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BFCSA: Revealed: How the RBA kept the banks afloat with a $4 billion daily lifeline

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Revealed: How the RBA kept the banks afloat with a $4 billion daily lifeline

Australian Financial Review Sep 7 2018 11:00 PM

Karen Maley

 

It's an eerie parallel. In early 2008, the forbearance of the newly installed government in Canberra was being sorely tested – as it is now – when the country's big four banks hiked their home interest rates in tandem, even though the Reserve Bank of Australia had not raised its official interest rates.

The then treasurer Wayne Swan urged customers to vote with their feet, just as Prime Minister Scott Morrison is advising borrowers to shop around.

But a decade ago the frictions were forgotten as the GFC hit. Now, for the first time, RBA leaders give a detailed account of how they worked side by side with the banks during those dark times, and how the banking guarantee turned into a "nice little earner" for Canberra.

Central bankers shun the spotlight, it's part of their DNA. Typically, top executives at the Reserve Bank of Australia carry out their work in hushed tones behind closed doors. But in 2008 senior Reserve Bank of Australia officials took centre stage in a draining, protracted struggle as they fought to sandbag Australia's banking system from the maelstrom that was the Global Financial Crisis.

For months, there had been ominous signs that something was awry. September 2007 witnessed the first run on a British bank in 150 years, as panicked savers queued up outside branches of Northern Rock, which had relied on borrowing from international money markets to fuel its exponential growth.

The following March, US investment bank Bear Stearns was swallowed up by larger rival JP Morgan Chase after the firm's long-time clients and trading partners, worried about its huge bets on toxic subprime mortgages, raced to withdraw funds.

Scale of destruction

In Australia, October 2007 saw the troubled non-bank mortgage lender RAMS – which was struggling to roll over $6 billion in short-term funding – taken over by Westpac. Within months, investment banks Babcock & Brown and Allco, which had also enjoyed spectacular debt-fuelled expansions, were in a death spiral as nervous lenders pulled funding.

But it wasn't until September 2008, after prominent US financial services firm Lehman Brothers filed for bankruptcy protection and as US insurance giant AIG teetered on the brink of collapse, that the world would discover the scale of destruction wreaked by a full-blown financial crisis.

Those at the front line of the battle have now spoken to AFR Weekend about those nightmare times, their discussions with their offshore counterparts, and the ingenious mechanisms they came up with to ensure that Australia's banks had enough funding to allow them to come through the global financial meltdown largely intact.

Australia's efforts were led by the then head of the RBA, Glenn Stevens, and what he describes as his "fabulous team": deputy governor Ric Battellino (who had previously spent decades running the RBA's financial markets operations and who Stevens says "understands the mechanics of central banking better than anyone in the world, probably"), Philip Lowe (now RBA governor, then in charge of financial stability), Guy Debelle (now deputy governor, then running financial markets) and Malcolm Edey (who led the RBA's economics team).

Of course, in the halcyon pre-crisis days, the Australian banks had enjoyed a level of profitability that made them the envy of their brethren around the world. This meant that, unlike many US and European banks, they hadn't been tempted to load up on with US subprime securities to boost earnings.

As a result, even when global financial markets were in complete disarray and asset prices were plunging, the RBA didn't find itself confronted with a bunch of banks with unsaleable, and worthless, US subprime bonds on their books. Instead, Australia's central bank knew exactly what needed to be done.

"The main thing we did – which a lot of other central banks didn't – was that we realised very early on that this was a liquidity crisis, and the answer was to flood the banks with liquidity," recalls one former senior RBA official.

Key issue

"I think the Bank of England helped to precipitate the crisis with Northern Rock. It took the attitude, 'you've behaved very badly, you need to be punished'. But that's such a counter-productive approach."

In contrast, he says, "the RBA stepped in very early and provided a heap of liquidity to the banks until they could get their funding sorted out".

Glenn Stevens, Reserve Bank governor from 2006 to 2016, agrees.

"Your job as a central bank in these situations is to liquefy the system to the extent needed. Most of that liquidity provision can come through your standard facilities, and, if need be, you can invent some new things. Or you can widen the pool of eligible collateral if that seems sensible."

As a result, he says, the key issue becomes "do all the players in the system have appropriate collateral to bring us if they feel in need of extra liquidity?"

In its daily market operations, the RBA made sure it was extremely generous with the cash it made available to the banks. "It was far above what they needed. There was so much money available," recalls one senior RBA official.

Just how much money is evident in the figures. According to the RBA's 2009 annual report, the central bank's daily cash advances to the banking system averaged close to $4 billion in the year to June 30, 2009, up from $2.5 billion in 2007/08, and many times the daily average of $750 million in the five years before the financial crisis.

What's more, in September 2007, as TV footage showed the queues snaking around Northern Rock branches, the RBA announced that from the following month it would accept residential mortgage-backed securities, backed by prime full-doc AAA-rated residential mortgages, as security for its loans.

The RBA was also quick to realise the potential tensions if the banks' access to offshore funding dried up. After all, Australian banks raised about 60 per cent of their funding from wholesale markets, and almost half of this came from offshore. Some $220 billion in offshore borrowings were due to be repaid within a year.

Funding needs

Guy Debelle recalls that from late 2007 he and Charles Littrell, a senior APRA executive, had been having regular chats with the banks, taking a keen interest in their plans for raising funds offshore, and quizzing them about what assumptions they were making about their market access.

"It was often me and Charles having a chat with the bank treasurers," recalls Debelle. "We were keeping a pretty close eye on what their funding needs were going to be."

Debelle sums up the message that he and Littrell were giving the banks: "It was very much, 'when it's fair sailing – not even good sailing, just fair sailing – hit the market."

Bank treasurers took the hint. They tried to change their funding structure by issuing longer-dated debt, even though this was more expensive. And when conditions In global markets temporarily improved in mid-2008, they hit global markets hard, almost doubling their bond issues from a year earlier.

But waters became treacherous after Lehman's collapse on September 15, 2008.

As Stevens explains, "my feeling has always been that having seen Bear Stearns get sorted, there was an assumption that entities bigger than them would always be sorted out ... When it became apparent that assumption was mistaken, then we were in a new ballpark."

He adds that "in an environment when everybody was already on edge, that proved to be the final straw, and capital markets essentially closed for a while."

This tested the resilience of banks worldwide, as panicked savers rushed to withdraw deposits. Ken Henry, the then Treasury chief who is now chairman of the National Australia Bank, later recounted that he'd even had a call from his mother asking whether she should withdraw all her savings from her bank.

"I think about late 2008 I did start to get really worried," recalls one senior RBA official. "It really was quite scary. Once you get a run like that, with rumours going around about people going into banks and taking out suitcases full of cash – in fact there was a rumour that one of the senior board members of one of the banks was doing it."

Markets shuttered

With global markets essentially shuttered, Australian banks were relying heavily on the RBA to cover their funding needs.

"The banks were dealing directly with the RBA. There was continual contact with the banks. All day, every day, the banks were dealing with us," he adds.

"It was a help that we had the trust of the four majors here. They trusted the RBA and kept it fully informed of everything they were doing. From that perspective, the trust between the RBA and the majors was important in terms of getting through."

It didn't take long for the banks to cotton on to the fact that their salvation lay in the Reserve Bank, rather than their regulator, the Australian Prudential Regulation Authority.

"Banks very quickly realised that the only one that could provide the liquidity they needed during that period was the RBA," he says.

But this reliance meant there was an extraordinary burden on the central bank to ensure that the banks were supplied with enough funding – or, in central banking terms, liquidity.

And that's where the RBA's decision to accept residential mortgage-backed securities, backed by high-quality home loans, as collateral for loans from the central bank comes in.

Debelle explains that at that stage, the banks didn't hold a lot of high-quality liquid assets – such as government bonds – on their balance sheets, largely because a succession of bumper government budget surpluses had shrunk the amount of government debt on issue.

"What they did have were the mortgages that they had written themselves. And so we got them to package them up into a security, so they didn't just dump a bunch of mortgages on us," he explains.

"We required that, because if we got stuck with them then we were going to have to sell them, or manage them. So you need a vehicle in place beforehand."

Same structure

Fortunately, banks had been issuing mortgage-backed securities before the crisis, and they essentially used the same structure for bundling their mortgages up in securities which they handed to the RBA.

This mechanism allowed Australia's banks to borrow tens of billions of dollars from the RBA. As at the end of December 2008, the RBA held $44.7 billion in these self-securitised mortgages as security for loans. By June 2009, that had fallen to $21.2 billion.

This worked exceptionally well for the big four banks – the Commonwealth Bank of Australia, Westpac, NAB and ANZ Bank – which had ample high-quality residential mortgages on their balance sheets that they could package up as security for loans from the Reserve Bank.

The hitch was that some of the smaller regional banks had dropped lending standards in an aggressive bid to expand their market share before the GFC hit.

What stopped them from packaging up their own home loans as collateral for loans from the RBA?

"They could have, but that wasn't going to solve the problem. These small banks had much lower quality assets on their books," explains a former top RBA official. He rues that APRA "had really taken its eye off the ball for the smaller banks".

Did he tell Stevens about the extent of the problem? "I didn't have to tell Glenn, he knew they were in poor shape. The issue was what to do about it."

The gravest fears concerned two regional banks: Queensland's Suncorp (which had $75 billion of assets) and West Australia's Bankwest ($60 billion). The West Australian bank's problems were exacerbated by the predicament of its own parent, the British bank HBOS, which was itself in dire financial straits, and was ultimately rescued by British taxpayers after being bought by Lloyds at the height of the financial crisis.

Stronger player

In October 2008, the Commonwealth Bank announced that it would pay $2.1 billion to buy Bankwest.

"They were absorbed by a stronger player," Stevens says.

"What I'd say is that when circumstances come along that place an entity under some pressure, it's pretty likely that one of the solutions that's going to be thought about is they get absorbed by someone stronger. And in most crises that happens."

Did the RBA put pressure on the Bankwest's struggling parent HBOS to sell its Australian offshoot?

"The Reserve Bank is not in a position to dictate to the parent," Stevens replies. "However, we were apprised of what was going on. And my feeling was that that particular transaction more or less took off the table a problem we really didn't want to see get worse.

"And so I was content with it, acknowledging that there were competition ramifications."

Still, Stevens notes that the extent to which the takeover diminished competition is a moot point. "Actually, that competition wasn't going to be there anymore because the business model that allowed it – namely the wholesale funding access – was gone. So that form of competition was no more.

"And that wasn't something any regulatory authority or central bank or anyone else decided. It was capital markets that ended it."

The RBA had another major problem to contend with. In late September 2008 global markets received another jolt when the Irish government gave a blanket guarantee to all Irish banks, covering €440 billion of customer deposits and bank borrowings. Germany, Denmark and Greece quickly followed suit with unlimited deposit guarantees.

Widespread phenomenon

As Stevens recalls, "When I saw the Irish guarantee, I thought that this is a phenomenon that will probably become widespread. And it did.

"Then it becomes very difficult for any government to answer the question, 'Why are you not prepared to guarantee yours in some way?'"

The Irish move galvanised Australian authorities. Earlier initiatives to guarantee bank deposits had been caught up in political point scoring, as the Rudd government's proposal to guarantee individual deposits of up to $20,000 was attacked by Malcolm Turnbull, the then Opposition leader, who claimed it did not go far enough and that the guarantee should apply to deposits of up to $100,000.

At an emergency all-day meeting held at the RBA's Martin Place headquarters on Friday, October 10, the Council of Financial Regulators (which includes the RBA, APRA, the Australian Securities and Investments Commission and Treasury) agreed that the Australia government needed to act to support its banks.

The following Sunday, the Rudd government unveiled its proposed bulwark. It had decided to guarantee all wholesale borrowings of Australian banks, building societies and credit unions, which allowed them to take advantage of the government's Triple A rating. Financial institutions with a rating of Double A minus or above charged a fee of 70 basis points – a relatively low charge compared with other countries – while banks with lower ratings paid a higher amount.

"I think that with the wave of governments feeling the need to issue guarantees of various kinds, it was going to prove very difficult – if not impossible – to completely stand aside from that, no matter how strong you felt your institutions were," says Stevens.

"I felt that ours were strong, but in those times of very febrile, volatile perceptions, it's probably not prudent to take too many chances."

Debelle agrees. "If the other countries hadn't done that, I don't know that we would have gone down that path. But with the others doing it, there was absolutely no choice."

But there was some consternation at Canberra's decision to offer sweeping and free guarantees of all retail deposits. In particular, the RBA was concerned that this would encourage large depositors to put their surplus cash into banks, rather than the short-term money market, which was still working well. The RBA argued that those with large deposits should pay a hefty fee for the government guarantee.

Within a fortnight, the Rudd government had bowed to the RBA's concerns. It announced that the free government guarantee would only apply to deposits of up to $1 million, with a fee applying on larger amounts.

Armed with their new Triple A weapon, Australian lenders hit the market, issuing $73 billion of bonds ($70 billion of which sported the guarantee) in the first three months after it came into effect, compared to only $2 billion in the three months before its introduction. What's more, no claims were ever made against the Australian government, and the fees charged generated $4.5 billion of revenue.

As Debelle quips, "it turned into a nice little earner for the government."

The government guarantee also proved to be a critical lifeline for the smaller, regional banks. "If it hadn't been for the bank guarantee, someone else would have taken over Suncorp," recalls a former senior RBA official. [ANZ was at that stage circling the Queensland lender.]

"I think if it weren't for the actions of the RBA and the bank guarantee, there would have been three or four bank failures ... none of the smaller banks were going to survive." In the Australian context, this would have resulted in smaller, regional banks being absorbed by their larger, more robust competitors.

So just how grateful were the banks for the RBA support?

In denial

"They were very grateful," he says. "There was a constant, 24-hour discussion between the major banks and the RBA every day ... The four majors all understood exactly what was done to look after them. And I have to take my hat off to the bank treasurers, they kept on top of the situation."

In contrast, he says, many of the smaller lenders failed to come to grips with their predicament. "I think the boards and the chairmen and the senior executives of some of the smaller banks were in denial. It was pathetic.

"They couldn't understand why they'd got into the situation and what they should do about it. They were blaming everybody else ... They didn't cover themselves with glory at all."

Debelle agrees that the banks were grateful, "at the treasurer level at least".

"They appreciated the various forms of support. They recognised that us expanding our liquidity provision and the guarantee absolutely helped. And if you asked them today, I think they would still say that."

But, he shrugs, "whether the message got lost slightly further up the chain, maybe..."

Did he find it somewhat grating that after the crisis had abated, bank bosses began to pat themselves on the back and to argue that the fact that Australia had not been forced to bail out its banks demonstrated what exemplary managers they'd been.

"A little bit," he concedes.

Still, he adds: "What they hadn't done was go and buy a lot of terrible assets. So that was good."

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