How far will regulators go in order to mitigate the potential of a bank run? We take a look at the key issues executives need to be across from APRA’s proposed changes to liquidity requirements.

Liquidity problems kill banks. In an increasingly online world, deposit runs can and will be far faster than in the past – Silicon Valley Bank (SVB) being the case in point. However, the reality is that unless all deposits are invested in liquid assets then a deposit run has the potential to bring down a bank – that is no more true today than it was 100 years ago. What is different today is the speed at which those runs can take place.

In November 2023, APRA commenced consultation on proposed changes to Prudential Standard APS 210 Liquidity, designed in response to the lessons learned from events in early 2023 – most notably the March 2023 collapse of SVB. The proposals set out fundamental changes to the Minimum Liquidity Holdings (MLH) regime and in their current form, have significant impacts for ADIs operating under the MLH regime.

The proposed changes are far greater than the post-GFC liquidity policy changes, with substantial financial costs and operational impacts. All MLH ADIs need to closely analyse the costs and operational impacts of these proposals and start preparing now for the inevitable transition to a more complex, and specific regulatory regime – regardless of where the final proposals land.

Overview of the changes

APRA sets out its view that the proposed targeted revisions would ensure that:

  1. ADIs on the MLH regime value liquid assets at their market value; 
  2. All ADIs have robust processes for accessing exceptional liquidity assistance from the Reserve Bank of Australia (RBA), where needed; and
  3. Contagion risk is reduced by strengthening the composition of MLH liquid assets

Set out at this high level, the revisions sound reasonable; however, they have significant ramifications. Despite being listed third, the change to the composition of eligible liquid assets is by far the most significant. It means that MLH ADIs will no longer be allowed to hold other ADI debt instruments to meet APRA’s liquidity requirements and instead will need to hold lower-yielding government securities. Senior executives of MLH ADIs need to be across the impact of the proposals in the following key areas:

  • Profitability will be reduced significantly as a result
  • Far greater sophistication of interest rate risk management will be required
  • Complexity and operational risk management will increase and new skills, expertise and oversight will be required across all three lines of defence.

APRA’s latest proposals may be considered to be harmonising MLH and LCR regimes, in that all ADIs will materially meet their liquidity requirements by holding government securities. Although APRA does refer to ‘alignment’ with LCR in its consultation, it appears that this is not the primary motivation. Rather, reflecting on the SVB collapse, APRA seeks to ‘reduce the risk that stress could be propagated across the financial system as banks draw down on their liquidity buffers’.

Are APRA’s proposed changes to MLH and the significant income hit for small ADIs reasonable to achieve this objective?

Profitability will be reduced significantly as a result

As APRA notes in its release “We recognise the impact these proposals may have on some smaller banks, including financially”. Smaller ADIs generally have lower profitability and maintain high liquidity ratios, reflecting diseconomies of scale, and often, their mutual status. All MLH ADIs need to model the impacts on their portfolios and profitability; as APRA notes in the letter, ‘holdings of other bank securities represent a large share of MLH ADIs’ existing liquid assets, at around 60 per cent on average.’ When fully implemented, this change is likely to involve reductions in profitability, with significant variability in the range depending on the portfolio and assumptions. The impact will be felt progressively from 2025, consistent with APRA’s proposed phased implementation.

ADIs will need to consider this strategically including, for example, whether to increase lending rates making them less competitive, balancing the cost implications against other planned initiatives to provide better member services. In some cases the impact may be so great that they cause Boards to question ongoing sustainability. Perversely, it may also cause some ADIs to reduce liquidity buffers they hold above regulatory minimums to partially mitigate the costs.

To the extent that MLH ADIs hold other ADIs debt securities to satisfy part of their liquidity needs, the proposal also means that issuing ADIs may lose a funding source and will need to obtain other, potentially more expensive, funding or reduce balance sheet growth.

Far greater sophistication of interest rate risk management will be required

With a substantial part of the balance sheet invested in fixed rate government securities an interest rate risk management approach will need to be adopted involving entering into interest rate derivatives as hedges – an activity many smaller ADIs would not have previously undertaken. Expectations for governance and risk management approaches have been strengthened even further with revisions to APS 117 Interest Rate Risk in the Banking Book coming into effect from 1 October 2025. These requirements are a step change, particularly for mutual ADIs that are contemplating mergers which are likely to result in Significant Financial Institutions designation.

Specific expertise is needed to design and implement appropriate interest rate hedging strategies, execute them, then operationalise other areas such as payments, accounting and reporting. Risk functions will need to build out appropriate oversight and challenge capabilities, including risk reporting. This will be a new activity and discipline for many ADIs. How will smaller ADIs obtain this expertise at the various levels needed, including at Board level? Without expertise, the potential for unexpected, or poor, outcomes is obviously heightened and awareness of issues may come too late in the piece.

Furthermore, over time there may be a temptation at some ADIs to take interest rate risk positions in an attempt to reduce the cost of running the liquid asset portfolio. There are far too many instances around the world of unexpected losses when this happens in banks without the appropriate depth of experience, infrastructure and oversight across the three lines of defence.

Complexity and operational risk management will increase

The proposals heighten both complexity and operational risk. Take, for example, financial accounting; APRA’s proposal is that government bonds will be accounted for on a mark-to-market basis. Derivatives will need to be valued as well, and hedge accounting will need to be considered. Will this involve ADIs needing new IT systems as well as operational processes?

APRA also sets out its expectation that ‘all ADIs have robust processes for accessing exceptional liquidity assistance (ELA) from the Reserve Bank of Australia (RBA), where needed’. This means that ADIs will need to be positioned to provide ‘any information requested by APRA or the RBA in relation to the ADI’s ELA request. An ADI must have the operational capability to provide information along with its application for ELA or within other timeframes specified by APRA.’ Given any such information request will be situation dependent, APRA has not been able to detail the specific information or types of information that will be requested. Therefore, it is not immediately clear what may be expected with this new requirement and therefore how ADIs can best position themselves to revise processes to meet it.

What next?

Understanding the impact of the proposed changes on your business, including the strategic implications is paramount. Decisions need to be made on the basis of robust modelling and it is imperative to understand the impacts on your profitability and liquid asset portfolio.

Rhizome works with firms across the financial sector to understand, prepare for, and implement regulatory change, including as it relates to APS 210 Liquidity. Rhizome also undertakes comprehensive reviews of ADIs’ liquidity risk management frameworks as required in APS 210 Liquidity.

Please reach out to us for more information.

This communication provides general information which is current at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Rhizome Advisory Group Pty Ltd shall not be liable for any errors, omissions, defects or misrepresentations in the information or for any loss of damage suffered by persons who use or rely on such information (including for reasons of negligence, negligent misstatement or otherwise).