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Can Australian banks withstand a liquidity crisis?

 

27 March 2020

Investment

 

 

 

 

 

Countries are in lockdown and economies have ground to a halt as governments take firm action to control the spread of COVID-19. Investors thinking beyond the immediate health crisis want to know: how well protected are Australian banks from financial disruptions that may follow?

The last major shock to the global banking system came with the financial crisis in 2008-09. That crisis caused widespread damage to financial systems and highlighted that banks in many countries had not always managed the risks associated with their activities appropriately.

But thanks to steps that have been taken since the financial crisis to improve the banking system’s resilience, financial institutions globally - and in Australia particularly - are now in a far better position to withstand adverse shocks than they were in the past.

Specifically, regulatory authorities such as the Australian Prudential Regulation Authority (APRA), financial institutions and financial markets globally have:

  • increased their focus on risk and resilience in the banking sector by managing banks’ capital and liquidity positions, and
  • implemented a revised framework for capital and liquidity requirements.

The aim is to ensure banks have adequate capital and liquidity positions.

A bank’s capital position refers to the difference between its assets and liabilities. A bank's capital provides it with the ability to absorb losses.

Liquidity refers to a bank’s ability to meet financial liabilities when they are due, such as returning cash deposits to consumers and businesses that have entrusted their savings to the bank, when requested.

A healthy capital and liquidity position allows a bank to withstand a financial shock in much the same way as a large asset base and reliable income stream can help an individual to absorb a temporary financial setback.

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Strengthening the capital position

In Australia, the 2014 Financial System Inquiry introduced a number of additional measures to strengthen the Australian financial system.

These included ensuring Australian banks’ capital ratios are ‘unquestionably strong’.

To determine whether a bank’s capital ratio is ‘unquestionably strong’, APRA looks at the quality of its capital, assessing what proportion is the most secure form, known as the Common Equity Tier 1 (CET1) capital.

To be considered ‘unquestionably strong’, the types of CET1 capital which includes retained earnings and common shares, must form at least 10.5% of the overall bank’s capital.

Other types of instruments such as contingent convertibles or hybrid securities also make up the bank’s broader capital requirements, but are assessed at a secondary level.

Australian banks have substantially increased their capital ratios since the financial crisis in 2008. The quality of their capital has also improved.

Based on Tier 1 capital ratios, the major Australian banks also appear strong relative to international banks.

Strengthening liquidity

Another important component of banks’ resilience is their ability to withstand significant funding withdrawals.

Banks can obtain the funds they need to run their businesses and offer loans to customers - such as mortgages, business loans, and credit cards - from a range of sources including:

  • Retail deposits from consumers and small-to-medium sized businesses
  • Wholesale deposits from large corporations, pension funds and government
  • Wholesale debt such as funds borrowed on interbank lending markets
  • Equity from shareholders

The financial crisis showed that many banks globally relied too heavily on short-term funding from the interbank lending markets. As a result, when faced with disruptions in these funding markets, banks struggled to continue to operate as usual as they could not access the funds they needed at the time when they needed them.

Regulators responded to these lessons from the crisis by introducing new prudential liquidity requirements. Banks now have to adhere to minimum liquidity standards to ensure they hold stronger buffers in case of liquidity shocks.

One requirement is that banks must hold a buffer of High Quality Liquid Assets, which can be quickly and reliably converted to cash, to cover net cash outflows in a 30-day stress scenario.

Australian Government Securities and State government securities are examples of this type of asset. Since the financial crisis, banks have increased the proportion of these assets that they hold.

Another liquidity requirement is that banks must hold a minimum level of stable funding to cover the duration of their long-term assets (such as home mortgages and other long-term loans they provide to their customers).

Stable funding includes equity, long-term debt and sticky deposits such as those from retail customers or small to medium-sized enterprises.

The intention is to ensure that banks have sufficient funds to meet their financial commitments in a timely manner during any given year.

Taken together, these actions were designed to strengthen the capital and liquidity positions of the banking sector in Australia. Indeed, they have put the banks in a much stronger position than they were prior to the Global Financial Crisis. These actions are also expected to help the banks weather a disruption to a liquidity crisis if it comes.

 

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As always, talk to your Private Banker for guidance on the investment strategy that suits your personal situation.

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