APRA Warns Australian ADI’s

May 16, 2012

Banking

Australia has been relatively lucky that we avoided the worst excesses of the pre-GFC years and that consequently we’ve been able to skirt the edges of the GFC. Of course mining booms Mark I and II have in no small way contributed to this as has the 4 pillars policy insofar as it stopped an Australian Bank from gathering the national scale to materially launch into international markets and get involved in the mess that became the GFC.

Indeed arguably Macquarie Bank and its protegé ALLCO were the only large-scale Australian Financial institutions to really suffer materially from the GFC – sure funding and liquidity has been effected for everybody and certainly the Federal Government felt the need to lend Australian Banking its balance sheet and AAA credit rating in October 2008 but largely Australian Banking has only been ravaged by the internal domestic landscape not the blight that is global finance.

In a speech Friday titled “Life in the Slow Lane” the Australian Prudential Regulatory Authority’s (APRA) Chairman John Laker made it obvious that he wants this to remain the case but equally the challenges ahead for ADI Boards and managers is now small task.

In an environment of lacklustre credit demand, ADIs will have to look elsewhere and work harder to maintain profitability. This is not a simple proposition. There is also pressure on profitability from other angles. Net interest rate margins, for example, have been dampened by more expensive deposit funding costs and higher bank risk premia in global funding markets. And the boost to profitability in recent years from lower bad and doubtful debt charges is likely to wane. Looking ahead, ADIs will also be required to operate with larger capital bases, maintain increased holdings of lower yielding but higher quality liquid assets and adopt more prudent funding profiles as they make the transition to the Basel III reforms.

In summary Laker is saying that Banking is now and in the future a lower return business than it was in the past. Thus there is a regulatory challenge as APRA seeks to empower Boards and Managers to make the transition to this realisation at a time of increasing costs and in a manner that serves the macro-stability goals of the regulator not the short-term share price or half-yearly performance goals of management and shareholders.

This is no small task and ADI’s are apparently making the transition with APRA’s nudging,

In the face of these constraints, strategic ambitions will be crucial in determining how ADIs negotiate the slow lane and maintain their financial strength and profitability in a durable way. For this reason, APRA is placing high priority on the oversight of ADI strategies as part of its supervisory efforts, including in its regular discussions with boards and senior management. Before the crisis, strategic ambitions were often couched in terms of ‘above system’ rates of growth and the achievement of such rates was a commonly used metric of success. It is a metric, however, that may have no regard for the quality of assets going onto the balance sheet.

These days, we see little unbridled ambition expressed in this form. Where we do, we will challenge the board and senior management on whether growth targets can be realistically achieved through superior products or services or whether the institution is at risk, in colloquial terms, of ‘taking in others’ washing’.

But even the more common strategic response from the ADI community is, according to Laker still potentially problematic and Laker sets out what’s happening, what the Banks are doing and what APRA is guarding against. The full speech is worth a read and can be found here but today i want to concentrate on Funding and Liquidity.

As a former Treasurer of and ADI Liquidity and Funding are close to my heart. It is what you do all day every day. Sure the balance sheet stuff like interest rate risk management is important and a bit of fun and there are lots of other meetings you dragged into but at its core the job of Treasurer is to make sure the money is always there – funding and liquidity – and if you can do it in a manner where no one has to think about it or you then you have done your job.

Now in his speech Laker says that Credit Risk is the most important inherent risk to an ADI. But I reckon that for a well diversified lending portfolio credit risk is secondary to liquidity and funding in terms of how quickly it can bring a Financial Institution to its knees. Even if the problem starts with credit it manifests in the confidence of your lenders (depositors or wholesale counterparties or both) which quickly and ultimately flows through to funding and liquidity.

So, in the wake of JP Morgan’s debacle last week and the revelation that the models didn’t take Liquidity into account it seems appropriate for me to deal with this part of Laker’s speech first. He starts this section by saying,

The acute dislocation in global funding markets in late 2011 has been a reminder, yet again, of the importance of ADIs having strong liquidity and funding positions.

The next few months might just reinforce it once more if this recent escalation in Europe and slowdown in China gets any worse.

But the key point here and one I think many people misunderstand is that the Australian banking System got lucky in the GFC when it comes to Funding and Liquidity.

We got lucky because the Australian Government lent the Triplest of Triple A ratings to the deposits of every Australian for a few years from October 2008, lent the Triplest of Triple A ratings to the big banks to guarantee a flow of funds from offshore back in late 2008 and 2009, China came back with a vengeance and we got Mining Boom MArk II which masked for a time the deleveraging of Australian Households and the impact this had on growth.

But importantly the Australian financial system got lucky because of this household retrenchment and material and I’d argue structural return to more savings. Major BAnk funding on balance sheet from deposits has increased 25%  since 2007.

Lower credit growth and high rates of saving are positive dynamics for ADI balance sheets: weaker asset growth reduces overall funding demands while the high rates of saving have reflected in strong deposit inflows. ADIs have taken advantage of these conditions to put themselves on a stronger balance sheet footing. In the case of banks, domestic deposits now account for over 50 per cent of funding, up from 40 per cent in 2007 and the highest share since 1998. The share of short-term wholesale funding has shrunk by a similar proportion since 2007 and the duration of wholesale funding has been pushed out. ADIs have also been building up their holdings of cash and liquid assets.

APRA knows that risks remain – what happens when the economic sunshine comes out again, which it eventually will, and some or a large swathe of these deposits get redeployed to equities or simply consumed? Where will the money come from then to replace these deposits.

So Laker expressly says that APRA is heavily involved with ADI Treasurers both day-to-day and in preparation for Basel III implementation.

Indeed Laker expressly says that Boards,

…should be asking questions of their treasurers such as ‘How long could the ADI operate profitably without access to offshore wholesale funding or securitisation markets?’ ‘How long could we operate without the ability to issue short-term debt?’ ‘What is the risk/return trade-off in lengthening the maturity profile of wholesale funding by one month? One year?’ ‘What is our tolerance for relaxing our risk appetite and what are the consequences?’ Increasingly, boards are asking ‘Do we want to rely on short-term funding markets to fund loan growth at all?’ This focus on risk appetite is leading to a change in mind-set among retail and business bankers, where the garnering of sticky deposit funding counts and is being built into business targets.

So make no mistake even MLH ADI’s will be effected by the changes coming down the line from APS 210 and the changes it will cause in the Australian Funding and Liquidity landscape. This last bit, bolded, of the above quote highlights the risks that accrue to the smaller players in the Australian Banking Landscape such as Credit Unions and Building Societies whose member base represent the very sticky deposits that Laker wants the Majors to chase. So just who will fund the smaller ADI’s? they’ll need to diversify their funding sources.

So the challenge for Boards of smaller ADI’s is that their Treasurers need to be able to answer similar but very different questions to the ones Laker posed above. And if these smaller ADI’s don’t have a Treasurer then the Treasury operatives or the CFO better have the treasury skills to answer these questions. Otherwise they may run into regulatory strife.

Clearly Basel III is impacting on Capital but equally Funding and Liquidity remain top of mind. The Australian banking system with its reliance on offshore funding is lucky that at a time of heightened global tensions and funding constraints that Australian household retrenchment has provided the funds to bridge the funding gap.

Have  a great day

Gregory McKenna

www.twitter.com/gregorymckenna

Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If however you do need advice on Investments, Economics, Funding and Liquidity, Interest Rates and Forex and Derivative markets we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au


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