On Friday September 10, the Australian Prudential Regulation Authority (APRA) announced that by the end of FY22, locally incorporated Authorised Deposit-taking Institutions (ADIs) should reduce their reliance on the Committed Liquidity Facility (CLF) to zero, subject to market conditions. APRA expects ADIs to purchase the High Quality Liquid Assets (HQLA) necessary to eliminate the need for the CLF. Specifically, no ADI should rely on the CLF to meet its minimum 100% Liquidity Coverage Ratio (LCR) requirement from the beginning of 2022—although ADIs may continue to count any remaining CLF as part of their liquidity buffer.
A key feature of the LCR, as set out in the Prudential Standard APS 210 Liquidity (APS 210), is that ADIs may apply for a CLF provided by the Reserve Bank of Australia (RBA) to meet the LCR requirement. The CLF was introduced to the LCR framework in Australia in 2015 in response to the relatively low levels of government debt on issue at that time. APRA currently assesses the size of the CLF annually that an ADI may recognise in its LCR. In conducting its assessment, APRA considers the extent to which an ADI demonstrates that it meets the requirement to make every reasonable effort to manage its liquidity risk through its own balance sheet management before applying for a CLF for LCR purposes. In late 2020 and early 2021, APRA wrote to ADIs noting that the amount of Australian government securities (AGS) and semi-government securities (semis) had increased significantly, and future CLF allocations were likely to continue to decrease as the amount of AGS and semis on issue was projected to increase. Furthermore, it would be reasonable to expect that if outstanding government securities continued to increase beyond 2021, CLF allocations would no longer be required.
The RBA has been reducing the size of the CLF over time. Initially, the facility was AUD 274 billion in 2015 and has since reduced to AUD 139 billion as the size of the HQLA market has grown. The commitment fee for the undrawn CLF from the RBA has also increased over time to the point where it was no longer significantly advantageous to hold bank and residential MBS (RMBS) paper for LCR purposes. From 2015 to 2019, the Reserve Bank charged a CLF fee of 15 bps per annum on the commitment to each bank. Following the 2019 review of the CLF, the CLF fee was increased in 2 steps, to 17 bps per annum on 1 January 2020, and to 20 bps per annum on 1 January 2021.
The initial market reaction was very orderly, with bank paper moving 3-4 bps wider, but we understand this was largely pre-emptive caution from dealing desks rather than based on significant sell flow. Meanwhile, semi-government spreads tightened 1-2 bps in the long end of the curve post the announcement. Generally, technicals remain sound, with the feeling that supply/demand dynamics in the Australian dollar senior bank space will remain supportive of spreads in the medium term, and recent offshore funding from the majors is only adding to this. There is, however, the possibility that regional bank paper could come under pressure, without the same access to offshore primary markets. However, the spread between regionals and majors has tightened in recent times, creating room for a potential reversal given the recent regulatory change.
We are also mindful of the potential for some short-term risk around selling large parcels of bank paper in the next couple of weeks. With three of the four banks working to a September year-end there is less appetite for them to greatly increase their trading book inventory, and any large sell flow may have a bigger impact than it normally would.
Western Asset’s View
We think the directive to reduce the CLF to zero by the end of 2022 will have only a modest impact on the market. Whilst senior unsecured bank paper and AAA RMBS (Internal securitisation and other) will be less in demand than prior to the decision, the additional costs of holding these assets under the current CLF arrangement has seen some repositioning over time. The time frame is such that it will also enable Bank Treasuries to undertake an orderly transition, and our expectation is that most securities will run off, rather than being sold in secondary markets. The lack of senior unsecured issuance primarily as a result of strong deposit growth and the use of the RBA’s TLF for concessional funding should also mitigate any potential negative reaction in credit spreads.
We also note that currently the major banks are operating with a significant buffer in their LCR coverage with ratios close to 130%. This provides the banks with the option of reducing this buffer down to 115%-120%, which would still provide a meaningful over-collateralisation in comparison to the regulatory minimum of 100%.
Should the market reaction and therefore valuations move beyond our benign base case, we would look to cautiously add to exposures. This follows from having reduced our holdings of senior unsecured paper in most accounts six months ago at their recent tights.