The recession might be upon us, but the credit crunch is becoming more of a horrid, distant echo for Australian banks and financial institutions.

The two are linked, of course: the recession dampens the demand for funds, while the seven week rebound in markets and returning confidence have added to the feeling that banks are not going to fail and will be able, one way or another, to meet their debts.

Money market liquidity and conditions in Australia have now calmed down to the point where cash balances held in the Reserve Bank’s Exchange Settlement Accounts have fallen to their lowest level since the collapse of Lehman Brothers last September.

As well, spreads on short term funding have eased to the point where they are close to two years, if not already there.

Figures published on the RBA website show that the banks held $2.327 billion in their ESA’s last Friday to cover the weekend and $2.421 billion overnight Monday.

That’s the amount of money the banks keep to handle overnight liquidity calls from settlement of banking and other transactions.

And in another indicator this morning, the spread between the 90 day bank bill rate of 3.08%, and the expected cash rate, fell to 0.27% — the lowest for two years (give or take a day or two). It’s certainly the lowest for the 18 months since the crunch first started gathering steam.

The banks are now more focused on meeting their overnight settlements, rather than worrying if their peers will be around in the morning to continue dealing, or would fail outright — as several did in the US in 2008 when Bear Stearns, Lehman, Merrill Lynch, Washington Mutual and Wachovia all failed or were forcibly taken over by other banks at the direction or supervision of regulators.

Here the ESA’s have been an important indicator of banking pressures since the credit crunch started in August 2007. The ESA balances ballooned as the banks (with the RBA’s blessing) listed the cash they held in accounts each night as they grew more fearful about their peers and whether they would fail.

The failure of Northern Rock in the UK, then big losses in Germany, the US, Japan and again in the UK, and more worries about the stability of the financial system saw the amounts held in these accounts maintained at high levels. They rose when Bear Stearns was bailed out in March 2008, and then eased dramatically as the markets thought the worst was over.

Even when pressures re-emerged in the US, UK and Europe in August, the ESA balances were low, but the rapid collapse of Lehman Brothers saw the amounts held jump sharply to $5 and $6 billion, and then $8 billion and finally over $11 billion a night as it seemed the global financial system would freeze and then implode. The collapse of the first attempt by the US to set up a fund to aid stricken banks didn’t help and it added to the intense pressure on liquidity.

Froze it did, and the high balances and fraught confidence levels were maintained through December into January, February and then early March as it seemed Citigroup and Bank of America might topple over or be nationalised by a reluctant US Government.

But as confidence started returning from mid March onwards, as conditions started stabilising and the freefall in the economy and markets eased, share markets and commodities starting rising, leading to more confidence. This showed up in an easing in market liquidity and short term interest rates.

The ESA are now back to their lowest since September 15. But they are likely to kick up this weekend and then next Monday, ahead of the release of the stress tests on the balance sheets of the 19 biggest banks in the US. If they are OK then there will be another easing of tension in the markets.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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