Like a shag on a rock

Buttonwood

Collateral damage

How bank funding may be squeezed in the next crisis.

WHEN the financial system teetered on the brink of collapse in 2008, the biggest problem was a lack of liquidity. Banks were unable to refinance themselves in the short-term debt markets. Central banks had to step in on a massive scale to offer support. Calm was eventually restored, but not without enormous economic damage.

But has the underlying problem of liquidity gone away? A research note from Michael Howell of Crossborder Capital argues that, in the modern financial system, central banks are no longer the only, or even the main, providers of liquidity. Instead, the system looks a lot like that of the Victorian era, with banks dependent on the wholesale markets for funding. Back then, the trade bill was the key asset for bank financing; now it is the mysteriously named “repo” market.

A repurchase, or repo, agreement involves a borrower selling a bunch of securities for cash and agreeing to buy them back later for a higher price. The difference between the two prices represents the interest payment. The market is huge: a survey by the International Capital Market Association estimated that, in June this year, European repo agreements were worth €5.6 trillion ($6.4 trillion).

To borrow in the repo market, banks need assets to pledge against the loans—collateral, in other words. And, Mr Howell argues, it is the supply of, and demand for, collateral that determines liquidity in the financial markets.

The problem is that not all collateral is treated equally. Lenders worry that, if the borrower fails to repay, the securities they are left holding may not sell for their face value. So they apply a discount, or “haircut”, to the collateral, depending on its perceived riskiness. At times of stress, lenders get nervous and apply bigger discounts than before. This is what happened during the financial crisis (see table).

Bigger haircuts mean that borrowers need more collateral than before in order to fund themselves. “When market volatility jumps, funding capacity drops in tandem and often substantially,” writes Mr Howell. The result, a liquidity squeeze at the worst possible moment, is a template of how the next crisis may occur (although regulators are trying to reduce banks’ reliance on short-term funding).

Viewed in this light, global liquidity should not be measured merely by the size of central banks’ balance-sheets but by the availability of acceptable collateral as well. On Mr Howell’s calculations, global collateral shot up in the aftermath of the financial crisis, but grew much more slowly from 2012 onwards. This may explain why global growth has been so sluggish.

Traditional quantitative easing may do little to help. “Simply expanding the central bank balance-sheet by buying in Treasuries from the private sector is robbing Peter to pay Paul,” writes Mr Howell, since the bonds could have anyway been used as collateral for repo transactions.

Given that funding conditions resemble those in Victorian times, Mr Howell thinks that central banks should return to the policies favoured by Walter Bagehot, a former editor of this newspaper, and focus, above all, on the smooth running of the credit markets. If they do not, the risk is that a shortage of collateral may induce another funding squeeze; low as they are, government-bond yields may then fall even further as banks scramble to get hold of them for funding purposes.

This view is an interesting contrast with a popular investment theme of the moment—the idea of “quantitative tightening” (QT). Central banks are slowing their pace of asset purchases; China has been offloading some foreign-exchange reserves. Since many people think that central-bank purchases have been propping up the financial markets, their fear is that QT may cause bond yields to rise in the absence of central-bank support.

These differing interpretations point to the difficulty of analysing a broad concept like “global liquidity”. It is reminiscent of the problem of defining the money supply during the heyday of monetarism in the late 1970s and early 1980s. Everyone can agree that notes and coins are money but the wider the definition, the greater the scope for disagreement. Use the wrong measure, and the monetary signals may completely mislead. A fast-changing financial system makes things even harder: how does Bitcoin fit into global liquidity calculations?

Such complexity makes the withdrawal of monetary stimulus by central banks even more difficult. The IMF warned in a paper last year that “central banks’ exit strategy needs to be mindful of disruptions to the financial plumbing”. Even if they manage that trick, Mr Howell is surely right. One day the financial headlines will be dominated by worries about a collateral shortage.

Article 2

Australian banks

Like a shag on a rock

A good run for Australia’s big banks may be ending

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BANKS in Australia, like the rest of the country perhaps, have a certain upside-down quality to them. Their share prices broke free from the gravitational pull that dragged down their international rivals’ during the financial crisis. In recent years they have soared as others have sagged (see chart). Now that big banks in other rich countries are regaining their poise, it is the turn of Australia’s to slide. This topsy-turviness may yet continue given the worsening outlook Down Under.

Serving a buoyant domestic economy with none-too-fierce competition, and unburdened by flailing investment-banking arms, Australia’s big four lenders—Commonwealth Bank, National Australia Bank (NAB), ANZ and Westpac—used to delight shareholders with bumper dividends. But concerns over their balance-sheets and exposure to Australia’s frothy housing market have caused their shares to dip by 10%-16% in the past month. Annual results released in recent weeks lacked the ebullience of past years, with lending margins slipping and costs ticking up.

Investors fear that the exceptional circumstances underpinning the vibrant returns of recent years are coming to an end. The commodity “super-cycle” that boosted both Australia and its banks has fizzled. Unemployment is creeping up.

The biggest concern is the health of banks’ mortgage books. Home loans have been fabulously lucrative for Australian banks. According to Brian Johnson of CLSA, a brokerage, returns on them top 50%, levels which would make even pre-crisis Wall Street bankers salivate. A concentrated market—the big four dominate finance and move prices in lockstep—and rising house prices have kept margins high and losses low.

No wonder, then, that domestic home loans now represent 40-60% of Australian banks’ assets, up from 15-30% in the early 1990s. Mortgages in New Zealand account for another 5-10%. A growing number of loans are going to property speculators, or to homeowners paying back only the interest on their loan. That could make a downturn disastrous.

House prices have been supported by low interest rates around the world, which have helped funnel money into relatively high-yielding Australian assets (including bank stocks). This has been compounded by cheap money domestically: the central bank cut its main rate to 2% on May 6th, the lowest level ever—down from 4.75% in 2011.

Stress tests in November suggested that a property downturn would ravage banks. Around 80% of mortgages are variable-rate, so even a small rise in interest rates would result in higher repayments for borrowers and, in all likelihood, a surge in defaults. Regulators fret about the lack of diversification in banks, especially given their dependence on foreign money for funding. They want banks to curb growth in the riskiest mortgages and to finance them with more equity and less debt.

A government inquiry into the Australian financial system called for banks to be better capitalised. Dividend growth has slowed as a result; on May 6th NAB announced it would issue A$5.5 billion ($4.4 billion) in new shares, though some of that will go towards extricating it from its misfiring British subsidiary, Clydesdale Bank, which it wants to spin off. Collectively, Australian banks may need as much as A$40 billion in fresh capital to meet regulators’ demands.

The big four are still highly profitable, and their returns will remain better than most despite all the new equity they will have to raise. After all, banks around the world are being forced to fund themselves with more equity. Aussie borrowers are less likely to default on mortgages than American ones, as lenders have a claim on all their assets, not just the property in question. Loan-to-value ratios are stable.

But regulators’ changing tone has brought other concerns to the fore. Credit growth in Australia is slowing, raising the spectre of fiercer competition for market share. Expansion into crowded Asian markets seems difficult. That leaves little scope for the diversification watchdogs want. If they cannot make banks less dependent on mortgages, they will have to find other ways to make them safer.

Article 3

Global banks

Дата добавления: 2015-10-29