Following the collapse of SVB and Credit Suisse, Mutual Limited CIO Scott Rundell shares his post mortem:
The worst is behind us – Aussie banks are liquid
With the risk of new financial crisis waning, 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.
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. I covered this in my note last week (here), so I won’t re-hash it too much.
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.
Also read: Capital Notes Holders Wiped Out in Credit Suisse Debacle
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 requirements between Australian and other jurisdictions, including the US, is the treatment of interest rate risk hedging
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
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.
Also read: SCAM ALERT – CBA and Peony Asset Management
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.
