In an address to the AOFM Fixed Income Forum in Tokyo on Wednesday (24 May), the Reserve Bank of Australia’s (RBA) head of domestic markets, David Jacobs, reflected on the central bank’s efforts to shore-up liquidity in the Australian banking sector at the height of the COVID-19 pandemic.
The central bank sought to stimulate economic activity by offering cheap funding to banks via an extensive bond purchasing program and the opening of a three-year term funding facility (TFF).
The RBA purchased approximately $360 billion in government bonds and issued $190 billion in funding via the TFF.
However, as a result of the economy’s rapid recovery and the subsequent (and ongoing) fight to quell inflation, the RBA has now moved to “unwind” these measures.
According to Mr Jacobs, approximately $20 billion of purchased bonds have since matured, with the pace of maturities expected to increase to between $35–45 billion per year.
Concurrently, banks have repaid approximately $4 billion (2 per cent) in TFF funding, with “large maturities” due ahead of September this year and June next year.
“This unwinding of the balance sheet will have a number of interrelated effects on the Australian financial system, as it works its way across bank funding, the bond market and money markets,” Mr Jacobs observed.
According to the RBA’s head of domestic markets, this process would likely “run smoothly” but acknowledged it may pose stability risks if banks don’t move quickly to shore-up their liquidity positions as they wane off cheap RBA funding.
He noted that by drawing on TFF funding, the banks received a “liquidity upgrade”, securing funding against a “broad set of collateral”— mainly securitised mortgages.
This, in effect, “boosted” their high-quality liquid asset (HQLA) holdings, strengthening liquidity coverage ratios (LCRs).
“As the TFF matures, this process will go into reverse — liquid assets (and liquidity ratios) in the banking system will fall if banks do not respond,” Mr Jacobs observed.
Mr Jacobs said to mitigate liquidity risks, banks would need to look for other sources of HQLAs, which he said would take the form of Australian government bonds (AGS) or semi-government bonds (semis).
“…And that has indeed been happening, with banks purchasing large amounts of these bonds over recent months,” he noted.
Banks have also increased their exposure to longer-term debt, issuing “large volumes” of long-term bonds.
Mr Jacobs also noted the ramp up in term deposit incentives, with at-call depositors offered “attractive returns”.
“So, that process of balance sheet adjustment in the banking system is well underway,” he observed.
Australia’s response to US banking ‘shock’
During his address, Mr Jacobs also unpacked the domestic market’s response to volatility in the US banking sector, triggered by the collapse of three regional banks — Silicon Valley Bank, Signature Bank, and First Republic Bank.
He claimed Australian markets “successfully weathered” the volatility despite funding pressures associated with the “sharpest tightening in monetary policy in over 30 years”.
He acknowledged, however, that the instability caught markets by surprise.
“Many people were attentive to the possibility of financial strains as interest rates rose around the world, but I think it is fair to say that relatively, few believed these strains would lead to major bank failures, given the efforts over recent years in strengthening bank regulation,” he said.
Mr Jacobs noted the impact on government bond yields — which saw “large movements in both directions” — the widening of credit spreads, and a dry up in liquidity in secondary markets.
But he said ultimately, the Australian banking system was well placed to withstand the volatility, attributing the sector’s resilience to strong regulatory settings.
“It is difficult to be definitive about the reasons for the robust performance of Australian markets through this period, but there are a few factors that likely contributed,” he said.
"The most important factor is the strength of the Australian banking system. Australian banks are well-regulated, highly liquid, and have capital levels that are ‘unquestionably strong’.”
He noted Australia is the only jurisdiction to require large banks to hold Pillar 1 capital against interest rate risk in the banking book.
“While volatility in global markets was transmitted to Australia, the underlying driver of that volatility — a fear of systemic banking stress — was never an issue domestically,” Mr Jacobs said.