Risk reduction puts banks' loans all at sea

20:00, Jun 25 2013

Kiwis are reticent creatures, hiding away in the woods in the dark. Kangaroos, on the other hand, are so annoyingly meaty, beaty, big and bouncy, Australians like to drive around in utes and shoot them.

That these contrasting creatures represent their respective islands is somehow appropriate. Chalkie has noticed over the years how Aussie businesspeople are generally more willing to unburden themselves than their Kiwi counterparts.

Perhaps it should be no surprise then that a potentially big issue for the banks is squarely on the radar across the Tasman, but only whispered of behind closed doors on this side of the ditch.

Admittedly, it is the sort of thing only certain kinds of bankers fully understand but Chalkie reckons we ought to be thinking about the implications.

So far only banking website interest.co.nz appears to have noticed it.

The gist of the thing can be gathered from a letter signed by senior executives of five Australian banks, in which they said an international financial proposal "would have significant systemic implications for Australian banking, whose adverse effects are probably shared by very few other economies".


One that certainly does share them is New Zealand.

The reason New Zealand and Australia are particularly affected relates to our banks' reliance on borrowing money from overseas. According to the Reserve Bank, foreign currency funding in April this year was about $75 billion, or about 22 per cent of total funding.

This money must be converted to New Zealand dollars to be useful and herein lies the problem.

The method banks use to convert foreign currency funding into local currency funding is typically the cross-currency swap. Chalkie reckons it works something like this.

The New Zealand bank issues a bond in foreign currency, say euros, which means it borrows euros and has an obligation to pay interest and repay the principal in euros.

Meanwhile, a foreign institution borrows money in New Zealand dollars, incurring an obligation to pay interest and principal in New Zealand dollars. One example of this type of borrowing is a big foreign institution, such as the World Bank, tapping overseas demand for high-interest deposits by issuing "eurokiwi" bonds.

The New Zealand bank then swaps the euros it raised for the kiwis raised by the foreign insto, thus obtaining New Zealand dollar funding, and each agrees to pay the other's interest during the period of the bond. At maturity, the New Zealand bank pays the foreign bank's New Zealand dollar obligation and vice versa.

The deal works because the foreign insto gets the euro funding it wants plus a margin from the New Zealand bank, known as the swap spread. The New Zealand bank, meanwhile, gets more New Zealand dollar funding than it could get just from domestic sources, while hedging its foreign currency exposure through the swap deal.

Unfortunately, Chalkie can't say anything about individual swap deals because they take place one bank to another, "over the counter", and there is no public register of contracts.

This is the area our international regulators, in the form of the Basel Committee on Bank Supervision and the International Organisation of Securities Commissions, have decided to poke their noses into.

According to their consultation document, "the recent financial crisis demonstrated that further transparency and regulation of [over the counter] derivatives and participants in the OTC derivatives markets was necessary to limit excessive and opaque risk-taking through OTC derivatives and to reduce the systemic risk posed by OTC derivatives transactions, markets, and practices".

Most of the measures proposed by the regulators involve requiring OTC contracts to be traded through a central clearing house, which would make the deals more visible and mitigate the risk that one party to a contract doesn't fulfil their side of the bargain.

However, foreign currency derivatives such as cross-currency swaps don't lend themselves to central clearing because they are too variable. As a result, the regulators suggest requiring parties to pay a sort of deposit, known as margin, on each swap deal. The idea is that a party failing to pay in full when the deal settles will forfeit its margin.

As a benchmark, the regulators suggested the margin for currency derivatives should be 6 per cent of the notional exposure. And both parties would have to post the full value amount of margin in real money, rather than netting out their exposures, so that there was a real capital pool to call on.

Chalkie has not attempted to figure out what this would mean for New Zealand banks because it would probably cause lasting damage to his mental faculties. However, the Australian banks have had a go at it.

In a submission to the regulators, they said "the modelled worst case . . . would result in the Australian banking system being required to post in the order of US$250 to US$300 billion of initial margin".

That's a lot of money to leave hanging around.

Even in the least costly scenario, they said, "We would expect the Australian banking system to be required to maintain a gross initial margin pool of US$30 to US$40b."

The main culprit for such a large margin requirement for the Australian banks was the cross-currency swap.

"The Australian banking system has a significant requirement for this product, which would be severely impacted by the potential requirement for both parties to post initial margin. For every US$1000 million issued by an Australian bank, the global system will absorb approximately US$160m of initial margin based on current assumptions."

Such a high cost was peculiar to the Aussie banking system and not warranted by the actual risk of the swaps, they argued.

So we have a highly specific and public statement from Australian banks arguing against a measure proposed by international regulators. The Reserve Bank of Australia has also published detailed information about the banks' use of cross currency swaps and how they would be affected.

In a Bulletin paper this month RBA staff wrote: "Irrespective of whether cross-currency swaps transition to central clearing or remain in a non-centrally cleared environment, requirements to post initial margin under the reforms are likely to increase the 'up-front' cost to Australian banks of using cross-currency swaps to hedge their overseas funding."

The banks would naturally seek ways to avoid those costs and "there is a risk that banks may respond to an increased cost of using cross-currency swaps by engaging in less effective and more complex hedges."

Either way, Chalkie reckons banks face higher funding costs, which means higher costs for bank customers. No wonder the Aussies are a bit concerned. We would be looking at a similarly big impact, not that you would know.

When Chalkie sounded out a couple of big banks on the issue he got replies ranging from "it's just a proposal" to "it's not something we have a comment on".

Our own Reserve Bank wouldn't say whether it had figured out the potential effects or what it thought of the proposal.

Instead, it said: "As with all international developments, the Reserve Bank will take a considered view of the guidelines once they have been finalised. Any decision to adopt them will be based on what is appropriate in the New Zealand context, and will take into account the impact on domestic banks in light of the appropriate application of international standards."

How vague, unhelpful, and typically Kiwi.

*Chalkie is written by Tim Hunter, the deputy editor of the Fairfax Business Bureau.