Rating the banks’ readiness

The Australian banking system should be better set up to deal with the economic consequences of COVID-19 than it was for the 2008-9 financial crisis. Government support and an accommodative regulator will also help. But rating agency commentary and actions underscore that there is no easy way out of an all-encompassing downturn.

Laurence Davison Head of Content and Editor KANGANEWS
Matt Zaunmayr
Deputy Editor KANGANEWS

In mid-March – just as the response to the COVID-19 outbreak ramped up – Australia’s banks appeared to be well set for funding, after being active in the first six weeks of 2020 particularly in offshore markets. The big four had taken advantage of conducive conditions to raise an aggregate of nearly US$17 billion equivalent across currencies and asset classes. S&P Global Ratings noted that the banks “have significantly completed their wholesale term funding for the financial year”.

Furthermore, the major banks’ latest pillar-three reporting prior to the crisis suggests their liquidity coverage ratios (LCRs) and net stable-funding ratios (NSFRs) are well above the regulatory minima (see table 1).


 Regulatory minimumANZCommBankNABWestpac
LCR 100 141 134 129 130
NSFR 100 116 113 112 112

*Data as at 31 December 2019, except ANZ NSFR (30 September 2019)
Source: Australian Securities Exchange 16 March 2020

Commonwealth Bank of Australia (CommBank)’s Sydney-based head of term funding, Fergus Blackstock, confirms that the bank went into the period of volatility with a strong balance sheet. “There were very good deposit flows into CommBank through last year, which have continued this year. Credit growth was also relatively good, particularly in mortgages, but deposit growth far outpaced credit growth. This limits our need for wholesale term funding.”

Releasing pressure valves

COVID-19 creates some obvious areas of potential stress for Australia’s banks. Social-distancing policies are hammering households and businesses, and banks’ lending books will inevitably suffer from consumers’ decreased ability to pay back loans.

Various measures have been enacted to mitigate the fallout in the financial sector. First in place was the Reserve Bank of Australia (RBA)’s 25-basis-point cash rate cut on 3 March. An emergency cut down to the RBA’s effective lower bound of 0.25 per cent followed on 19 March.

A Fitch Ratings report published on 17 March states these cuts will put bank earnings and profitability under pressure – prefiguring later ratings action – but will also help prop up the economy and support bank asset quality. Federal and state governments are delivering fiscal support, which should also provide relief by helping businesses and households remain solvent.

S&P’s expectation in mid-March was for bank credit losses to double to about 30 basis points in 2020, albeit from a historically low level in 2019, with losses on business loans expected to be the most substantial. The rating agency’s report states: “Nevertheless, we expect the impact on the Australian banking system to be relatively small in the short term, on the back of sound long-term economic prospects and our forecast rebound in economic growth as this event passes.”

S&P also identified short-term offshore borrowing as a potential immediate risk for banks. This type of funding is more susceptible to negative market sentiment and an increase in spreads during refinancing.

There were signs of heightened volatility in short-term markets in mid-March, which the RBA immediately greeted with increased repo operations. On 16 March, as part of an announcement from the Council of Financial Regulators (CFR), the central bank revealed it would increase its provision of one-, three- and six-month repo for as long as was necessary to support commercial bank liquidity.

The RBA’s exchange settlement balances, which measure daily demand from commercial banks to settle balances with the RBA and with one another, indicate banks immediately took advantage of the extra repo funding (see chart).

An ANZ research note published on 17 March stated: “This injection of liquidity, and the knowledge that the RBA will be proactive in managing funding market stress, should lead to some reduction in Australian dollar funding stress. This has already played out to some extent…We think these funding market stresses will continue to unwind. But it is not a straightforward path and is predicated on what additional actions the RBA takes and a reduction in US dollar funding stress.”

Martin Whetton, CommBank’s Sydney-based head of bond and rates strategy, added in a daily research report on 17 March that the RBA’s liquidity injection caused one-, three- and six-month bank bill spreads to overnight index swap to narrow from wide levels.

More positive news for the banks came on 19 March, as the Australian Prudential Regulation Authority (APRA) elected to relax some capital requirements to give lenders capacity to provide credit through the crisis.

“There have been very good deposit flows into CommBank through last year, which have continued this year. Credit growth was also relatively good, particularly in mortgages, but the rate of deposit growth far out-paced credit growth. This limits our need for wholesale term funding.”

System support

Fitch’s 17 March report says the regulatory response from the CFR has been in line with rating agency expectations for system support. “The action by the RBA, ASIC [Australian Securities and Investments Commission], APRA and government has been aimed broadly at shielding the economy from the impacts of COVID-19 and promoting stability and liquidity within the financial system.”

The next stage of support was the RBA’s Term Funding Facility (TFF), announced as part of a raft of QE measures on 19 March. The facility, and the expectation that it will be expanded if required, appears to secure banks’ wholesale funding needs. Global market activity since the acceleration of the COVID-19 crisis suggests liquidity may be available to Australian banks but pricing may not be supportive of ongoing lending. The Australian government clearly regards this as critical to the success of social distancing.

Bank issuance in global markets resumed quickly after a hiatus. For instance, on 17 March, Royal Bank of Canada priced a €1 billion (US$1.1 billion) covered bond while Bank of America and Goldman Sachs issued a combined US$5.5 billion. The US dollar market had more than a half-dozen new corporate deals priced on the same day.

Since then, the euro and US dollar markets have seen a panoply of issuance from banks and corporates. Two Australian corporate borrowers – Transurban Finance and Toyota Finance Australia – issued in the euro market in early April. However, local banks have been absent from domestic and global markets, buoyed by their pre-funding positions and the security of the TFF.

Deposit growth could also help keep the banks out of funding markets, as consumers switch out of riskier assets and into deposits for relative safety. All things considered, most market participants expect little or no wholesale issuance from the Australian major banks in the near term.

“Profitability starts to burn as soon as banks have a critical mass of customers receiving loan holidays. The banks have fixed costs and while they may be able to make cuts, it is hard to see how they can do so in a way that keeps pace with the revenue decline.”

Unquestionably strong – for now

The banks have made many changes since the financial crisis to ensure they are unquestionably strong, as regulators require. As a result, their creditworthiness does not seem in immediate danger from the current crisis. However, the COVID-19 outbreak and its effect on the economy still have the government and regulators pondering how they can get banks to maintain the flow of credit to the real economy.

S&P predicts a manageable impact on Australian banks if the virus outbreak subsides after the second quarter of 2020. However, the rating agency states that major problems could emerge if the crisis is longer and more severe. First, dislocated funding markets would weaken banks’ ability to provide credit. Second, a fall in economic activity could lead to a sharp rise in unemployment and a drop in property prices, leaving the banks exposed to property lending problems.

Meanwhile, Fitch downgraded the long-term issuer default ratings of the Australian major banks and their New Zealand subsidiaries on 7 April, to A+ from AA-, and kept all four on negative outlook. The decision reflects the expected effect on the banks’ core markets and operations of measures governments are implementing to limit the spread of COVID-19.

Fitch has also revised its outlook for Australia’s operating environment factor to negative. Downside risks are considerable, it adds. “The agency’s base case is for a sharp downturn in economic growth in H1 2020, with only partial stabilisation in Q3 2020 and a gradual recovery beginning in Q4 2020.”
Bank asset quality will deteriorate and be offset only partially by government and bank support, Fitch predicts. This will develop over the next 6-12 months, but a fall in profitability is likely to eventuate more promptly due to low interest rates and declining business activity, the rating agency explains.

Fitch also expects bank capital ratios to come under pressure, but buffers built since the financial crisis have put each of the banks in a “reasonable position to withstand a downturn that modestly exceeds our base case”. The liquidity and funding positions of the banks can withstand short-term pressures, given the RBA support, Fitch states.

Moody’s Investor’s Service did not go as far, but on 2 April it revised its outlook on the Australian banking system to negative. This is despite its belief that the banks are in a solid position to manage the requirements placed on them to support the economy during the crisis.

In fact, Frank Mirenzi, Sydney-based vice-president and senior credit officer at Moody’s, says all government actions to date reinforce the importance of the banking system within the Australian economy and the likelihood of government support.

The Moody’s analysis focuses on what comes next and how Australian banks are positioned to manage it. For this reason, the rating agency’s view does not rest on specific modelling of the duration of the crisis.

“It is going to take a long time for the economy to recover after it returns to ‘normal’, irrespective of whether that takes six months or even longer,” Mirenzi says. “Some sectors will be slow to recover and others may not recover at all. This will affect borrowers’ credit quality and thus that of the banks.”
He adds: “On the other side of the crisis, the banks will have weaker loan portfolios [while] at some stage needing to rebuild capital positions that have been allowed to slip for the time being.”

Moody’s assesses six factors in building its overall outlook on a banking sector. Its announcement on 2 April drops Australia in two of these – asset risk and capital – to “deteriorating” from “stable” (see table 2).


FactorOutlook (2 April update)Previous outlook
Operating environment Deteriorating Deteriorating
Asset risk Deteriorating Stable
Capital Deteriorating Stable
Profitability and efficiency Deteriorating Deteriorating
Funding and liquidity Stable Stable
Government support Stable Stable
OVERALL Negative Stable

Source: Moody's Investors Service 2 April 2020

On asset risk, Moody’s notes that problem loans are set to rise “from a very low base” because of the ongoing disruption. The effect is likely to be particularly acute in the residential mortgage book, which comprises two-thirds of Australian bank assets.

While Mirenzi emphasises that Australian banks came into the crisis with strong capital positions, he also points out that asset quality and profitability were already weakening. Lower interest rates – which bottomed out at the start of the COVID-19 crisis – were putting downwards pressure on revenue even from performing loans. This and other factors have hampered banks’ ability to self-generate capital – a situation that will only worsen as more loans fall into hardship.

Bank credit quality is constantly suffering while the crisis is ongoing. “Profitability starts to burn as soon as banks have a critical mass of customers receiving loan holidays,” Mirenzi explains. “The banks have fixed costs, and while they may be able to make cuts it is hard to see how they can do so in a way that keeps pace with the revenue decline.”

Moody’s base case is for a slow rebound. Mirenzi says the agency is factoring in a lengthy adjustment period after COVID-19 risk recedes; for instance, with a long lag while people who have been rendered unemployed return to work at the same level they left.

The rating agency is looking beyond the near term on the issue of Australian banks’ calls on capital markets as well. The big four rely heavily on international markets for wholesale funding and Mirenzi says this leaves them vulnerable to global investor sentiment when they return to new debt issuance.