RDP 2019-09: Australian Money Market Divergence: Arbitrage Opportunity or Illusion? 3. Estimation Results

We estimate the net return the major banks could earn on each money market trade for every month from January 2008 to June 2019 (see Table A1 for a data summary). By substituting for τ it in Equation (4), the net return on asset i at time t is given by:

9 N R it =G R it [ CET1Rati o t ¯ * w i *( EF R t DF R t )+DF R t ]

Most of the variation in the total cost of funding money market positions has been due to developments in debt funding. The total cost of debt has fallen significantly since 2008 (Figure 5). This decline can be attributed to the fall in the average interest rate payable on debt. At the beginning of the sample, the debt funding rate was well below the cash and other money market rates (Figure 6). While the debt funding rate has broadly moved lower in absolute terms over the period in line with the stance of monetary policy, it was around 25 basis points higher than the cash rate during 2018, reflecting that there was less than full pass-through. The increase in the debt funding spread to cash was largely due to competition for deposits and longer-term debt following the financial crisis (Atkin and Cheung 2017).

Trends in the total cost of funding positions have been similar in all four money markets but the composition has changed noticeably (Figure 5). At the same time as the total cost of funding debt declined by around 500 basis points, the total cost of equity rose marginally. This was mainly due to increased equity funding. In the repo market this has not had any material consequences since positions are funded with almost no equity at all. The higher risk profile of bank bills relative to collateralised trades, such as repos, makes equity funding a little more important for investing in this market. However, because under our methodology foreign exchange swaps attract a relatively high risk weight (based on prudential standards), the role of equity funding is much more important for these positions. Equity accounted for around 20 per cent of the total cost of funding these assets by 2018, up from around 5 per cent in 2008.

Figure 5: Total Cost of Funding
Decomposition by weighted cost of debt and equity
Figure 5: Total Cost of Funding

Sources: APRA; Authors' calculations; Bloomberg; RBA

Figure 6: Money Market Interest Rates
Spread to overnight indexed swaps, one-year rolling averages
Figure 6: Money Market Interest Rates. The graph illustrates that the spread between the rate at which banks can access debt funding (what we call the debt funding rate) and the returns available on money market trades (i.e. money market rates) has narrowed significantly over the sample. The graph plots the one-year rolling averages for the debt funding and money market interest rates from 2008 to 2019 YTD. All data are expressed as a spread to overnight indexed swaps to account for changes in the risk-free rate over the sample. The debt funding rate was much lower than the risk-free rate (captured by overnight indexed swaps) at the start of the sample, increased sharply alongside a broad repricing of risk following the financial crisis and has remained above the cash rate since 2011. The spread of money market rates to the risk-free rate has remained relatively constant throughout the sample.

Sources: Authors' calculations; Bloomberg; RBA

During the first half of 2008, major banks could earn a net return on investing in bank bills and foreign exchange swaps of around 110 basis points, and around 60 basis points on repo (Figure 7). The profitability of money market trades declined in the second half of 2008 and net returns have generally been negative (or marginally positive) since 2011. Two main developments have driven this result. The cost of debt has risen relative to gross returns. At the same time, the proportion of more expensive equity funding has increased.

Figure 7: Net Return on Money Market Trades
Figure 7: Net Return on Money Market Trades

Sources: APRA; Authors' calculations; Bloomberg; RBA

The increase in the repo rate during 2018 made lending cash under repo only marginally profitable. The repo spread to cash averaged around 40 basis points, but the net return from lending under repo is estimated to have been less than 20 basis points. Bank bill rates also rose over this period, but not sufficiently to make investing in bills a profitable money market trade. Gross returns from lending Australian dollar cash in the foreign exchange swap market also rose in 2018. The bases measured in both USD and JPY have persisted since 2014. Relative to cash rate expectations, the gross return on USD swaps increased to 60 basis points. However, under our methodology, the net return of lending cash under USD swap remains close to zero. This outcome is due to swaps being attributed higher risk weights, resulting in a larger share of equity funding. The gross return on JPY swaps also increased to 90 basis points relative to cash rate expectations. Under our methodology this has been associated with positive net returns from lending Australian dollar cash into the JPY swap market of around 30 basis points. Subsequently in 2019, net returns in all these money markets declined as the spread between money market rates and cash rate expectations narrowed.

Our results do not in any way address whether banks are less active as market makers for customers who continue to take investment positions. Nor should the approach be interpreted as suggesting that the major banks have no position at all in money markets.