RBNZ throws cold water on RBA by Leith van Onselen

I have noted before the penchant of New Zealand’s regulatory authorities to act as a kind of trans-Tasman conscience for Australian banking authorities. After all, they share the same banking system but are less constrained by any perception of the need to sustain confidence.

And yesterday, the Reserve Bank of New Zealand’s (RBNZ) quarterly statement on monetary policy contained a blunt warning on Australian bank funding costs:

…stock prices of Australian banks have fallen recently and CDS spreads have become elevated (figure 3.6), suggesting that, unless conditions improve, the risk premium on term funding will rise. There is not a one-for-one relationship between the CDS spreads and wholesale term funding costs, but there is a high correlation between the two measures. CDS spreads on Australian banks could have risen for a number of reasons, including concerns around global banking risks, the use of the CDS market as a hedge against Asia-Pacific risks, or Australian banks’ reliance on foreign funding markets. How sustained these pressures will be remains uncertain. If conditions do not improve, these pressures will see monetary conditions tighten, and banks would be likely to increase lending and deposit rates relative to the OCR.

As stated many times before, the Australian banks have been willing enablers of Australia’s housing bubble via their:

increased emphasis on housing lending relative to other forms of lending (such as lending to businesses);
which has been funded to a large extent by heavy offshore (foreign) borrowings.

This structural shift toward housing lending is clearly evident by the below chart, which shows the dramatic rise in mortgage lending releative to other forms of lending over the past 20 years.

Regarding the banks’ heavy offshore borrowing, consider the below chart, which I have produced from Australian Bureau of Statistics (ABS) data, showing the breakdown of offshore borrowings by Australian depository corporations, split-out between short-term debt (maturing in less than 12 months) and long-term debt (maturing in more than 12 months). Depository corporations comprise banks (accounting for the overwhelming majority of foreign funding), building societies, credit unions and registered financial corporations.

Depository Corporations Gross External Liabilities

As you can see, offshore borrowings by depository corporations has exploded over the past 20 years, from around $50 billion in 1988 to around $650 billion currently.

Currently, depository corporations have around $310 billion of short-term foreign borrowings maturing within 12 months, in addition to another $350 billion of longer-term foreign borrowings outstanding. Other things equal, this $310 billion of short-term foreign borrowings must be refinanced within 12 months just to maintain the current level of credit within the Australian economy (let alone increase it).

Now consider the total value of Australia’s residential housing stock split-out by equity and debt (see below). There is currently around $1.2 trillion of housing debt supporting around $4.1 trillion of housing assets.

What should be clear from the above charts is that the growth in Australian housing values has been funded, to a large extent, by foreign borrowings, much of it short-term.

A key risk going forward is that the banks’ ability to refinance their borrowings rests with the willingness of foreign investors to continue to lend them money. But in times of heightened risk-aversion – such as the impending European debt crisis – foreign investors can become nervous and less inclined to continue extending credit, which could leave Australia’s banks, house prices, and broader economy exposed to a sudden funding freeze.

Indeed, the above RBNZ charts suggests that markets are already re-pricing Australia’s debt upwards because of the riskiness of Australia’s housing market and the banks’ offshore funding vulnerabilities.

There are mitigating factors. The sharp slowing of household credit growth is working in the banks’ favour as it has significantly reduced their offshore funding requirements – Australia’s banks are set to borrow only around $100 billion in the wholesale debt markets (mostly from offshore) this year according to Reuters. Some support can also be expected from the introduction of covered bonds, legislation for which was introduced yesterday.

Yet markets are unconvinced, deeming the Aussie banks considerably riskier than their US counterparts based on CDS spreads. And compare RBNZ’ frankness about this fact with recent RBA rhetoric:

…there have been pressures in funding markets for some European banks recently, but at this point not to the same extent as in October 2008. Bank capital levels are improved from three years ago and leverage is reduced. We have not seen significant funding problems for US or UK banks recently; their problems at present seem to relate more to the possible size of legal costs arising from pre-crisis lending standards. Overall, we have not, to this point, seen the widespread withdrawal of willingness to deal with counterparties that we saw in late 2008.

Perhaps, but we are seeing GFC levels of stress in key market indicators for Australian banks.

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