From the AFR this morning comes a new headache for the major banks:
Australia’s big banks are vigorously fighting a new regulation for derivatives proposed by international financial regulators that would add hundreds of millions of dollars to their funding costs and may lead to higher interest rates being passed on to consumer and business borrowers.
As a consequence of a plan that aims to reduce systemic risk in the global financial system, proposed by the Group of 20 and being implemented by the International Organisation of Securities Commissions, Australian banks would need to pay a margin of 6 per cent on about $350 billion of cross currency swaps.
The swaps are used to hedge foreign exchange and interest rate risk for offshore transactions.
…The problem is unique to a handful of countries such as Australia and Canada, which are heavy users of cross currency swaps due to a shortage of deposits and reliance on international funding markets to fund their loan books.
Ironically, Australia and Canada are two of the strongest banking systems in the world and escaped being seriously damaged by the GFC.
As I have argued for five years, the major Australian banks are nowhere near as clear of shadow banking as they make out. The interest rate and currency swaps are classic examples of shadow banking activities. That is, they facilitate the mediation of investor funds not deposits, they do so without the traditional banking backstops of capital reserving, which is what is being proposed, and they enable enormous leverage off the books. Of course the majors do enjoy lender of last resort support which shadow banks don’t so as I wrote in The Great Crash of 2008, these instruments should be viewed as shadow banking activities rather than the users as shadow banks.
Ignore the final sentence of the article. Canada may have avoided much of the damage to its financial system but Australia did not. We went from having a privately owned and operated banking system that had responsibility for assets, liabilities and liquidity to one completely dependent upon public support for assets (demand stimulus), liabilities (guarantees) and liquidity (RBA cash for coconuts facility). The real irony of the final sentence is that the derivatives in question are right at the core of the damage done to the Australian financial system in the GFC.
How are the banks countering?
The letter by the banks to IOSCO notes the allocation of funds to fixed income in Australia is low, despite the $1.5 trillion superannuation pool, making them more reliant on international funding. “This has created a structural requirement for Australian banks to tap offshore capital markets and swap the proceeds back to the local currency,” the letter says. It says Australian banks would be required to post between $US30 billion and $US300 billion of initial gross margin, depending on the final rules set out by IOSCSO.
I’ve always found this argument amusing. The problem is not a shortage of deposits. It is an excess of lending for mortgages and overvalued housing creating a self-fulfilling prophecy of over-consumption and massive current account deficit requiring funding.
The same Australian regulators that have so far to a man failed to address any of the implications of their GFC rewriting of the financial system will do the same this time, of course. However, they may be up against it given the worthwhile goals underpinning the entire exercise:
In the aftermath of the 2008 global financial crisis, the G20 signed a commitment for derivatives trades to be transacted through central clearing parties.
The goal is to reduce counter party risk which was exposed by the collapse of Lehman Brothers
The first wave of reform will ensure more plain vanilla derivatives such as interest rate swaps are centrally cleared, including on the Australian Securities Exchange.The idea is to make non-clearing more expensive and incentivise the clearing of derivatives.
I have some sympathy for the banks. If you’re going to let them borrow in global markets then you sure as Hell want them using these derivatives lest you repeat the mistakes of the Latin American debt crisis (that is, if your currency falls your debt burden rises). But the basic push by global regulators is absolutely spot on and should not be resisted by any sane person. If the banks have to pay to stabilise the system they overuse then so be it. The end result will be a more stable system with less public support. That will reduce any rising funding costs fallout, unless of course you’re currently getting the same stability free of charge from your home country via guarantees.
This is just one more example of the slow but steady current account squeeze Australia has found itself in since the GFC that will, in the end, force us to change our economic model one way or another.
