Background
The past week or so has been wild for global markets with some very wide trading ranges across bonds, stocks and hybrid securities, aka AT1. Offshore credit markets have also been volatile, and while we have seen some widening in local A$ credit, the moves have been relatively muted by comparison.
The collapse of Silicon Valley Bank (‘SVB’) in the US and contagion effects represents ground zero for this saga and story of woe. While regulatory action was taken to stem the blood-letting, confidence on whether these actions were enough waivered from day-to-day. Eventually it appears all was good in the hood, but then more recent comments from US Treasury Secretary Yellen poo-pooing expansion of current depositor support programs have added to inter-day volatility. This will likely remain a moving feast for days, probably weeks, to come.
Adding to the sense of impending market doom, early last week, the lights almost went out on Credit Suisse. After more than 160-years in business, the Swiss bank faced its own crisis of confidence, with visions of Lehman Brothers coming back to haunt markets. After a few days of angst and anxiety, the Swiss National Bank brokered a deal for UBS to acquire Credit Suisse. As part of the deal, however, a meaningful wedge of Credit Suisse AT1 capital was wiped out. Against the natural order of capital, Credit Suisse equity survived. Heads were scratched.
With the risk of new financial crisis waning, I thought it constructive to conduct a brief post-mortem of recent events. Now, ‘Post mortem’, ‘noun: an examination of a dead body to determine cause of death.’ After last night’s comments from Yellen, one could suggest said body has a pulse. Nevertheless, I expect the worst is behind us and we’re seeing some involuntary death spasms… if that is in fact a thing.
In the following piece I provide a review of Australian bank liquidity, and why we’re ‘different’ to US banks. I also look at the Credit Suisse situation, and why Australian bank AT1 capital, and Tier 2 capital for that matter is sound. Lastly, some commentary around how local bond and credit markets have performed of late.
Before I proceed, a shout out and a gentlemanly tip of the cap to Brendon “Coop” Cooper at WBC who has published two very informative pieces on bank liquidity and AT1 dynamics recently. Some might be tempted to call my “borrowing” of his words as “blatant plagiarism”, however I prefer to term it as “para-phrasing with respect.” And, besides, plagiarism is the sincerest form of flattery.
Australian Bank Liquidity
Concern for Australian bank liquidity, particularly the regionals, stemmed from the situation that engulfed Silicon Valley Bank. Contagion risk, unfortunately saw other smaller US regional banks hit with deposit runs. SVB’s issues were not caused by any systemic shock, although the genesis of their downfall was rooted in the pandemic and monetary policy responses. The main cause was risk management incompetence – both at the bank level, but also within the US regulatory framework.
To recap, through an absence of interest rate risk management, SVB left its balance sheet exposed to rising interest rates. A defence of SVB’s failings here, as weak as it is, is the fact they were not required by regulators to hedge interest rate risk. Under the Trump Presidency, regulatory hurdles for banks were loosened. As a consequence, SVB had no requirement to meet Liquidity Coverage Ratio (‘LCR’) or Net Stable Funding Ratio (‘NSFR’) minimums. Looking further afield, less than 10% of US banks (by total assets) are required to meet minimum ratio requirements in this regard. Australian banks on the other hand…
“Australian liquidity rules (APS 210) apply to all ADIs through either the Liquidity Coverage Ratio (LCR) for large banks or the Minimum Liquidity Holdings (MLH) rules for smaller banks. The minimum requirement under the LCR is 100% (HQLA/net cash outflows), however all LCR banks are currently well above 120%, while MLH banks are required to hold liquid assets in excess of 9% of total assets. It should also be noted that the bulk of deposits at domestic MLH institutions are retail (i.e. sticky) providing a strong starting base in liquidity terms.” (WBC).
Liquidity requirements for US banks are applied according to the size of the bank. Only banks with asset bases >US$750bn are required to meet the kind of LCR requirements that all Australian banks are required to meet. SVB was ranked 18th by total assets, but accounted for <1% of system assets. Regulatory wise, it slipped under certain minimums for wholesale funding, and were not subject to LCR or NSFR requirements.
Australian banks on the other hand must hold minimum HQLA, or “High Quality Liquid Assets”, in order to meet minimum LCR’s. Australian banks are subject to one of the most conservative interpretations of the LCR regulatory requirement. They can only hold cash, ACGB’s and Semi’s as HQLA’s, and at the moment cash is elevated, which is evidenced by elevated ES balances – i.e., very liquid. US banks on the other hand have a broader range of assets they can hold for liquidity purposes, including investment grade credit or equity for some banks….and only for those banks big enough to fall within the regulators net.
SVB was undone by the lack of interest rate hedging, which is not standard practice (not having it that is) and underpins my earlier accusations of gross incompetence. One key difference in capital requirementsbetween Australian and other jurisdictions, including the US, is the treatment of interest rate risk hedging. “Australian regulators have included IRRBB as a Pillar 1 requirement, with a capital charge reflecting risk. In other jurisdictions this risk is largely a Pillar 3 disclosure requirements, with the potential for a supervisory add-on to capital if required by the regulator. As a result, domestic banks offer strong disclosure, active risk management and a capital charge in place for this risk.” (WBC).
In addition to LCR requirements, Australian banks are required to maintain contingent liquidity in the form of self-securitised assets, with a cash value equivalent to at least 30% (onto the LCR). The collateral needs to be needs to be unencumbered, and not held as collateral for any other purpose.
So, no liquidity issues here.
Not all AT1 is created equal…some are more equal than others
UBS acquired Credit Suisse for CHF3bn (US$3.3bn) at the insistence of the Swiss National Bank. Credit Suisse equity holders received UBS stock in return, albeit at a deeply discounted price. Credit Suisse’ “alternative tier 1” capital was wiped out. Swiss authorities said those security holders would receive absolutely nothing, a move that is at odds with the usual hierarchy of losses when a bank fails, with shareholders typically the last in line for any kind of payout. Heads were being scratched.
As a result of this very surprising, some might say, shocking turn of events, central banks and regulators around the world, including the BOE and ECB, released statements saying that common equity will be the first to absorb losses, and only after this will AT1 and Tier 2 securities incur potential losses in a non-viability situation.
Where does that leave A$ AT1? Local AT1 securities have worn some pain as holders shoot first (sell) and ask questions later. Looking at the non-viability and credit hierarchy, under APRA guidelines the definition of non-viability is broad, effectively being triggered when APRA decides either i) conversion or write-off of capital instruments is necessary because, without it, the ADI would become non-viable; or, ii) without a public sector injection of capital, or equivalent support, the ADI would become non-viable.
Conversion….”AT1 and Tier 2 instruments must contain a provision that requires the conversion to equity in a non-viability event, resulting in the dilution of equity holders. Write-off will only occur where conversion to equity is not possible (this includes some unlisted issuers). Australian instruments also allow for partial conversion, which was not possible in the case of CS.” (WBC)
Importantly for tier 2 investors also, ranking rules dictate that APRA… “must provide for all AT1 capital instruments to be fully converted or written-off before any Tier 2 instruments are required to be converted or written-off. Any conversion or write-off of Tier 2 instruments will only be necessary to the extent that conversion or write-off of AT1 was required, and deemed insufficient for recapitalisation.” (WBC)
Market reactions…
Concerns the world was hurtling toward another financial crisis triggered a flight to quality in the past week or so. Bonds yields plunged and risk assets were abandoned with varying degrees of severity and indifference. Inflation risk was consigned to the back seat with a growing belief the Fed, ECB, RBA et al would be forced to halt their rate hike activities in order to preserve financial stability. The ECB, then the Fed has subsequently proven these beliefs to be wrong, for now. The longer run concern now is with rate hikes continuing, and potential credit rationing following banking turmoil, one or more central banks will fall off the narrow path between containing inflation and supporting growth. Plunging yields suggest rate cuts are on the way.
Three-year ACGB yields fell -82 bps to 2.818% while the SVB and then CS saga played out. Market implied terminal cash rate pricing went from pricing in two more hikes to pricing a pause, followed to cuts in coming months. The ASX 200 lost ground, down -6.50% over the period in question (vs -4.75% for the S&P 500), while major bank AT1 lost -4.00% - 5.00% in local markets, and as much as -10.0% in US markets. Bank credit spreads widened, +15 bps at their worst, with 5Y indicative spreads rising from +91 bps to +106 bps (green line in the first chart overleaf). As I type, major bank senior spreads are back around +98 - 99 bps vs a long run average of +95 bps. Tier 2 spreads have been modest in the grand scheme of things, around +15 bps wider, possible +20 bps to +225 bps for 2028 callable paper.
It is worth noting the relative stability and resilience of A$ bank spreads, and A$ credit spreads in general. Not just through the recent hiccup, but other incidences of market dysfunction also – A$ spread performance is adhering to the historical play book. The SVB situation came to a head on March 8th (when they announced a capital raising and sold long-dated government bonds at a heavy loss). For the sake of this exercise, we’ll look at month to date performance, just because. US and EU financial spreads are +40 bps and +30 bps wider MTD, which is a 30% to 40% move. At their peak, US and EU financial spreads were around +55 bps wider in each. A$ financial spreads are +3 bps or +4 bps wider over the same period, or around 3% to 4%, peaking at +6 bps to +9 bps.
We expect A$ spread resilience to persist, and while the US banking sector remains somewhat in a state of flux, we feel regulators have done enough now to prevent a further meaningful sell off in spreads – beyond the wides already seen at least.
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