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Australian Banks Can Ride Out Market Jitters


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Australian Banks Can Ride Out Market Jitters

Australian banks are unlikely to encounter similar developments to those that have recently shaken the global industry. The recent collapse of Silicon Valley Bank and downgrade of First Republic Bank (both U.S.-based regional banks) highlight the risks from an asset-liability mismatch and unstable deposits. In addition, the write-off of Additional Tier-1 (AT-1) capital instruments issued by Switzerland-based Credit Suisse has startled many market participants.

Australian banks have different business models to these banks. They are mainly focused on conventional banking and operate with sound funding and liquidity under prudential regulations. That places the industry adequately to weather the current market instability.

In our view, Australian banks can navigate a short-term disruption in the financial markets triggered by the recent events. Prolonged dislocation of financial markets, however, would erode the banks' earnings and pose risks to our ratings on smaller institutions.

Exposure To Large Unrealized Losses Is Low

Australian banks are not reliant on generating interest income from long-dated debt securities. In addition, accounting policies followed by the banks reduce the risk of a buildup of large unrealized losses in securities portfolio without being reflected in banks' capital.

Australian banks hold debt securities mainly for liquidity management. Conventional retail and commercial banking forms by far their largest business line. Customer loans and advances account for 68% of the total reported assets of the four major banks (see table 1).

Conversely, cash, bank balances, and other forms of debt securities form only about a quarter of the four major banks' reported total assets. Their interest income on securities comprise a relatively insignificant 6.4% of the latest full-year gross interest incomes. Banks may have combined a small portion of their interest income from securities with that on loans and advances in some cases.

Table 1

Australian Banks Carry Limited Risks From Unrealized Losses From Debt Securities

(In bil. A$)





Typical accounting method
Cash, liquid assets, bank balances, balance with central banks, reverse repurchase agreements* 168.1 168.0 211.4 111.5 Initially at fair value and subsequently at amortized cost
Trading securities - FVTPL 35.2 25.3 40.6 24.3 Fair value through profit and loss account
Investment or banking book - FVTOCI 76.8 79.1 42.1 74.9 Fair value through other comprehensive income
Investment or banking book - FVTPL 0.0 1.3 - - Fair value through profit and loss account
Investment or banking book - Amortised cost 7.9 3.2 - 1.2 Amortized cost
Total cash & debt securities 288.2 276.9 294.1 211.9 N/A
Net loans and advances 672.4 878.9 680.4 739.6 N/A
Total reported assets 1,085.7 1,215.3 1,055.1 1,014.2 N/A

Source: Bank disclosures. S&P Global Ratings. ANZ: Australia and New Zealand Banking Group Ltd. CBA: Commonwealth Bank of Australia. NAB: National Australia Bank Ltd. WBC: Westpac Banking Corp. Data as of Sep. 30, 2022 except for CBA whose data are as of June 30, 2022. * Readily convertible to known amounts of cash within three months and are subject to an insignificant risk of changes in value. FVTPL: Fair value through profit and loss account. FVTOCI: Fair value through other comprehensive income. . N/A--Not applicable.

Most of the debt securities held by Australian banks are at low risk of changes in value. The four major banks hold 62% of their total assets classified as liquids and debt securities in assets such as cash, balances with central banks, bank balances, or reverse repurchase agreements. These assets are readily convertible to known amounts of cash within three months, and carry insignificant risk of changes in value.

Of the remaining securities held by Australian major banks, 97% are accounted based on fair value through either profit and loss account or other comprehensive income. A drop in value of these securities due to unrealized losses is reflected in the banks' reported capital under both accounting methods.

Most Liabilities And Customer Loans Reprice Regularly

Australian banks reduce their interest rate risks via synthetic and natural hedges. Typically, all the commercial lending is priced on a floating basis relative to a benchmark interest rate such as the three-month Bank Bill Swap Rate. In addition, about 80% of retail lending is typically priced on variable interest rates, which means that the banks may periodically reprice the loans--for example, when their borrowing costs increase. The proportion is currently running lower at about 65% because many borrowers locked in the historically low fixed interest rates over the past two years. On the liabilities side, the banks typically hedge all their wholesale term debt against movements in currency and interest rates. Furthermore, more than 95% of deposits from households and small businesses mature within six months.

Prudential Regulation Strongly Incentivizes Banks To Reduce Interest Rate And Liquidity Risks

Major Australian banks have strong disincentives against high interest rate risk. A unique feature of bank regulation in the country requires the larger banks to hold regulatory capital for interest rate risk in their banking books. Risk weighted assets for interest rate risk in the banking book form a significant 8.5% of the major Australian banks' total regulatory risk weighted assets (see chart 1).

Furthermore, the regulation results in increased capital charges for interest rate risk during periods of market volatility. And the internal capital adequacy assessment process (ICAAP) requires the banks to address stress scenarios to capture interest rate risk in the banking book.

Chart 1


Regulation of funding and liquidity also requires the banks to be prepared for the risk of a sudden outflow of funds. Similar to the regulation in most developed banking jurisdictions, the net stable funding ratio (NSFR) regulation in Australia requires stable sources of funding to cover longer-dated assets (see chart 2). In addition, the larger and more complex Australian banks are required to comply with the liquidity coverage ratio (LCR) regulation. This means that banks must always hold highly liquid assets to meet cash outflows under an assumed scenario of acute short-term stress over a period of 30 days.

Chart 2


AT-1 Instruments Of Listed Banks Are Unlikely To Be Written Off

Australian regulatory standards seem indifferent between conversion and write-off of banks' AT-1 capital instruments in a loss absorption or a nonviability event. Rather, the focus of regulation in a loss absorption or a nonviability event seems to be on the consequent immediate and unequivocal addition to the common equity tier-1 capital of the bank. Nevertheless, under the regulation, the issuing bank may clarify within the issue terms whether the AT-1 will be converted or written-off in a loss absorption or a nonviability event.

Therefore, in theory, an AT-1 instrument issued by an Australian bank may be written off--rather than being converted--even when common equity is outstanding.

In practice, however, terms of AT-1 issued by listed banks (or banks with listed parents) typically clarify that these instruments would convert into common equity in a loss absorption or a nonviability event. Consequently, we expect that AT-1s issued by these banks would be converted into common equity in a loss absorption or a nonviability event. Notably, listed banks (or banks with listed parents) account for virtually all the AT-1s issued by Australian banks.

In contrast, unlisted issuers (such as mutual banks) may sometimes only specify the write-off option in a loss absorption or a nonviability event because of practical constraints to conversion. Such issuers would be required to write-off the AT-1s in a loss absorption or a nonviability event.

The regulatory standard makes it clear that that the terms of AT-1 issues must allow immediate and irrevocable write-off if (for any reason, whatsoever) the issuer is unable to convert within five business days of notification of a loss absorption event. Also, all AT-1 capital instruments must be fully converted or written-off in a loss absorption or a nonviability event before any tier-2 capital instruments are converted or written-off.

Australian Banks' AT-1 Issuance Could Become More Difficult And More Expensive

The write-off of AT-1 issued by Credit Suisse has reminded the market of the extreme vulnerability of such instruments if a bank gets into trouble, and of their dependency on decisions taken by regulators and governments. We anticipate that investors in AT-1 will take time to become comfortable with all the potential ramifications of holding these instruments in a riskier operating environment. As a result, new issuance could be more expensive and more vulnerable to sentiment.

AT-1 markets have previously closed for several months, but the size of the hit to Credit Suisse's investors may lengthen the period of reduced market access. Even though the structure of AT-1 instruments shows marked differences across the world, we predict that investors will demand notably higher coupon rates for new AT-1 instruments in future. The extent to which this trend plays out could vary for individual banks, jurisdictions, and instrument structures, as investors work through their revised perceptions of risk.

We therefore expect that the cost of regulatory capital will come under pressure, and this may lead to reduced regulatory capital flexibility across the sector. Banks with capital needs may have to reposition toward common equity raising or reduced distribution levels, or else curtail balance sheet expansion. This trend may improve the quality of capital for those banks but may also have implications for balance sheet strategies and lending capacity.

Banks Can Wait Out Short Periods Of Funding Market Disruption

Australian banks face elevated funding needs over the next two years. Rising interest rates, reduced deposit growth, and unwinding of monetary support from the central bank are amplifying pressures on bank funding. Term funding from the Reserve Bank of Australia (RBA) provided during the pandemic is due to mature by June 30, 2024 (see chart 3). In addition, the banks need to refinance their maturing term debt, although these maturities are relatively low due to reduced capital market issuance in the past three years.

Chart 3


Australian banks should be able to meet this elevated funding requirement. We believe that banks are adequately placed to wait out brief disruptions such as those seen in the past few weeks. The funding task facing major Australian banks is broadly in line with their peak term debt issuances in 2016 in their run-up to meet the NSFR regulation. In our view, Australian banks follow satisfactory funding and liquidity management. Their regulatory funding and liquidity metrics remain sound. Banks have been issuing term debt in domestic and offshore capital market in recent months. There appears to be appetite for senior, secured, and tier-2 securities of Australian major banks in the domestic and global markets.

We estimate the major banks need to collectively issue about A$15 billion-A$20 billion in tier-2 instruments in each of the next three years to meet the regulatory total loss absorbing capacity requirement and refinance the existing tier-2 debt. Naturally, the elevated issuance of tier-2 will reduce the need for senior debt issue.

Chart 4


The Risk To Ratings On Smaller Banks

While our ratings on the major Australian banks have room to absorb some deterioration in operating conditions, those on the smaller banks could be at risk if the dislocation of local or global financial markets is prolonged. The significant dependence on offshore borrowings remains a vulnerability for the Australian banking sector.

In our view, smaller Australian banks are more sensitive to financial market dislocation although they do not access offshore borrowings themselves. A disruption in access to offshore markets (for example due to prolonged dislocation of global or domestic financial markets) or a significant rise in wholesale borrowing costs would depress bank earnings.

Stronger franchises and scale would enable major Australian banks to outprice smaller banks, if needed, during difficult operating conditions. In addition, instability in the financial system could trigger an outflow of deposits from smaller Australian banks to the larger ones in a flight to quality.

For now, we think the industry has sufficient fundamentals to hunker down against the financial market jitters.

Related Research

This report does not constitute a rating action.

S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).

Primary Credit Analyst:Sharad Jain, Melbourne + 61 3 9631 2077;
Secondary Contacts:Nico N DeLange, Sydney + 61 2 9255 9887;
Lisa Barrett, Melbourne + 61 3 9631 2081;

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