Guy Debelle: Regulatory reforms and their implications for financial
markets, funding costs and monetary policy
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, to the Financial Services Institute of Australia, Adelaide, 18 September 2012.
* * *
Matt Boge provided invaluable help in the preparation of this speech.
It is a pleasure to speak here today in my home town. Neil Grummitt has spoken about some
of the details of the regulatory reform process currently underway in Australia and globally.
My aim is to consider some of the broader implications of the reforms.
Before doing so, there is an important point to make. The changes we all see the banking
and financial system undergoing are not purely the result of regulatory changes. Rather there
are a number of forces all pushing in the same direction. Some of the changes we see are
self-imposed, as financial institutions look at the lessons learned over recent years and seek
to increase their own resiliency to future developments. Some are being imposed by the
market in terms of the availability of both the quantity and price of particular channels of
financing. Others reflect pressure from rating agencies.
Currently, all of these forces are generally aligned in changing the structure of the financial
system in the same direction, although they may vary in terms of degree. In that sense, the
impact of regulation may not be as large as it appears on the surface. Rather regulation is, in
many cases, serving to reinforce the other forces at work. But the regulatory changes will be
more binding when these other forces are no longer all pushing in the same direction. The
experience over many years is that some of these forces are certain to wane when the credit
cycle is in full upswing. In the good times, self-discipline can falter under the weight of
competitive pressures, as can market discipline. Hopefully in those circumstances, the
regulatory framework will continue to impart the necessary restraint.
Today, I'm going to focus on the Basel III reforms. Other reforms, such as those around
central clearing and OTC derivatives are also having a significant impact on the way many of
you do business, but I will leave them for another time. The Basel III measures will
strengthen the requirements for financial institutions' liquidity and capital. It is the impact of
some of these reforms on financial markets and on funding costs that I would like to address
today.
In thinking about this issue, it is important to remember that the intent of the regulatory
reforms is to alter the incentives for financial institutions and thereby bring about changes in
behaviour. The prices of various financial products will change from their pre-crisis levels.
This is not an "unintended consequence" (a phrase which personally I think is overused) but
a desired outcome.
So let me give a quick summary of the Basel liquidity reforms. The 40 or so largest
deposit-taking intermediaries in Australia will be required to hold high-quality liquid assets in
quantities sufficient to withstand a 30-day period of stress. This liquidity coverage ratio, or
LCR, is a much tougher metric than that used in the past, both in terms of the severity and
length of the stress period for which sufficient liquid assets need to be available, and in the
criteria for what qualifies an asset as liquid.
The test of whether an asset is liquid and of high quality is whether the asset would be able
to maintain its value in the private markets during periods of severe stress. The financial
crisis revealed that the universe of such assets was a lot smaller than banks (and some of
their regulators) had previously assumed. In particular, the liquidity-generating capacity of
private sector debt deteriorated significantly during periods of market stress, even where
such debt had been highly rated. This was the case for both securitised assets - such as
asset-backed commercial paper and residential mortgage-backed securities - as well as
unsecured paper. For many of these assets, the only source of liquidity proved to be the
central bank. This was true in the Australian market as well as internationally.
In recognition of this, the intent of regulatory reform globally is to require financial institutions
to hold more of their liquidity in debt securities issued by sovereigns or other official sector
bodies, subject to the requirement that these issuers are themselves highly rated and their
securities are liquid. All else equal, this would be expected to widen the spreads between the
yields on high-quality sovereign debt and the yields on private debt securities. However, to a
large extent, such repricing occurred globally during the financial crisis as the market itself
reached the same conclusion as to what constituted a liquid asset. That is, the self-evident
lesser liquidity of much private sector debt prompted financial market participants themselves
to adjust the liquidity risk premia they required on this debt, quite independently of any
direction from regulators.
Within the Australian market, a reassessment of risk and changes in investors' tolerances for
assuming such risk have been important in driving the spreads between Commonwealth
Government Securities (CGS) and yields on highly rated private debt securities. Since the
financial crisis, there has been a considerable widening in these spreads (Graph 1).
Graph 1
It is unlikely that any regulatory initiatives, and certainly not those related to Basel III liquidity
requirements, have been behind the strong demand for CGS we have seen in recent years.
Indeed, the major source of demand for CGS has come from foreign investors, including
central banks, sovereign wealth funds and pension funds attracted by the comparative
strength of the Australian economy and the sovereign's credit standing. Non-resident
investors now hold more than three-quarters of outstanding CGS. In contrast, the Australian
banks own very few CGS (Graph 2).
Graph 2
Within the Australian market, the only assets deemed to meet the Basel standard for liquidity
are CGS, semi-government securities, cash and exchange settlement balances at the
Reserve Bank. As is well known, under any conceivable scenario, the supply of CGS and
semis in Australia will be insufficient for ADIs' liquidity requirements. For this reason, the
Reserve Bank has announced it will establish a committed liquidity facility (CLF).1 On the
payment of a 15 basis point fee, ADIs will be able to obtain a commitment from the Reserve
Bank to provide liquidity against a broad range of assets under repurchase agreement.
Eligible assets will include a range of highly rated private debt securities, including an ADI's
self-securitisations. The Bank's commitments to ADIs to provide liquidity against these
assets will be recognised by APRA for the purposes of compliance with the Basel III liquidity
standards. Central bank committed liquidity facilities will also be used to meet the Basel
standards in certain other jurisdictions with insufficient liquid assets.
As I have said before, this arrangement is, to a large extent, the formalisation of the
pre-existing liquidity arrangements in Australia and is very much consistent with the
principles of central banking described by Bagehot.
The imposition of the fee ensures that the intent of the Basel standard will be met. By
charging ADIs for the liquidity insurance the central bank provides, the appropriate incentive
is established for ADIs to manage their liquidity risk. At the same time, the design of the CLF
will contain the impact of regulatory-induced demand for liquid assets, in an environment
where so few outside assets exist.2
As noted already, CGS yields have fallen well beyond levels that could have been induced
by the liquidity regulations. This is evidenced by the fact that banks own so few of them. For
banks, the spreads to interbank rates at which many CGS currently trade implies that
settlement balances at the Reserve Bank would be a higher yielding investment and at least
as free of risk. Similarly, the large negative spread to swap is confirmatory evidence of the
shortage of CGS relative to the strong demand for the asset.3
Recent trends within the Kangaroo bond market also illustrate that broader market dynamics
have had a greater influence on the relative prices of debt securities than prospective
regulatory developments.
When APRA was making its initial assessment of what securities would qualify as liquid
assets for the Basel III framework, there was concern expressed in some quarters about the
consequences for the Kangaroo market if supranational and foreign agency debt were not
considered level 1 assets. Seen from the perspective of today, it is apparent that these
concerns were overstated. As AAA rated Kangaroo debt will be eligible for the CLF, it is only
the payment of the fee, or liquidity premium, that distinguishes these securities from CGS
and semis for regulatory purposes. The subsequent repricing of much Kangaroo debt far
exceeds the size of the fee. In many cases, this repricing has rather been due to altered
perceptions of their creditworthiness by ratings agencies and market participants.
More generally, great store is often placed in terms of whether an asset is eligible for repo
with the central bank or not. Reliance on repo eligibility does not strike me as the cornerstone
of a resilient issuance program. But in recent months, we have seen a number of non
repo-eligible Kangaroo issues come to market, including from some first-time issuers. This
indicates that there are other more important elements that determine investor demand than
being considered a level 1 asset or repo eligibility.
In addition to the issue of which securities can be held as liquid assets, the other dimension
to liquidity regulation is how many of these assets need to be held. In this regard, the
Basel III liquidity framework makes certain assumptions about the likely calls on liquidity that
a bank would experience during a 30-day period of stress.
One assumption, based strongly on the experience of the past five years, is that any liquidity
commitments ADIs have made to other financial institutions, including structured investment
vehicles and conduits, will be called upon in full during the stress scenario. This has
significantly lessened the incentives for structures designed to exploit opportunities for
regulatory arbitrage, such as the conduits that issued asset-backed commercial paper.
Again, though, the decline of many of these structures can hardly be attributed solely to
regulatory change. Their viability was undermined when investors and ratings agencies also
came to the view that the quality of such instruments was largely tied to the quality of the
supporting institution.
This has also seen a decline in the number of mortgage warehouses, as the providers of the
warehouses have significantly increased the price to account for the much greater liquidity
risk. Most non ADI mortgage providers don't really have a balance sheet to warehouse the
mortgages on, so we have seen a marked decline in their number and market share over the
past five years.
In terms of the support that an ADI provides to its internal business units, changes to the
regulatory framework will alter how ADIs price liquidity and capital usage across the different
components of their businesses. By their nature, these internal prices are rarely transparent
to outside observers, but the incentives created by such transfer prices can have significant
implications for financial markets. This repricing across all product lines is going on currently
and still has some way to run. We have already seen its effect on the pricing of undrawn
lines of credit, for example, where the increase in the price resulting from their increased
liquidity cost has seen a marked reduction in their prevalence.
Another example, observed by the RBA through our market operations, has been the
tendency for government bond dealers to fund their positions at rates that exceed the
unsecured borrowing rates in the interbank cash market. To the extent that unnecessarily
high internal funding rates on these trading desks have fostered such an outcome, the new
liquidity regulations may well encourage some revision to these practices.
Calls on a bank's liquidity will also arise when they are unable to roll over or maintain their
existing funding. Assumptions regarding the likelihood of this are based on the regulators'
views about what forms of funding are more stable than others. Going forward, these
"run-off" assumptions should be expected to influence the funding strategies adopted by
ADIs.
To give one example: the incentive for ADIs to issue short-term debt to other financial
institutions will be considerably reduced under Basel III, as funds borrowed with less than
31 days to maturity would need to be invested entirely in liquid assets. Thus there will be a
marked decline in the provision of such debt by banks.
At the same time, the demand for liquid bank debt from other financial institutions, such as
insurance companies and pension funds, is increasing, in part as a result of regulatory
developments in those sectors.
So there is a decrease in supply and an increase in demand for liquidity. Normally, in
economics, such a situation would result in a change in the price (of liquidity in this case) to
clear the market. My concern is that it is not clear that the demand and supply curve for
liquidity provided by the regulated financial system will intersect at any reasonable price.
How this is resolved is not entirely clear. If it were to push the supply of liquidity outside the
regulated system, that would not be a good development.
In any case, it is quite probable that new funding instruments will emerge that seek to
accommodate the new regulations. In some other jurisdictions, a greater reliance on debt
with 31-day notice periods (given the 30-day liquidity stress scenario) has already been
observed. Regulators and financial institutions will need to ensure that this does not create a
new stress point at 31 days as funding piles up at that maturity.
One product where we are yet to see the effect of the new liquidity regulation on pricing is
at-call deposits. Relative to other types of deposits, these products are very expensive from a
liquidity point of view, but they still offer interest rates that are a large spread above the cash
rate. As banks focus on the liquidity costs of such products, I would expect to see these rates
decline relative to those on other types of deposits. Indeed, it would be surprising if the
repricing doesn't occur fairly soon given the liquidity regulations take full effect at the
beginning of 2015.
However, our liaison with banks suggests that these deposits are particularly sensitive to
changes in pricing, so there is a big disadvantage in terms of losing deposits to your
competitors if you are the first to reprice for the new regulations. But if an institution has a
large reliance on this source of funding, it won't be able to change that reliance overnight on
the 31st December 2014. Just like supertankers, funding structures take a long time to
change direction, and that change of course needs to be occurring around now.
On the subject of funding, one notable feature of banks' funding over the past three or four
years has been the shift away from short-term debt securities toward deposits, in particular,
term deposits (Graph 3). This shift has been a deliberate strategy on the part of the banks
and has been brought about by significant changes to their pricing structure. The interest
rates offered on term deposits to both retail and wholesale customers are now priced well
above the rates at which the banks issue equivalent maturity debt securities, such as
certificates of deposit (Graph 4).
Graph 3
Graph 4
Given the forthcoming liquidity regulations, a shift toward deposits certainly makes sense.
The Basel III framework views deposits as a much more stable source of funding, and has
lower run-off assumptions for most types of deposits than it does for wholesale debt
securities.
However, as with the relative price of liquid assets, one can't explain all of the movement in
deposit pricing in terms of prospective liquidity regulations. The intensity of the competition
and the rates paid on some of these deposits far exceed the implied regulatory incentive.
Why, then, are banks willing to pay such high rates for this type of funding? To a large
extent, the impetus has come from an internal reassessment of funding resiliency, the rating
agencies and the broader market, where a bank's ability to attract deposits has received
greater attention since the financial crisis. Quite possibly, some of the focus on
deposit-to-loan ratios and similar metrics is misplaced. Regardless, while term deposits
appear to be a very expensive source of funding, in the current environment, banks
presumably believe the alternatives would be even more expensive for their overall cost of
funds.
Nevertheless, the effects of changes in funding composition on the total change in funding
costs for ADIs in the past five years has been fairly marginal. The increase in the cost of
funding for banks and, ultimately, their customers, has been driven considerably more by a
fundamental reassessment within financial markets of the risks associated with credit and
liquidity exposures.
The regulatory effort towards promoting more stable sources of debt funding and greater
capital buffers for financial institutions is driven by a desire to foster financial system stability.
As has been noted before, and as is apparent from the intense competition for deposits,
changes in this direction have also been pursued by the banks on their own initiative,
presumably in the belief that this will lower their overall cost of funding in the market. To the
extent that regulations push ADIs to adopt a funding structure that market discipline would
not make them otherwise adopt, the difference is likely to be small and the effect on overall
funding costs would be smaller still. Moreover, as both APRA and the Reserve Bank have
argued, any costs of this magnitude are well worth paying for a more stable financial
system.4
As regards the broader macroeconomic impact of the increase in ADIs' funding costs, it is
important to remember that in the setting of monetary policy, the Reserve Bank Board is
conscious of the various rates at which credit is being priced. Consequently, where there has
been an overall rise in the funding cost structure for intermediaries, the Board is able to set
its cash rate target to appropriately take into account the effect on lending rates. In the
current environment, there has been ample scope to lower the cash rate sufficiently so as to
bring these other rates to where they need to be to achieve the desired stance of monetary
policy, be they mortgage rates or business lending rates.
In this regard, it is important to stress that the transmission of monetary policy is still very
effective in Australia. Not only do lending rates respond to changes in the Board's cash rate
target, there is no sense in which the aggregate supply of credit appears to have been
constrained by the ongoing changes in ADIs' funding patterns.
Finally, it has been suggested that while the regulations may not have a large impact on the
supply of credit in the current environment, banks may have difficulty funding an increased
demand for credit. However, I think this concern is misplaced. In an environment where the
demand for credit has picked up because the world is a better place, funding conditions for
intermediaries are also likely to be much easier. Moreover, from a macro perspective, there
is unlikely to be a funding problem for the system as a whole when the world is a happier
place, even if an individual institution is not 100 per cent sure where the next funding dollar is
coming from.
So, to conclude. There have been a number of significant changes to the structure of
financial markets over the past five years, in terms of pricing as well as the composition of
funding and lending. Regulatory reforms have certainly played a role in those changes, but
one of the main points I hope to leave you with today is that the regulatory reforms have
often served to reinforce changes resulting from a self-reassessment or resulting from
market pressures. While these forces have all been working in the same direction in the
current environment, the regulatory reforms will aim to ensure that these changes to a more
stable financial structure endure when the environment is less conducive to self-discipline
and as market pressures abate.