Thursday, December 23, 2010

SOW - Sam Birmingham

1. Wholesale Debt: Risks & Benefits

Australian lenders have increasingly relied on wholesale debt markets to fund the expansion of domestic loan books.

Benefits of wholesale debt issuance include:

• Expanded Lending: There is a finite pool of domestic funding (equity capital, customers deposits, etc) available to retail lenders. In the absence of further capital, domestic lending would be severely curtailed, with negative implications for asset values, business investment and so on.

• Efficiency: The globalisation of finance and development of wholesale debt markets provides retail lenders with access to significantly larger and more efficient pools of capital.

• Price: As a consequence of these efficiencies, retail lenders are (or at least should be) able to secure funding at a lower cost than would otherwise be the case.

However, sourcing capital from wholesale debt markets is not without risk. Such risks include:

• Liquidity Events: In the event of another GFC-type situation, the liquidity of wholesale debt markets could be severely constrained – particularly in circumstances where foreign debt providers are pressured to repatriate funds to support their local economy. Such global liquidity events leave our lenders starved of capital – potentially at a time when they need it most.

• Maturity Profiles: As is typical of the liability side of retail lenders’ balance sheets, there tends to be a mismatch between the maturity profile of wholesale debt and the assets that it is used to fund. When such mismatches occurred in the GFC, banks were forced to roll over short-term wholesale debt at significantly higher margins – putting pressure on their profitability and/or customers’ finances in the process.

• Currency Risk: Unless appropriately hedged, the AU$ burden of foreign currency-denominated debt could increase in the event that our currency depreciates. As with global liquidity events (above), such situations tend to occur when our domestic economy can least afford it.

These risks can be mitigated by increasing the pool of domestic savings upon which retail lenders’ might draw to fund their lending activities. This could be achieved in various ways: from providing tax concessions on bank deposits and boosting superannuation savings, to freeing up franking credits or establishing a sovereign wealth fund. 2. Government Guarantee of Bank’s Wholesale Debt

On 12th October 2008, the Rudd Government announced the guarantee of deposits up to $1m in authorised deposit-taking institutions (“ADIs”), as well as guaranteeing wholesale debt securities issued by ADIs, in exchange for a fee. This guarantee applied for debt terms up to five years, with the fee based upon the credit rating of the security in question (from 70bp for AA-rated issues to 150bp for BBB and unrated issues).

The window for guaranteed wholesale debt issues closed on 31st March, 2010. At this time, the amount of guaranteed debt outstanding was $166b – equating to approximately 7% of total ADI liabilities – the vast majority of which was long-term debt (maturities from 15 months to 5 years).

From a revenue perspective, the fees paid by ADIs who took advantage of the guarantee contribute some $100m per month to Government’s coffers
(Note: This amount will steadily decline until 5 years after the last guaranteed debt securities were issued, as guaranteed debts expire / are rolled over). Nonetheless, it must be noted that this income is not earned without risks to the nation’s finances.

Guaranteed debt represents a significant contingent liability on the Government’s balance sheet. Whilst the likelihood of the guarantee being called upon may still seem remote to many, one can’t help but be reminded of the Irish Government’s ill-fated guarantee of its own banking sector… *ahem*

3. Role of Securitisation

To the extent that it provides for the efficient allocation of capital, securitisation is an example of productive financial innovation.

However, over recent decades the securitisation market grew to such an extent that its overall benefits were outweighed by the risks involved in bundling up huge volumes of securities where risks were poorly understood and severely mispriced (until the GFC saw them re-priced, that is).

These ballooning risks were largely a consequence of misaligned incentives and responsibilities, and a lack of transparency:
• Issuers were encouraged to sell ever-increasing volumes of the securities in order to “feed the beast” – with sales staff and their managers enjoying massive bonuses as a result of their efforts;
• Ratings agencies were paid by the issuer, giving rise to perceptions that their ratings were more generous than should have been the case;
• And so on.
Given that securitisation played such a significant role in fuelling the global property boom, subsequent sub-prime meltdown in the US and the ensuing Global Financial Crisis, it would be easy to write off securitisation as “the spawn of the devil” and throw it in the financial innovation trash-can.

But should that really be the case? After all, securitisation can be beneficial to the extent that it provides for the efficient allocation of capital.

The problem is that it came to play far too central a role in financial markets – with all lending institutions relying on it to some degree and business models of certain non-bank lenders imploding when securitisation markets froze.

If securitisation is to continue, regulators should give special consideration to:

Concentration of Risk

Regulators must first consider the overall volume of funding sourced via securitisation programs and the risk that reliance on such programs places on the lending market as a whole.

Further, they should consider the importance of securitisation to individual institutions – particularly those who rely heavily on securitised funding and (as was the case with RAMS during the GFC) who may not be able to survive in the event of dislocations in securitisation markets.

In such situations, regulators should give consideration not only to the financial circumstances of the lender in question, but also to their position within the overall mortgage market and ensuring that a suitable level of competition is maintained.

Perhaps lenders who rely more heavily on securitisation could also be required to set aside additional capital under capital adequacy provisions?

Government Support

Through the AOFM, our Government has now agreed to provide up to $20b ($4b of which was announced by Treasurer Wayne Swan this past weekend) of liquidity to the domestic RMBS market. However, we have not yet had a legitimate debate on the extent to which taxpayers should be “on the hook” for any defaults under this program.

If the Government feels the need to “step in” to stimulate this market (ie. there is insufficient demand for RMBS from private investors), doesn’t that answer the question as to whether these securities are appropriately priced and that the Government may be exposing taxpayers to an unreasonable risk of capital losses?

How appropriate is it for the Government to invest in RMBS, particularly in circumstances where there may be better uses for limited Government funds?

Is this program solely designed to ward off an imminent housing market collapse, or does it genuinely enhance competition?

And from a generational equity perspective, young Australians already face sky-high house prices and previously unfathomable debt burdens in order to simply “get a foot in the property market”… Should we really be shackling these generations with the risk of capital loss on such public investments on top of their own private losses in the event of a housing market decline?

4. Restoring Competition

Before considering how best to return competition to the financial services sector, one must first consider whether competition has actually diminished.

Admittedly, since wholesale debt markets froze during the GFC and non-banks have subsequently struggled to finance the expansion of their mortgage books, up to 90% of home loans have been written by “The Big Four” banks. At the same time, our major lenders have increased their variable interest rates beyond the scope of RBA rate hikes on a number of occasions… But is this really a product of the lack of competition?

I submit that it is not so much a lack of competition that is the problem, but a lack of sustainable competition.

In response to the Treasurer’s reform package announced over the weekend, Bank of Queensland CEO, Graham Liddy, argued that:

“You can access funding today, but it’s still the cost that is the anti-competitive issue”

Similarly, in its submission to the Senate Inquiry into Competition in the Banking Sector, CUA argued that:

“(O)ne of the major factors restricting competition within the Australian banking sector is the difficulty CUA and other customer-owned financial institutions have in accessing reasonably priced funding from both domestic and overseas markets.

Sadly, both BOQ and CUA fail to grasp the difference between competition and sustainable competition.

Let us consider for a moment that the levels of competition prior to the GFC were not sustainable – after all, the business models of various non-bank lenders who aggressively drove margins down over the preceding years collapsed as soon as (excessively) cheap money sources dried up.

Accordingly, the goal of reform should not be to return the competitive framework to pre-GFC levels.

Furthermore, the goal of sustainable competition should not be driven solely by price considerations (ie. interest rate changes) and allegations of “blatant gouging” (I’m looking at you, Joe Hockey).

After all, relying on competition to drive down lending margins is not sustainable anyway, because once borrowers expect that the reductions will continue, they feel confident to assume a larger debt and any “savings” are quickly capitalised into higher asset prices… Then we’re back to square one.


Sam Birmingham said...

Thanks for publishing my submission, David.

And more importantly, thanks for putting on the competition... It's been a real eye-opener for me, and hopefully for a lot more of your readers too.


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