1. What are the risks and benefits of large bank wholesale debt and how should each be addressed?
The benefits of wholesale funding are quite straightforward: assuming global wholesale debt markets are operating in an efficient manner, they represent an almost endless source of funding for a bank that faces pressure raising sufficient retail funding to satisfy the needs of its loan book. This is particularly important in Australia, where the willingness and desire of people to borrow money far outweighs their ability and desire to save it. Wholesale funding has historically played the role of a ‘plug’ on the balance sheet of banks, filling the shortfall between deposits taken and loans advanced.
The role of wholesale funding has become even more prevalent in recent years, as the focus for both borrowers and lenders shifted to a borrower’s ability to service debt at current and “expected” interest rates, with little consideration given to their overall level of indebtedness (which any self-respecting lender will justify by making reference to the inconsequential levels of loss historically realised on loans advanced to households and lenders mortgage insurance placed on any loan written in excess of an 80% loan to valuation ratio). The result has been an exponential increase in household debt and further challenges for banks wishing to fund their slice of the ever growing household credit cake.
Furthermore, in the post-GFC banking world, wholesale debt represents an attractive funding option as the competition for retail deposits has driven the price of deposit funding up significantly.
The risks of wholesale debt to financial intermediaries are varied, but all tend to stem from the relatively short term of such facilities. 3 and 6 month facilities are common – the latter of which needs to be rolled-over 50 times in the contractual life of a typical mortgage. There are two key categories of risk – or rather, impact, that arise from the use of wholesale borrowings to fund balance sheet growth. Broadly speaking, these impacts arise from the “rollover risk” of wholesale funding – that is, the potential inability to replace maturing wholesale debt with new wholesale debt.
Of course it is rare for any bank to experience a repricing of wholesale funding in isolation, save for a significant downgrade to its external credit rating. Therefore, the overall impact of limited access to wholesale debt markets is a function of the entire sector’s reliance on wholesale debt.
Risks to liquidity
In a fractional reserve banking system, the measure that ensures, to an extent, a bank’s capacity to satisfy the demands of depositors and other creditors is the amount of liquid assets held on the balance sheet. Liquid assets are typically maintained at levels which cover the bank’s day-to-day cash needs and to withstand an ‘adverse’ scenario, in which abnormally high cash demands are placed upon the bank. The threat posed to a bank’s liquid assets by wholesale funding manifests when a piece of debt matures and the bank is unable to secure ‘new’ debt to replace the maturing debt and the maturing liability must be met from the bank’s liquid asset reserves. Considering an Australian bank, on average, maintains around 5% of the liquid assets necessary to satisfy the simultaneous claims of all its creditors, it is clear that the inability to rollover a portion of wholesale debts will soon erode available cash and other liquid assets, rendering it unable to satisfy further claims from creditors i.e. it would be in a state of default.
The obvious mitigant to address this risk is to maintain a higher level of lower-yielding liquid assets, which places a bank in a position to better fund the redemption of maturing liabilities from its own reserves. The reduced interest income from doing so would need to be recouped from the loan book. i.e. interest rates on loan products would need to be higher than they otherwise would.
Risks to capital
In the scenario described above in reference to liquidity risks, it is unlikely that funding will be unavailable in a purse sense of the word. During the GFC, when banks described “difficulty in rolling over their maturing debt financing”, what they were actually experiencing was “difficulty in rolling over their maturing debt financing at suitable price”. Even whilst the walls of the global banking system are crumbling, counterparties in wholesale markets still have their price.
As we have witnessed since the race that stops the nation last stopped the nation, banks are limited in their ability to reprice loan assets. Even attempts to move a further 20bp above what the RBA moves its target cash rate by sees political parties tripping over one another to introduce “reform” in pursuit of the all-important mortgage holder vote. Put simply, if a bank is unable to pass on the increased cost of wholesale debt that prevails in a risk-averse wholesale funding market, it has the potential to lose money on its loan book – and in doing so, erode its capital base. Once a bank’s capital base is eroded, depositor and other creditors’ claims are jeopardised. i.e. it would be in a state of insolvency.
Similar to addressing liquidity risk, the primary method for protecting against this risk would be to maintain a higher portion of its balance sheet as capital in order to be able to withstand a higher level of losses. Again, the increase in latent money would necessitate higher interest rates across the loan book to pick up the earnings slack.
2. Given securitisation was at the centre of the GFC, what role should it play in renewed competition?
Securitisation is a useful and legitimate tool for managing a bank’s balance sheet. Assuming that the bank is satisfied the structure of the transaction leaves no recourse to its own financial well-being (i.e. If securitisation investors, not the bank, wear the loss of defaults in the underlying pool of mortgages), then it is not required to hold regulatory capital against the loans. The inflow of cash from selling these assets is also an attractive funding option. There should be no concerns with securitisation being part of a diversified set of options used by a lender to manage its balance sheet.
Similar to wholesale debt, the pricing of securitisation funding now seems much more attractive following the rapid increase in the cost of retail deposit funding. Greater access to securitisation funding would likely reduce banks’ funding costs and allow for lower lending rates.
However, the panacea which securitisation is spruiked as in the current debate suggests an appetite for this funding to be relied upon as an integral part of lenders’ business models – in particular the smaller participants in the industry. This is a cause for concern. In its extreme, such a strategy was employed by various non-bank lenders, who did not have a license to raise retail deposits, from the period of the late 1990s until the GFC - a period which saw significant contraction of bank lending margins due to the increased competition brought about by these lenders. The banks had the last laugh when securitisation markets froze, choking the funding sources for these lenders, who had little choice but to offer themselves for sale to the very institutions they had spent their lives battling. Smaller deposit taking lenders experienced the same pressures but, as their banking licenses allowed, had the ability to raise funds in the retail deposit market and were able to keep funding their lending activities. If we are to promote a higher degree of reliance on securitisation for smaller deposit taking institutions, we may not be so lucky when the next crisis hits.
3. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
It seems that when phrased in the context of the current debate, the notion of “competition” is a proxy for lower margins on standard variable rate mortgages (it seems unreasonable to suggest that politicians and consumer groups are advocating true competition, where strong and adaptive institutions thrive whilst weak and stagnant ones fail). As highlighted at earlier junctions of this submission, measures taken by the Government to enhance lenders’ access to these streams of funding would indeed allow banks to maintain their interest margins with lower variable mortgage rates.
But if we also consider lower variable mortgage rates in the context of the focus on serviceability referred to earlier, it is unlikely that banks and borrowers will be satisfied to settle on the reduced payments required to service a loan at the lower rate. Borrowers will be buoyed by an increase in the maximum loan amount now offered by their bank and the banks will of course be happy to extend the additional credit. As some of the most indebted households in the developed world, it cannot be argued that further indebtedness at the hands of government is a desirable outcome.