Category: Banking Culture

Reforms On Incentives To Centrally Clear Over-the-counter Derivatives

The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) has published their final report on Incentives to centrally clear over-the-counter (OTC) derivatives.

The total value of OTC derivatives was recently reported at US$595 Trillion, a massive number. The approach is been to allow the growth of these instruments, but to encourage central clearing rather than bi-lateral dealer arrangements to give greater visibility to the exposures involved.  They propose capital incentives for centrally cleared transactions.

We discussed this in a recent video. This is a highly speculative market, and whilst shining more light on them may help, the more fundamental question which should be asked is why allow these to exist at all. The financial markets would be safer if they were limited to only underlying transactions, not speculative positions.   At the moment, there is a risk that the derivatives markets could swamp, and bring down the normal banking system in a crisis, and that risk remains un-quantifiable.  Another reason for structural separation.

 

The central clearing of standardised OTC derivatives is a pillar of the G20 Leaders’ commitment to reform OTC derivatives markets in response to the global financial crisis. A number of post-crisis reforms are, directly or indirectly, relevant to incentives to centrally clear. The report by the Derivatives Assessment Team (DAT) evaluates how these reforms interact and how they could affect incentives.

The findings of this evaluation report will inform relevant standard-setting bodies and, if warranted, could provide a basis for fine-tuning post-crisis reforms, bearing in mind the original objectives of the reforms. This does not imply a scaling back of those reforms or an undermining of members’ commitment to implement them.

The report, one of the first two evaluations under the FSB framework for the post-implementation evaluation of the effects of G20 financial regulatory reforms, confirms the findings of the consultative document that:

  • The changes observed in OTC derivatives markets are consistent with the G20 Leaders’ objective of promoting central clearing as part of mitigating systemic risk and making derivatives markets safer.
  • The relevant post-crisis reforms, in particular the capital, margin and clearing reforms, taken together, appear to create an overall incentive, at least for dealers and larger and more active clients, to centrally clear OTC derivatives.
  • Non-regulatory factors, such as market liquidity, counterparty credit risk management and netting efficiencies, are also important and can interact with regulatory factors to affect incentives to centrally clear.
  • Some categories of clients have less strong incentives to use central clearing, and may have a lower degree of access to central clearing.
  • The provision of client clearing services is concentrated in a relatively small number of bank-affiliated clearing firms and this concentration may have implications for financial stability.
  • Some aspects of regulatory reform may not incentivise provision of client clearing services.

The analysis suggests that, overall, the reforms are achieving their goals of promoting central clearing, especially for the most systemic market participants. This is consistent with the goal of reducing complexity and improving transparency and standardisation in the OTC derivatives markets. Beyond the systemic core of the derivatives network of central counterparties (CCPs), dealers/clearing service providers and larger, more active clients, the incentives are less strong.

The DAT’s work suggests that the treatment of initial margin in the leverage ratio can be a disincentive for banks to offer or expand client clearing services. Bearing in mind the original objectives of the reform, additional analysis would be useful to further assess these effects.

In this regard, the Basel Committee on Banking Supervision issued on 18 October a public consultation setting out options for adjusting, or not, the leverage ratio treatment of client cleared derivatives.

The report also discusses the effects of  clearing mandates and margin requirements for non-centrally cleared derivatives (particularly initial margin) in supporting incentives to centrally clear; and the treatment of client cleared trades in the framework for global systemically important banks.

The final responsibility for deciding whether and how to amend a particular standard or policy remains with the body that is responsible for issuing that standard or policy.

The BCBS, CPMI, FSB and IOSCO today also published an overview of responses to the consultation on this evaluation, which summarises the issues raised in the public consultation launched in August and sets out the main changes that have been made in the report to address them. The individual responses to the public consultation are available on the FSB website.

The five areas of post-crisis reforms to OTC derivatives markets agreed by the G20 are: trade reporting of OTC derivatives; central clearing of standardised OTC derivatives; exchange or electronic platform trading, where appropriate, of standardised OTC derivatives; higher capital requirements for non-centrally cleared derivatives; and initial and variation margin requirements for non-centrally cleared derivatives.

CBA Stands Firm on Bonuses

On Monday (19 November), the seventh and final round of the royal commission hearings kicked off with CBA chief executive Matt Comyn being grilled over the group’s remuneration structures, via InvestorDaily.

Counsel assisting Rowena Orr questioned the major bank boss about frontline staff receiving ‘short-term variable remuneration’, or STVR.

“Short-term variable remuneration is what many people would think of as an annual bonus, is that right?” Ms Orr asked.

“Yes,” Mr Comyn confirmed. “We do not refer to it in that way, but it is a bonus.”

While he admitted that the bank has made a number of changes to its remuneration structure, including work towards the Sedgewick recommendations, Mr Comyn explained why CBA is standing firm on bonuses.

“We believe it is important to have an element of remuneration which is not fixed. We believe it is a well-designed set of metrics or a way for them to earn their short-term variable remuneration; it is both a way of eliciting discretionary effort and a way beyond termination as a form of consequences. It is also a way to make consequences clear to individuals,” he said.

After being prodded by Ms Orr for clarification, the CBA chief explained that “discretionary effort” is the difference between what staff might have otherwise have done if they were paid a fixed salary.

Ms Orr asked why staff can’t be motivated simply by being paid a fixed salary.

Mr Comyn used an offshore example to try and illustrate his response, alluding to a female employee at one financial institution in the United Kingdom that decided to stop paying bonuses.

“I’m talking specifically about a home lender. What they were in effect paid was 98.5 per cent of their prior year’s fixed remuneration and short-term variable reward. So they were guaranteed that remuneration,” he said.

“When I asked her what had changed, her answer was simply ‘I probably work 30 per cent less’. She was one of their best performing lenders.”

Mr Orr offered alternative ways of motivating staff instead of a bonus: “positive feedback for their performance; encouraging them to take pride in their work; encouraging them to have a sense of satisfaction in helping one of your customers; giving them additional responsibilities as a reward for performance; promotion; a higher base salary.”

Mr Comyn said all of these were appropriate ways of driving staff. However, he maintained that CBA has decided for now to continue using short-term variable rewards, or bonuses, to motivate fits sales force

Why Easy Credit Is Not So Easy Anymore

From MPA.

More talk of credit tightening.

I think most of you will agree that in the past getting approved for a credit card wasn’t exactly difficult. I’ve heard some jokingly say that if you had a pulse you could get a card. A little cynical perhaps, but the fact is banks loved approving credit cards. It’s no mystery why, as where else could they generate those sorts of returns?

I’m sure you recall going to a shopping centre or airport and being accosted by an overly enthusiastic bright-eyed credit card salesperson. They couldn’t wait to get you a nice, new shiny credit card, perfect for buying things you didn’t need, with money you didn’t have. Between letters and emails sent by the banks with headings like, “You have been approved!” before an application had even been lodged, to credit cards being offered by anyone from supermarkets to airlines, the banks’ addiction to credit cards was obvious.

For better or for worse this may all be about to change. New regulations with regard to credit cards came into effect on July 1st with more to follow early next year.

One of the big issues being looked at is the time it takes for many people to pay off their credit cards. I can’t think of another type of loan where, with minimum payments, the loan may take longer than the borrower’s lifespan to retire. I’ve seen many credit card statements where the micro writing at the bottom of the page says something like, “At the minimum payment this debt will take 72 years to pay off”. I know life expectancy is improving, but come on! Can you think of another type of loan where the payments would outlive the borrower?

The government is onto this and is concerned about people that cannot pay down their credit cards within a reasonable period and are being exposed to high interest charges as a result. While the banks are publicly agreeing with this, the cynical side of me feels they would be quite happy to leave things as they are.

Following on from this, ASIC recently produced a report which put forward that credit card applications should be assessed on the basis that the credit limit can be retired within three years. It’s looking like this will become policy starting January 2019.

This will be a game changer and will instigate a massive change to how credit card applications are assessed. It’s a welcome change as it will help save people from themselves and hopefully ease household debt levels that seem to be ever increasing, with much of it on credit cards. One thing is for sure, it will mean getting approved for a credit card will be much tougher and this may even result in the review and possible adjustment of current credit card limits.

The days of the banks pushing limit increases are also over. It wasn’t long ago that people would receive endless letters and emails offering to increase their limits. It always struck me as odd that when someone was applying for a home loan they had to provide endless amounts of supporting information, but if they wanted a credit card it was often just a few mouse clicks away.

It appears the banks’ desire to benefit from high interest generating products clouded their judgment when applying sensible lending policies. In other words, the higher the return the lower the scrutiny.

New regulations now prohibit banks from pushing unsolicited credit limit increases which is a very good thing, as offering more and more credit to often venerable people was in my opinion predatory behaviour and not at all responsible.

The royal commission continues to reveal questionable behaviour by the banks and I feel further reform is on the way, but I do have a concern.

While we all want the banks to behave, we’re already seeing lending tightening up and this is causing real issues for people and businesses— and potentially the economy. Many people are quick to cry foul of the banks however let’s not forget that we are a credit-driven society and if credit dries up, everything else tends to dry up too and we all suffer.

I would like to think some middle ground will be found, where banks will act more responsibly when approving credit, but will remain open for business with providing credit in general.

Author: John Dickinson director of DebtX Mediation Services.

Why The Big Four Banks Soon Mightn’t Exist

It will be worth watching the final round of hearings at the banking royal commission, which begins today. The chief executives of each of the big four will be recalled for reexaminations, via The Conversation.

 

It might be the final time they appear in the same room. It might even be the last time there’s even such a thing as the big four.

Not only are the so-called four pillars under attack from the Commissioner Kenneth Hayne, but there are also enormous economic and technological pressures that are already beginning to undermine their special status.

Together, these pressures have the potential to radically change the banking landscape over the coming decades and bring an end to the Four Pillars policy under which Westpac, the Commonwealth, the ANZ and the National Australia Bank have been effectively protected from takeover and prevented from merging.

Although never a formal law, the understanding that none of the big four can merge has been an accepted rule in Australian business since the late 1980s, when the then treasurer Paul Keating made it clear he would block takeovers.

Eggs in one basket

Since then the big four banks have changed in two important, but related, ways.

Over the past few years they have retreated from their overseas banking ventures, largely divesting themselves of their sometimes ill-judged foreign acquisitions.

And they have recently sold off most of their local wealth management (insurance and investment) subsidiaries.

These divestments mean we are left with four enormous retail-oriented banks that dominate both the banking system (with almost 80% of banking assets) and the stock market (four of the top six companies on the S&P/ASX 200).

Their profitability is heavily dependent on lending for housing, which in turn is heavily dependent on the housing market.

That market is already beginning to contract, meaning the big four are going to find it increasingly hard to maintain their stellar profits.

No longer unique

What’s more, the near monopoly they have had on processing payments is under threat.

In Britain around 1,000 bank branches are closing per year in the wake of a technologicial revolution that makes it possible to process payments away from branches and away from banks. The rate of these closures is climbing.

Mobile banking means that many basic transactions that used to require a visit to a branch can be done online. Australia’s New Payments Platform means that payments to people such as tradies can be made anywhere, any time, in real time and at minimal cost. Use of the platform isn’t limited to the big four.

The Reserve Bank reports that after only eight months of operation the number of payments on the platform already exceeds the number of cheques.

Too many branches

Compared with other countries, we have a lot of bank branches.

Australian banks operate more than 5,000 branches, most of them owned by the big four, as well as 30,000 automatic teller machines, and more than 900,000 EFTPOS terminals at supermarkets and Post Offices.

In the United States, just one bank, the Bank of America, has 67 million customers.

Here more than 140 banks (technically, authorised deposit-taking institutions compete to serve a population of just 25 million.

Inevitably at least one of the big four will come under pressure to fold, be taken over, or merge with one of the others.

Vanishing support

The four pillars policy is “aimed at ensuring that whatever other consolidations occur in retail banking, the four major banks will remain separate”.

In 1997, the Wallis Financial Systems Inquiry recommended it be scrapped.

On the other hand, the 2014 Murray Inquiry into financial services recommended that the policy be retained.

But the Murray inquiry, probably due to its narrow terms of reference, found little of the egregious misconduct that has been uncovered by the royal commission. This calls into question the inquiry’s conclusion that there is adequate competition in the banking system.

Indeed, this conclusion was rejected in a recent Productivity Commission report, which stated bluntly that “the Four Pillars policy is a redundant convention”.

An end in sight

The end of the four pillars policy needn’t mean the end of competition. Smaller, cheaper competitors will be doing more of what the big four did.

A shakeout of bank branches is long overdue, however painful that may be in many small towns, where despite the serious problems raised at the royal commission, a bank branch is still an important part of the community.

Undoubtedly, such a major disruption, unless managed carefully, will be harrowing for many customers and staff.

But for the long-term stability of the economy, it is incumbent on governments to address the inevitability of a smaller, more technologically driven banking system – one that hopefully, after the royal commission, will operate ethically for the benefit of customers.

Author: Pat McConnell, Visiting Fellow, Macquarie University Applied Finance Centre, Macquarie University

APRA bracing for end of ‘economic summer’

APRA is undertaking work to keep Australian’s financial institutions secure if and when the economic summer ends, said newly appointed deputy chair, via InvestorDaily.

APRA’s deputy chair John Lonsdale made the comments at FINSIA ‘The Regulators’ event saying that Australia had endured 27 years of continuous expansion but no summer lasts forever.

“Australia’s unprecedented period of uninterrupted economic growth may have years yet to run. We hope it does.

“But when our economic summer inevitably ends – and winter, autumn or just an unseasonal cold snap arrives – the work that APRA is undertaking means Australians can be confident that the financial institutions they rely on are resilient,” he said.

Mr Lonsdale said that over the coming year APRA would focus on policies and actions to withstand any conditions, starting with a review into the regulators enforcement strategy.

“The review will make recommendations on which enforcement issues APRA should consider acting on, what factors we should take into account, and whether there are any practical or legislative impediments to us pursuing a stronger approach,” he said.

Without pre-empting the review, Mr Lonsdale said the authority was willing to consider a strong appetite for formal enforcement action but would remain true to it’s purpose as a regulator.

“We will, however, remain a supervision-led, rather than enforcement-led, regulator with a focus on pre-emptively tackling problems before they compromise an entity’s ability to meet its obligations to beneficiaries, or rectifying adverse outcomes in the best interests of customers.”

Mr Lonsdale said the group would continue into 2019 looking at cases of misconduct that had been raised during the royal commission which may see more enforcement action taken.

“We are also re-examining cases of potential misconduct by regulated entities raised during the royal commission where the evidence presented was either new to APRA or contradicted what we had previously been told,” he said.

APRA would also continue to administer and monitor the BEAR to ensure it is being followed by all the players in the industry said Mr Lonsdale.

“We are actively making sure the regime is firmly embedded in the major banks – and preparing other ADIs to implement it – rather than assessing whether it is yet achieving its objectives,” he said.

Mr Lonsdale said the following year would also see APRA make further advancements towards implementing the final elements of the complex Basel III capital framework for ADIs.

“A key component is rethinking how Australia’s relatively more conservative capital approach can be explained to provide greater transparency about the strength of our banks and more flexibility in times of stress,” he said.

The authority was also working on developing a formal prudential framework for recovery and resolution, to help stressed institutions restore themselves or in extreme cases manage orderly failure of entities beyond help.

“Our ability to create such a framework has been enhanced by the recently passed legislation expanding APRA’s crisis management powers, which provided a clear basis to make prudential standards on resolution.

“These are powers APRA hopes never to need; however, possessing a strong framework to manage failures and crises is a critical component of a resilient financial system,” he said.

APRA was also working with super groups to finalise member outcome packages as well as moving towards an aligned framework for private health insurance with that used in life and general insurance.

Mr Lonsdale finished by saying APRA keenly awaited the final report of the royal commission and would react to its recommendations.

“Both the report, and the government’s subsequent response to its recommendations, will become high priorities for us once they are made known, and we are confident that the financial system will ultimately emerge stronger from the scrutiny,” he said.

A tip for bankers ahead of the royal commission

An interesting piece in the The Conversation.  suggesting that regulation of banking will not deliver the outcomes we need:

The financial services royal commission resumes for its final round of hearings on Monday, and reappearing before Justice Hayne will be the chief executives each of the big six institutions he has in his sights: the Commonwealth Bank, Westpac, AMP, Macquarie, ANZ, and the National Australia Bank.

At issue are shocking abuses of trust, and when the government responds after receiving the report in February it will be under pressure to introduce tighter rules that more closely regulate bankers’ behaviour.

There’s another, better, path it could follow. It could loosen the rules and treat bankers more like doctors.

Crude attempts to regulate behaviour fail

We trust doctors, not because their behaviour is tightly regulated but because it is self-regulated. As professionals they strive to be trustworthy, in the same way as citizens who don’t cheat on their social security claims, or restaurant customers who don’t eat without paying.

A regulation imposed on top of a relationship of trust can ruin it.

In a famous study titled A Fine Is A Price, economists Uri Gneezy and Aldo Rustichini examined what happened when an Israeli daycare centre attempted to impose fines on parents who picked up their children late.

 

Surprisingly, the trial of the fine resulted in more, rather than fewer, late pickups.

In the eyes of the late parents, the fine changed late pickups from bad behaviour into an acceptable outcome of cost-benefit analysis. They simply interpreted the fine as a babysitting cost, and weighed it against the benefit of arriving when it suited them. Moral motivations were crowded out.

Doctors take vows

Professionals with ethics take vows to honour their duty to their clients, even where the costs of doing so are greater than the benefits of not doing so.

Service providers who don’t take ethics seriously weigh the costs and benefits of acting in the interests of their clients versus acting in their own interests. This ‘moral optimization’ may take account of ethics, but only if it pays.

Many financial services workers don’t take ethics seriously partly because they have been trained in economics or finance – disciplines which teach that cost-benefit analysis applies to everything.

A start would be to train them better. Their teachers could listen to the words of the creator of much of the theory used to justify performance pay, Michael Jensen of Harvard:

We teach our students the importance of conducting a cost-benefit analysis in everything they do. In most cases, this is useful – but not when it comes to behaving with integrity.

When integrity is at stake it is better to replace moral optimization with moral prioritization, by giving priority to moral principles like telling the truth or looking after vulnerable clients.

Money changes things

Recent research on the psychological power of money suggests that financial market participants are at risk of negative ethical tendencies when money is used as an incentive, or even when they are just reminded of its importance, so-called money priming.

Money is used as an incentive to in order overcome the so-called principal-agent problem in which agents, (workers or chief executives) are tempted to put they own interests ahead of those of the firm they work for.

It can work, but if high-powered financial incentives communicate that the recipient’s only goal should be to maximise profit, then a culture of material self-interest takes hold, constrained at best by the letter of the law. And this crowds out other interests, such as those of their customers.

This means high-powered financial incentives can solve one kind of untrustworthiness, but only by creating another.

Professionals such as doctors and teachers solve the principal agent problem in another way: through ethics.

Banking could be a profession

Rather than further regulation, we propose a greater focus on ethics through a program of professionalisation, including:

  1. Establishing an interim professional body run by outsiders who come with a proven ethic of serving the public in fields such as education or health. After five years the finance industry can apply to the government to staff and run the body itself, subject to performance.
  2. A winding back of regulation in order to signal that “you are professionals who have to take responsibility for ethical judgements”. The professional body could stand down senior managers deemed to be showing commitment to the new culture.
  3. A fundamental change of bonuses so that they become incentives for ethical behaviour. We suggest an automatic bonus payment of 10-20% of total pay. It could be withheld for two reasons: either poor financial performance of the firm, or an ethical breach. In effect, it would be a negative bonus. Multiple ethical breaches would result in the loss of professional status and employment.

Regulation hasn’t worked

Automatic bonuses remove the extreme money priming of the finance industry, and they can be helpful in maintaining employment in the event of a downturn. They can simply be reduced instead of laying off staff, as happened during the global financial crisis.

Boosting regulation and boosting the capability of regulators, as many say they want, could work against developing the ethics and the trust that makes other professions work.

Authors: Warren Hogan Industry Professor, University of Technology Sydney; Gordon Menzies Associate Professor of Economics, University of Technology Sydney

Effects of Housing Lending Policy Measures According To The RBA

RBA Deputy Governor Guy Debelle summarised the Bank’s assessment of the various measures put in place to address the risks around housing lending.   He argues risks are under control, though external shocks could still hit household balance sheets.  Loose ending is not seen as a risk…. Hmmmm! Whilst the regulatory measures have significantly reduced the riskiness of new housing lending, we have masses of loans written under weaker regulation, which are exposed.

The motivation for implementing these various measures was to address the mounting risk to household balance sheets arising from the rapid growth of certain forms of lending, in particular lending to investors and interest-only (IO) lending. The strong growth in investor borrowing was increasing the risk that investor activity could be excessively boosting housing prices and construction and so increasing the probability of a subsequent sharp unwinding. This risk is greater for investor borrowing than owner-occupiers as investors can behave pro-cyclically, withdrawing from the market as it declines. The rise in the prevalence of interest-only borrowing for both investors and owner-occupiers increased the overall risk profile of household borrowing. No principal is repaid during the IO period, and the increase in required repayments can be large when the IO period expires.

I don’t see the riskiness of the borrowing as being the source of the negative shock. My concern is for its potential to be an accelerator to a negative shock from another source. To put it another way, I don’t regard it as likely that household borrowing will collapse under its own weight. Rather, if a negative shock were to hit the Australian economy, particularly one that caused a sizeable rise in unemployment, then the risk on the household balance sheet would magnify the adverse effect of that shock. This would have first order consequences for the economy and hence also for monetary policy.

To repeat the conclusion of the assessment in the FSR: the measures have helped to reduce the riskiness of new borrowing. In turn, this has stemmed the increase in household sector vulnerabilities and improved the resilience of the economy to future shocks. The measures have led to a slowing in credit growth but there is little evidence to suggest that the measures have excessively constrained aggregate credit supply. Housing credit growth has slowed, but it is still running at 5 per cent.

The various measures implemented to address the riskiness of housing lending fall into three categories:[1]

  1. Lending standards or serviceability criteria. This includes tightening up the assessment and verification of borrower income and expenses, the discouragement of high loan-to-valuation ratio (LVR) loans and ensuring that minimum interest rate buffers were being applied, including on existing loans.
  2. Investor lending growth benchmark. A 10 per cent cap on investor lending growth was introduced in December 2014.
  3. A cap on the share of interest-only loans in new lending of no more than 30 per cent.

These measures were introduced progressively over a number of years. The scrutiny on serviceability by both APRA and ASIC has been underway for over four years now. For example, in September 2015, APRA noted that by then, serviceability practices had been tightened, such as the haircutting of various forms of income, including rental income. At the same time, APRA reported that minimum interest rate buffers and floors were also being more consistently applied.

This means that these tighter lending standards have been in place for a while now. They are not a recent phenomenon. But this also makes assessing the overall impact difficult in some cases, though the effect of some of the measures has been obvious. There clearly has also been an interaction between them.

What Has Been the Effect of These Various Measures?

  1. Different interest rates are now charged across the various types of mortgages. Interest rates are higher on investor lending and interest-only lending than they are on owner-occupier lending (Graph 1). Previously there was little, if any, variation in the interest rate charged on different types of loans, beyond the size of the discount that varied with borrower income and the size of the loan.
    Graph 1
    Graph 1: Variable Housing Interest Rates

     

    Rather than use quantitative restrictions on the flow of new investor or interest-only lending to meet the requirements, banks chose to increase the interest rate on all loans of these types, both new and existing. Judging by what happened, it appears that the impact of the interest rate changes on borrower activity was difficult to calibrate. The banks seem to have increased rates by more than enough to achieve the requirements with most significantly undershooting the caps on both investor lending growth and the share of IO loans.

  2. Investor lending growth took a while to respond to the introduction of the growth benchmark, in part because banks didn’t increase interest rates on investor loans until some time after its introduction (Graph 2). But there was a sharp and immediate slowing in response to the cap on IO lending. The share of IO loans in the flow of new lending declined sharply from 40 per cent in March 2017 to 17 per cent by September 2017 and has remained around 15 per cent since then. At the same time, the share of new lending with LVRs greater than 90 per cent has declined for both owner-occupiers and investors. In particular, there is now only a very small amount of loans to investors being written with LVRs over 90 per cent. Investor credit is now barely growing. Lending to owner-occupiers has slowed but is still growing at 6½ per cent.
    Graph 2
    Graph 2: Investor Housing Credit Growth
  3. As a result there has been a sizeable shift in the composition of the stock of housing lending. In addition, in response to both measures, a sizeable number of borrowers switched from an investor and/or IO loan to a principal and interest (P&I) owner-occupier loan reflecting the now significant interest differential. As a result of switching and weaker growth of investor lending, we estimate the share of housing loans to investors has declined by 5 percentage points to around one-third. Interest-only loans currently comprise 27 per cent of the stock, having been as much as 40 per cent (Graph 3). These changes decrease the riskiness of the stock of housing lending.
    Graph 3
    Graph 3: Interest-only Lending
  4. There has been a decrease in maximum loan sizes offered by banks to new borrowers in response to the tightening of the serviceability requirements. How big an effect might this have?[2] As any of you who have applied for a home loan may know, often the bank is willing to lend you much more than you want to borrow. Now they are willing to lend you less on average, by around 20 per cent. How much impact this actually has in aggregate depends on how many people are now constrained by this lower maximum loan size that weren’t previously. Using data from the HILDA survey, we estimate that the share of borrowers who are near their maximum loan and so are affected by this change is small, though for those who are constrained the effect can be quite large. Our assessment is that the aggregate impact is less than it would appear on the face of it.
  5. As a consequence of the greater scrutiny of interest-only lending and the tightening of serviceability requirements, some borrowers are no longer able to roll over their IO loan at the expiry of the IO period. The shift to a P&I loan can cause their required payments to increase by as much as 30–40 per cent.[3] Liaison with lenders suggests that some borrowers have encountered repayment difficulties after switching to P&I repayments at the end of their IO terms, but that many have subsequently been able to adjust to higher payments within a year. Loan-level data from the Reserve Bank’s Securitisation Dataset supports this. It is also worth remembering that this process has already being going for quite some time, but we have yet to see it have a material effect on arrears rates. It still has a couple more years to run before the stock of expiring IO loans will have all been written under the current tighter serviceability criteria. But based on the experience to date, I don’t see this is a material risk, particularly given the current favourable macro environment.

Competition

Turning now to look at the effect on these measures on competition. (This is covered in more detail in the FSR Chapter). The investor lending benchmark did have a competitive impact for a time in that it constrained the ability of smaller lenders to gain market share by increasing their lending faster than 10 per cent. That said, with investor lending growing at or below 5 per cent since early 2016, it has not been a significant constraint on most lenders increasing their market share for some time now. Indeed, recently we have seen smaller lenders again gaining market share. Currently the major banks’ share of new lending is at its lowest in a decade. At the same time, there was no constraint on the ability of smaller lenders to gain market share in the owner-occupier market. The interest-only cap did not obviously have an effect on competition. Again, with nearly all lenders well below the 30 per cent threshold, it is not a binding constraint on lenders from increasing their market share.

The tighter lending standards have seen an increasing share of borrowers obtain finance from non-ADI lenders. These lenders are subject to regulatory oversight but less than that of ADI lenders. They are subject to ASIC’s responsible lending standards but not to prudential supervision by APRA. Non-ADIs’ housing lending has been growing rapidly, over twice the rate of growth of ADIs. As a result, the estimated non-ADI share of housing credit has also increased, although it remains less than 5 per cent of the total.

Effect on the Housing Market

The integral relationship between debt and housing prices means that these measures have clearly influenced conditions in the housing market. The FSR analyses in detail the impact on the housing market of the investor lending benchmark in 2014. It uses the fact that the share of investors varies across different parts of the housing market. Differentiating between ‘high’ investor regions and ‘low’ investor regions, the analysis shows that high investor regions had very similar price growth to low investor regions before the benchmark was implemented. In contrast, after the benchmark was introduced, house price growth has been notably slower in the higher investor regions.

Other factors may have also contributed to the divergent price growth between the high and low investor regions. For example, regions with a high share of investors may have also experienced larger increases in housing supply and so slower price growth in the period after the benchmark was introduced. The analysis attempts to control for these other factors and concludes that the policy effect accounts for around two-thirds of the 7 percentage point difference in average cumulative housing price growth between high and low investor regions from December 2014 to mid 2018 (Graph 4).

Graph 4
Graph 4: Housing Price Growth in High and Low Investor Regions

Again it is worth reiterating that the measures are aimed at the resilience of household balance sheets, not house prices. The assessment of their effectiveness is around the riskiness of household balance sheets, not the outcomes in the housing market. But at the same time, they clearly are having a notable effect on the housing market.

Housing construction activity has been at a high level for some time now. Our forecast is for it to continue at this level for at least a year given the amount of work in the pipeline. Beyond that, we expect construction activity to decline from its peak. Off-the-plan apartment sales in the major east coast cities have declined since around mid 2017, with developers citing weaker demand from domestic investors, as well as from foreign buyers. One risk is that tighter lending standards could amplify the downturn in apartment markets if some buyers of off-the-plan apartments are unable to obtain finance. This could lead to an increase in settlement failures, further price falls and even tighter financing conditions for developers. However, to date, in our liaison with developers, few have reported much evidence of this.

While not directly related to the housing measures, there has been some tightening in credit for developers of residential property. This reflects lenders’ reducing their desired exposure to dwelling construction, which is higher-risk lending, particularly given the longer planning and construction lags of higher density dwelling construction. That is, banks are less willing to lend given the fall in prices. To the extent that the housing policy measures have contributed to the decline in investor demand and prices, they have indirectly affected developers’ access to finance. There is a risk that this process overshoots leading to a sharper or more protracted decline in activity than we currently expect.

The effect of a tightening in lending to developers seems to me to be a higher risk to the economic outlook than the direct effect of the tighter lending standards on households, which has ameliorated risk. Relatedly, there may also be a bigger impact on lending to small business given the extensive use of property as collateral for small business loans. This would be further exacerbated if the banks’ risk appetite for small business lending declines for other reasons.

Housing prices have fallen by almost 5 per cent from their late 2017 peak while the pace of housing credit growth has slowed over the past couple of years. The fall in housing prices is a combination of a number of other factors, including the very large increase in the supply of houses and apartments both now and in prospect. It also reflects a reduction in foreign demand, which has been affected by a tightening in the ability to shift money out of China and an increase in stamp duty in some states.

Some have attributed the slowing in housing credit solely to a tightening in the supply by banks in response to regulatory actions. Others have suggested there has been a weakening in housing demand and so demand for credit, including because of the high level of and weaker outlook for housing prices. To me, reductions in both the demand and supply of credit have been at play and it is hard to separate their effects. For example, tighter lending conditions have reduced how much some people can borrow, and this contributed to weaker demand for properties and so softer prices. Price falls have themselves contributed to weaker demand by investors who are no longer confident of rising values. Assessing the relative importance of demand and supply is also complicated by the fact that banks have cut back most on their lending to less credit-worthy borrowers, but have more aggressively targeted safer borrowers with lower interest rates.

Conclusion

The regulatory measures have significantly reduced the riskiness of new housing lending. A smaller share of new loans are to investors, are interest-only, have high LVRs or are to borrowers more likely to have difficulty repaying the loan. But it takes time for the riskiness of the stock of outstanding loans to improve. When you implement a change in lending standards the existing loans are no different to how they were the day before. But over time a larger share of outstanding loans will have been written with more stringent lending standards, while the larger share of principal and interest loans will see more of the outstanding loans have a declining balance over time. Finally, in assessing the overall riskiness of the debt both before and after the various measures, it is worth remembering that arrears rates remain low.

To conclude, the available evidence suggests that the policies have meaningfully reduced vulnerabilities associated with riskier household lending and so increased the resilience of the economy to future shocks.

 

Thinking About Banking From The Inside

I discuss the current state of banking in Australia with businessman John Dahlsen, who was a director at ANZ for many years.

He brings his extensive experience to the issues facing the sector, and lays out an approach which would create more customer centric, efficient and lower risk banks.

 

 

Westpac And ASIC Go Back To Court On HEM

From The Conversation

Very rarely does a judge tear up a multimillion-dollar penalty signed up to by both the regulator and the alleged perpetrator.

Yet that’s what Federal Court judge Nye Perram did on Tuesday, throwing out a A$35 million settlement between Westpac and the the Australian Securities and Investments Commission over its alleged failure to properly assess whether borrowers could meet their repayments before signing them up to mortgages.

Agreed settlements are common

In commercial litigation, as in most litigation, there is an emphasis on trying to settle matters early before they are heard in court.

In criminal law matters the prosecutions encourage early guilty pleas in exchange for lower penalties.

The Australian Securities and Investments Commission (ASIC) has been increasingly resorting to early settlements as a means of achieving cheaper and quicker outcomes.

The quick win for ASIC is an enforceable undertaking and a media release. The quick win for the other party is avoiding a drawn-out court case and being able to get on with its business.

Courts usually rubber-stamp them

Where the alleged breach of the law is serious, necessitating a large penalty, a judge has to formally approve the settlement, in a hearing until now regarded as something of a rubber-stamping exercise.

As the Hayne Royal Commission into the Misconduct in Financial Services has pointed out, the downside of such quick settlements can be that the facts aren’t established in court and the law isn’t tested.

Where they are established and the law is tested, as Justice Yates did earlier this year in Australian Transaction Reports and Analysis Centre versus Commonwealth Bank of Australia very big penalties can be handed down – A$700 million for more than 50,000 breaches of the Anti-Money Laundering and Counter-Terrorism Financing Act.

Along with it were landmark judgments that establish the scope of the law and tell firms what to avoid in the future.

This time the court said no

On Thursday Justice Perram in the Federal Court sought the right to do the same.

He rejected the joint application for settlement between ASIC and Westpac Banking Corporation for a penalty of A$35 million.

The problem, as he pointed out was that it was not clear from the agreed facts what actual contraventions of the National Consumer Credit Protection Act 2009 Westpac had been accused of.

He asked ASIC and the Westpac to redraft the agreed settlement and return to court by 27 November 2018.

To establish the law and what happened

The case matters because the Financial Services Royal Commission has been examining the use of computer programs to determine the ability of borrowers to repay loans.

It is possible that many Westpac loans were approved to customers who would have been found to be unable to meet the repayments had their individual circumstances been examined, and it is possible that is in breach of the law.

But without a clear judgment or a clear statement of facts for the court to examine, or a clear judgment from the court, it is impossible to tell.

That’s why Justice Perram said no, to establish what the law requires and what Westpac did.

Author: Michael Adams Professor of Corporate Law & Governance, School of Law, Western Sydney University

ANZ “Enhances” Verification Requirements

ANZ has announced that it will implement a swathe of changes to its home and investment lending policy., via The Adviser.

ANZ has informed brokers that it will introduce enhanced home loan verification requirements, effective from 20 November.

Key changes include the following:

PAYG income: Brokers are required to obtain three months’ bank statements showing salary credits in order to verify income (in addition to payslips).

For casual, temporary and contract employees, six months of continuous employment is required, supported by six months of bank statements showing salary credits.

Overtime, bonus and commission income: Brokers are required to make inquiries of customers as to whether any of their income is comprised of overtime, bonus or commission, and record the overtime/bonus/commission amounts in the Statement of Position, adding that brokers should also include an explanation of the income in their submission/diary note.

In line with current ANZ policy, any income from bonus, commission or overtime needs to be removed from the income calculation and shaded in accordance with credit policy (currently 80 per cent), before being added back to the customer income, using the ANZ Toolkit.

However, the bank noted that if the overtime/commission/bonus amount cannot be identified from the customer’s payslips, or the customer has chosen to provide six months’ salary credits rather than salary credits and payslips, further payslips may be required in order to verify the amount of income that is derived from bonus, overtime or commission payments.

Casual, temporary or contract employment: Where a customer is in casual, temporary or contract employment, the customer will need to provide evidence of six months of continuous employment via salary credits through either ANZ transaction history or OFI bank statements.

In order to satisfy the continuous employment requirement, customers cannot have a gap greater than a total of 28 days (either continuous or cumulative), which ANZ said is measured by the pay period start/end dates on payslips or the number of salary credits available on ANZ transaction history/ OFI bank statements.

Additional checks by ANZ for irregular income: An additional check will be performed by ANZ to confirm if a customer’s income is irregular. If the assessor cannot satisfy themselves of the reasons for irregular income via the documents provided, the Statement of Position and any relevant diary notes, then they will contact the broker for further information.

OFI home loan: Three months of statements are required (even if the home loan liability is not being refinanced) to confirm monthly repayment amount and that the account conduct is satisfactory.

Where the loan account is less than three months old, a copy of the Letter of Offer (LOO) or the loan transaction history (showing balance AND at least one repayment) is considered acceptable provided the above conditions are also met.

Rental expenses: Three months of bank statements showing rental payments made by the customer will be required, or a lease agreement to verify the ongoing rental expense.

Additional commentary regarding customer’s financial situation

Brokers are required to make adequate inquiries with customers about their financial situation and provide additional commentary to explain any material differences between verification documents (for example, bank statements) and customer-stated income or expense figures in the Statement of Position, as well as any potential indicators of financial hardship.

ANZ stated that indicators of financial hardship may include adverse account conduct (e.g. overdrawn, excess, late payments, arrears), regular overdrawing of an account due to gambling transactions, and payday lender transactions.

Brokers have also been asked to include any additional commentary/explanation in a diary note, which the bank said will form part of ANZ’s assessment.

Changes to Broker Interview Guide:  Also effective on 20 November, ANZ has also announced that it will change questions in its Broker Interview Guide in relation to inquiries into a customer’s future financial circumstances, which will apply to all home and investment loan applications.

Key changes include: More detailed information required from customers who have stipulated a significant change to their future financial circumstances including the requirement for supporting documentation in some instances.

More detailed information required from customers who are approaching retirement including the requirement for supporting documentation in some instances.