Watch out for basis risk – CLSA’s Johnson

Australian lenders are facing basis risk amid the shortage of bank deposits and variable rate loans, according to bank analysts at CLSA, a Hong Kong-headquartered investment group.

Brian Johnson, the Sydney-based regional head of bank research at CLSA, told Private Debt Investor that Australian banks are exposed to basis risk when hedging long-positioned USD-denominated debt against short-positioned Australian dollar-based assets.

Basis risk is the financial risk that arises from offsetting investments in a hedging strategy which creates the potential for excess gains or losses. The reason why basis risk matters to lenders is because of the implications for liquidity, the bank analysts observed.

Speaking to Johnson at CLSA Investors’ Forum 2018 held in Hong Kong about the reasons why banks are facing basis risk in residential lending, he explained: “[Because the] Australian debt market is not deep enough to fund an A$1.7 trillion-sized mortgage.”

In fact, Reserve Bank of Australia, the central bank, stated in its annual report published on 20 September that the total value of housing loans in Australia was sized at A$1.64 trillion during 2017 and 2018.

Two private credit managers with a presence in Australia also agreed with Johnson that the country’s capital market is not large enough to service the residential loan issuance.

Among others, international banks and private credit managers are the main participants in this real estate lending segment, Martin Priestley, a Sydney-based head of debt for Asia Pacific at TH Real Estate, told PDI, in a separate interview.

On the corporate credit side, CLSA’s bank analysts suggest that most of the growth in bank deposits has come from corporates. In other words, corporate treasurers could find a way to finance businesses by either liquidating the existing assets or running down bank deposits.

Although CLSA’s analysis shows a slowdown in capital expenditure among Australian corporates, financial officers from these corporates can also borrow short-term in the London Interbank Offered Rate (LIBOR) market, or in the 90-day bank bill market.

However, Johnson points out that there is illiquidity risk when using swap for 90-day bank notes against five-year term loans. “In Australia, here is the problem,” he said.

Considering one of the characteristics of the Australian capital market, which is relying on offshore funding, if US dollars appreciate in value against Australian dollars, those who funded local mortgages in US dollars will have to service the debt with more cash.

This liquidity crunch would also cause a higher demand for monetary easing. According to Katherine Leong, a senior analyst in the domestic markets department at the Reserve Bank of Australia speaking publicly on 11 April, if demand for cash or exchange settlement balances were to increase, the Reserve Bank would respond by increasing the supply of cash as well, to keep that cash rate near the target.

As the bank bills mature in 90 days, those who keep hedging these instruments for cash every maturity date using the index swap are exposed to basis risk, according to Johnson. “It just saves you for 90 days, but it does not save you for the long-run,” he said.