The international economic and financial crisis revealed several inadequacies in Australian banking and financial regulation. Large Australian banks remain dependent on international investors to secure wholesale debt. Demand for securitisation increased in the decade before the economic and financial crisis. The Australian Government responded to the unprecedented uncertainty after the collapse of Lehman Brothers by providing a guarantee to ensure the stability of financial institutions, particularly the large banks. The guarantee reduced competition in the financial industry with large banks benefiting from lower costs of borrowing. The introduction of a covered bond market, increasing household savings and creating a retail corporate bond market will provide diverse sources of finance for Australian banks to enhance competition and maintain financial stability.
Wholesale debt has become an important source of finance for large Australian banks. Since 2007, wholesale debt from domestic and international institutions increased by 7 percent and composes almost 25 percent of funding for banks. Large Australian banks utilise wholesale debt to refinance maturing debt and increase liquidity. The perception wholesale debt is more stable than short term debt resulted in the increase in wholesale debt by large banks. Since mid 2007 the cost of wholesale debt has increased. The cost of three year bonds issued in Australia increased to 220 basis points higher than the government yield and 280 basis points for bonds issued in international markets.
Large Australian banks have become dependent on international wholesale debt markets for finance. The Reserve Bank of Australia estimated international investors provide $320 billion or approximately 70 percent of Australian banking wholesale long term requirements in May 2010. Large banks constituted a large proportion of the amount. International investors perceive the dependence on international capital to finance Australian banks wholesale debt risky with the price of risk premiums increasing with institutions repricing risk. Ric Battellino, Deputy Governor of the Reserve bank of Australia asserted Australian banks understand the risks of wholesale debt and it contributed to their relative good performance through the international financial crisis.
International investors may consider Australia’s household debt levels a possible risk. International investors possessed $645 billion of wholesale debt and deposits in May 2010. If the European sovereign debt crisis expands or investors consider the high household debt is unsustainable the large banks may incur higher interest costs and the size of loans would be smaller. Australia’s total mortgage debt in April 2010 was $1.1 trillion and consumer debt was $141 billion. Reducing household debt will require a change in consumer preferences. Households will have to increase savings and extinguish debt.
The Australian Government introduced the Guarantee Scheme for Large Deposits and Wholesale Funding to provide stability for long term liabilities and preserve the flow of international capital. The response undermined the principle espoused in the Wallis Inquiry not permitting public finance to underwrite banking capital. Between October 2008 and March 2010 the Australian Government provided continuous credit and access to finance for financial institutions. The Guarantee assumed responsibility for debt with a rolling maturity date of five years. A fee of 70 basis points per annum applied to AA rated institutions. A fee of 100 basis points per annum applied to A rated institutions and a fee of 150 basis points per annum applied to BBB rated and unrated institutions. The increased cost of financing for smaller and regional banks resulted in the ‘crowding out’ of smaller institutions from the wholesale debt market. It strengthened the position of the larger banks. The Australian Government estimated large banks raised approximately $160 billion and smaller banks raised approximately $32 billion during the Guarantee Scheme.
The Australian Government decided to withdraw the Guarantee Scheme on 31 March 2010. The decision was prompted by the large banks reduction in borrowing. No further guaranteed wholesale liabilities or term deposits will be issued. Liabilities assumed by the guarantee scheme will remain guaranteed until maturity or purchased and extinguished by the issuer. The Guarantee Scheme will be responsible for guaranteeing at -call deposits until it ceases in 2015. The Treasurer estimates the banks paid $5.5 billion in fees for utilising the scheme excluding early payments.
The wholesale guarantee is likely to adversely affect fiscal policy. It contributed to the deficit budget. The mid-year economic and fiscal outlook published by Treasury in early November 2010 announced total liabilities of the scheme amounted to $148.7 billion in October 2010. It decreased from $169.9 billion in April 2010. The decrease in large deposits exceeding $ 1million resulted in the decline in total liabilities. Treasury stated the guarantee scheme and liabilities posed a risk for fiscal policy in the unlikely event an Australian bank became insolvent. Surplus budgets are required to reduce the impact of a future crisis.
Securitisation became an important source of financing for smaller banks. Securitisation is the practice of combining various types of contractual debt, such as residential mortgages and offering the debt to bond markets. The increasing demand for Australian residential mortgage backed securities prior to 2007 resulted in international issuance constituting more than half of outstanding Australian residential backed mortgage securities. International structured investment vehicles (SIVs) constituted a significant proportion of international investor capital. SIVs utilised short term financing and invested in long term assets, such as residential mortgage backed securities, a business strategy vulnerable to the reappraisal of risk. The decrease in finance and exposure to poor performing assets and inadequate liquidity compelled many SIVs to liquidate their portfolios and sell Australian residential mortgage backed securities in the secondary market. In 2010, $18 billion of residential mortgage backed securities has been issued compared to $45 billion in 2008.
Securitisation will remain an important part of the financial industry. However, the size of the securitisation market will most probably be smaller. Mortgage originators and smaller bank relied on securitisation for finance. Smaller banks constituted 33 percent of the residential mortgage backed securities market before mid 2007 and provided 40 percent of the issuance. The Australian securitisation market was tarnished by the high level of delinquencies, opaque nature and complicated security structures of American mortgage backed securities. The majority of Australian residential backed mortgages are supported by prime loans and almost all are protected by lender’s mortgage insurance. A revitalised securitisation market emphasising AAA rated residential mortgage backed securities could provide an opportunity for smaller banks, some credit unions and building societies to compete with large banks. Small banks were able to compete with large banks prior to 2007 when liquidity was greater and the cost of funding was lower.
Introducing an Australian covered bond market would provide a source of liquidity for financial institutions. Covered bonds are debt securities endorsed by a pool of banks assets. The cost of raising funds in wholesale markets has increased since the beginning of the international financial crisis and the sovereign debt crisis in Europe. The Banking Act 1959 does not allow Australian banks to issue covered bonds. The legislation intends to protect depositors and avoid customers withdrawing funds in the event of a ‘run’ on banks. An amendment to the Banking Act would be required to permit Australian banks to issue covered bonds. Bank assets would have to be separated. The capital available to depositors would be reduced. The Australian Prudential Regulation Authority would be involved in regulating the covered bond market. It would be responsible for ensuring a degree of protection for depositors and creating a market for investors of high rated debt products.
Increasing household savings would provide banks with a larger source of deposits. The low level of household savings compelled large banks to utilise wholesale debt. Wholesale debt financed the strong demand for business and household lending. Since 2002, the level of household savings has increased. Several factors have contributed to the increase in household savings. A significant increase in income growth accompanying an improvement in the terms of trade, moderation in the growth of capital gain, a sustained increase in the level of real interest rates until 2008 and households are aware of the risk concerning the high level of household debt.
The Henry Review recommended several initiatives to increase household savings. The introduction of a personal savings discount of 40 percent would apply to interest earned from bank deposits. It will also include residential rental income, capital gains and interest expense from listed share investments. Another recommendation involves widening the exemption for interest withholding tax for finance raised by banks operating in Australia from international sources. The recommendations provide incentives for households to increase savings and allow banks to diversify their funding requirements.
A strong corporate bond market could reduce Australian banks dependence on international wholesale debt markets and improve competition. Corporate bonds provide investors with the opportunity to invest in Australia’s public debt rather than bank debt. The Australian Securities Exchange has requested permission to create government and retail corporate bond markets. The retail corporate bond market could utilise superannuation savings to finance investment in the banking sector and reduce Australian banking reliance on international wholesale debt. Government approval to trade Commonwealth Government Securities on the Australian Securities Exchange would provide retail investors with a visible market price for investments issued by Australian corporations and persuade them to diversify savings in the fixed income market.