Australian regulators are discussing a new system of liquidity rules for the Australian banking system that will force the banks to protect themselves against higher interest rates in times of crisis.

The new system will push up funding costs for the banks, who will then attempt to pass them on to customers by way of higher interest rates, or smaller reductions in rates when the Reserve Bank cuts (or higher rises when the RBA starts lifting rates).

The discussions are being held between the major regulators, APRA, the Reserve Bank, ASIC and Treasury and conducted through the Council of Financial Regulators.

If there’s agreement, they will start from January 1, according to a speech by a senior executive with APRA, its General manager, David Lewis.

He told a Sydney finance conference yesterday:

“APRA has long preferred a scenario-based approach – one which measures a bank’s liquidity needs against a range of different stress scenarios. “We will shortly be releasing a policy discussion paper which will propose changes to existing scenario parameters – particularly those dealing with a ‘name crisis’ and a ‘market disruption’ – which take on board lessons learnt from the global financial crisis. If accepted, these changes will take effect from 1 January next year.”

It is the first mention in public of the timing of the changes: APRA chairman, Dr John Laker did not refer to it in his appearance before the Senate Economics Committee earlier this month (On June 4).

It sounds boring, but the political bunfight will be intense when the new rules emerge. The banks will fight and argue to avoid them because funding conditions will be much easier and the need for the changes will be less apparent.

But banks have been complaining about the impact of what’s called “rollover risk” for sometime now. It was how the Commonwealth Bank justified its 0.10% rise in variable home loans rates two weeks ago. The ban clamed higher funding costs as borrowings rolled over (i.e. matured and were then renewed) into new loans at higher rates.

News of the new system appeared buried in the preliminary report on Australia from the International Monetary Fund this week.

“The planned introduction of new liquidity guidelines is welcome, ” the IMF commented.

“Recognizing the increased importance of liquidity and the rollover risks associated with short-term liabilities, banks have started to increase medium-term funding.

“However, future liquidity positions should be based on prudentially enforced liquidity guidelines.

“The stability benefits of strengthening liquidity positions and reducing rollover risks justify the likely increases in funding costs.

“Exit strategies from the policy measures introduced during the financial crisis are, appropriately, being considered.

“We recognize that the risk-pricing element of the wholesale funding guarantee provides a natural exit strategy once markets normalize.

“The ongoing work on crisis preparedness will help strengthen financial stability.

“Importantly, a framework is being developed to deal with liquidity or solvency problems in major banks in Australia and New Zealand, in the unlikely event that they should emerge,” the IMF said.

What the new liquidity system will in fact be is Australia’s regulatory response to the credit crunch: the US, UK and Europe are thinking about new regulators, new rules, higher capital weightings for some types of banking and fretting about banks being “too big too fail”.

Rollover risk was identified as the major potential problem for the Australian banking system in a stress test conducted by the IMF on our banks and financial system a couple of years ago.

It found our banks could withstand a rise in unemployment, but more importantly, a shut off from global credit markets for up to three months. Little did anyone know was that what would happen within a year of that test being finalised and the results released.

It’s what happened after Lehman Bothers collapsed last September. Australia’s banks found they couldn’t borrow offshore and with other Governments introducing guarantees, our Government introduced the current three year guarantee on deposits. This particular point was confirmed a few weeks ago by Prime Minister Rudd in a speech to the Queensland ALP conference.

In its report this week, the IMF actually urged the regulators in Australia to conduct an even tougher stress test on the banks to test their chances of surviving.

“We commend APRA for regularly stress testing the banking sector and we advise the use of more extreme scenarios than applied in the past and the inclusion of Australian banks’ overseas subsidiaries.

“Prudential judgment should be used to assess the adequacy of the banks’ capital buffers, and capital requirements raised if necessary.

“Our preliminary analysis suggests that banks will be able to withstand potential further losses from a sizable downside shock,” the IMF said.