Guy Debelle: Bank funding and capital flows
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, at the 23rd Australasian Finance and Banking Conference, Sydney, 15 December
2010.
* * *
Thanks to Alex Heath, Chris Stewart and Crystal Ossolinski for their help in preparing this speech.
The financial crisis has led to a significant re-assessment of risk. Having been underpriced
for a number of years prior to 2007, risk was rapidly and substantially re-priced as the
financial crisis unfolded. Counterparty risk came to the fore and there has also been a more
fundamental re-assessment of the importance of liquidity risk. There is a new-found, or
refound, appreciation for the complex ways in which risk can affect the broader financial
system.
Given the pivotal role of banks in the financial system, the evolution of the financial crisis has
placed particular focus on them and the way they fund themselves. Because one of the main
features of banking business is maturity transformation, banks were exposed to the
realisation of a liquidity shock. Problems associated with liquidity (or more precisely the lack
of it) proved to be an important channel for shocks in one part of the financial system to be
propagated to others.
The re-assessment and the re-pricing of these risks have caused changes in the structure of
funding of Australian banks. Today, I will discuss these developments on the liability side of
banks' balance sheets. But at the same time, there have also been changes on the asset
side of their balance sheets, with credit growth slowing significantly, particularly lending to
large businesses. The combination of these changes, together with the investment-focused
growth of the Australian economy, has had a marked effect on the composition of capital
flows to Australia which I will discuss later in my talk. These developments may well persist
for quite some time to come.
Bank funding1
The re-pricing of risk significantly increased the cost of wholesale funding for the global
banking system. At the shorter end of the yield curve, the rise in costs primarily reflected
counterparty concerns. This is best exemplified by the spread between a short-term rate in
the interbank market and the expected policy rate (Graph 1). As has been noted in the past,
this spread serves as one of the better summary illustrations of the evolution of the financial
crisis.
In Australia, this spread never rose as much as it did in other countries, reflecting the general
absence of counterparty concerns and the associated smoother functioning of the interbank
market throughout most of the crisis. As Graph 1 shows, this spread has fallen back in
Australia to be not far above its pre-crisis levels: pre-crisis the 90-day spread averaged
around 10 basis points, now it is around 20 basis points. It is not surprising this spread has
narrowed so far. By and large, one would expect that in more stable times, counterparty
concerns would be reasonably absent over shorter horizons and so not much of a risk
premium should be present in the pricing. But when counterparty concerns are rising, they
tend to be rapidly incorporated into this spread.
Graph 1
At longer terms, the effect of this repricing of risk is much more stark and, while pricing has
eased back from its peaks, it still remains well above its pre-crisis levels (Graph 2). The
overall cost to a major Australian bank of issuing a three-year bond has risen to around
120 basis points over the government bond yield compared with around 50 basis points
precrisis. Graph 2 shows that similar, but larger, developments have occurred in other banking
sectors.
Graph 2
In addition to this effect on the pricing of wholesale funding, the re-assessment of risk has
had a marked impact on the structure of banks' funding (Graph 3). Banks, their regulators
and markets have re-assessed the riskiness of different sources of funding, particularly
liquidity risk and the related concept of rollover risk. This change in perspective is embodied
in the new Basel standards for the banking system.
Graph 3
One notable change is the rise in the share of deposits from less than 40 per cent in 2007 to
over 45 per cent currently. The Deputy Governor Ric Battellino talked about this at this
conference last year.2 The desire to increase the share of deposits reflects the assumption
that deposits represent a more stable source of funding.
In order to boost their share of deposit funding, banks in Australia have competed
aggressively in terms of price. An indication of the degree of competition for deposits is the
extent to which there has been an increase in the cost of deposit funding relative to the cash
rate since mid 2008: the average cost of the major banks' new deposits is now only slightly
below the cash rate, whereas prior to the onset of the financial crisis, deposit rates were
about 150 basis points below the cash rate (Graph 4).
Graph 4
Competition has been strongest for term deposits. The average rate on banks' term deposit
specials is currently more than 70 basis points above market rates for debt of equivalent
terms (Graph 5). In the few years prior to the global financial crisis the average rate was
generally about 60 basis points below. This is notwithstanding the fact that wholesale debt is
a liquid tradable instrument whereas a deposit is not; one might expect that this liquidity of
wholesale debt would result in it being cheaper.
Graph 5
Rates on at-call savings deposits - including bonus saver, cash management and online
savings accounts - have also risen relative to the cash rate. The average rate on the major
banks' at-call deposits, which account for a little under half of their total deposits, is currently
estimated to be around 40 basis points below the cash rate compared to around 100 basis
points below in mid 2007.
So the bottom line of all of this is that the deposit market has been extremely competitive.
The most marked increase in competition occurred late last year and the early part of this
year. Since then, our liaison suggests that competitive pressures have not intensified further
but nevertheless they remain at a high level. As Ric Battellino noted last year, at some point,
it is likely that the elasticity of deposits to price declines. This means further increases in
prices result in the banks mostly shuffling the deposits between themselves, rather than
generating further increases in the share of funds investors allocate to deposits.
At the same time as banks have increased the share of deposit funding by around
7 percentage points, the share of longer-term wholesale funding has also increased by a
similar amount. This increase in the share of funding sourced from deposits and long-term
debt has mirrored a decline in the share of funding sourced from short-term wholesale debt,
both from domestic and foreign markets. The share of short-term funding has fallen by
10 percentage points over the past three years, a very large change indeed.
As a result of these changes, the vulnerability of the Australian banking system to any further
seizures in global financial markets has decreased. But these changes have increased the
cost of funding for the banking system as a whole. The costs of all forms of funding have
risen, and, at the same time, banks have shifted to more expensive sources of funding. As I
said earlier, this shift has reflected market and regulatory pressures following a
reassessment of risk.
The re-pricing of risk has increased the cost of intermediation from its pre-crisis level, when it
was arguably underpriced. This rise in the cost of intermediation is reflected in the increase
in lending rates relative to the cash rate.3
The financial crisis also raised awareness of the other sources of risk for the global banking
sector. For a number of European banks, the currency and maturity mismatch between their
assets and liabilities raised significant issues throughout the crisis and continues to be a
vulnerability. The fact that this issue is ongoing has been reflected in the recent rise in the
EUR/USD cross currency basis swap. In contrast, the Australian banks hedged the currency
risk of their offshore borrowing using instruments that were maturity matched. As a result
they did not face the issues that some European banks faced of funding US dollar assets
from a euro funding base.
The US dollar swap lines that a number of central banks, including the RBA, established with
the Federal Reserve were established in large part to alleviate these stresses stemming from
the European banking system. As their funding was being severely curtailed from other
sources, the European banks turned to the swap market to fund their long-dated and illiquid
US dollar asset positions. This demand from European banks for US dollars each day, at the
same time as supply was being reduced, caused the price of US dollars to rise dramatically
in all markets and time zones.4
The RBA participated in the swap line to help distribute US dollars into this time zone (the
Bank of Japan's participation served a similar purpose).5 It did not reflect any issue with the
Australian banking system's own need for US dollars. The funds provided under the swap
line were cheaper than the extremely wide market price at the time. As a result, Australian
based banks availed themselves of this and in a number of cases on-lent the funds to banks
in other jurisdictions. The provision of these funds globally alleviated the strains in the swap
market and the spread declined. Once it declined below the price of the swap line, demand in
Australia dried up and the facility was no longer offered here, although it continued to attract
demand for a longer period of time in other markets.
Bank's assets
While these developments have been taking place on the liability (funding) side of banks'
balance sheets, there have been some interesting developments on the asset side too.
Since mid 2008, there has been a significant easing in the pace of credit growth, particularly
for the business sector (Graph 6). Further disaggregation indicates that the easing in credit
growth has been most striking for large businesses (Graph 7).
Graph 6
Graph 7
The decline in credit outstanding to large businesses reflects a number of factors:

Some businesses have found it more cost effective to access funds directly from the
market rather than through the banking system.

In 2009, there was a record level of equity raisings by large businesses that enabled
them to repay debt (Graph 8).

There has been a tightening in lending standards for some sectors, most notably
commercial property.

A number of large businesses, particularly in the mining sector, have been able to
fund their activities and repay debt from their retained earnings resulting from their
strong cash flow (Graph 9).
Looking forward, given the expected prominence of resource investment for GDP growth, it is
quite possible this pattern of subdued business credit growth relative to robust growth in the
economy might persist. The RBA's forecasts have investment increasing as a share of the
economy in the period ahead to historic highs. Much (although not all) of this pick-up in
investment is in the resources sector. The companies undertaking this investment tend to be
much less reliant on credit intermediated through the domestic banking system. Instead they
are likely to fund a sizeable share of this investment from global capital markets either
through direct raisings or syndicated loans.
Graph 8
Graph 9
This slowdown in growth on the asset side of the balance sheet has alleviated pressures on
banks to increase their funding. Over the past couple of years, credit growth has been slower
than the growth in deposits for the first time the early 1990s (Graph 10).
Graph 10
As mentioned earlier, part of the explanation for the strong growth in deposits is the
increased competition for deposits in the banking system. But another part of the explanation
reflects the changed nature of the financial flows in the economy. While parts of the
corporate sector may be less reliant on the domestic banking system for their funding,
ultimately a large part of the funding they raise from other sources still finds its way into the
domestic banking system in the form of corporate deposits. Hence, if the economy evolves
as forecast, it's quite possible this pattern of deposit growth outstripping credit growth
continues and deposits may continue to rise as a share of bank funding.
Bank funding and capital flows
These changes in bank funding, as well as in the funding of the increase in capital
expenditure, are apparent in the financial accounts side of the balance of payments. These
are the capital inflows that are the counterpart of the current account deficit.
The net capital inflow into Australia masks very large gross capital flows both into and out of
the country. For example, over the past five years, the average annual net capital inflow
amounted to $55 billion. This net capital inflow comprised:

foreign investment in Australian equity of $54 billion;

Australian investment in foreign equity of $51 billion;

foreign investment in Australian debt of $95 billion; and

Australian investment in foreign debt instruments of $43 billion.
Given the size of these gross flows, it can be somewhat misleading to analyse shifts in
capital flows or how the current account deficit is funded by focusing on net flows only.
For a number of years prior to 2007, Australian banks were a steady source of capital inflow,
representing around 4 per cent of GDP, or around 80 per cent of net private sector inflow
(Graph 11). These capital inflows reflected the fact that Australian banks found it cost
effective to raise wholesale funds offshore to fund domestic asset growth. That these net
flows into the banking sector were similar in size to the current account was as much
coincidence as causation in my opinion.
Graph 11
Given the changes to bank funding and the slowdown in the credit growth discussed above,
financial inflows in the form of offshore debt raisings by Australian financial institutions have
declined. In the first three quarters of 2010, the net inflow of foreign funding to banks was
only 1 per cent of GDP. All of this occurred in the first quarter of the year, with the net
amount of offshore funding by the banking sector amounting to zero in the two most recent
quarters. At the same time, the current account deficit has fallen to around 21⁄2 per cent of
GDP.
Going forward, the forecast rise in the investment share of the economy is likely to see an
increase in capital inflows. As discussed above, given that mining companies are likely to
rely less on locally intermediated debt to fund their activities, there are likely to be further
changes in the composition of net private capital inflows away from banks towards
nonfinancial corporates. Some of this might be in the form of increased direct debt raisings,
some might be in the form of an increase in retained earnings. So the current account deficit
may increase from its current level, but on the capital account side, there may not be a
concomitant increase in banks' net offshore raisings.
Conclusion
The financial crisis has had a marked impact on financial flows globally. In this speech I have
described some of the effects it has had on financial flows in the Australian economy. The
funding of the Australian banking system has changed quite markedly as has the cost of that
funding. In addition, the forecast composition of growth in the Australian economy and the
funding of that growth may have implications for the asset side of the banking system's
balance sheet. It is quite possible that intermediated credit growth will be slower, and deposit
growth relatively higher, than has been the case in recent years. These changes have been,
and may continue to be, reflected in the changed composition of capital flows to the
Australian economy.