Philip Lowe: Opportunities and challenges for market-based financing
Speech by Mr Philip Lowe, Deputy Governor of the Reserve Bank of Australia, to the ASIC
(Australian Securities and Investments Commission) Annual Forum 2014, Sydney, 25 March
2014.
* * *
I would like to thank Ivailo Arsov, Mitch Kosev and David Wakeling for valuable assistance in the preparation of
this talk.
When I was invited to speak at this conference, the ASIC organisers suggested the topic
"Opportunities and Challenges for Market-Based Financing". I was very pleased to be able to
accept the invitation as this topic is an important one. It is currently also a highly relevant
topic given the Australian Government's recently commissioned inquiry into the Australian
Financial System.
I would like to start with a quote from the final report of the previous inquiry into our financial
system - the Wallis Inquiry which handed down its findings 17 years ago. In particular, the
report observed:1
The evolution of financial systems has been characterised by a continuing
struggle between financial intermediaries and financial markets.
While the inquiry was wary about making precise predictions, there was quite a strong sense
in the report that financial markets would inevitably win this struggle; that over time, markets
- including the bond market - would become increasingly important in connecting savers to
borrowers. It was thought likely that improvements in technology and access to information
would allow better and more differentiated pricing of risk. And that this, combined with
increased household savings in superannuation funds and a shift in investment preferences,
would give markets the edge over the traditional financial intermediaries, namely the banks.
While we have seen some steps in this general direction, including the financing of
mortgages through residential mortgage-backed securities (RMBS), things have not exactly
turned out this way. Improvements in information technology have greatly improved access
to information. However, the challenge turned out not to be so much in accessing the
information, but in using the information well. It also turned out that households' investment
preferences did not change that much and that to the extent that they did change, it was
mainly reflected in an increased appetite for equities. As a result, while market-based
financing has developed over time, it has not grabbed the upper hand as some had thought
likely at the time the Wallis Inquiry delivered its final report.
One area that has attracted considerable attention is the non-financial corporate bond
market. Some commentators have lamented the fact that the Australian market has not
developed more rapidly, with most business borrowers still connecting with savers over the
balance sheets of financial institutions. Some of these commentators have also lamented the
fact that superannuation funds - who they see as a natural buyer of corporate bonds - seem
to have had only a limited appetite for these bonds.
Given this background, I thought it would be useful to briefly discuss recent developments in
the Australian non-financial corporate bond market as well as the role that superannuation
funds have come to play in intermediating between borrowers and savers. I would then like
to discuss the role that market-based corporate financing can play in providing a form of
insurance against stresses in the banking system and the possibility of a lack of competition
in the banking system.
The Australian corporate bond market
By international standards, the Australian corporate sector makes relatively little use of the
domestic
bond market, especially the bond market. Since the mid 2000s, the available
internationally comparable data suggest that average annual bond issuance by Australian
corporations has been the equivalent of just under 1 per cent of GDP, with around two-thirds
of total issuance taking place offshore, rather than in the domestic market (Graph 1). In most
other countries with which we normally like to compare our financial markets, the corporate
sector makes greater use of bond funding.
Graph 1
The relatively high reliance of Australian issuers on the offshore market is evident in the data
on the composition of corporate bonds outstanding (Graph 2). Currently, bonds that were
issued offshore account for around 80 per cent of the outstanding value of bonds issued by
Australian-based corporations. A decade ago, this figure was considerably lower at around
50 per cent. The offshore market is favoured by companies that want to raise foreign
currency funding as a natural hedge against their foreign currency revenue. It has also
proven easier to issue large amounts and at longer tenors in the offshore market than it has
in the domestic market.
Graph 2
Another perspective on recent trends can be gained from looking at the data on the number and
credit ratings of the individual bonds that have been issued domestically and offshore (Graph 3).
Graph 3
A number of observations stand out:
1. The number of Australian companies issuing bonds is quite small. On average, over
recent times, only around 30 bonds have been issued in the domestic market per
year, with just a few more being issued in the offshore market. In terms of size,
offshore issues tend to be substantially larger and they also tend to have longer
maturities.
2. During the global financial crisis, issuance of bonds in the domestic market all but
ceased, with only a handful of companies going to the market in 2008 and 2009.
During this period, there was some issuance in the offshore market although the
number of bonds issued was substantially lower than in the years both before, and
after, the crisis.2 This partly reflected the very high spreads being demanded by
investors at the time.
3. There was significant issuance of AAA securities in the domestic market prior to the
financial crisis, although these securities were credit wrapped by bond insurers.
During the crisis most of these insurers were wound down following large ratings
downgrades, and this segment of the market has subsequently disappeared.
4. The publically available information indicates that not a single corporate bond with a
credit rating below BBB- has been issued in the domestic market. In contrast, since
2000, around 30 bonds rated below BBB- have been issued in the offshore market
by Australian corporations.
5. Recently, there has been a pick-up in both the number (and value) of BBB-rated
issuers in the domestic market. Last year, a total of 16 BBB-rated bonds were
issued, the highest number on record. In another positive sign, the average maturity
of these bonds was noticeably longer than in previous years.
Putting all this together, the Australian corporate bond market is relatively small in size and is
less well developed than corporate bond markets in a number of other countries. Total
outstandings in the domestic market amount to around $50 billion compared with total
corporate debt outstanding of a much larger $920 billion. Notwithstanding this, regular
activity is occurring in the market across much, although not all, of the credit spectrum. And
over recent times, issuance appears to have picked up a little, particularly by lower-rated
companies.
The role of superannuation
I would now like to turn to the issue of superannuation funds and their role in the provision of
market based finance. This is obviously an important issue given the rising share of national
savings being managed by these funds (Graph 4). In the late 1980s/early 1990s, a little less
than 20 per cent of the flow of new national savings was being directed into superannuation.
Today, the figure is almost double that.
Graph 4
According to the latest figures, superannuation funds currently hold around $7 billion of
domestically issued corporate bonds (Graph 5). This represents around 15 per cent of the
total outstandings in the domestic market, with Australian mutual funds and non-resident
investors together holding a further 60 per cent of bonds on issue. All up, domestically issued
corporate bonds account for less than 1 per cent of total superannuation assets.3
Graph 5
One reason that is sometimes given for superannuation funds' relatively limited holdings of
corporate bonds is that these funds have a strong preference for equities - currently, around
50 per cent of Australian superannuation funds' assets are invested in equities, whereas in
many other countries the comparable figure is less than 40 per cent.
This apparent preference for equities is, however, only a partial explanation at best.
Australian superannuation funds do hold a large portfolio of fixed-income securities.
However, within this portfolio, there are just not many fixed-income securities issued by the
corporate sector. In contrast to only modest growth in holdings of corporate bonds,
superannuation funds have purchased very large volumes of bonds issued overseas and by
authorised deposit-taking institutions (ADIs) based in Australia (Graph 6). Indeed,
superannuation funds' holdings of bank bonds have risen from around $8 billion a decade
ago, to around $40 billion today. This suggests that the issue is not so much a lack of
appetite for bonds, but rather the relative risk-return and liquidity characteristics of the
corporate bonds on offer.
Graph 6
Interestingly, superannuation funds have also purchased significant volumes of bank
liabilities other than bonds, including bank equity, bank short-term debt and, most notably,
bank deposits (Graph 7). Indeed, bank deposits have been amongst the fastest growing
asset classes for the superannuation sector over recent times. As a result of these
developments, super funds currently hold $440 billion of liabilities issued by banks,
representing 15 per cent of the banking sector's total liabilities.
So as things have turned out, superannuation funds, rather than financing the corporate
sector directly, have helped finance the banks, which in turn have financed the corporate
sector. In effect, we have seen a lengthening of the chain of financial intermediation - from
savers to superannuation funds to banks to borrowers. This is not quite the financial
disintermediation that some had expected a decade and a half ago.
Graph 7
Superannuation funds have, nevertheless, been an important source of market-based
funding through another channel - namely through the purchasing of corporate equity
(Graph 8). Over the past decade, superannuation funds have increased their net investment
in Australian equities by the equivalent of around 2 per cent of GDP per year, which in
current dollars is equal to an annual net new investment of around $30 billion. This suggests
that there is not a natural reluctance by the superannuation sector for corporate exposure,
but rather that equity represents a more attractive option than debt.
Graph 8
In this context, one issue that is worthy of further analysis is that of liquidity. Given that
balances in superannuation funds are essentially "at call" and can be moved at short notice,
these funds need to ensure that they remain quite liquid at all times. This inevitably reduces
the attractiveness of relatively illiquid assets like corporate bonds. From one perspective it
seems slightly curious that long-term retirement savings can be moved at short notice. Over
time, there may be a benefit in exploring other arrangements that are more conducive to
investments in illiquid assets.
Does it matter?
With these facts as background, I would like to pose the question of whether any of this really
matters: does it matter whether or not we have a corporate bond market and does it matter
what the size of that market is? After all, the Australian economy and financial system have
performed well over the past two decades and there does not appear to have been
systematic difficulties for the corporate sector in accessing finance.
In answering this question it is useful to think about the implications of the corporate bond
market for both the overall stability of the economy and for the efficiency of financial
intermediation.
In terms of stability, one of the arguments for a vibrant corporate bond market is that it can
effectively act as a "spare tyre" - if the banking system gets into difficulty, the bond market
can take its place in providing credit to businesses and thus allow the economy to continue
operating relatively normally.
The available international evidence is broadly consistent with this argument, although the
transition from bank finance to bond finance in times of stress is not a seamless one given
that the events that cause problems for banks can also cause markets to freeze up for a
time. Nevertheless, in severe downturns, markets do seem to recover more quickly than do
banks, which because they are highly leveraged, can find it difficult and time consuming to
get back to normal operations.4 Interestingly, the evidence also suggests that during milder
downturns, banks tend to be more stable providers of credit than are markets. This partly
reflects the tendency for banks with long-term clients to keep supporting those clients if they
can, whereas markets can abruptly shut for a time.
The recent experience in the United States and Europe provides an illustration of the
constructive role that the corporate bond market can play during times of severe stress in the
banking system. Banks in these areas have been capital constrained, have faced higher
costs of raising funds and have had a diminished appetite for lending. As a result, at a time
when bank credit outstanding has been unchanged or declining, the outstanding value of
corporate bonds on issue has been rising, particularly in the United States (Graph 9).
In terms of efficiency of the financial system, the bond market can play the role of the
competitive edge: ensuring that banks do not charge too high a price for financial
intermediation. We saw a clear example of this in the 1990s in Australia. On that occasion,
mortgage lenders were making very high returns on new mortgage loans, with the spread
between the mortgage rate and the cash rate reaching around 43⁄4 percentage points. The
RMBS market emerged partly in response to this and over time the extra competition led to
mortgage spreads falling considerably. More broadly, the corporate bond market can
improve the overall efficiency of the financial system through offering a broader range of
maturities and loan structures than banks are able, or willing, to do.
Graph 9
So, in effect, the bond market can be seen as providing a form of insurance - insuring that in
times of banking system stress the process of financial intermediation can continue and, at
other times, insuring that any lack of competition in the banking sector does not lead to
excessively high prices for financial intermediation.
Importantly, to play this role the corporate bond market needs to be able to come to life when
it is most needed - when it is needed as the spare tyre or when it is needed to provide
competition. In a perfect world, the market would be deep and liquid at all times, but I don't
think this is required for the market to play this important insurance role. Instead what is
needed is that we have the general infrastructure that would allow the market to respond as
necessary.
Here, I think Australia is relatively well placed. The legal apparatus exists to issue corporate
bonds. The trading arrangements are well established. We have a reasonable number of
financial institutions that are able to assist companies in issuing bonds. We have businesses
that have experience in the market. And we have superannuation and other funds that are
willing to purchase bonds at the right price. This financial infrastructure means that we can
have some confidence that there is capacity for the corporate bond market to fulfil this
important insurance role.
From this perspective, the fact that over recent times the corporate bond market in Australia
has been relatively subdued compared with the markets in Europe and North America can, at
least partly, be explained by the different outcomes in the banking sectors. In Australia, our
banks are in sound shape and have been willing to lend. In contrast, many of the North
Atlantic banks have had severe difficulties and have had little appetite for new loans. Indeed,
lending rates charged by euro-area banks have often exceeded the cost of bond market
finance for even fairly lowly rated companies (Graph 10). In this environment, it is not
surprising that bond issuance has increased.
Graph 10
In contrast, in Australia, while a rise in the cost of bank funding over recent years has meant
that some businesses have been able to raise funds in the bond market more cheaply than
obtaining a bank loan, the number of businesses that have found themselves in this position
is relatively small. By and large, the Australian banking system has been able to meet the
financing needs of most of the corporate sector.
Looking forward, we need to ensure that the infrastructure that supports the bond market
remains in place and that it is strengthened over time. This strengthening is a gradual
process and there have been some steps in this direction over recent times. These steps
include: efforts to simplify prospectus requirements for retail vanilla bonds and ease the
personal liability of company directors; improving market transparency through the RBA's
publication of new measures of corporate bond yields; the lengthening of the government
bond curve; and the listing of certain fixed-income securities on the Australian Securities
Exchange. These are all welcome developments.
Conclusion
In conclusion, let me try to briefly summarise.
Bank-based finance remains the dominant form of finance for Australian companies.
Superannuation funds have been prepared to finance banks and have effectively outsourced
the credit assessment function for much of the corporate sector. Partly as a result, the
development of a deep and liquid corporate bond market is still a work in progress.
But an equally important observation is that we do have the infrastructure that could support
a strong and very active bond market in times of stress or inadequate competition. In this
way, this infrastructure provides a form of insurance. We need to make sure that we nurture
this infrastructure so that we can continue to be confident that the corporate bond market will
be there when it is most needed. Given this perspective, I think it is probably better to think of
markets and institutions as being complements, rather than as being engaged in some type
of struggle for supremacy.
Thank you very much for listening.