A JP Morgan analyst explains why Australia's improving budget position is putting pressure on bank margins

  • Australian banks are facing a “liquidity shock”, which is pushing up short-term bank lending rates.
  • According to JP Morgan analyst Henry St John, it can be partly attributed to the improvement in the federal government’s budget position.
  • When government revenue increases but bond issuance remains constant, it creates a drain on private sector deposits.
  • St John said short-term funding stress could be partly alleviated by a reduction in government bond issuance. He also suggested changes to the composition of the banks’ funding mix.

The rise in funding costs for Australian banks has been a hot topic of conversation in recent months.

It’s led to speculation that major banks may try and pass those costs onto borrowers in the form of higher mortgage rates — an action already taken by smaller lenders.

Some have attributed the funding pressures to flow-on effects from a similar rise in US dollar borrowing costs.

But according to JP Morgan analyst Henry St John, “it has become increasingly apparent that idiosyncratic local drivers have also been at play”.

St John said one of those factors is the recent improvement in the federal government’s budget position.

Government tax revenues beat forecasts in the 2017/18 financial year, driven by more income tax in the wake of 2017’s record run of jobs growth and a surge in company tax as profits rose:

Source: Australian government

How it works

As it turns out, higher government revenues have been a key driver of the increasing gap between bank credit growth and deposit growth in 2018.

In his analysis of housing credit data last week, St John said “the persistent credit-deposit gap suggests that banks will continue to face stress in short-term funding on an ongoing basis, and particularly around quarter-ends”.

Source: ANZ

So what has government revenue got to do with it?

This is where the Australian Office of Financial Management (AOFM) comes in. It’s the body responsible for the issuance of Australian Commonwealth Government Bonds (ACGBs).

Importantly, the AOFM continues to issue debt at the same rate it did before the budget improvements. The difference is that now, the government doesn’t need the cash. So the money gets stored in the government’s bank account at the Reserve Bank.

“When the fiscal backdrop improves outside of a budgetary change, it’s because revenues are greater than expected — individuals and corporations are paying more to the government,” St John told Business Insider.

“If the AOFM’s issuance program is unchanged, then this amounts to a leakage of deposits out of the private sector. The money comes out of the private economy, but is not being redeployed (via expenditure). Instead, it sits on the RBA’s balance sheet in the government’s deposit account.”

That creates what St John refers to as a “liquidity shock” for banks. And it puts upward pressure on the bank bill swap rate (BBSW), which is the interest rate banks pay to lend to each other.

Liquidity shock vs funding shock

Importantly, St John drew a distinction between a liquidity shock and a “funding shock”, neatly summarised in the table below:

Source: JP Morgan

What the table indicates is that the liquidity shock is being reinforced by reduced demand for short-term funding as credit growth slows.

Credit growth to Australian housing investors is still growing, but at the slowest level on record.

In effect, when credit growth slows, it creates a negativee feedback loop for short-term liquidity. St John explains it as follows:

For a world in which credit growth is strong and accelerating, banks are observing larger loan books, which means they need to hold more high-quality liquid assets (HQLAs) for regulatory purposes. And as they receive interest repayments on an ongoing basis, they are trying to redeploy this cash into higher yielding securities (or new loans).

In the current state of the world, we have a widening credit-deposit gap (liquidity shock) without the increase in credit growth (funding shock), and so while the banks want to be holding more liquid assets to combat this issue, their overall asset needs aren’t rising. This is exactly why you see pressure in short term borrowing rates.

It’s a complex, interrelated web. But the end result is that it’s contributing to the funding squeeze faced by Australian banks.

Policymaker response

All of this raises two questions:

1. Why doesn’t the RBA intervene by adding more liquidity as part of its daily open market operations (OMOs)?; and
2. If the government is in surplus, why doesn’t the AOFM dial back its bond issuance?

St John told Business Insider that the answer can be attributed partly to policy makers’ adherence to maintaining the status quo.

“I think there’s a philosophical argument from the RBA’s perspective, where it doesn’t want to intervene in what should be a privately funded market,” he said.

However, right now it’s a private market that isn’t functioning very smoothly.

“I mean, if there’s a premium of as much as 55 basis points on the BBSW, you’d think it should be profitable for someone to lend at those rates. But no one has the liquidity to do so because of the credit-deposit gap,” St John added.

Meanwhile, “the justification from the AOFM is that they want to be signalling to the market they’ll always be reliable.” For now, that means no adjustment to bond issuance — even though the government is booking higher revenues and the need for debt is falling.

Addressing tighter liquidity in domestic money markets “doesn’t explicitly fall within anyone’s mandate, so it’s sort of slipped through the cracks,” St John told BI.

What can the banks do?

The various dynamics at play have put Australian banks between a rock and a hard place, as external factors create a short-term liquidity squeeze which has been exacerbated by the slowdown in credit growth.

Still, St John said one option for the banks is to look at the composition of their funding mix.

“If it’s a liquidity issue rather than a funding issue, they can feasibly have less short-term financing and more medium-term debt,” St John said.

He noted that longer-term bond spreads and rates on credit default swaps (CDS) for Australian banks have hardly moved. (A CDS is a form of insurance on credit exposure, so little activity in that market suggests investors are relatively calm about the underlying financial strength of the banks).

“So an argument could be made for the banks to move their funding out a little bit,” he said.

To conclude, St John said that eventually short-term money markets can return to equilibrium as the banking system adjusts to slower credit growth. But it’s a process that will take time.

“The most obvious channel by which funding market stress can be alleviated would be a slowing of issuance commensurate with the improving fiscal stance,” he said.

For now, “we can continue to monitor the size of the RBA’s deposit liabilities as a guide to whether the private banking system’s credit-deposit gap growth is expected to persist”.

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