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Australian Money Market Divergence: Arbitrage Opportunity or Illusion?

Belinda Cheung and Sebastien Printant
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Sebastien Printant: Reserve Bank of Australia

RBA Research Discussion Papers from Reserve Bank of Australia

Abstract: In recent years, the spread between money market interest rates has widened. One implication is that the price of Australian dollars diverges across these markets. Even after risks associated with creditworthiness, liquidity and other factors have been taken into account, it appears that unexploited arbitrage opportunities persist. Typically the literature only assesses the profitability of arbitrage by calculating the return from funding at low money market rates to invest at higher rates. However, banks have broader balance sheet considerations that need to be taken into account. We therefore take a 'whole-of-balance-sheet' approach to assessing the potential for arbitrage opportunities available to the four major banks in Australia. this takes into consideration that banks optimise their balance sheet not only by funding themselves at the lowest possible rates to maximise profitability, but also for compliance with prudential regulation, maintenance of capital adequacy, and opportunity cost in asset allocation. We find that once asset-specific funding costs are taken into account, short-term money market trades would have generally not been profitable for the major banks. Overall, the incentive for banks to arbitrage has fallen since 2008. Our result reflects both a rise in the cost of debt funding relative to market returns and an increase in the share of equity funding. We also note that the deployment of balance sheet space to money market trading incurs a significant opportunity cost, when compared to lending for residential housing. Not surprisingly, the balance sheets of the major banks are therefore skewed toward more profitable lending activities, rather than money market trading.

Keywords: arbitrage; banks; funding costs; money markets (search for similar items in EconPapers)
JEL-codes: G10 G11 G18 G21 (search for similar items in EconPapers)
Date: 2019-09
New Economics Papers: this item is included in nep-mon
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