With the recent announcement by Fitch Ratings of downgrades of the major banks long term credit ratings and Standard & Poors putting Australia’s sovereign rating on negative outlook we thought it would be worth updating our clients on how this, together with difficult operating conditions associated with COVID-19 lockdowns, has affected the banking sector as a whole.
Major bank down grades
Fitch rating announced on April 7 that it had lowered the long-term ratings on Australia’s four major banks to A+ from AA- citing expectations of a significant economic shock in the first half of 2020 due to measures taken to halt the spread of COVID-19. Concerns centre around how the current lock down will affect the ability of businesses to repay loans which will in turn have an impact of the credit quality and profitability of the banks.
This down grade on its own should not affect investment policies or the overall cost of bank borrowing as Fitch is widely regarded as the third ratings agency in Australia. Most investment policies also follow market convention of discarding the lowest of the three ratings and the applying the lower of the remaining two ratings when applying investment ratings.
The bigger concern will be if either S&P or Moody’s follow suit as this will push the major banks firmly into the single A rating bracket for most investors causing breaches with many current policies.
What is the likelihood that this may occur?
Standard and Poor’s have a slightly different rating model from the other agencies in that every bank rating starts off with Australia’s anchor point know as Banking Industry Risk Assessment (BICRA) methodology. Once the BICRA has been set, bank specific factors are evaluated to come up with a standalone credit profile for each bank before being assessed for any likely government support. Australia’s systemically important banks have been identified as the 4 major banks and Macquarie. There is an applied assumption in their rating that these SIBs will be supported in the event of a crisis (generating the phrase “too big to fail”).
On April 8 S&P moved to revise Australia’s AAA sovereign rating and changed the outlook to “negative” given the budget difficulties that lie ahead after announcing the massive stimulus packages in the wake of COVID-19. This outlook assesses the potential direction (in this case) of the long term credit rating over the intermediate term with any changes being assessed over the next six months to 2 years.
As stated above, banks in Australia are tied to the country’s BICRA, or anchor point. Given the four majors have been identified as SIBs their ratings were also placed on negative outlook along with the semi government authorities such as NSW Treasury Corp and Treasury Corporation of Victoria.
Markets have largely shaken this news off with both credit default swaps and margins offered in the secondary market for longer term bonds tightening slightly. This would indicate that the market is happy there is no imminent threat of a S&P single notch downgrade.
Investment managers should however take this into consideration when reviewing investment policies and your Laminar advisor can help in this regard.
Government banking support packages
The government is acutely aware of the impact that market disruptions such as COVID-19 can have on the availability of credit. Banks generally move to a more conservative stance during such crises and the availability of loans becomes more difficult.
To encourage ADIs to support businesses during this difficult period the RBA announced a special low cost Term Funding Facility on March 19. The TFF allows ADIs to enter into repurchase transactions with the RBA for three years at a funding cost of just 0.25%. All ADIs, including the regionals and mutual ADIs, that hold eligible collateral can access this facility to an amount equal to 3% of total outstanding credit.
The total amount set aside for this facility currently stands at $90 billion.
In addition to this facility, non-bank lenders and smaller ADIs that don’t have access to the TFF can gain access to a further $15 billion made available by the Australian Office of Financial Management’s (AOFM) structure finance support fund.
These facilities add further support to the already robust regulatory framework that APRA has in place to ensure Australia has a robust banking system.
To ensure ADIs have access to the wholesale markets for funding and have sufficient access to liquidity in the event of a crisis, they must hold a certain percentage of their balance sheet in self securitised assets.
Self securitisation is a process of turning illiquid mortgage assets into mortgage backed securities that are held on the ADIs own balance sheet as an asset. In times of crisis APRA allows these securities to be used as collateral for repurchase transactions with the RBA. A “repo” is where the ADI sells these securities to the RBA while simultaneously agreeing to buy them back for a known amount at a future date. The difference between these buy and sell prices equates to the funding cost that the RBA charges. As part of the TFF outlined above, not only have APRA allowed self securitised assets to be used as collateral for repo transactions they have also mandated ADIs to increase the size of these facilities from 10% to 25% of total liabilities.
This provides ADIs with a vast amount of liquidity reserves.
Laminar Capital is a leading arranger of self securitisation programs for the regional and mutual ADIs having completed more than 20 transactions which gives us the insight into the level of liquidity they have access to and the comfort we have in recommending deposits in these institutions to our customers.
A strong regional banking sector is vital for competition in the Australian Financial System and formed part of the government’s 2018 Productivity Commission Report
While the current operating environment is difficult for all ADIs, the current support measures that are in place together with the strong regulatory environment makes Australia’s banking system very resilient and able to withstand the current operating environment.
For more information please contact your Laminar relationship manager.