Asset transformation towards liquidity

In his keynote address to the Thomson Reuters 3rd Australian Regulatory Summit, Philip Lowe, Reserve Bank Deputy Governor, outlined the state of play in creating a less risky and more liquid financial market.

Lowe said one of the critical functions of the financial sector was to undertake maturity transformation - that is, when the financial system transforms illiquid longer-term assets into liquid assets.

"The best, and most obvious, example, of this type of transformation is an at-call bank deposit," he said.

"The holder of a deposit has a completely liquid claim on the bank - the full face value of the deposit can be drawn on at any time, for any purpose. Yet deposits are primarily invested in assets, namely bank loans, which, typically, are not particularly liquid and have long maturities."

After outlining how banks have been working through risks, the next sector to get Lowe's attention was the asset management industry, a sector that is gaining in relative importance.

Looking back at experiences in Australia, such the run on mortgage trusts operated by Estate Mortgage in the early 1990s which was followed by runs on a number of unlisted property trusts operated by other non-banks, as investors sought to withdraw their funds prior to the periodic (and downward) shift in unit prices.

Then there was the more recent freezing of unit trust redemptions in 2008.

With these incidents in mind, along with current international discussions, there were five brief observations that Lowe said were "perhaps useful" to make:

1.     The importance of investors understanding the nature of the liquidity promise being made.

2.    The benefit of clear rules around the process for freezing redemptions, including who was responsible for making those decisions.

3.    The importance of appropriate separation between bank-managed investment funds and the bank owners. APRA has prudential requirements for banks to address potential contagion risk between other members of the group.

4.    Frequent updating of unit prices, because the experience of the early 1990s illustrated the problems that can arise when there is a lag between changes in the value of the underlying assets and in unit prices, creating an additional incentive to redeem in a falling market.

5.    The runs on investment trusts and subsequent freezes did not lead to systemic problems in the financial system. In neither of the cases highlighted by Lowe was there a significant fire-sale of assets. The unit prices declined and investors experienced losses as the value of the underlying assets declined. But this did not lead to stability issues in the broader system, although the freezes did cause hardship for some individual investors.

"So our own experience is that these types of disruptions in the asset management industry can be managed. However, the degree to which this lesson can be applied more broadly remains to be seen," Lowe said.

In the subsequent Q&A, Lowe said he believed that region-specific speed limits, through macroprudential regulation (as has been done in New Zealand for a booming Auckland housing market) were not a necessity in Australia. In any case, Lowe gave a tick of approval to APRA's approach, which is essentially to speak behind closed doors with the banks.

He pointed to the move to limit investor loans to ten per cent of the portfolio, or to require higher serviceability levels.

"Conversations with various banks around the country indicates that those measures seem to be having a positive, albeit modest, effect. It's worth waiting to see how those measures play out," Lowe said.