Are You Liquid? / by Adam Howard

I reckon the world has become obsessed with debt lately; everyone either wants it, wants to get rid of it or is terrified of it.  Or all three.  Yep, most commonly all three.

But what about debt’s long lost brother?  Cash. 

There’s not a great deal said about cash these days.  Most of the talk is about your credit card or home loan, with cash almost being treated as a legacy of a bygone era.

A time when you walked into a store, grabbed a bottle of coke and gave the shopkeeper your shrapnel.  Or at the end of the week when you had finished all your shifts you were given your envelope full of notes.

Now it’s just tap ‘n go, or hit refresh in the browser;  funds not there then all of a sudden there.

Cash is a strange thing.  It’s a form of debt in its own right.  Originally issued by governments as a promissory note against that government’s gold reserves, it has now become something a lot more abstract.

Printed by central banks, at a profit mind you, and with no real link to any universally valued object since 1974 when President Nixon discarded the Gold Standard.

We just all accept it’s worth something. 

Less and less people are carrying cash though, with studies in the UK showing that 45% of people carry less cash now than they did 2 years ago, 10% of people don’t even carry a wallet anymore and 25% more would like to only carry a device instead of a wallet.

As people choose to use less cash Governments are also experimenting with getting rid of their large denomination notes. The US removed notes larger than $100 in the 1960s, the Indian Government tried and failed to remove 100 and 500 rupee notes from circulation in 2015 and the Euro Zone is soon to remove 500 Euro notes from circulation.

Here’s a strange fact though;  in Australia there seems to be a bit of push and pull going on, because while the Australian government likes the idea of removing all high value notes from circulation, there is a 20 year trend upwards in the number of $50 and $100 notes actually being issued.

Governments’ arguments for removing large notes include reductions in tax evasion and welfare fraud, and reducing liquidity available to fund criminal activities.

But regular people like cash.  It’s private, liquid and instantaneous, fosters trust in transactions and can be relied on in emergencies.

Here’s another funny thing; demand for cash in Australia increased in October 2008, just following the Global Financial Crisis, even though our banking system was left largely unscathed.

An RBA report noted this increase and also noted that only about 20% of the increase in demand could be accounted for by increases in bank account deposits, with the report concluding that a potential reason was that people must be hoarding cash to protect themselves against a potential bank failure.

So, where are we now?

Our transactional system is more and more a cashless process, and people are adjusting to that by carrying less cash, whilst at the same time protecting themselves against the rise of this system by holding more high value notes.

That tells me people don’t trust the current system; think there is some risk they could get swindled or the actions of others could put their hard-earned at risk.

This is a common concern; that the banks, who hold our cash for us, will somehow mess things up to a large enough degree that we wouldn’t be able to get our money out.  And this is when bank runs occur. 

Think, lines of people stretching out of the door of the bank as customers in a panic try to get their cash out before the cash is all gone….

And that’s what all the hullabaloo about banks being under pressure from the authorities at the moment regarding investment loans and interest only home loans is about; the fear that banks will lend poorly, get it badly wrong, begin to fail and experience a bank run.

Our regulators; the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC); are putting the acid on the banks to do the following:

-          Hold more cash (they call it Tier 1 Capital) as a percentage of total loans.  It used to be that banks needed to hold slightly less than 10% of the value of their loan book in liquid assets, but that’s now been increased to 11-12%.  A big jump when your loan book is worth in the hundreds of billions of dollars.

-          Increase the amount of home loans on principal and interest repayments as a percentage of their total loan book; and

-          Limit the growth of their investment loan book to a maximum of 10% book growth per annum.

Loans are now also broadly ranked from most to least risky as follows:

-          Least risky:  home loans on Principal and Interest reductions;

-          A bit more risky:  home loans on Interest Only repayments;

-          Quite risky:  investment loans on Principal and Interest reductions; and

-          The riskiest:  investment loans on Interest Only terms.

And this is why there is now a large gap between the rate you’re offered on your home loan and what you will be offered on your investment loan. 

In fact, it’s why some banks aren’t even offering investment loans or interest only terms at the moment. 

They can’t afford it; don’t have enough capital; not liquid enough.

So, people are subconsciously worried about the liquidity of our banks, while the regulators are clearly quite obviously worried about the liquidity of our banks.

Maybe worried is the wrong word.  Maybe concerned enough to take action is the best way to put it….

On the other side of the coin (sorry, bad pun), what about households?  You and me?  Are we liquid? 

We are the ones borrowing all this money from the banks; living these lives; buying this stuff.  Are we liquid?

And what IS liquid? 

Liquid is solvent, and solvent, in the financial sense, is defined as being able to pay one’s debts as and when they fall due.

Most households probably meet that standard.  Able to pay their home loan each month, pay their power bill, pay their rates.  Stuff like that.

But what if something bad happened?  That’s why APRA and ASIC are making the banks improve their liquidity; just in case something bad happened.

Well, Australian Bureau of Statistics (ABS) statistics showed that as at 31/12/2016 Australian households had net assets of $9.4 trillion; net, so after home and investment loans have been stripped out.

And of that net worth, there was $1 trillion in cash and deposits.  Not bad, right?

I mean, total household debt Australia-wide is $1.7 trillion, but households also hold $1 trillion in cash.  What’s the big deal?

But then the ME Bank Household Comfort Report found that 1 in 4 Australian households have less than $1,000 in savings, and that their primary concerns are being able to pay for the necessities of life:  groceries, petrol and utilities.

What Are Households Worried About

What the….?

So, who has the cash?  And who are these households that have almost none??

Now, I don’t want to start a class war, but it does seem the rich are getting richer and the poor get the picture….

The middle class appear to be less middle and more the working poor these days, and the reason is flatlining wages and earnings. 

The cost of everything is going up, while our wages aren’t.  At least, that’s the case for the middle class; the average wage earner.

Here’s a link to a story on wages growth that pretty clearly shows wages growth has tanked since 2010 and is now about 2% per annum.

Wages Growth in Australia

And now here is a link to a database that was created by French economist Thomas Piketty that measures income distribution over a 70 year period across 39 countries:

World Income Inequality

You can see from these graphs that in Australia the top 10% of earners AND the top 1% of earners haven’t had it this good since just after World War II, with the top 10% managing to nab 32% of total income, and the top 1% nabbing almost 10%.

Not as bad as the US, where the top 1% command 20% of total income, but not great either…

Let’s quickly look at liquidity standards comparatively for a second. 

Banks are asked to hold as much as 11% of their total loan assets in the form of tier 1 capital to protect against a major economic shock that might result in a larger than usual proportion of those loans going into default; going bad.

 Let’s assume that what the banks are being required to do is hold 11% of their total assets in cash.

I am betting that if we asked the average Australian household to meet the same standard they would fail dramatically. 

If we just used the average house as the total of household assets, and then assumed it is worth about $450,000, then we would need the average household to hold $45,000 in cash or liquid assets.  No chance….

Why would they need to do that, though?  A reasonable question.

What if something bad happened?  A death; serious illness; a lost job.  You need to have some type of cushion to help you survive.

Some people might have cash.  Some might have insurance.  But I bet a lot have nothing, and that’s scary.

I don’t want to get all preachy here, but in an environment of record low interest rates we should all be doing our best to either pay back as much debt as possible, or save some cash, or both.  Hopefully both….

So, we have a lot of illiquid households earning less in real terms, carrying a lot of debt.

The banks are worried about those households and their ability to pay their bills, even though they were the ones that happily lent the money in the first place.

It seems like what we have at the moment, with regulator pressure and changing bank policy is a rush to shut the gate, while we all watch the horse galloping towards the horizon.

The regulators are terrified that the banks’ relentless search for higher net profits through more and more home and/or investment lending will leave our economy badly exposed if there is another global economic hiccup.

And there will be another hiccup.  It’s just a question of when…and how….

The banks respond to this regulator pressure to hold more capital by warning everyone that this extra cost will HAVE to be passed onto borrowers by charging higher rates.

So, debt begins to cost more, at some time households want to keep costs down, particularly one of its biggest costs; the family home loan.

On the flipside, households ARE trying to repay debt and save more, and the signs of that are obvious; less economic activity.  Less spending on designer jeans, new cars and degustation dinners.

More saving and more debt repayment instead, even though debt is costing more.

This lower level of economic activity results in lower than desirable GDP growth, which makes the politicians, economists and public servants worried Australia is more exposed to a global financial hiccup.

So, the politicians respond by lecturing households about their spending habits and addiction to debt, at a time when most households have been aware of the need to cut costs and reduce debt for a while.

Once again, another horse galloping towards the horizon.

It’s an endless, ridiculous cycle involving regulators and government, the banks and households, where, in my opinion, the only true level of accountability is at the household level.

Households need to pay their bills.  Households need to have money in the bank.  Households need to make decisions on a day to day basis that ensure they can continue to put food on the table.

While regulators and executives can sit far away and make pronouncements and talk in high minded tones about policy levers and whether they are set right.

Frustrating times….

I guess, considering most of us are part of households, the only really important question is, are you liquid??