Speech Managing Systemic Liquidity Risk

Well, first of all, thank you very much to Mark Bailey for hosting that panel. That was a very interesting discussion. Now, the clue is in the heading, Managing System Liquidity Risk. That’s what we’re about to speak to. Scott gave quite a few - a bit of a good, you know, setting for this session in his - in his opening remarks. I’ll just go through a little bit of a scene setter. A quick run through of who is on the panel and then we’ll go through some questions and explore the subject. Scott obviously mentioned the growth in superannuation in this country has been very substantial and clear the numbers are very large and getting larger and it won’t be long before, at least the superannuation assets, exceed those of the banking sector. Liquidity has been something that Australia has thought about in a formalised way over many, many years. In more recent times we, as a country and authorities and so on, are turning our minds to understanding just how banks and superannuation interact, I guess, through the concept of a liquidity event and understand what that looks like in more detail.

We are delighted to have on our panel today Brad Jones, Assistant Governor from the RBA. Next to Brad is Claire Thornton, Head of Treasury at AustralianSuper. Michael Clavin is next along the line, Head of Income and Markets at Aware Super. And on the end there, Joanne Dawson, the Group Treasurer of Westpac. Thank you so much. And I think maybe, Brad, if we can start with you and talk about the - I guess the - it’s nothing new that the RBA and others are looking at liquidity. So maybe you can get us started by what are the growing areas of focus in the RBA’s monitoring of liquidity risk in the Australian financial system, please.

Just a, sort of, high level conceptual framing I would say that the - our main area of focus is - well, considering spending a lot of time, considering how the next war could be different from the last. That’s really the high level conceptual framing that’s driving a lot of our work. If I were to very crudely summarise, the solution to nearly every potential problem in the Australian financial system for the last three or four decades, we simply had asked banks to hold more capital, more liquidity and that was it. That sort of focus is no longer sufficient. And there’s really two key changes that are driving this. One is the structure of the financial system is evolving in really profound ways. And second of all, the nature of the risks that are barrelling down at us, particularly from offshore, intense technological disruption, intense geopolitical disruption there’s a couple of examples. Basically mean that our approach to thinking about liquidity risk, systemic liquidity risk has to be a lot more expansive than it has been historically.

At a more concrete level we’re stepping up our analytical and operational focus on systemic liquidity risk in a couple of dimensions. The first is our work relating to disruptions that could affect the functioning of core financial markets, core funding and hedging markets that are critical to the economy. Our sense is the most likely source of disruption in the global bond market. That’s one piece of work. And separately, disruptions to institutions that basically move money through the pipes of the Australian financial system. It’s not just about banks. It includes financial market infrastructures, super funds, key entities involved in payments and so on. So the sorts of scenarios that we and APRA - our colleagues at APRA have in mind now are much more expansive than they were historically.

Yes. There’s plenty to think about. And maybe staying with you, Brad, you’ve recently talked about, I guess a new area - new era of where op risk and liquidity risk could interact in ways we’ve not seen before. Maybe you can expand on that for us all, please.

Yeah. This is the interaction between operational risk and liquidity risk is an example, one example of how we think the future is going to be different from the past. And this is also partly reflected, I should say, in APRA - in APRA’s recent focus on operational risk through CPS230 and others. I think it’s probably fair to say that in times past operational risk was considered to have very little, if any, connection to core financial risk. It was, sort of, this bucket of risk that kind of sat over on the side. But as critical services are increasingly digitalised and interconnected, as we saw overnight with AWS, our third party providers now are really key.

We can see at least two channels through which operational risk and liquidity risk could interact in disruptive ways. The first would be through confidence effects. Where, for instance, you could see a massive cyber attack or other operational disruption that basically undermines confidence in that particular institution and can potentially set off a digital run. A second channel would be where a major operational disruption, it could be a foreign adversary attempting to disrupt our payment system or it could be a massive settlement failure at a key FMI disrupted the flow of money through the pipes of the system. So they’re the two mechanisms.

We did see in April, what we think is probably a window into our future there. When a wave of credential stuffing attacks were launched at super funds right at the same time that you - that we saw significant pick up in financial market volatility around the time of the US tariff announcements. That to us is a bit of a shot across the bow and we’re certainly leaning into that. But I’ll just finish off by saying, I haven’t mentioned AI yet and I haven’t mentioned quantum yet. Quantum is coming for us and so the bank, we’re doing a lot of work, including with industry, to make sure we have a financial system here that is quantum ready.

Okay. Thank you for that. Just for, I guess, edification of the group in the room here today, I think about half the attendees would be from the industry super space, something like that, and lots of banks, lawyers and so on. Liquidity has been around for a long time, you know, APS 210 banks and so on. SPS 220 has been around for a while, where liquidity gets mentioned in the superannuation framework.

(Panel discussion)

Thank you. And I guess I want to talk about FX as a perfect point to come back to Brad as the guardian of the Australian dollar, the implications. Are you able to comment on the - I guess the implications for an FX market from the growth in super funds and their use of FX derivatives, the numbers there are very large.

Yeah. The first point I want to make for a bit of context, these are extremely deep markets. You know, the Aussies are the sixth most actively traded market in the world, swap volumes are going to exceed those in the spot market. We haven’t seen a need to intervene in the foreign exchange market since 2008. So the context matters there. Our current assessment is we do not see systemic issues today. COVID, I think, Claire was intimating, COVID was a live stress test. Industry got through that period in reasonable shape. Though I’d add in part because many super funds didn’t have the post margin on FX hedges. We’ve also observed a big uplift in the management of FX and liquidity risk across the super fund industry since that time. Michael was alluding to that. I think in times past a lot of funds basically just rolled one month forward. The suite of strategies that are now being employed are a lot more sophisticated.

All of that said there’s a but coming and this is the but, it would be a, we think, a dereliction of our duty not to be thinking about how that relatively benign current conjunctural environment could evolve in the future. And to that I would say three things. First of all, the growth in foreign exposure, asset exposure for this industry and the foreign currency implications of that, are going to be very material. Vis-a-vis say the volume of bank offshore funding that’s being swapped back into Aussie heading in the other direction. So there’s some interesting potential implications over the long-term for supply demand imbalance there. The second thing is we also know, because of the demographic profile, that there will be a relatively larger share of fixed income holdings from our super fund industry over time. And the hedge ratio on foreign fixed income tends to be across the entirety of the industry, about three times higher than for equities differs across individual funds but that’s at the aggregate level. So there will be more hedging-related demand from that evolution. And the third change is that margining and collateral requirements will also increase over time, not just because the gross numbers are going up but also because of counterparty limits and it’s quite reasonable to expect that foreign banks, standing on the other side of some of this activity, might be inclined to offer less favourable terms than some of our domestic banks. So there’s a few reasons as to why that system or those forces could change over the next five to 10 years.

Okay. Thank you for that.

(Panel discussion)

I guess, let’s all sort of reflect on the heading on the slide there. I know, Brad, you made a couple of comments already and I’ll ask others to put their views in as well. I guess the key question is, how prepared are we for a systemic liquidity event and what more do we think at this point in time we need to, as an industry. We’ll start, maybe with Brad, and I’m happy to go down the rest of the line, please.

APRA have recently undertaken a system-wide stress test with their regulated entity. So I don’t want to pre-empt what they might say. What I can say though is the starting position is certainly one of strength. Larger banks have significant holdings of liquid assets. Our medium to smaller-sized banks are thinking hard and not just about the size but the composition of their assets. Making sure that they can raise liquidity, including through repo’ing them, rather than dumping them out in the open market, which we think is important. I mentioned before, super funds are increasing the sophistication of their liquidity risk management. Our FMIs and payment system are thinking harder about big liquidity disruption. So all of that, as Jo alluded to is, I think, cause for some comfort. That said, we all know through lived experience if there is a systemic shock, particularly one coming from abroad, our financial system won’t be immune. And so we are doing a lot of work across multiple domains to harden the system and prepare the system to be able to withstand very significant disruptions.

What we are - where our mind is - is turning most acutely is to a number of shocks occurring simultaneously. We’re not just thinking about isolated shocks. We’re thinking about a number of shocks coalescing. And so with that in mind, if I can offer some free advice, you stress test, reverse stress test very creatively. I don’t think that this should be the past will repeat as a great guide, given my opening remarks, and we would really encourage industry to challenge their core assumptions and make sure that those are robust because that’s really the starting point for these sorts of exercises. So we’re in a good - we’re in a good place but there’s absolutely no reason for complacency.

Okay. Thank you for that. I remember in my former life sitting in a room with somebody talking about the - you know, the Enron going bust as a stress event and people arguing, well, that would never happen. And of course it did. I guess we’ll just very quickly get some other comments on the same question, just down the panel. So, you know, how prepared are we and what more do you think we need to do? I guess there’s a very positive message I think we are trying to get across here. That this is a subject - that an issue that a lot of smart people are thinking about and that when people go to do their jobs inside industry funds, you may not have an APS to attend but that doesn’t mean you’re not thinking about liquidity. And you’re not living it every day and sweating the detail. So - but having said all that, how do you feel in terms of, I guess, preparedness for an event from the industry super side.

(Panel discussion)

Okay. Well, thank you for that. We are just a bit over time. I guess the key message to leave is that this is a terrific situation for the country. Lots of smart people thinking about the situation. Applying the right lens. It’s a good situation to have. As you can see from the panel we are in very capable hands going forward and AFMA is delighted to, sort of, help promote this conversation. So please if I can ask the audience to say thank you to the panel and straight after this there’s coffee out the back. So thank you for that.