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With so much political and consumer debate raging over mortgage pricing and competition, Graham Mott, Head of Securitisation and Funding at Deloitte examines the drivers impacting the funding costs of Australias major banks and other nancial institutions. He looks at the case for covered bonds and explores the alternatives available to government to balance a stable and sound banking system with a competitive mortgage industry for consumers.
Funding landscape
To fund our growth as a nation, Australia has had to rely heavily on offshore funding to supplement what is available domestically. Whilst there has been a signicant drive to attract retail deposits, Australias major banks continue to require annual funding of between $20 billion and $40 billion each from the term wholesale funding markets. Whilst the majors have managed to meet this challenge and deal relatively comfortably with the removal of the government guarantee earlier in 2010, the funding task will remain a key area of focus in 2011 and beyond. In addition the proposed new Basel III rules are expected to increase this term funding requirement. This emphasis means that all banks, more than ever are focussing on balance sheet management of both the asset prole and funding mix, and the impact on liquidity. For non major banks and non bank nancial institutions, the drying up of the securitisation market outstanding RMBS issuance is down 50% at close to 2004 levels has meant a greater dependency on the AOFM investment, with $16bn to date allocated for RMBS with a further $4bn made available. And like the major banks, the balance sheets of non major banks and non bank nancial institutions are also heavily dependent on offshore investors. These increased costs reect both the war for deposits and more expensive wholesale funding. Regional and non-banks margins have also been squeezed reecting the more expensive government guarantee pricing, as well as the greater dependency on wholesale markets. With securitisation markets remaining an expensive and elusive alternative, for some non-bank lenders this has meant a need to migrate towards the higher margins of near prime lending, as the majors vacate this space in the market. This move depends of course on investor appetite and warehouse capacity, but interestingly, it is not constrained by borrower demand. Even with the AOFM investing at attractive levels for AAA RMBS paper, the three year AAA paper is pricing at approximately 100 - 110 basis points for the regional banks (a spread of 10 - 20 basis points outside the AA rated major bank unsecured debt issuance). When the more junior notes are included in the mix, the spread widens further. However with the recent moves in mortgage rates, we estimate that even non-banks are now back in positive net prot territory to the tune of 20 30 basis points. But they still rely on the below market AOFM funding to ensure this continues. With a quoted net interest margin of approximately 235 basis points, the majors retain a substantial advantage over their rivals reecting a 50% weighting of retail deposit funding, a signicant component of which is in transaction or call accounts, paying well below the cash rate. This is offset to some extent by the greater overheads (cost to income ratio of 40%) and the regulatory capital charge.
Impacts on pricing
The major banks have experienced approximately 120 -130 basis point funding cost increases since the start of the GFC and despite all four big banks having responded by raising interest rates relative to the cash rate, depending on the bank, the amount passed on to the customer is closer to 110 120 basis points.
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Non Bank
Standard Variable Rate 7.80%
Major Bank
BBSW 5.05%
We outline some of the positives for covered bonds below and consider where they tick some important boxes for the stability of Australian banks into the future: Industry participants indicate that if structured correctly, even single A rated banks may be able to issue AAA rated covered bonds. The experience has shown that AAA covered bonds typically price considerably cheaper in the market than unsecured bank debt. This reects their linkage to the sovereign rating, the enhanced liquidity and the appetite of a new sovereign rather than credit investor base. Advocates point out that even a BBB bank can achieve a AA covered bond and accordingly a pricing benet will still exist for these institutions The pricing benet is expected to be signicant and interestingly provides greater benet relatively for the lower rated banks or ADIs. The indicative ve year pricing differential is provided in gure 3 and was supported by the recent Bank of New Zealand (BNZ) covered bond transaction in New Zealand.
We expect to see Australias rst covered bond issued in the rst half of 2011.
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To facilitate this, like Australias global counterparts, it will be necessary to ensure covered bonds constitute eligible High Quality Liquid Assets (HQLA) for banks under Basel. If so, liquidity will be enhanced and it will ll the gap required to meet Basel III requirements where an estimated $100bn more liquid assets are required to supplement government and semi government bonds. This liquid asset eligibility is also likely to create a domestic market appetite to reduce dependency in the long term on offshore funding. Allowing covered bonds as HQLA will also reduce the costs to borrowers by improving the yields earned by banks on its liquid assets. The term structure is also attractive for Australian banks. Given that the annual funding requirement remains a challenge, covered bonds will represent an important tool in the Treasury management for banks to lengthen the maturity prole of debt issuance, improve the matching with the asset prole, and reduce the annual funding requirement. Importantly, covered bonds also meet the regulatory need to lengthen debt maturity at the right price Combining liquid asset eligibility and term structure with the bullet maturity of covered bonds would result in the banks being able to retain a new class of sovereign rates investor to Australia. Such investors have taken up the government guaranteed paper issued by banks but are new to the domestic market. Covered bonds would therefore improve banks ability to fund themselves and reduce the potential for credit constraint on growth as the government guaranteed paper matures over the next two years.
Even at the lower 5% level mooted by commentators, the major banks could issue more than $90bn of covered bonds. Interestingly this would be greater than the current levels of RMBS.
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Industry analysts estimate that by using the high stress scenarios provided by APRA, the impact on the interests of depositors is negligible even at a covered bond pool level of 14% of total assets. Other mechanisms that are being offered through the debate include enhancing the depositor insurance scheme that exists to protect depositors. Such enhancement could be bank funded. Rating agencies note that covered bonds improve the rating of the issuer so long as the level of covered bonds does not increase to beyond about 20%.
With the AOFM renewing its commitment to invest in more RMBS issuance which will continue to support the smaller banks and non banks, the question is: Is the extra $4bn enough?. There will need to be alternative models emerge to achieve greater choice in the market place and to wean the users off government support.
Competition
Obviously in the current political climate, it is important to balance the stability of the major banks with enhanced competition. Competition is important for both consumer choice and pricing. Covered bonds are likely to benet consumers with a $100+ billion injection of cheaper funding into the balance sheets across the banking sector which should fuel growth and would help the case for lower interest rates for all ADI customers. However whilst it is believed that Australias single A rated banks could achieve a AAA covered bond issuance, it is less likely for BBB rated banks or below, and it will not be available for non banks. It is therefore possible that a covered bond market would increase the distance between the major banks and the rest. However interestingly lower rated banks obtain a greater relative percentage reduction in their cost of funding from covered bonds. In France, the Caisse de Renancement de lHabitat (CRH) model allows all banks to pool assets into a collective covered pool (in proportion to the balance sheet size) and provides all participants with the same cost of funding benet. Although more egalitarian, this approach still retains the overall existing large bank/small bank differential in pricing. This could neatly form part of the Treasurers banking reform toolkit for the Credit Union and Building Societies (CUBS) sector.
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