One of the effects of the Basel III reforms on Australian banks is that they will need to hold a much greater quantity of high quality liquid assets.
This is the result of both the required liquidity coverage ratio (in force from 1 January 2015) and the net stable funding ratio (in force from 1 January 2018). These liquid assets must be liquid in commercial practice, not merely in legal form. In Australia, they are currently in very short supply. To date the only assets accepted by APRA as meeting the requirements of a liquid asset are Commonwealth and State Government securities. The aggregate of these securities on issue is nowhere near enough to meet the likely liquidity requirements and, at least at present, something like over 60% of outstanding Commonwealth Government bonds are held by foreign investors. A bank may plug the gap with a committed secured liquidity facility provided by the RBA, but only after it has done what it can to reduce its liquid asset requirement by other means. The RBA Facility requires RBA repo-eligible securities to be available as collateral.
There are a number steps banks may take to reduce the liquidity shortfall: purchasing whatever high quality liquid assets they can, increasing their maturity profile and increasing retail deposits. How much can be achieved by these measures is not yet known.
Another way to address the liquidity requirements is to manufacture more tradeable securities of the requisite credit quality with a view to them becoming liquid. Here the policies of Basel III may intersect with other policy initiatives intended to stimulate the development of a vigorous, liquid, local bond market. These include proposals to relax the conditions of offering retail debt and the listing of Commonwealth Government Securities to assist with the establishment of benchmark pricing.
The development of a deeper, more liquid bond market is desirable from a number of perspectives. As a prudential matter, it makes sense for longer-term assets to be held in the capital markets rather than in the banking sector and for liquid asset requirements to be met by the holding of securities available in the market, rather than by a commitment of the central bank. A greater supply of longer term, fixed interest investments may also be socially useful. It can provide the source of retirement incomes for an ageing population, either through direct holdings, or through funds or as the assets backing annuities.
But liquid bond markets are not easy to start. Historically they tend to result from significant government intervention, usually in the form of borrowing. While the current proposed reforms are welcome and the liquidity requirements of Basel III are stringent, it is too much to expect that these alone will produce a liquid market. There is of course a robust wholesale debt capital market in Australia. There are periodic bouts of retail debt and fixed interest preference share issuance. But for those domestic markets to be truly liquid would require much more issuance and many more investors and traders. It is harder to see where these will come from. In the wholesale market, the relative absence of regulation makes transactional and compliance costs very low, but the volume issued domestically is constrained so long as it is easier to access cheaper funding offshore and swap the proceeds back into Australian dollars. Fixed interest end investors (and their advisers) remain the exception in Australia, deterred by the fear of inflation, the lack of liquidity and an uncompromising system of equity-biased taxation. The cash for bond investment is accumulating in superannuation funds but it needs to be in the best interests of the members for the funds to switch from equities to bonds.
A liquid domestic bond market would be a good thing for the Australian financial system but to bring it about it will need a more radical stimulus than the requirements of Basel III.