Internal consistency of risk free rate and MRP in the CAPM

Reserve Bank assistant governor Guy Debelle said this week the demand for
Australian bonds was coming largely from the sovereign wealth funds of foreign
governments.
Mr Debelle said the Reserve estimated that 75 per cent of Australian bonds were
owned offshore. He said foreign demand for Australian bonds could be partly
responsible for the recent strength of the Australian dollar.
110. The heightened demand for CGS from foreign investors appears to have pushed
domestic investors into state government debt. While Australian investors only hold
around 25% of CGS, they hold around 60% of the market value of state government
debt (up from 53% in June 2007). 33
111. This heightened demand from foreigners comes at the same time that changes to
banking regulations are raising the demand for CGS and state government debt from
Australian banks. Specifically, under Basel III regulations banks will be required to
hold an increased proportion of their balance sheet in high quality liquid assets. The
purpose of this regulation is to ensure that banks individually, and the banking system
as a whole, can avoid the need to engage in ‘fire sales’ of illiquid assets in the event of
a runs on the banking system (and thereby avoiding a systemic reduction in the value
of all such assets held in the banking system).
112. In describing the implementation of Basel III, APRA’s Charles Littrel has stated: 34
First, we intend to ensure that each bank reasonably optimises its use of
Commonwealth Government Securities and semi-government securities, which
are the most liquid assets in our market. But at the same time, holdings of this
stock cannot allow the liquidity in these markets to be soaked up.
113. The problem for Australia is that there simply are too few CGS and state government
debt instruments on issue that will allow the Basel III induced demand for these assets
to be satisfied (at least without destroying the liquidity of these assets). RBA Assistant
Governor Guy Debelle has explained the magnitude of this effect in the following
way. 35
The Basel liquidity standard requires that banks have access to enough highquality
liquid assets to withstand a 30-day stress scenario, and specifies the
characteristics required to be considered an eligible liquid asset.
33 Lancaster and Dowling, The Australian Semi-government Bond Market, RBA bulletin, September Quarter 2011, page 53.
34 APRA’s Basel III Implementation rationale and impacts, Charles Littrell, Exec. GM, Policy, Research and Statistics, APRA,
APRA Finisia Workshop, Sydney, 23 November 2011.
35 Guy Debelle, RBA Assistant Governor (Financial Markets), Speech to the APRA Basel III Implementation Workshop 2011
Sydney - 23 November 2011.
Competition Economists Group
www.CEG-AP.COM
30