The fall from peak just a few months back has now risen to 117.4 basis points, compared with 114.9 last week and now 82 basis lower than the previous low last year. So bank funding continues to ease.
This week we will get the RBA and Fed minutes, otherwise it is a lighter week for data, though Central Bankers will be at the Jackson Hole Symposium, Wyoming, USA discussing “Challenges for Monetary Policy” – timely or what… and our own Philip Lowe will be in attendance and participating in a panel discussion.
Personally I think the title should have been the failure (or limits) of monetary policy! Central Bankers still think they pull the strings on the global economy, it’s a pity they fail to see the levers are not connected to the real world any more.
Reflecting the era ahead, the BBSW fell again and is now 114.9 basis points from peak just over 6 months ago.
This week we get June wages growth data on Wednesday and Jobs growth Thursday. We will also get more consumer confidence data on Tuesday and Wednesday, as well as a further read on business confidence.
In addition, China will release more data on Wednesday covering sales, investment and production, interesting in the context of the trade wares.
The profit reporting continues with Bendigo and Adelaide Bank already released today and Insurer QBE on Thursday.
Finally, the RBA will be busy, with Christopher Kent, Assistant Governor (Financial Markets) speaking on Tuesday, and Guy Debelle, Deputy Governor – Risks to the Outlook – on Thursday.
In the June RBA Bulletin, there was an article which describes how the RBA executes its market interventions to effect a cash rate change. It is important to understand these inner workings, despite it appearing complicated on first blush.
And consider this, this tool box is being used by many central banks around the world to direct the financial system.
In summary, the RBA’s operations in domestic markets support the implementation of monetary policy. The most important tool to guide the cash rate to the target set by the Board is the interest rate corridor. To support this, the RBA pursues daily open market operations in order to keep the pool of exchange settlement (ES) balances at the appropriate level for the cash market to function smoothly. The daily market operations are conducted to offset the effects on liquidity of the many transactions between the banking system and the Australian Government. Open market operations are primarily conducted through repos and FX swaps. These provide flexibility for liquidity management and also help to manage risk for the RBA’s balance sheet.
The cash rate is a key determinant of interest rates in domestic financial markets and hence underpins the structure of the interest rates that influence economic activity and financial conditions more generally.
This helps to explain the sharp falls in the BBSW rates, which are now around 87 basis points lower than the recent peak. Such a fall has been engineered.
The cash rate is an effective instrument for implementing monetary policy because it affects the broader interest rate structure in the domestic financial system. The cash rate is an important determinant of short-term money market rates, such as the bank bill swap rate (BBSW), and retail deposit rates (Graph 1). These rates – as well as a number of other factors – then influence the funding costs of financial institutions and the lending rates faced by households and businesses. As a result, the cash rate influences economic activity and inflation, enabling the RBA to achieve its monetary policy objectives. However, while changes in the cash rate are very important, they are not the only determinant of market-based interest rates. Other factors, such as expectations, conditions in financial markets, changes in competition and risks associated with different types of loans are also important.
Graph 1
The Cash Market and the Interest Rate Corridor
The RBA implements monetary policy by setting a target for the cash rate. This is the interest rate at which banks lend to each other on an overnight unsecured basis, using the exchange settlement (ES) balances they hold with the RBA. ES balances are at-call deposits with the RBA that banks use to settle their payment obligations with other banks. Banks are required to have a positive (or zero) ES balance at all times, including at the end of each day. It is difficult for institutions to predict whether they will have adequate funds at the end of any particular day, which generates the need for an interbank overnight cash market. Those banks that need additional ES balances after they have settled all payment obligations of their customers, borrow from banks with surplus ES balances. The interbank cash market is the mechanism through which these balances are redistributed between participants.
The RBA sets the supply of ES balances to ensure that the cash market functions smoothly by
providing an appropriate level of ES balances to facilitate the settlement of interbank
payments. The RBA manages the supply of ES balances available to the financial system through
its open market operations (see below). Excessive ES balances could lead institutions to lend
below the target cash rate, while a shortage might result in the cash rate being bid up above
the target.
The interest rate corridor ensures that banks have no incentive to deviate significantly from
the cash rate target when borrowing or lending in the cash market. Banks can borrow ES balances
overnight on a secured basis from the RBA at a margin set 25 basis points above the cash rate
target. As a result, banks have no need to borrow from other banks at a higher rate. Similarly,
banks receive interest on their surplus ES balances at 25 basis points below the cash rate
target. Therefore, they have no incentive to lend to other banks at a lower rate.
The operation of the interest rate corridor means that there is no need for the RBA to adjust
the supply of ES balances to bring about a change in the cash rate (Graph 2 and Graph 3). For
example, when the RBA lowered the cash rate target by 25 basis points from 1.5 per cent
to 1.25 per cent in early June, the rates associated with the corridor also moved
lower, to be 1.0 per cent on overnight deposits and 1.5 per cent on
overnight loans (down from 1.25 per cent and 1.75 per cent). A bank that
would have previously required a return above 1.25 per cent to lend ES balances in the
cash market is, under the new corridor, willing to lend at a lower return. And so a bank wanting
to borrow cash pays a lower rate than before. Similarly, if the RBA had instead raised
the cash rate by 25 basis points from 1.5 per cent, the corridor would have moved up,
to be 1.5 per cent to 2.0 per cent. A bank that would have previously lent
surplus ES funds to another in the cash market at 1.50 per cent would, under the new
corridor, no longer have an incentive to do so. Indeed, it would require a higher return to lend
ES balances, rather than leaving those funds in its ES account and receiving 1.50 per cent
from the RBA. Hence, a bank wanting to borrow in the cash market would have to pay a higher
interest rate than it did previously.
In other words, interbank transactions automatically occur within the interest rate corridor without the RBA needing to undertake transactions beyond its usual market operations to manage liquidity.
Graph 2
Graph 3
The incentives underlying the corridor guide the cash rate to the target and ordinarily all transactions occur at the rate announced by the RBA. The last time there was a small deviation in the published cash rate (which is a weighted average of all transactions in the cash market) from the target (of 1 basis point for two days) was in January 2010 (Graph 4). The lack of deviation of the cash rate from the target has brought about a self-reinforcing market convention where both borrowers and lenders in the cash market expect to transact at the prevailing target rate. This market convention helps to address the uncertainty that banks would otherwise face about the price at which they can borrow sufficient ES balances to cover their payment obligations each day. In 2018, daily transactions in the overnight interbank market were typically between $3 billion and $6 billion.
Graph 4
As in Australia, many other central banks implement monetary policy with an interest rate corridor to guide the policy rate. The width of the corridor tends to differ, typically from 50 to 200 basis points. The choice of the width of the corridor is seen as a reflection of a trade‐off between interest rate control and the desire to avoid the central bank becoming an intermediary in the money market. All other things being equal, cross-country studies suggest that a narrower corridor is preferred by central banks that have a strong preference for low volatility of short-term interest rates, whereas a wider corridor is usually preferred by central banks that seek to encourage more interbank trading activity.
Over the past 10 years, many central banks (other than the RBA) have significantly expanded
their balance sheets. This has resulted in significantly more liquidity in their respective
systems and so banks typically do not need to borrow funds in the overnight cash market. In
these cases, the policy rate typically converges toward the rate on deposits paid by the central
bank; this is often referred to as a ‘floor system’. Small changes in liquidity in
such a system do not tend to have much effect on the policy rate.
Liquidity Management and Open Market Operations
Transactions between the government (which banks with the RBA) and the commercial banks would, by themselves, change the supply of ES balances on a daily basis. ES balances in accounts of commercial banks increase whenever the government spends out of its accounts at the RBA. Similarly, when the government receives cash into its accounts at the RBA, such as from tax payments or debt issuance, ES balances decline. The RBA monitors and forecasts these changes actively through the day. It offsets (i.e. ‘sterilises’) these changes in ES balances with its daily open market operations so that government receipts and payments do not affect the aggregate level of ES balances. If transactions that affect system liquidity were not offset by the RBA, ES balances would be much more volatile and the payments system would suffer frequent disruptions (Graph 5). Ultimately this is likely to lead to a more volatile cash rate.
Graph 5
The main tools used in open market operations are repurchase (repo) agreements and foreign exchange swaps. Both repos and foreign exchange swaps involve a first and a second leg (Figures 1 and 2):
The first leg of a typical repo in open market operations (which injects ES balances)
involves the RBA providing ES balances to a bank and the bank providing eligible debt
securities as collateral to the RBA. Taking collateral safeguards the RBA against loss in
the case of counterparty default. The second leg, which occurs at an agreed future date,
unwinds the first leg: the bank returns the ES balances and the RBA returns the securities
to the bank.
The first leg of a foreign exchange swap designed to inject ES balances into the system
involves the RBA providing ES balances to a bank and the bank providing collateral in the
form of foreign currency to the RBA (typically US dollars, euros or Japanese yen). The
second leg, at the agreed future date, consists of the bank returning the ES balances and
the RBA returning the foreign exchange.
Figure 1
Figure 2
Repos and swaps provide more flexibility for liquidity management than outright purchases or sales of assets since they involve a second leg (when the transaction unwinds) with a date chosen to support liquidity management on that day. It also allows the RBA to accept a much broader range of collateral, such as unsecured bank paper, than it would be willing to purchase outright. By contrast, buying (and then selling) securities outright requires the RBA to take on the price and liquidity risk associated with owning the assets outright. Conducting open market operations by buying and selling government securities outright, while also ensuring that the RBA’s market operations do not affect liquidity in the bond market, would require more government securities than are available in Australia.
The size of daily open market operations is based on forecasts of daily liquidity flows between
the RBA’s clients (mainly the Australian Government) and the institutions with ES accounts.
In a typical round of market operations, a public announcement is made at 9.20 am that the RBA
is willing to auction ES balances against eligible collateral for a certain number of days
(ranging from two days to several months, with an average term of around 30 days). Institutions
have 15 minutes to submit their bid. The RBA ranks these bids from highest to lowest repo
rate and then allocates ES balances to the highest bidders until the amount the RBA intends to
auction has been dealt. All auction participants are informed electronically about their
allocation. If they have been successful, they will pay the rate at which they bid for the
amount allocated. The aggregate results of the auction, including the amount dealt, the average
repo rate and the lowest repo rate accepted are published.
Market Operations and the RBA Balance Sheet
The transactions entered into as part of open market operations are reflected in changes in the
RBA’s balance sheet. Changes in the size and composition of liabilities (mainly issuance of
banknotes and government deposits) may need to be offset via open market operations to ensure
that the availability of ES balances remains appropriate for the smooth functioning of the cash
market (Graph 6).
Graph 6
Open market operations affect the asset side of the balance sheet (Graph 7). When the RBA purchases securities under repo, it has a legal claim on the security that was transferred as collateral for the duration of the repo. These claims appear as assets on the balance sheet, along with outright holdings of domestic government securities. When the RBA uses foreign exchange swaps to supply Australian dollars into the local market, the foreign currency-denominated investments associated with the swap are also reflected as assets on the balance sheet. The choice between using repo, foreign exchange swaps or outright purchases to adjust the supply of ES balances is determined by market conditions and pricing. When a large amount of ES balances needs to be supplied or drained, such as when a government bond matures, the RBA might choose to do so using a combination of instruments.
Graph 7
The RBA supplies ES balances not only for monetary policy implementation but also to facilitate
the functioning of the payment system. Over recent years, the RBA has been providing more ES
balances to banks to enable the settlement of payments outside normal banking hours, such as
through direct-entry and the New Payments Platform. These ES balances are supplied under ‘open
repos’. An open repo is set up in a similar way to the repo explained in Figure 1, with
the initial leg transferring ES balances to banks in return for eligible debt securities as
collateral. However, the date of the second leg is not specified, so it is open ended. The ES
balances are available (and the claim on securities remain on the RBA’s balance sheet) until
the open repo is closed out. These ES balances provided under open repo are held purely to
facilitate the effective operation of the payments system after hours and cannot be lent
overnight in the cash market. As a result, they have no implications for the implementation of
monetary policy. Currently, these balances are around $27 billion. The remainder of ES
balances that are available for trading in the cash market are referred to as ‘surplus ES
balances’, and are the focus of daily open market operations. Recently, surplus ES
balances have been around $2–3 billion. This amount has increased in recent years as
demand for balances has risen, partly in response to new prudential regulations on liquidity.
The Bank Bill Swap Rate continues to fall, reflecting lower rates here are overseas. This should give the banks more ability to pass on full rate cuts and protect their margins. Remember that a few months we were looking at significant positive swings, now we are ~46 basis points down compared with the low point past year.
Yes, deposit holds are seeing rates being chopped by 25 basis points or more, as banks seek to repair margins and compete for mortgage refinancing. The race towards zero continues….
The Bank Bill Swap Rate continues to track down, which means that Banks are sitting on considerable funding advantage, which is being used to discount attractor mortgage rates.
However, there is a strong case now for banks to reverse their out of cycle rate hikes imposed on borrowers over recent months, irrespective of whether the RBA moves the cash rate down next month.
This would help household with their budgets, and help support the weakening economy. They could also stop the rot in terms of falling bank deposit rates.
Just days after CBA announced it was cutting its rates and stepping away from its competitors, another big four has matched the changes across the board – and likely triggered a continued decrease in fixed rates at lenders of all sizes.
The newly announced decreases go into effect at Westpac tomorrow for
fixed rate loans paying P&I and are open to both new and existing
customers switching into a fixed rate.
“As expected, it hasn’t taken Westpac long to match the fixed rate cuts this week from Commonwealth Bank,” said Steve Mickenbecker, Canstar group executive of financial services.
“These decreases are a further sign that the big banks are wanting to
fight back to regain the market share losses to the local arms of
foreign banks and other domestic lenders over the past 12-months.”
At Westpac, the three- and five-year fixed rates for owner occupiers
paying P&I are to decrease by 0.10% while the four-year rate will
drop by 0.20%.
Fixed rates will also decrease for investors paying P&I, by 0.06%
for two-year, 0.20% for three-year, and 0.10% for five-year,
demonstrating “the bank’s desire to increase investment lending in the
face of declining demand,” according to Mickenbecker.
Other lenders have already been making moves of their own to stay competitive.
Suncorp has announced a discount for its three-year fixed package
rates for eligible new home lending, meaning the non-major currently has
the lowest three-year fixed rate in the market at 3.49% for owner
occupied and 3.69% for investment.
“We are now eagerly awaiting the response from the other two major
banks and the rest of the market, in light of these competitive fixed
rates from the country’s two biggest lenders,” concluded Mickenbecker.
The Bank Bill Swap Rate has been moving higher recently, suggesting more bank funding pressure ahead. Expect more deposit rate cuts (banks can do this and get almost no coverage or complaints, weirdly), whereas mortgage repricing always gets attention.
No help to those households reliant on income from deposits. We think the banks are still sitting on eroding margins.
He concludes that “Global developments undoubtedly influence Australian financial conditions. In particular, developments abroad can influence the value of the Australian dollar and affect global risk premia. But changes in monetary policy settings elsewhere need not, and do not, mechanically feed through to the funding costs of Australian banks, and hence their borrowers are insulated from such changes”.
But the higher bank funding rate spreads which see here are perhaps more of a reflection of the risks the markets are pricing in, than anything else. Yet this was not discussed. Too low rates here for several years are the root cause (and guess where the buck for that stops?). This led to overheated lending, and home prices, which are now reversing, with obvious pressures on the banks. This leaves the economy open to higher rates, from overseas ahead.
This is the speech:
Australia is a small open economy that is influenced by developments in the rest of the world.
Financial conditions here can be affected by changes in monetary policy settings elsewhere, most
particularly in the United States given its importance for global capital markets. However,
Australia retains a substantial degree of monetary policy autonomy by virtue of its floating
exchange rate. In other words, a change in policy rates elsewhere need not mechanically feed
through to Australian interest rates. While Australian banks raise significant amounts of
funding in offshore markets, they are able to insulate themselves – and by extension
Australian borrowers – from changes in interest rates in other jurisdictions.
Just before delving into the details, some context is in order. First, Australian banks have long
borrowed in wholesale markets, including those offshore. However, they do so much less than used
to be the case (Graph 1).[1]
For a number of reasons, domestically sourced deposits have become an increasingly large share of
overall funding for banks.[2]
Graph 1
Second, to the extent that Australian banks have continued to tap offshore wholesale markets, it
is worth reflecting on some of the characteristics of this borrowing. For instance, some
banking sectors around the world borrow in US dollars in order to fund their portfolios of US
dollar assets.[3] This
can leave them vulnerable to intermittent spikes in US interest rates. However, this is
generally not the case for Australian banks. Rather, a good deal of the borrowing by Australian
banks in US dollars reflects the choice of the banks to diversify their funding base in what are
deep, liquid capital markets. By implication, if the costs in the offshore US dollar funding
market increased noticeably relative to the home market, then Australian banks can pursue other
options. They might opt to issue a little less in the US market for a time, switching to other
markets or even issuing less offshore. They are not ‘forced’ to acquire US dollars
at any price, as some other banks may be. Another important feature of this offshore funding, as
I will address in detail in a moment, is that the banks are not exposed to exchange rate risks
as they hedge their borrowings denominated in foreign currencies.
Independence – It’s an Australian Dollar Thing
As you are well aware, the US Federal Reserve has been raising its policy rate in recent years,
and interest rates in the United States are now higher than in Australia. These developments
reflect differences in spare capacity and inflation: unemployment in the United States is at
very low levels, inflation is at the Fed’s target and inflationary pressures appear to be
building. Since August 2016 – the last time the Reserve Bank changed its cash rate
target – the Federal Reserve has raised its policy rate seven times, by 175 basis points
in total (Graph 2). Yet while Australian banks raise around 15 per cent of their
funding in US dollars, interest rates paid by Australian borrowers since then have been little
changed.
Graph 2
How is it that interest rates for Australian borrowers have been so stable, despite Australian
banks having borrowed some US$500 billion in the US capital markets, in US dollars, paying US
dollar interest rates? The answer lies in the hedging practices of the Australian financial
sector. As I’ll demonstrate, Australian banks use hedging markets to convert their US
interest rate obligations into Australian ones.
The Australian banks fund their Australian dollar assets via a number of different sources. Some
of their funds are obtained in US dollars from US wholesale markets. In order to extend these
USD funds to Australian residents, they convert the US dollars they have borrowed into
Australian dollars soon after the securities are issued in the US. On the surface it would
appear that such transactions could give rise to substantial foreign exchange and interest rate
risks for Australian banks given that:
the banks must repay the principal amount of the security at maturity in US dollars. So an
appreciation of the US dollar increases the cost of repaying the loan in Australian dollar
terms; and
the banks must meet their periodic coupon (interest) payments in US dollars, which are tied to
US interest rates (either immediately if the security has a floating interest rate, or when
the security matures and is re-financed). So a rise in US interest rates (or an appreciation
of the US dollar) would increase interest costs for Australian banks that extend loans to
Australian borrowers.
However, it is standard practice for Australian banks to eliminate, or at least substantially
reduce, these risks. They can do this using a derivative instrument known as a cross-currency
basis swap. Such instruments are – when used appropriately – a relatively
cost effective way of transferring risks to parties with the appetite and capacity to bear them.
Simply put, cross-currency basis swaps allow parties to ‘swap’ interest rate streams
in one currency for another. They consist of three components (Figure 1):
first, the Australian bank raises US dollars in the US wholesale markets. Next, the
Australian bank and its swap counterparty exchange principal amounts at current spot
exchange rates; that is, the Australian bank ‘swaps’ the US dollars it has just
borrowed and receives Australian dollars in return. It can then extend Australian dollar
loans to Australian borrowers;
over the life of the swap, the Australian bank and its swap counterparty exchange a stream
of interest payments in one currency for a stream of interest receipts in the other. In this
case, the Australian bank pays an Australian dollar interest rate to the swap counterparty
and receives a US dollar interest rate in return. The Australian bank can use the interest
payments from Australian borrowers to meet the interest payments to the swap counterparty,
and it can pass the interest received from the swap counterparty onto its bondholders;
At maturity of the swap, the Australian bank and its swap counterparty re-exchange principal
amounts at the original exchange rate. The Australian bank can then repay its bond
holders.[4]
In effect, the Australian bank has converted its US dollar, US interest rate obligations into
Australian dollar, Australian interest rate obligations.
Figure 1
An analogy related to housing can help to further the intuition here. Imagine a
Bloomberg employee who owns an apartment in New York but has accepted a temporary job in Sydney.
She fully expects to return to New York and wishes to keep her property, and she does not wish
to purchase a property in Sydney. The obvious solution here is for her to receive rent on her
New York property and use it to pay her US dollar mortgage. Meanwhile, she can rent an apartment
in Sydney using her Australian dollar income. In other words, our relocating worker can
temporarily swap one asset for another. As a result, she can reduce the risks associated with
servicing a US mortgage with an Australian dollar income.
As I mentioned earlier, it is common practice for Australian banks to hedge their foreign
currency borrowings with derivatives to insulate themselves and their Australian borrowers from
fluctuations in foreign exchange rates and interest rates. The most recent survey of hedging
practices showed that around 85 per cent of banks’ foreign currency liabilities
were hedged (Graph 3). Also, the maturities of the derivatives used were well matched to
the maturities of the underlying debt securities.[5]
This means that banks were not exposed to foreign currency or foreign interest rate risk for the
life of their underlying exposures. By matching maturities, banks also avoided the risk that they
might not be able to obtain replacement derivatives at some point in the future (so called
roll-over risk).
Graph 3
For the very small share of liabilities that are not hedged with derivatives, there is almost
always an offsetting high quality liquid asset denominated in the same foreign currency of a
similar maturity, such as US Treasury Securities or deposits at the US Federal Reserve. Taken
together, these derivative hedges and natural hedges mean than Australian banks have only a very
small net foreign currency and foreign interest rate exposure overall (Graph 4).
Graph 4
So who is bearing the risk?
Despite Australia’s external net debt position,
in net terms Australian residents have passed on – for a cost, as we shall see – key
risks associated with their foreign currency liabilities to foreign residents. Australian
residents have found enough non-residents willing to lend them Australian dollars and to receive
an Australian interest rate to extinguish their foreign currency liabilities. As a result,
Australians are net owners of foreign currency assets, not borrowers.[6] Collectively,
Australians have used hedging markets and natural hedges to (more than) eliminate their
exchange-rate exposures associated with raising funds in offshore markets.
Australians’ ability to find non-residents willing to assume Australian dollar and Australian
interest rate risks is a reflection of the willingness of non-residents to invest in Australian
dollar assets. This in turn reflects Australia’s status as a country that has long had strong
and credible institutions, a high credit rating and mature and liquid capital markets. The
willingness of these non-resident counterparties to assume these risks via a direct exposure to
Australia’s banking system – sometimes for as long as thirty years – reflects the fact that
Australia’s banks are well-capitalised and maintain high credit ratings. In short, Australians
have found a source of finance unavailable domestically (at as reasonable a price), and
non-residents have found an asset that suits their portfolio needs.
Since there are no free lunches in financial markets, there is the question of the cost for
Australian banks to cover these arrangements. One part of this cost is known as the basis.
An imperfect world
Some swap counterparties have an inherent reason to enter into
swap transactions with Australian banks. In other words, such exposures actually help them to
manage their own risks. Non-residents that issue Australian dollar debt – in the so called
Kangaroo bond market – are a case in point. These issuers raise Australian dollars to fund
foreign currency assets they hold outside of Australia. This makes them natural counterparts to
Australian banks wanting to hedge their foreign currency exposures. Similarly, Australian
residents invest in offshore assets. To the extent that they want to hedge the associated
exchange rate exposures, they too would be natural counterparties for the Australian banks.
However, it turns out that these natural counterparties do not have sufficient hedging needs to
meet all of the Australian dollar demands of the Australian banks. So in order to induce a
sufficient supply of Australian dollars into the foreign exchange swap market, Australian banks
pay an additional premium to their swap counterparts on top of the Australian dollar interest
rate. This premium, or hedging cost, is known as the basis. Simply put, the basis is the price
that induces sufficient supply to clear the foreign exchange swap market.[7]
Since the start of the decade, the basis has oscillated around 20 basis points per annum (Graph 5).
Typically, though not always, the longer a bank wishes to borrow Australian dollars, the higher
the premium it must pay over the Australian dollar interest rate.
Graph 5
You may be wondering why Australian banks are willing to pay this premium; why don’t they
instead only borrow Australian dollars in the Australian capital markets to meet their financing
needs? In addition to the prudent desire to have a diversified funding base as I mentioned
earlier, the short answer is that it may not be cost-effective to raise all their funding at
home. What tends to happen is that banks – to the extent possible – seek to equalise
the marginal cost of each unit of funding from different sources. If they were to obtain all of
their funding at home, that would be likely to increase the cost of those funds relative to
funds sourced from offshore. So the all-in-cost of the marginal Australian dollar from domestic
sources will tend to be about the same as the marginal dollar obtained from offshore.
Astute students of finance will also wonder why the basis is not arbitraged away.[8]
The answer is that structural changes in financial markets have widened the scope for market
prices to deviate from values that might prevail in a world of no ‘frictions’. This
is consistent with the concept of ‘limits to arbitrage’ (which the academic
community only started to re-engage with in the past couple of decades). Arbitrage typically
requires the arbitrageur to enlarge their balance sheet and incur credit, mark-to-market and/or
liquidity risk. As Claudio Borio of the BIS has noted: balance sheet space is rented, not free.
And the cost of that rent has gone up.[9]
What about financial conditions more generally?
None of this is to suggest that
monetary policy settings in the United States (and elsewhere for that matter) have no impact on
financial conditions here in Australia. But the link is neither direct nor mechanical.
The primary channel through which foreign interest rates influence Australian conditions is
through the exchange rate. An increase is policy rates elsewhere will, all else equal, tend to
put downward pressure on the Australian dollar, because capital is likely to be attracted to the
higher rates of return available abroad. A depreciation of the Australian dollar in turn will
tend to enhance the competitiveness of our exporters, including those services priced in
Australian dollars like tourism and education. Through various channels, exchange rate
depreciation can also loosen financial conditions in Australia, which is not always the case in
other countries, particularly those for which inflation expectations are not well anchored and
where there are substantial foreign currency borrowings that are unhedged.[10]
Foreign monetary policy settings, particularly those in the United States, can also affect global
risk premia. We are now approaching a period when US monetary policy is moving to a neutral
stance. This follows a lengthy period of very easy monetary conditions, which may have
encouraged investors to ‘search for yield’ to maintain nominal portfolio returns in
an environment of low interest rates. The expectation of low and stable policy rates and
inflation outcomes in turn compressed risk premia across a range of asset classes. In the period
ahead, it seems plausible that term and credit risk premia will rise, which will increase costs
for all borrowers, Australian banks included.
ASIC says the Federal Court of Australia today ordered Westpac Banking Corporation (Westpac) pay a pecuniary penalty of $3.3 million for contravening s12CC of the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) through its involvement in setting BBSW in 2010.
In reasons for making the pecuniary penalty order, Justice Beach noted the legislative constraint he had in imposing the order,
‘If I had been permitted to do so I would have imposed a penalty of at least one order of magnitude above $3.3 million in order to discharge [the objectives of specific and general deterrence]. But I am not free do so.‘
Justice Beach concluded in his reasons,
‘Westpac’s misconduct was serious and unacceptable…Westpac has not shown the contrition of the other banks. Moreover, imposing the maximum penalty is the only step available to me to achieve specific and general deterrence. The message that should be sent is that if you manipulate or attempt to manipulate key benchmark rates you are likely to have the maximum penalty imposed, whatever that is from time to time.‘
The Court also ordered that an independent expert agreed between ASIC and Westpac be appointed to review whether Westpac’s current systems, policies and procedures are appropriate, and to report back to ASIC within 9 months.
It was also ordered that Westpac pay ASIC’s costs of and incidental to the penalty hearing as agreed and assessed.
Today’s court orders follow Justice Beach’s judgment, delivered on 24 May 2018, which found that Westpac on 4 dates in 2010 traded with a dominant purpose of influencing yields of traded Prime Bank Bills and where BBSW set in a way that was favourable to its rate set exposure. His Honour held that this was unconscionable conduct in contravention of s12CC of the ASIC Act.
His Honour also found in his 24 May 2018 judgment that Westpac had inadequate procedures and training and contravened its financial services licensee obligations under s912A(1)(a), (c), (ca) and (f) of the Corporations Act 2001 (Cth).
ASIC Commissioner Cathie Armour welcomed today’s decision and noted that ‘ASIC brought this litigation to hold the major banks to account for their unacceptable conduct, and to test the scope of the law in combating benchmark manipulation. ASIC actions have led to these successful court outcomes, and also contributed to new benchmark manipulation offences being enacted by Parliament, and the calculation method and administration of the BBSW being radically overhauled.’
On 5 April 2016 ASIC commenced civil penalty proceedings in the Federal Court against Westpac, alleging in the period between 6 April 2010 and 6 June 2012 (inclusive) it traded in a manner that was unconscionable and created an artificial price and a false appearance with respect to the market for certain financial products that were priced or valued off BBSW.
This mirrored proceedings brought in the Federal Court against the Australia and New Zealand Banking Group (ANZ) on 4 March 2016 (refer: 16-060MR), against National Australia Bank (NAB) on 7 June 2016 (refer: 16-183MR) and Commonwealth Bank of Australia (CBA) on 30 January 2018 (refer:18-024MR).
On 10 November 2017, the Federal Court made declarations that each of ANZ and NAB had attempted to engage in unconscionable conduct in attempting to seek to change where the BBSW set on certain dates and that each bank failed to do all things necessary to ensure that they provided financial services honestly and fairly. The Federal Court imposed pecuniary penalties of $10 million on each bank.
On 20 November 2017, ASIC accepted enforceable undertakings from ANZ and NAB which provides for both banks to take certain steps and to pay $20 million to be applied to the benefit of the community, and that each will pay $20 million towards ASIC’s investigation and other costs (refer: 17-393MR).
On 21 June 2018, the Federal Court in Melbourne imposed pecuniary penalties totalling $5 million on CBA for attempting to engage in unconscionable conduct in relation to BBSW. CBA admitted to attempting to seek to change where BBSW set on five occasions in the period 31 January 2012 to 15 June 2012.
On 11 July 2018 ASIC accepted a court enforceable undertaking to address its BBSW conduct which provides for CBA will pay $15 million to be applied to the benefit of the community and $5 million towards ASIC’s investigation and legal costs (refer: 18-210MR).
In July 2015, ASIC published Report 440, which addresses the potential manipulation of financial benchmarks and related conduct issues.
The Government has recently introduced legislation to implement financial benchmark regulatory reform and ASIC has consulted on proposed financial benchmark rules.
On 21 May 2018, the new BBSW methodology commenced (refer: 18-144MR). The new BBSW methodology calculates the benchmark directly from market transactions during a longer rate-set window and involves a larger number of participants. This means that the benchmark is anchored to real transactions at traded prices.
We track the movement in the Bank Bill Swap Rate, as this directly, or indirectly impacts Australian bank funding costs, and of course has led to significant numbers of smaller banks repricing their mortgage books higher in recent weeks.
The latest data shows that last week the 3 month benchmark fell very slightly, leaving funding costs 23.50 basis points higher than the lows in February.
This mirrors recent changes in the US 3-Month rate which is also slightly lower, but we also note that locally some overseas investors are repatriating money back to the US (encouraged by recent tax changes) and perceived elevated risks in the banking system here, relative to the USA.
The main force at work which may still lift mortgage portfolio rates higher is the aggressive attractor rates now available from several of the major banks as they fight to write the lions share of smaller loan volumes. Our surveys suggest that lower risk owner occupiers and investors can wrangle some really cheap rates at the moment. But this puts more pressure on margins and the back book.
At some point the funding pressure dam will burst….
