Transcript of Question & Answer Session Bond Market Liquidity, Long-term Rates and China

Steve from EY. The question for both of you, mainly directed towards Guy first, around liquidity. You mentioned the liquidity is more expensive?[inaudible] than it was before the GFC. Committed liquidity facility probably irritated with the ADI by saying I was generally surprised, not expensive and there are several reasons you can see that in the financial markets are the costs of liquidity. No one seems to be complaining about costs [inaudible], more so collectively the ADI have asked for more and prepare to give more in total. So I was curious as to whether your inclined to price [inaudible]?

So I, sorry, as you know, the father of the Committed Liquidity Facility I'm going to be very defensive in my answering of this because I actually think of, course, it's been designed perfectly. As I would. But, so let me explain how we came up the price. So what we're trying to do is replicate the liquidity premium in high quality liquid assets. That's how we tried to calculate the price. We've got something on our website that would explain it, it goes into some more gory detail as to how we came up with that price.

We are not, so all, as I said, all we're trying to do is replicate the liquidity premium in bond markets in roughly normal times. And our best guess, and it's a pretty difficult thing to do, is 15 basis points is pretty close to the mark. I actually don't think, I actually think if you look at the behaviour of banks, they're reasonably indifferent between the two. There are higher rates of return on other assets that reside in their balance sheet but that's because they've got credit risk in them. We are not only trying to extract the credit risk premium because they're still wearing the credit risk against which they have to do a whole bunch of other things that Wayne talked about. So I mean I would say the thing is appropriately priced because we came up with the price but I do actually, but the motivation for the price was to replicate the liquidity premium.

The other thing I supposed I'd point out is this liquidity, and Wayne mentioned this during his talk, is that liquidity provision has always been there implicitly. What we're actually doing now is making people actually pay for it. So the price prior to the beginning of this year was actually zero, now you're making the banks actually pay 15 basis points which is higher than zero.

So Sophia Rodrigues from Market News and this question is for Guy Debelle. You mentioned in your speech about what assets the capital output of China, you don't know what they're buying. What are the chances that are that capital flows to Australia and what impact would it have on the exchange rate?

Well as I said, the answer is the same as for any other financial market, we neither know what the private part of China is buying, nor do we know what the public part of China is selling. And it's the net, as I said, it's the difference between those two portfolios which makes the difference. So I know as little about it here as I do about in any other market. I mean the opacity around what the, people have estimates about what the competition of SAFE's assets are but they're purely pretty much guesses, sometimes slightly more informed guesses.

I said, you know, we've got one of the largest asset managers, well the largest asset manager pretty much in the world, although the Fed keeps on reminding me that they've got a larger balance sheet than SAFE does. But anyway, they have, you know, $3.5 trillion worth of foreign assets. That's a big number. We just don't have much visibility as to what exactly they're holding beyond the fact that if you've got a $3.5 trillion portfolio you're probably holding something of everything.

Guy, I'm going to ask you to chance your arm on US official interest rates.

Oh, I don't, I don't know.

When, when might they increase?

I don't know. I mean the---

And supposing they were to increase, what would be the impact, the immediate impact on the Australian economy? You did touch it in your speech on bond markets.

Yeah, yeah. No, no. I mean, the market has a 1 in 3 expectation for tomorrow – it's priced by January next year. That's what the market thinks. My guess is, if there will be, I'd be surprised if there wasn't a bit of volatility when they raise rates. As I've said, I think I said this this time last year, when also the market had a 1 in 3 expectation of a rise in interest rates a few months out from there, that there is some stuff out there which is predicated on basically zero funding costs. That probably doesn't work when funding costs aren't zero and will probably fall over.

What it is, it's not entirely clear. Are we more confident it's not directly on the books of the core banking system? Yes, which is potentially different to previous episodes. Will there be an increase in volatility? It'd be surprising if there wasn't because historically that's always happened. I mean I suppose the other point to make is that every, I mean there's are a couple of things which are interesting to reflect on. One is, it's nine years since the Fed last raised interest rates. That's a decently large chunk of people in the market who have never experienced an environment where rates actually go up. Some of them are, most of them have never actually never experienced an environment where rates actually change in the US, let alone go up. So that I think will be, that'll be interesting to see how that goes. So as I say, we've had a long time of this sort of environment and some behaviours have probably evolved which are not going to be sustainable when rates are no longer at zero and, you know, stuff will probably happen as a result. Every time we've had a rise in US interest rates in the past of, you know, and they're reasonably few and far between, things seem to happen after that.

You would've thought, the only thing I would say this time around is that this is the most well telegraphed rate rise in the history of rate rises. So if you're not ready for it, you're sure as hell have been warned, and really you've got no excuse. You know, the exact timing in the end really is neither here nor there. As I said, you have no excuse this time around for not being prepared.

Thank you for not propping too much back on that question. I think we have a question here. Robert Armstrong, from the NAB. I just wondered Wayne, perhaps Guy, there's a lot of talk about digital disruption, changes to platforms, the way people do business these days. I just wondered how both the global and the local regulators are thinking about the future impact of that on the banking systems as we move forward?

It's a good question, I don't necessarily have a good answer for because there's a lot of thinking going on but necessarily a lot of answers. But just as it's, just as no doubt, in all the organisations that you work for there is a lot of thought being given to, well what does it mean, what does it mean for individual business line? What does it mean for individual products? I mean, regulators are having to think the same thing, what does it mean for our structures, our frameworks, etc.? Because the, in many cases we have legislative frameworks, regulatory frameworks, supervisory approaches, that are all sort of built, almost in a sense of the old fashioned concept of the bank – it's a legal entity with physical assets and you can go and you can almost touch them. And that's, you know, the world is going completely in the opposite direction. But the boundary of the bank, where does it start and finish, is becoming much more difficult.

So we have to think quite hard about it. And there's obviously the dimensions that are positive in the sense of there's opportunities for banks who are nimble and ahead of the game. There's the competitive threat issue that has to be thought through. There's the security issue, there's the cyber security issues that have to be thought through. So all these things are certainly on the agenda. There isn't I think probably like industry, regulators are still grappling with knowing where are these things, how are these things going to play out, and therefore what's the right response to them? It's hard for regulators to try and maybe even dangerous for regulators to try and think, as I've said in my remark, we sort of know how these are going to play out and therefore set up a regime in anticipation of them because inevitably the world will go a different way to whatever we think.

I mean to pick up on your theme and your session, I mean that's one where I think reactive, you know, it's a reaction not driving. And that's been true for the last, you know, few hundred years really. There's been technological changes which have come along which have changed the way that financial intermediation has been provided, not all of those technological innovations have been for the better, and that's probably going to be the case this time around as well. Some of them clearly have been for the better, some not necessarily so. But, you know, there's always in this part of space I think much more of a reactive thing rather than necessarily a proactive just because of the inherent difficulty in being able to tell what the future's going to bring.

Elaine Grace, Actuaries Institute. The Bank of England has recently conducted, or started to conduct a study on the economic risk of climate change and stranded assets. I guess, I'm just wondering whether the RBA or APRA have taken any similar studies or plans for the future?

We certainly think about that issue. Have we done the sort of detailed studies that the Bank of England has done? No, we haven't yet. We're observing what all the banks are doing and thinking about, in thinking about their approach to climate change and how they want to respond to it. We're thinking about our superannuation sector or observing how the superannuation sector responds in terms of its investment strategies, etc. But we haven't yet got to a view ourselves about that we feel we need to apply on those sorts of things just at this point.

So I'd just say two things. One, purely from a markets point of view, I mean, one question to ask is, is it priced right? And also if you think, and over a long horizon, I mean if you think about it, having an impact over a long horizon, it obviously has an impact in terms of superannuation decisions which are a long horizon decision. But if you look at say the composition of the ASX 200 today, it is not going to look like that in 20 years' time for any number of reasons, one of which will be climate change. And the question is, how much of that is actually priced, reflected in current pricing over something which is ultimately a reasonably long-lived thing?

The other thing I'd say though is that, as you may well know, that this is an item on the FSB's, quite high on the FSB's agenda, partly reflecting the fact that the Chair of the FSB is also the Governor of the Bank of England, but nevertheless, it's an item high on that agenda at the moment and for the next while indeed, I believe there's a conference in London on this topic in the next couple of days, FSB conference. So the focus on that in the global regulatory community I suppose is there at the moment.

So it's an international debate viewing models is kind of also about risk sensitivity in banking capital. Do you have any comments on your views about loss of risk and how they'll play out in the broader economy?

Sorry, what a loss of what?

It's more you isn't it than me? Sorry, I'm not, I'm not, you mean, if you move, what? This is basically the history of the Basel committee on which---

No, no, no, no. But in a sense of this reflects the iterations over the Basel Committee's history on which Wayne is a hell of lot better to comment than I am given his direct involvement in it. But I mean, to some extent the original capital. If I, you know, I may get this wrong. But Basel I was basically non-risked based capital.

Well, very simple.

Yeah, like, yeah, okay. And then Basel II was an acknowledgement of that. And then Basel III is probably somewhere in between. But as I said, you're much better to describe that than I.

It's something, it's like the regulator putting a price on risk. And the price, the regulator puts on risk is not necessarily what you might observe as the market price of the risk or your assessment of what that right risk is. You know, most institutions have developed some form of economic capital estimate that was used to price and allocate capital and measure returns, etc. And that's your estimate of the economic risk of particular businesses and you therefore work out the prices and rewards that you expect from those businesses.

When regulators come in with something different, particularly if that something different is binding and above your estimate, then it drives not necessarily the most efficient behaviours. And the whole idea of bringing models into the regulatory framework was to try and better align regulatory measures of risk with genuine economic measures of risk or prices of risk. Now, so we think that's better because it's more likely to generate efficient behaviour, drive sensible risk taking if the regulatory price of risk is consistent with what we perceive to be the real price of risk. If you take the models out or take risk sensitivity away then you risk driving a bigger wedge between what people think is the right price of risk and what the regulators impose. And therefore, you in a sense start creating a distortion and in a sense people won't necessarily be making efficient decisions on terms of where they are allocate their capital. And so that's the question we have. The thing that stops us going right the way down that path is simply, how do you get these reliable measures that regulators can trust?