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When the banks move debt “off balance sheet”, is this some form of financial jiggery-pokery? Well no, sort of…

On again off again

Banker of Last Retort

If we total up the announcements made by Australian banks over the past week or so, it appears that something like $20 billion of off-balance sheet debt will be brought back on to their balance sheets.

Most of the announcements attempt to present the change as a strategic decision (is any other kind ever announced in media releases?), somehow made as a measured response to the sub-prime crisis.

In point of fact our banks have no alternative. They must put the loans on to their balance sheet, and any implication otherwise reflects an attempt to make a virtue out of a necessity.

As part of securing a precious AAA credit rating for a securitisation program, financial engineers arrange for a bank to provide a “standby liquidity facility.” In effect an SLF is a guarantee from a bank that it will provide funding equivalent to the debt issued by the securitisation program.

The purpose of the SLF is to provide comfort to the investors. They can buy commercial paper or notes from (lend money to) issuers (from here your correspondent will refer to them as “borrowers” – perhaps less technically correct, but far easier to understand), confident that the borrower has the ability to repay them because it has a guaranteed capacity to borrow from the bank if required.

Naturally, banks charge a fee for providing an SLF. They also charge a margin if the SLF is actually used. At the time the deals were put in place, those margins – typically an additional 40 to 60 points – were such a large premium over the market rate that no-one involved expected that they would ever actually be called upon.

Of course the liquidity crisis has knocked pricing for six. The market has moved so much that arrangements intended as nothing more than a parachute have actually worked to cap the interest rate payable by borrowers. SLF pricing that was intended to work as a penalty is now a relative bargain, and the borrowers have called upon the SLFs to avoid paying more in the market. Quite rational from their point of view, and there is nothing that the banks could do to stop them.

So debt is moving on to bank balance sheets because the borrowers are choosing to use cheaper bank finance rather than pay market rates.

The various references to “off-balance sheet” might be seen by some as suggesting some kind of financial jiggery-pokery, and the uninitiated might imagine that these were arrangements put in place to fool Australian Prudential Regulatory Authority, the bank regulator. Nothing could be further from the truth. These securitisation structures have been carefully disclosed to APRA, which (as far as it was capable) painstakingly scrutinised, and approved them.

“Well,” asks the curious reader, “if the securitisation structures aren’t being used to fool APRA, why are they being used?”

The answer is that securitisation allows banks to reduce the amount of “prudential capital” that they must set aside, which helps them to cut their costs.

So by allowing banks to cut costs by moving debt off balance sheets and into securitisation vehicles, but not otherwise, APRA has effectively provided an incentive for them to report in a less transparent fashion.

The world in which that lack of transparency was acceptable has come to an end. Investors went on strike, refusing to lend to the black boxes except at a swingeing premium.

This is where your correspondent observes a neat irony. The classical view is that regulators are necessary to protect against market failure. Here it seems that the market has worked to protect against regulator failure.


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