RBA Flags Possibility of Negative Equity in Future But It Doesn’t Mean Much
- Published on
- 21 Oct 2021, 05:42 PM
By Sophia Rodrigues
(Sydney, October 21, 2021)—The Reserve Bank of Australia incurred a record “unrealised” valuation loss of A$8.2 billion in the financial year ending June 2021 and has flagged the possibility of going into a negative equity position in future due to large valuation losses.
This would, however, not have any impact on its functioning.
“Such an outcome, if it were to occur for these reasons, would not affect the Reserve Bank’s ability to operate effectively or perform any of its policy functions,” the RBA said in the 2020-21 Annual Report, published Thursday.
The valuation loss was due to appreciation of the Australian dollar over the year (A$3.5 billion), a rise in bond yields locally and offshore (A$2.0 billion) and the unwinding of premiums on domestic government bonds that were purchased at a higher price than their face value (A$2.7 billion).
The unrealised valuation loss and realised valuation loss of A$0.2 billion from maturities of bonds that were purchased at a premium, partly offset by gains from foreign-exchange activity, resulted in underlying earnings of A$4.2 billion and accounting loss of A$4.3 billion in 2020-21.
The RBA’s underlying earnings was a record A$4.2 billion, a sharp jump from A$2.8 billion the year before, reflecting interest received from bonds purchased since the Covid-19 pandemic.
Despite the accounting loss, there was earnings available for distribution to the government because it comes out of underlying earnings minus realised valuation loss. This means A$3.9 billion was available for earnings.
However, a portion of this (A$1.247 billion) was retained as a transfer to the Reserve Bank Reserve Fund (RBRF) and the balance A$2.671 billion was paid as dividend to government.
The unrealised valuation loss was absorbed by unrealised profits reserve which was wiped off almost entirely to A$502 million from A$8.75 billion the year before.
This means the RBA has only a tiny capacity to absorb future valuation loss through unrealised profits reserve. So at least on paper the losses would be absorbed from the RBRF. This explains why it flagged the possibility of negative equity in future.
HUGE INTEREST RATE RISK
The RBA has a policy of aiming to hold sufficient funds in the RBRF to absorb losses that might reasonably be anticipated from time to time. This is done through a framework that assigns capital to various risks on the bank’s balance sheet, including credit risk and market risk. CB-Intel explained this in an article on September 1.
In case of market risk, the RBA used a stress scenario of 25% appreciation of the Australian dollar and based on this, the target level of capital for exchange rate risk was A$12.8 billion, a little higher than a year earlier.
In case of interest rate risk, the scenario used was a 200bps rise in interest rates across the whole yield curve, which resulted in capital level of A$27.4 billion for domestic portfolio, marking a big jump from a year earlier due to significant expansion of the balance sheet. For foreign portfolio, the capital target was little changed.
Combining the capital calculations for credit risk, foreign exchange risk and interest rate risk, the overall figure for target balance worked to A$40.8 billion, a sharp rise from A$12.6 billion calculated for the year before.
However, the RBA is using an alternative assessment of risks associated with domestic bonds because its intention is to hold the bonds to maturity and therefore judges the financial risks are different from other bond holdings.
The RBA also calculated “earnings at risk” as A$2.0 billion, derived from calculating maximum annual decline in net interest earnings over coming year based on projected balance sheet and financial market expectations for the cash rate.
Based on all this and excluding interest rate risk from domestic bonds, the RBA arrived at RBRF at A$15.4 billion which is the amount at the end of June 2021 following transfer from realised earnings.
BALANCE SHEET GROWTH
The RBA’s balance sheet grew to A$540 billion over 2020-21 due mainly to a big jump in outright bond holdings to A$253 billion from A$73 billion the year before.
On the deposit side, there was a sharp jump in Exchange Settlement balances to A$342 billion from A$73 billion the year before. There was also an increase in deposits from foreign institutions with the RBA and it stood at A$12.1 billion at the end of June versus A$3.4 billion a year earlier (CB-Intel wrote two stories about this).
--Contact: Sophia@centralbankintel.com