the price of that issuance hasn’t moved “at all”.

Should there be a “liquidity event”, such as is possible from the debt crisis in Greece, Mr Debelle said banks in Australia have enough collateral in the local market to deal with any follow-on liquidity crunch.

Australian banks are also likely to continue lowering their exposure to overseas funding markets,

So the system is safe but what are they doing to ensure it remains that way? First thing is that the RBA remains rock steady in standing behind the Australian System in order to provide liquidity as required.

If a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral.

There are a number of important elements to Bagehot’s statement which I am going to discuss in some detail.

Starting at the end of the statement, and germane to the argument thus far, is that the bank must have good collateral. Therefore, critically, it is the asset side of the balance sheet which enables the bank to overcome a problem on the liabilities side: the central bank must be sure that it is lending against good collateral.

The second aspect of the statement which bears further discussion is that the central bank should lend to solvent but illiquid banks. I don’t see this as being materially separable from the collateral issue. As I have argued above, a bank’s solvency is most strongly influenced by the quality of its collateral. Capital and leverage play an important role too.

It is sometimes said that it might be difficult to determine whether the issue really is one of solvency rather than one of liquidity. Clearly, the fact that a liquidity issue has risen may well be a signal that the market has concerns about solvency. Hence the central bank certainly should pay heed to that signal from the market.

But the experience of the past few years demonstrates liquidity crises can arise because of uncertainties that can be exacerbated by funding structures which are heavily skewed to the short term. In keeping with my argument thus far, in my opinion, it behoves the central bank to look through those uncertainties to the underlying asset quality of the institution under question, and be prepared to lend secured against quality assets if the situation warrants.

So they are behind the system and the implicit comment here he is making is that the Australian Banking System has SOUND collateral on which the RBA can advance emergency funds if they are ever required. This is really important – for example at present in Europe covered bonds of some financial institutions are not trading at the normal discount to senior debt issuance but rather at the same elevated levels as senior debt issuance. This implies questions about overall asset quality of the institutions. We do not have this issue in Australia given the nature of the banking system and where the vast majority of the loans sit.

Importantly, and in contrast to their “wholesale” credit ratings the smaller ADI’s, such as Building Societies and Credit Unions, are in a much stronger position relative to the bigger ADI’s because they have the vast bulk, not just majority, of their assets either in home loans or their HQLA Liquidity book (DISCLOSURE: your blogger also has a paid position within the Mutual Sector). So in many ways these smaller institutions are stronger than their ratings suggest.

I’m still in Armidale so I’ve run out of time to draw this out a little further but I think you get the key points. the Australian banking system is strong and the RBA and APRA stand ready to continue to both oversee and support it. That is something to remember when the FCS gets changed or runs out in October.

The Australian banking system is strong but unlike the Tyrians we are adapting and vigilant to signs of crises and change.

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2 Comments on “RBA gives Australian banking a BIG tick.”

  1. tristencosgrove Says:

    Top effort with this post Greg. I love the history – Bagehot in 1873 “central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral.” I have come across this before and although I liked it, most folks don’t enjoy investigating this type of research. So long as someone is solvent but short-term illiquid there may still the ability of a rescue. Also perhaps when insolvent but still liquid, with more caution. It is when someone is insolvent (in the sense of debts more than assets) and illiquid at the same time that may be a bad idea to keep lending to such a person, institution, or nation. I love the historical commentary about Tyre and how no one should be complacent – well done.

    Reply

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  1. Weekend Reading – Stuff we found interesting this week | Lighthouse Securities - July 2, 2011

    […] also repoint you to this piece I wrote on the Australian Banking system afer Guy Debelle’s speech during the week where the […]

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