The moving parts of Australian bank wholesale funding costs

" Why are international investors demanding greater credit spreads from the major banks? In short, it’s because they can."
Philip Bayley, Industry Fellow, Monash University

Indeed, the key official Reserve Bank of Australia cash rate has not changed since it was lowered in April last year and most economists have expected another rate cut since then, not a rise.

So why has the cost of debt risen when the official cash rate hasn’t and is not expected to? One answer is as economic conditions weaken, interest rates will generally fall as demand for credit reduces. In the same way credit spreads will rise as lenders price in the increased risk of default in weak economic conditions.

It is the credit spread that has been rising for the banks and rising spreads make funding more expensive.

INCREMENTAL MOVEMENT

Examination of primary bond issuance by the major banks in the domestic market over the last year shows the credit spread on bonds with a five- year term to maturity has risen to 1.18 per cent in March, from a low of 0.80 per cent in May 2015.

The increase in cost is more than the typical 0.25 per cent incremental movement in the official cash rate favoured by the Reserve Bank (according to Reserve Bank data some term deposit rates also started moving up in February).

Yet it is hard to argue domestic economic conditions have deteriorated over the last 12 months or so.

Sure, the resource boom has ended and there are regional pockets of weakness but Australian Bureau of Statistics data show the overall economy grew at 3.0 per cent to the end of December and over the same period unemployment fell to 5.8 per cent from 6.2 per cent. The trend growth in the number of people employed increased by 2.2 per cent.

These measures do not suggest there will be a sudden rise in the level of bad debts experienced by the banking sector, at least not in consumer loan books.

EXTERNAL FACTORS

So maybe then it is external factors giving rise to concern, such as a persistent current account deficit that is being aggravated by the fall in commodity prices? Of course, this should be mitigated to some degree by a depreciating Australian dollar although its value has strengthened again in recent months. 

Examination of primary bond issuance by the major banks in international markets over the last year shows the credit spread on bonds with a five year term to maturity has ranged from as low as 1.01 per cent to 1.39 per cent, after being fully swapped back into Australian dollars.

Interestingly, the same 0.38 per cent increase in credit spreads is evident but so too is the greater credit spread demanded by international investors.

Moreover, looking at Charts 1 and 2, it is evident while spreads are increasing globally, they are increasing more for Australian issuers. That is, investors are asking a higher price for Australian risk.

Why are international investors demanding greater credit spreads from the major banks? In short, it’s because they can – international investors are well aware of the dependence of the banks on international debt markets to meet the funding requirement of their loan books.

As a result, international investors are the price setters for the banks’ wholesale funding. Arbitrage will ensure the cost of domestic wholesale funding is closely aligned.

While Australia’s major banks are dependent on international bond markets for term debt funding, international investors are not dependent on Australia’s major banks for investment opportunities.

Sure the major banks are among the most highly rated and profitable, in terms of return on equity and assets, in the world, but they are not the largest – they are not among the 29 global, systemically important banks identified by the Financial Stability Board.

Before considering the credit risk posed by the Australian banks, international investors will be focused on risks to the global banking system and will price those risks accordingly, as they change over time.

The credit risk posed by the major Australian banks will then be considered against this benchmark and priced as a tactical allocation in an international bond portfolio, as opportunities arise.

Depending on the relative position of the major Australian banks to developments in the global banking system, bonds issued by the banks will attract lower or higher pricing.

SPREADS

Consider the below chart, which shows the senior five-year credit default swap index for European financial institutions, compiled by index provider Markit. Against this, is mapped change in the five-year, credit default swap spread for ANZ.

The index represents the average of the five-year credit default swap spreads of the 30 largest financial institutions active across the euro zone.  The CDS spread for ANZ is used here because there is no equivalent index for the Australian market.

Moreover, the same CDS spreads for the other major banks tend to move in lock-step with those for ANZ. If nothing else, this demonstrates that institutional investors, domestic and international, do not differentiate between the major banks in any significant way. 

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For most of the last five years the credit risk of ANZ and, by implication, the credit risk of the major banks, has been assessed to be lower than that of European financial institutions, on average.

Over this period, the global banking system has had to deal with the increased capital and liquidity requirements of Basel III, along with little or no economic growth in the major developed economies of North America, Europe and Japan.

And in the euro zone, in particular, there was an extended period post-GFC, in which the viability of many banks was questionable.

Moves by the European Central Bank to prop-up many of the banks and the introduction of formal bank resolution schemes, quantitative easing and negative interest rates appear to have alleviated many of these concerns; sufficiently so, that since the beginning of this year, European financial institutions have been judged to be of lesser risk than the major Australian banks.

The significant collapse in iron ore and oil prices, to even lower levels than those seen in 2015, has been the focus of international investors since then, along with the implications of this for the credit quality of the Australian banks.

Australia is generally seen by international investors as being a proxy for China, and slowing economic growth in China is a driver of the collapse in iron ore prices and to a lesser extent, falling oil prices.

The connection between Australia and China is illustrated in the below chart, which presents credit default swap spread movements for Chinese sovereign risk and movements in Markit’s iTraxx Australian credit default swap index. The two measures have exhibited a correlation of 93 per cent since the end of the first quarter of 2015.

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Going forward, the introduction of so called ‘Basel IV’ total loss absorption capacity standards will affect all banks and not the Australian banks in particular. However, the introduction of a formal bank resolution scheme in Australia that goes beyond the extensive discretionary powers already held by APRA may well have an impact on the perceptions of international investors about the credit quality of Australian banks.

Indeed, anything that adversely impacts the credit quality of the major banks will drive up the cost of wholesale debt funding. Moves by the major credit rating agencies to lower the credit ratings of the major banks directly, or through the loss of Australia’s triple A credit rating, will drive up wholesale funding costs.

One factor that international investors do focus on, almost to the point of obsession, is the residential house price ‘bubble’. Should a ‘bubble’ (if indeed it exists) burst there will be obvious implications for the banks’ cost of debt.

Meanwhile, local developments such as a Royal Commission into the conduct of banks or provision of enhanced regulatory powers to ASIC are unlikely to register. Intense scrutiny of bank conduct is a global phenomenon.

Dr Philip Bayley is an Industry Fellow in the Department of Banking & Finance at Monash University, an advisor to AustralianSuper and Smarter Money Investments, a director of Australia Ratings, principal of industry consultancy, ADCM Services, and publisher of The DCM Review.