Bank funders and the future of the market gap
Every year, KangaNews and RBC Capital Markets host the heads of funding from Australia’s big-four banks to discuss market conditions and the outlook for their sector. In 2020, the COVID-19 crisis has reshaped the landscape completely – most notably by almost completely eliminating the majors’ funding gap and thus removing them from public senior debt markets since the first months of the year.
The funders discuss their reshaped issuance need, the Reserve Bank of Australia (RBA)’s term funding facility (TFF), the ongoing need to accumulate additional-capital issuance, Australian lending-book quality and credit growth, and global investor relations in an era of social distancing.
Perrignon We usually start this discussion with a funding conditions update, but this year it seems more like a ‘not funding’ conditions update. What is the background to the majors’ absence from capital markets for several months, what dynamics are at play and what is the outlook for their call on capital markets in the medium term?
KAU The TFF has been a near-term game-changer. It is one of a few liquidity provisions the RBA has implemented and it is perhaps the one with the biggest impact. Purely from a funding perspective, it has changed the dynamic a lot – but we still have a reasonably sized tier-two requirement given our total loss-absorbing capital (TLAC) obligations under local regulations.
It is certainly the case that there has been a big short-term change in our draw on funding markets. The TFF is only available until the end of March 2021, though – and then only for additional funding for credit growth.
BISCHOFF Among the range of decisions the RBA made on 19 March, the government bond-buying programme and the TFF have had a meaningful impact on funding and liquidity. As it has for ANZ, these measures have shifted the way we think about funding in the near term.
But I would say just as much of an impact was derived from the early stages of market volatility and some of the headline risk around drawdowns, and what this meant for bank liquidity.
Ultimately, the outcome for banks was very different from what might have been feared. There were immediate cash-rate cuts, QE and funding facilities in different forms. We also saw corporates, SMEs and retail customers pre-emptively drawing down on cash and, in some circumstances, taking deferral packages as a precaution rather than as a need.
But all this saw liquidity come back onto the bank balance sheet. This has been reflected in the magnitude of deposit growth we have seen. This is a unique event, resulting in the structural rebalancing of our funding gaps.
What is difficult to assess, though – and this can been seen in the different stressed scenarios the banks and regulators are running – is what the shape of recovery is going to be, the timeline of that recovery and what further actions may be taken by governments and central banks. While we may not return to the same issuance volume in the near term, we expect to be active in funding markets over time.
BLACKSTOCK The increase in deposits has certainly driven our strong liquidity position. In the results we released in mid-August, we pointed to a A$43 billion (US$30.8 billion) negative core-funding gap. In our case it has nothing to do with the TFF – it is purely the liquidity point that Alex Bischoff just described.
Having said this, we have drawn down some of the TFF available to us and we intend to draw down further. When we have access to this type of funding, which we are being encouraged to take, the reality is that it is available at a very competitive cost while being pari passu to senior or other forms of funding that is not regulatory-capital driven.
The reason we have not yet drawn down all the TFF on offer to us relates solely to the increased volume of deposits in the system. The big question for us is whether this phenomenon is structural or temporary. It is something we will have to watch very closely going forward.
MITCHELL We are talking about funding gaps for the banking system. Taking a very basic look at the initial TFF allowance and banks’ funding profiles up until the point when the first TFF tranche expires, it is almost a one-for-one replacement. We have been explicit, in our disclosures and results announcements, in suggesting the initial allowance covers the run-off of our term-funding portfolio over this period.
At the same time, benign credit growth means the asset side has not been coming on to the extent forecasters might have expected. This is separate from the deposit or liability side. We were reframing our funding task lower through the year as we were not seeing lending match up with forecasts.
In saying this, the TFF has replaced term funding we otherwise may have done. In effect, there is a narrowing of the funding gap to begin with and the RBA injecting more cash to the system via the purchase of government debt is only going to increase liquidity in the Australian system. It should see funding gaps shrink further as QE recycles through the system and ends up back on banks’ balance sheet as deposits.
An important distinction is the cash component versus the liquidity value of the TFF. One very effective decision APRA [the Australian Prudential Regulatory Authority] took through the peak of COVID-19 was to allow the TFF, as a committed facility, to be counted as an inflow toward our LCR [liquidity-coverage ratio] metric.
This is another factor relating to what we have seen with ESA [exchange settlement account] balances growing so much. The reality is that there is clearly a surplus of cash in the system, and this is causing a number of unusual outcomes. There is no specific requirement for this cash, but the liquidity component of the TFF is still very valid and relevant. When the TFF runs off and we lose this benefit, we will likely see the majority of the funds taken down.
Davison Is the disappearance of funding gaps a uniquely Australian phenomenon?
PERRIGNON I do not think it is. We have seen a global funding drawback and government support measures in a variety of jurisdictions, which are designed effectively to create the endpoint of supporting banks through what are clearly unprecedented times and to allow a broader transmission of credit into global economies.
On the other hand, the way the regulator and the RBA have designed the framework for funding in Australia is unique. Looking back to the financial crisis, the government at the time overlaid a guarantee structure to allow Australian banks to borrow externally in what was essentially a liquidity and funding crisis. Clearly, things are very different this time around.
Australian banks are in extremely good shape from a liquidity, funding and capital perspective thanks to the repair they affected after the financial crisis.
One could argue the design of the TFF was an attempt to transmit a low cost of funding in a way that stimulates lending in the real economy. Looking at the levered component of the TFF and the amount drawn down from it, though, it suggests there is just not a lot of credit growth in a system that remains extremely anaemic.
A new world for investor relations
Before COVID-19 hit, the big-four banks were among the most visible Australian bond issuers on the world stage, with frequent deals and in-person investor updates in every major jurisdiction. Not only has their issuance need all but disappeared but the nature of the crisis has forced them to re-imagine how investor relations works.
KAU The calls we have had with investors following our results have been well-received. Investors have appreciated that we have stayed in touch in what are certainly very trying circumstances. It is not the same as face-to-face meetings but, generally speaking, investors are very appreciative. We have not been involved in any deals, of course, so I cannot comment there.
Davison What is the banks’ read on demand for credit in global capital markets and the behaviour of credit spreads over the last six months?
BISCHOFF There is no doubt credit has reacted as one would expect it to in an environment of mass global policy easing via the range of different measures we have touched on already.
Everybody here has talked about the outlook and what their funding gaps look like in future. Structurally, it is difficult to say what the supply side will look like when the current situation normalises. On spreads, I suspect credit is in some ways at an artificially tight point, locally at least, because of the lack of supply from the major banks.
The spread story is similar offshore, but it is not so much down to lack of supply. US year-to-date issuance is at a record level but it is being underpinned by a massive QE programme. At some point this will normalise, just like every cycle we have been through over the past 10-15 years. We have seen the highs and lows of credit and we are certainly at a lower point for senior-paper pricing.
I think all of us would argue tier-two still looks relatively expensive to where senior paper is today, albeit on an historical basis. We are not back to where we were in January this year and it will be interesting to see what happens in the tier-two space over the coming year as markets perhaps start to function more normally.
The reality is that it is a pretty good environment if you want to issue. The only problem is that we don’t need to.
KAU It is a good point about the sheer volume of QE that has been prevalent around the globe. There was an initial shock, as there is in any crisis, but the actions of central banks have insulated markets.
One almost has to question whether this can be sustained going forward. I read recently that after the 20-plus per cent fall in US stocks in March this would be the first time a bear market has never retested the lows, after an initial bounce, before making new highs.
Of course we are not out of this crisis yet, but if this comes to pass it can only really be put down to the volume of QE. We all benefit from it, but we have to wonder where it leads us to in the future.
Perrignon How have loan books performed through the COVID-19 crisis so far? Have hardship requests and performance been on the up- or downside of expectations, and how has the picture changed since March?
BLACKSTOCK Our loan book has performed well so far, which has been assisted by the allowance of loan deferrals. There are areas of emerging stress in the industries that are most exposed to COVID-19, though – and I would be cautious about making statements on the outlook for financial-year 2021 beyond saying that we are actively modelling and stress testing.
MITCHELL The COVID-19 situation in Victoria has clouded the outlook. We are working through what this might mean for the trajectory of the recovery and, indeed, how much slower and shallower it may be.
Looking at risk-weighted assets (RWA), we did not see anything particularly significant on the risk-migration side. Again, it probably speaks to the significant scale of federal-government support that the activity of exposures in deferral remains uncertain.
On the deferral piece, pleasingly we have seen a portion of our deferral customers roll back into payments. Meanwhile, only 2 per cent of current deferrals have been turned over to our NAB Assist team, which undertakes product reviews and hardship.
It is very difficult to forecast, at this stage, what the ultimate deferral outcomes may be. In fact, the outlook is potentially more nuanced now than it was in the early days of the crisis, especially if we end up confronting a bifurcation of economic activity across the two major states – New South Wales and Victoria. It may not be until 2021 that we will be able to say it has played out.
BLACKSTOCK The outlook outlined in our results on 12 August had a central case very close to the RBA’s view on where unemployment and GDP are going. It is difficult to be clear on the outlook for RWA given there is a lot of uncertainty about timing of any potential vaccine and coming out of the current situation.
Mortgage and loan deferrals have been very helpful in supporting customers so far. There are signs of stress in some areas but, outside of the scenario analysis and the stress testing we continue to do, it is tricky to be definitive.
BISCHOFF It is hard to say anything beyond the fact that we have not experienced anything much different from what our peers have reported.
"Although the TFF is significant, I do not think it has changed our behaviour collectively as a banking system across the crisis. By this I mean, specifically, that it is unlikely we would have entered capital markets even without the TFF."
Davison How do the banks see the TFF panning out as a catalyst for a higher credit-growth trajectory?
MITCHELL In the first instance, it was probably overplayed – certainly for the major banks – how impactful the TFF would be on portfolio cost of funds. The TFF accounts for 3 per cent of liabilities – it is small.
To be clear, it is very economic and inside where term-funding levels were at the time in an absolute sense – but for a specified quantum of funding. Despite the rally we have seen since April, and the technical compression in major-bank funding spreads domestically and globally, the TFF is still economic. But the fact remains it is just one input into the banks’ cost of funds – and a relatively minor one at that.
The TFF is there to assist banks in supporting their customers and the broader economy, which in turn is designed to reinforce the financial system’s ability to get the transmission of price and availability of credit working. But with the uncertain outlook we have at the moment, we do not have a supply of credit issue – we have a demand issue. Until we see a clearer, positive outlook with a stable platform for economic growth and the reopening of the economy, it is hard to see appetite for credit returning.
It is currently very much a state of maintenance. Hopefully, we will start to see some credit appetite toward the end of this year and into next. The additional allowance of the TFF will come into play then and potentially support banks being able to finance growth out of this period.
BLACKSTOCK I agree with all these points. The factors are there to support supply of credit once demand picks up. But, with business confidence low and the outlook uncertain, it is difficult to say when that is likely to be.
I would add, though, that we are very much there to support our customers. There are lots of examples I am sure we could all point to that demonstrate how we have helped customers through this difficult period, be it through restructuring loans or alternative mechanisms depending on customers’ situations. It will take time for credit demand to pick up and, in the meantime, it appears we will be in a period of high liquidity – and certainly limited funding – for some time.
BISCHOFF The only other piece I would touch on is that, while not directly beneficial for the major banks, the other benefit the TFF has had relates to where relative capital-market pricing lands. It has allowed corporate borrowers to term out drawdowns over the last several months at far more efficient levels than they otherwise would have been able to achieve, and therefore has enabled them also to recoup some of the capacity they have with banks to deal with future shocks that may come through.
This is a pretty efficient tool when you think of what major-bank senior paper has come to represent as a benchmark in the domestic market. By this I mean it is more or less possible to read through the data on TFF allocations to see where large corporate exposures, represented by the additional TFF allowance, are starting to reduce. It seems to be the most logical scenario that these exposures should continue to come down as we go forward.
KAU Although the TFF is significant, I do not think it has changed our behaviour collectively as a banking system across the crisis. By this I mean, specifically, that it is unlikely we would have entered capital markets even without the TFF.
This is a significant contrast with, for instance, the Canadian and US banks. It was extraordinary to see the sheer amount of issuance they executed during the very worst of conditions. I guess this was largely for TLAC [total loss-absorbing capacity] reasons because it is unlikely to have been for demand reasons.
I suspect this is due to different ways of managing TLAC, but I’m not sure you would have seen us scrambling to access wholesale capital-market funds at the widest of levels at the worst point of the crisis. I think this is worth noting.
BISCHOFF I agree. It has definitely been the case that this has not been a liquidity-led crisis.
KAU It goes back to the point Scott Mitchell raised: this is very much a demand-led recession rather than a supply one.
Davison A number of analysts expect the banks to pick up their TFF usage towards the end of the facility’s window, to lock in term funds for the longest possible duration. What are the banks’ own expectations?
BISCHOFF From a Westpac Banking Corporation perspective, we have said we expect to draw down our full TFF initial allowance and our expectation is that the remaining industry-wide A$50-60 billion of initial TFF allowance will be fully drawn. The relative value of TFF cost of funds is still far better than what is on offer in capital markets.
This means close to A$90 billion, in total, that needs to be drawn down by the end of September given drawdowns have been limited to date.
KAU The RBA has said the same thing. Its expectation is that the TFF will be fully drawn within the allocated period. I agree, and in fact I would not say it is necessarily dependent on credit growth. The banks have let a lot of term funding mature because the TFF is there in the background and because we have had a bunch of deposit inflows. The economics behind the TFF remain pretty attractive, which is a key point.
Perrignon To what extent, if at all, are the banks concerned about a maturity spike in 2023 on the basis that the TFF offers only three-year funds? Has, or will, this reduce usage at the margin?
BLACKSTOCK The maturity profile should be manageable. While on paper it looks like it will cause a maturity spike, there is no impediment or penalty to early repayment. It is quite well designed to allow us to manage the maturity profile fairly smoothly.
MITCHELL We wouldn’t normally see this scale of maturity concentration in the system, or for banks individually, if we were purely talking about external term wholesale transactions that needed to be refinanced. There is not an issue around market capacity in the context of what the TFF is – which essentially is funding from an entirely new source.
This said, while it appears large from a forward-looking maturity-tower standpoint it is actually not that significant on the basis of the banks’ cyclical 30-, 60-, 90- and 270-day refinancing. It fits in reasonably well, or at least would not otherwise cause any particular focus if it was just part of the typical refinancing profile for any of our numerous other liability products.
Provided we have the tools and the flexibility to construct other forms of funding around it, and we absorb the TFF part of our liability base as it rolls in, it can be managed. I also echo the point about the prepayment feature. This provides maximum flexibility to manage the maturity profile. All in all, how significant the maturity spike will prove to be might be a little overplayed.
PERRIGNON There seems to be a consensus that the base TFF as it is designed as a source of funding remains competitive enough for all the majors to use it in full, and it sounds as if the ongoing question is really around the efficacy of the supplementary facilities.
How much credit growth there is in the system and how much animal spirit there is to borrow money going forward is the difficult question. That is, the key question seems to be what the usage rate of the supplementary facilities, whether it be the large corporate facility or the SME facility, will be.
Tier-two issuance will likely get most attention but the major banks will still be looking at periodic additional tier-one (AT1) refinancing transactions. A recent foray into the wholesale market by National Australia Bank (NAB) suggests banks may be open to exploring diverse issuance.
MITCHELL I wish I could take a little more credit on this, but Will Nigro, our acting head of capital, went down the path of creating the wholesale AT1 programme in 2019. The genesis of it was around adding flexibility to issue AT1 product.
This came into the spotlight in February this year when we were in the market with a retail transaction. It’s not that the market wasn’t supportive but that retail transactions have such a long open period between pricing and settlement.
Davison We have just passed the one-year anniversary of the RBA’s TLAC-equivalence regime and all the major banks have made significant headway on what is effectively a four-year ramp-up. How has this first year been?
KAU We were fortuitous in the sense that we had strong markets in the first six months of the regime being introduced. This underlines the importance of taking advantage of good market conditions when they present themselves. We all did multiple billions of dollars of tier-two issuance across all the different markets in that six-month period.
With the benefit of hindsight, this is the reason why we haven’t had to do the same level of issuance some other global banks did at the height of the crisis and over the past six months – being ahead of the run rate buys time to ride out difficult periods. It is the only really good way to manage through the cycle.
Collectively, as a jurisdiction, the Australian banks had a great experience across all tier-two markets and investors. It is always easier at the start of the process, though. The rest of the four-year transition period will most definitely be more difficult, even in favourable conditions. The outstanding volume we will be looking at is going to be a lot higher.
We need to be cognisant of this but it is certainly a case of so far, so good. If markets keep presenting themselves as they are at the moment, it is likely we will issue in the near-to-medium term.
MITCHELL I agree. The whole banking system was pretty active after the APRA framework came into place and we were quite fortunate with the conditions from then until the start of this year.
The market conditions we experienced were the most conducive we had seen in years, particularly for higher-beta spread product. The transactions we all printed went well, which was a good demonstration to investors.
It is an exploratory transition with the chosen product of tier-two but, as Mortyn Kau says, the outlook is pretty positive in the near-to-medium term. This is especially true in the current rate environment where almost the entire coupon being received by fixed-income investors comprises the spread over the benchmark they are receiving rather than the base rate or yield. This should be supportive of capital products.
Even so, thanks to the exploratory nature of the transition we really do not know the depth of tier-two demand out there. I’m sure there will be a challenging market at some point in the next three years. To avoid this we need to have thoughtful and creative strategies in place to achieve the quantum of funds that will be required.
Hopefully, we will continue the current cadence of issuance and deals will be received warmly and at a cost that is not too burdensome. At the same time, we want transactions to perform well for investors so they continue to participate in the primary market. But I think there is some exploration to be conducted over the transition period, which highlights the importance of being active when the market is supportive.
BISCHOFF The way the banks have engaged with markets to date has been very targeted and measured, which is in line with what we have seen in market conditions.
The depth of the US market has come to the forefront for tier-two deals in the context of available duration, the demand for US dollars and the search for yield. This focus certainly doesn’t seem likely to abate in the near term.
Importantly, banks are taking a pragmatic approach to duration. Ultimately, this is capital and we have to consider it in a different way from how we consider senior funding through the cycle. It has been encouraging to see trades with long tenors, and it’s clear that issuers are regarding duration as a key element of how they manage the future refinancing risk. This can only help with investor comfort.
In addition, most of the banks are around or slightly above 3 per cent tier-two ratios, just six months into the task – which is a positive message for investors to be seeing this quickly. I think there was an expectation of an endless wall of supply but certainly to date this has not occurred.
“Where base rates are means most of the yield on products is now from spread. Taking euros as an example, this has been a negative rates environment since 2014 and investors are still looking at duration. Markets believe rates are going to stay lower for longer and thus investors are willing to go further out the curve to pick up yield.”
Davison What are the prospects for tier-two deals with long tenor compared with the situation just ahead of the current crisis?
BISCHOFF Scott Mitchell made the point that where base rates are means most of the yield on products is now from spread. Taking euros as an example, this has been a negative rates environment since 2014 and investors are still looking at duration. Markets believe rates are going to stay lower for longer and thus investors are willing to go further out the curve to pick up yield.
The example for Australian banks is the euro 15- and 20-year covered-bond private placements we have done. Covered-bond margins offer little spread and yet the banks have been able to access a regular stream of demand for these deals since 2014, despite the rates environment. Unless there was a near-term view that rates and inflation were going to return, the demand for duration is likely to continue.
PERRIGNON This is certainly what I see from a dealer perspective. There was probably a degree of circumspection leading into the TLAC regime implementation about the prospect of Australian banks bumping up against each other given the ramp-up in tier-two issuance requirement. Clearly, market conditions have helped this situation over the past year. With base rates and spread product where they are, we have been surprised on the upside in regard to investor reception for Australian tier-two product over a very wide range of transactions and markets.
MITCHELL I think the point around different structures and tenors is underappreciated. As issuers, we are somewhat fortunate that we get to see the level of enquiry and appetite out there across the globe in various currencies, structures and jurisdictions.
The diversity and breadth of appetite is often underappreciated. It is always going to be at various levels of economics and we will move in reference to our own requirements and the way we choose to approach the transition. But I think it is very easy to underappreciate how significant the appetite is if you are not sitting in our chairs and getting the breadth of interest shown to us.
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