The contagion effect: how much will Australian banks be buffeted by Europe?

Westpac chief Gail Kelly has warned about “the contagion effect” from Europe.

Westpac chief executive Gail Kelly this week warned about Australian banks are vulnerable to “the contagion effect” of Europe’s ongoing financial woes, after the Commonwealth Bank of Australia delayed a Euro-denominated fund raising issue.

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies at University of Melbourne explains contagion and what could be in store for Australian banks.

What was it that the CBA planned to do and why is the significance of delaying it?

The CBA planned to do a covered bond issue in Europe - that’s a new facility available to Australian banks that is different from “traditional” securitisation and which is commonly used in Europe and is quite attractive to European investors. It’s only been available to Australian banks for a couple of months.

But one of the issues the banks are facing is the unsettled state of financial markets, particularly in Europe, with investors wary about lending funds to banks - even when they are secured against very good assets like the Australian mortgages involved here.

Although Australian banks have had a fairly large presence as borrowers in Europe, I think everybody is looked at suspiciously at any new security issues into the market the moment. Even though Australia’s four major banks are among only nine banks in the world that have AA ratings, when you get into a situation of general uncertainty, as you saw during the global financial crisis, markets just dry up. Investors aren’t confident about the safety of any assets.

Doldrums… Spanish market woes. AAP

So what does this lack of confidence mean for Australian banks?

Well, it puts us into a situation a bit like we faced during the global financial crisis where, while the picture is good for Australian banks, their capital ratios are strong, bad and doubtful debts are low, credit ratings are high, high profitability, very little concern about them not being properly regulated - the sector’s got everything going for it - they may still find trouble raising funds in European market.

The difference between then and now is that most Australian banks took the opportunity of the government guarantees on their debt raising during the global financial crisis to get themselves pretty well placed in terms of their finding requirements. So the immediate needs for funding from the European and international debt markets are probably not as great as they were in 2008. They are also competing more intensively in the Australian deposit markets, so their overall reliance on debt funding in international capital market is still reasonably high but not quite as urgent an issue as during the GFC.

But one could imagine should turmoil get even worse in the international capital markets, there is a possibility the government will feel the need to re-institute the guarantee scheme, although I think that would only happen if there was more chaos on international capital markets and governments of other countries also guaranteed their banks’ debt raising.

Are we likely to see the same sort of credit crunch experienced in 2008-2009?

Lots of banks particularly in Europe are reducing their exposures to government securities issued by various European governments. Having marked down the value of those assets, they are in the process of trying to rebuild their capital base and de-lever their portfolios, so there is an element of a credit crunch happening there. That’s one of the issues facing European countries in trying to resolve their current problems.

What that means for Australia isn’t so clear in terms of a credit crunch. The Australian banks are very well capitalised, all the information is that their exposures to European government bonds is very low. In the global financial crisis we had an increase in the cost of funding because of the higher cost of funding internationally. That flowed through to our domestic lending costs. So one could expect to see that happen again to some extent but perhaps not as much this time as the banks are pretty well funded and have their balance sheets in pretty good shape without having substantial amounts of debt to roll over in the short term. This of course would be the worst time to try to borrow on international markets.

Don’t touch… Europe’s crisis of confidence could be viral. AAP

Is the term contagion alarmist or reasonable? And what does contagion actually mean?

One of the characteristics of banking markets either domestically or internationally is there is a lot of confidence involved. People providing funds to banks really don’t know the quality of the underlying assets, which is why there is such an emphasis on bank disclosure. All you need is for people to start believing the underlying assets of the bank are not as sound as they thought and investors will start to withdraw funds. As soon as that happens, and other depositors become aware of that, you get “contagion” of other depositors queuing for their funds. In the modern world, of course, you don’t need physical queues, and most such action may occur in the wholesale markets with refusal to roll over loans, and most of this happening electronically.

Contagion is just like any contagious virus in that it can spread even if there is no real reason for the depositors to lack confidence in the first place, and if not prevented can lead to banks having to undertake fire sales of assets - which worsens their situation.

Another form of contagion is concern about exposure to common shocks or problems. Consider the situation where one particular bank is having problems because it has assets such as government bonds issued by European countries that have been marked down quite substantially and there is a risk of default. You don’t know whether your bank has similar exposures and that inability to distinguish between whether those problems are localised or widespread among banks will often cause people to become nervous about providing funds. And in a time of heightened uncertainty and nervousness, investors may not believe information disclosed by banks asserting the strength of their balance sheets. Ultimately, support by Central Banks may be necessary.