The mid-term outlook is encouraging from a number of perspectives:

* The outlook for the economy is strong on the back of buoyant commodity demand and this is supporting asset quality; bad debt provisions appear to be peaking.

* Australian Commonwealth Government debt is very low, obviating concerns that sovereign borrowing could crowd out the banks and creating capacity for future economic stimulus should there ever be a need.

* Bank capital and liquidity are much stronger than before, and will likely be reinforced by regulatory initiatives.

* While competition is re-emerging, consolidation and the exit of marginal players have allowed the surviving banks to improve their risk-adjusted loan pricing, largely compensating for increased funding costs.

The solid outlook and low-risk profile of the major Australian banks - ANZ, CBA, NAB and Westpac - have underpinned their strong access to offshore wholesale markets in non-guaranteed form from December quarter 2009 onwards. This has allowed the Australian Government to be the first to withdraw its crisis-related guarantee for wholesale funding and deposits above A$1 million.

Strong debt market access is important for the major banks because they have a structural reliance on wholesale funding, with a significant offshore component, as a result of: (i) tax treatment that provides incentives for individuals to save through their superannuation schemes not bank deposits and (ii) Australia's balance of payments deficit, approximately two-thirds of which is funded by banks' offshore borrowings. Moreover, with very low government debt and a modest corporate bond market, the Australian financial system remains highly intermediated.

While the major banks' funding profiles leave them potentially exposed to external shocks, they have been working to manage their sensitivity to wholesale market disruptions by effectively funding new loan growth out of long-term debt or deposits. Debt tenors have increased significantly, from a maximum of about five years pre-crisis to 12 years post-crisis, assisted by demand from longer-term investors such as pension funds and life insurers. The big banks are also pre-funding their requirements.

Collectively, these changes will allow the big Australian banks to accommodate, more easily, any further market dislocations and to lower their refinancing risk during 2012 and 2014, when there will be a concentration in the maturities of governmentguaranteed bonds issued by banks globally.

By contrast, Australia's smaller financial institutions - although having survived the downturn in pretty good shape overall - remain more affected by the lingering effects of the crisis. Their cost of debt issuance is still unfavourable relative to the major banks and potential regulatory changes have increased competition for deposits. Moreover, because their loan books are more heavily weighted towards residential mortgages, on which margins have improved less than business lending, they continue to face a margin squeeze.

Nevertheless, the smaller institutions have been well able to accommodate the withdrawal of the government debt guarantee - primarily because most have not been active users of the scheme, as a result of the higher fee structure for lower-rated issuers. Furthermore, other systemic support measures remain in place to smooth the transition to a non-guaranteed bank debt market.

First, the government guarantee for deposits below A$1 million, which account for over 99% of deposits according to government figures, is to remain in place until October 2011, when the dollar coverage level will be reviewed. Second, the Australian Office of Financial Management (AOFM) continues to support the residential mortgage-backed securites (RMBS) market by acting as a cornerstone investor in new issues by smaller institutions - although sizeable recent transactions without the AOFM's participation suggest that 'real money' investor demand for RMBS is slowly returning. Third, the Reserve Bank of Australia has permanently increased the range of assets it will accept for repo as part of its normal open market operations. Notably, they include accepting (under extraordinary circumstances) self-originated RMBS. Given Australian banks' large, prime residential mortgage books, this constitutes a very considerable liquidity backstop.

Remaining challenges

While conditions are improving, other challenges remain.

Housing still looks expensive and interest rates have been rising. However, house prices are being supported by the strong employment picture, net migration and an intensifying housing supply shortage. Banks are also protected from credit losses by relatively low average loan-to-values and cover from Australia's well capitalised mortgage insurance sector.

The Basel Committee has proposed widereaching changes to capital adequacy and liquidity rules. In Australia, the major banks could potentially be the most affected, but more by the liquidity proposals than the capital proposals.

Australian capital adequacy standards are conservative and already meet some of the suggested new standards. The introduction of a maximum leverage ratio could require capital increases at institutions with large wealth management operations and residential mortgage books, but only to a degree that they could easily accommodate.

The Committee's liquidity proposals would require far more wide-reaching changes, because they penalise the Australian major banks' combination of significant wholesale funding and loan books which are dominated by long-lived residential mortgage assets. To make matters worse, the proposals do not recognise as liquid assets the principal investment securities - bank bills and RMBS - that Australian banks hold to repo with the central bank.

As indicated, the banks have started to react by issuing longer-term debt and pricing up deposits, but the potential impact of the Committee's proposals is so profound that a major policy response will likely be required. Various suggestions have been floated for discussion, such as the introduction of tax incentives for individuals to invest in bank deposits and the creation of a covered bond market. Clearly there remains a high degree of uncertainty about the eventual regulation that will be adopted, but, with their solid credit fundamentals, Australian banks appear to be in a strong position to adapt.

Author affiliation:

Patrick Winsbury is Senior Vice President, Financial Institutions Group, Moody's Investors Service.

patrick.winsbury@moodys.com