Basel Committee’s low risk weight for covered bonds is credit positive for issuing banks

From Moody’s.

Last Thursday, the Basel Committee on Banking Supervision accredited covered bonds with low risk weights, closely following a precedent set by European regulation. A low risk weight is credit positive for issuing banks’ sales of covered bonds outside the European Union (EU) given the global application of the Basel rules.

In Australia, covered bonds funded about 10% of all outstanding mortgages in 2016, up from 6% five years earlier.  More will be funded this way once the new rules are in place.

Existing EU covered bond issuers will benefit from the Basel IV regulation because their covered bonds become a more attractive investment for non-EU bank investors. Amid rising minimum requirements for regulatory capital, risk weights applied in the calculation of banks’ stock of risk-weighted assets have gained importance in their investment decisions. European covered bond issuers can diversify their investor base and potentially reduce their funding costs as demand for their bonds increases. However, some issuers may be incentivised to increase their share of covered bond issuance in foreign currencies, thereby increasing their exposure to foreign-currency fluctuations given that cover pool assets typically are denominated in euros or other local European currencies.

Outside the EU, lower risk weights for covered bonds will foster the development of covered bond markets and encourage the bonds’ use as a funding tool. The additional funding source will make non-EU banks less reliant on deposits and the sometimes volatile unsecured wholesale funding market. Additionally, the covered bonds will provide an opportunity to improve their asset-liability matching, particularly for mortgages, which typically have 20- to 30-year maturities, versus five to 10 years for covered bonds. In the EU, banks investing to fulfil liquidity coverage requirements, for example, typically absorb about one third of primary covered bond market issuance.

Covered bond markets outside the EU include Australia, Canada, New Zealand, and Singapore, where the bonds have had a less relevant, but growing, role in financing local mortgage markets. In Australia, covered bonds funded about 10% of all outstanding mortgages in 2016, up from 6% five years earlier, but significantly less than in Sweden, where covered bonds finance about 55% of all outstanding residential loans, according to the European Covered Bond Council’s HypoStat 2017. Once Basel IV rules are implemented, we expect that non-EU banks will become more active investors in their domestic covered bond markets, thereby facilitating domestic mortgage funding.

Lower risk weights reflect covered bonds’ status as the only bank debt that cannot be bailed-in and that has a proven track record of sound credit and liquidity. Basel IV regulation stipulates certain requirements that issuers must fulfil to achieve low risk weights for their covered bonds beginning January 2022. The Basel IV requirements include that the covered bond issuer be subject by law to special public supervision designed to protect bondholders, that the value of the cover pool backing the covered bonds is restricted to a maximum loan-to-property value ratio of 80%, and that the covered bonds are protected by at least 10% over-collateralisation.

First Time Buyers Keep The Property Market Afloat – The Property Imperative Weekly – 9th Dec 2017

First Time Buyers are keeping the property ship afloat for now, but what are the consequences?

Welcome to the Property Imperative weekly to 9th December 2017. Watch the video, or read the transcript.

In our weekly digest of property and finance news, we start this week with the latest housing lending finance from the ABS. The monthly flows show that owner occupied lending fell $23m compared with the previous month, down 0.15%, while investment lending flows fell 0.5%, down $60m in trend terms. Refinanced loans slipped 0.13% down $7.5 million. The proportion of loans excluding refinanced loans for investment purposes slipped from a recent high of 53.4% in January 2015, down to 44.6% (so investment property lending is far from dead!)

While overall lending was pretty flat, first time buyers lifted in response to the increased incentives in some states, by 4.5% in original terms to 10,061 new loans nationally. At a state level, FTB’s accounted for a 19% per cent share in Victoria and 13.7% in New South Wales, where in both states, a more favourable stamp duty regime and enhanced grants were introduced this year. But, other states showed a higher FTB share, with NT at 24.8%, WA at 24.6%, ACT at 20.1% and QLD 19.7%. SA stood at 13% and TAS at 13.3%. There was an upward shift in the relative numbers of first time buyers compared with other buyers (17.6% compared with 17.4% last month), still small beer compared with the record 31.4% in 2009. These are original numbers, so they move around each month. The number of first time buyer property investors slipped a little, using data from our household surveys, down 0.8% this past month. Together with the OO lift, total first time buyer participation has helped support the market.

The APRA Quarterly data to September 2017 shows that bank profitability rose 29.5% on 2016 and the return on equity was 12.3% compared with 9.9% last year. Loans grew 4.1%, thanks to mortgage growth, provisions were down although past due items were $14.3 billion as at 30 September 2017. This is an increase of $1.5 billion (11.8 per cent) on 30 September 2016. The major banks remain highly leveraged.

The property statistics showed that third party origination rose with origination to foreign banks sitting at 70% of new loans, mutuals around 20% and other banks around the 50% mark. Investment loan volumes have fallen, though major banks still have the largest relative share, above 30%.  Mutuals are sitting around 10%.  Interest only loans have fallen from around 40% in total value to 35%, but this represents a fall from around 30% of the loan count, to 27%. This reflects the higher average loan values for IO borrowers. The average loan balance for interest only loans currently stands at $347,000 against the average balance of $264,000.  No surprise of course, as these loans do not contain any capital repayments (hence the inherent risks involved, especially in a falling market).

But there has been a spike in loans being approved outside serviceability, with major banks reporting 5% or so in September. This may well reflect a tightening of standard serviceability criteria and the wish to continue to grow their loan books. We discussed this on Perth 6PR Radio.  So overall, we see the impact of regulatory intervention. The net impact is to slow lending momentum. As lenders tighten their lending standards, new borrowers will find their ability to access larger loans will diminish. But the loose standards we have had for several years will take up to a decade to work through, and with low income growth, high living costs and the risk of an interest rate rise, the risks in the system remain.

On the economic front, GDP from the ABS National Accounts was 0.6%. This was below the 0.7% expected. This gives an annual read of 2.3%, in trend terms, well short of the hoped for 3%+. Seasonally adjusted, growth was 2.8%. Business investment apart, this is a weak and concerning result.  The terms of trade fell. GDP per capita and net disposable income per capita both fell, which highlights the basic problem the economy faces.  The dollar fell on the news. Households savings also fell. No surprise then that according to the ABS, retail turnover remained stagnant in October. The trend estimate for Australian retail turnover fell 0.1 per cent in October 2017 following a relatively unchanged estimate (0.0 per cent) in September 2017. Compared to October 2016 the trend estimate rose 1.8 per cent. Trend estimates smooth the statistical noise.

So no surprise the RBA held the cash rate once again for the 16th month in a row.

The latest BIS data on Debt Servicing ratios shows Australia is second highest after the Netherlands. We are above Norway and Denmark, and the trajectory continues higher. Further evidence that current regulatory settings in Australia are not correct. As the BIS said, such high debt is a significant structural risk to future prosperity. They published a special feature on household debt, in the December 2017 Quarterly Review. They call out the risks from high mortgage lending, high debt servicing ratios, and the risks to financial stability and economic growth.  All themes we have already explored on the DFA Blog, but it is a well-argued summary. Also note Australia figures as a higher risk case study.  They say Central banks are increasingly concerned that high household debt may pose a threat to macroeconomic and financial stability and highlighted some of the mechanisms through which household debt may threaten both. Australia is put in the “high and rising” category.  The debt ratio now exceeds 120% in both Australia and Switzerland.  Mortgages make up the lion’s share of debt.  In Australia mortgage debt has risen from 86% of household debt in 2007 to 92% in 2017.

Basel III was finally agreed this week by the Central Bankers Banker – the Bank for International Settlements – many months later than expected and somewhat watered down. Banks will have to 2022 to adopt the new more complex framework, though APRA said that in Australia, they will be releasing a paper in the new year, and banks here should be planning to become “unquestionably strong” by 1 January 2020.  We note that banks using standard capital weights will need to add different risk weights for loans depending on their loan to value ratio, advanced banks will have some floors raised, and investor category mortgages (now redefined as loans secured again income generating property) will need higher weights. Net, net, there will be two effects. Overall capital will probably lift a little, and the gap between banks on the standard and internal methods narrowed. Those caught transitioning from standard to advanced will need to think carefully about the impact. This if anything will put some upwards pressure on mortgage rates.

The Treasury issues a report “Analysis of Wages Growth” which paints a gloomy story. Wage growth, they say, is low, across all regions and sectors of the economy, subdued wage growth has been experienced by the majority of employees, regardless of income or occupation, and this mirrors similar developments in other developed western economies. Whilst the underlying causes are far from clear, it looks like a set of structural issues are driving this outcome, which means we probably cannot expect a return to “more normal” conditions anytime some. This despite Treasury forecasts of higher wage growth later (in line with many other countries). We think this has profound implications for economic growth, tax take, household finances and even mortgage underwriting standards, which all need to be adjusted to this low income growth world.

Mortgage Underwriting standards are very much in focus, and rightly, given flat income growth.  There was a good piece on this from Sam Richardson at Mortgage Professional Australia which featured DFA. He said that over four days in late September two major banks added extra checks to an already-extensive application process. ANZ introduced a Customer Interview Guide requiring brokers to ask questions about everything from a customer’s Netflix subscription to whether they were planning to start a family. Three days later CBA introduced a simulator that would show interest-only borrowers how their repayments would change and affect their lifestyle. Customers would be required to fill in an ‘acknowledgement form’ to proceed with an interest-only application.

Getting good information from customers is hard work, not least because as we point out, only half of households have formal budgeting. So, when complete the mortgage application, households may be stating their financial position to the best of their ability, or they may be elaborating to help get the loan. It is hard to know. Certainly banks are looking for more evidence now, which is a good thing, but this may make the loan underwriting processes longer and harder. Improvements in technology could improve underwriting standards for banks while pre-populating interactive application forms for consumers and offering time-saving solutions to brokers and Open Banking may help, but while Applications can be made easier, this does not necessarily mean shorter.

More data this week on households, with a survey showing Australians have become more cautious of interest only loans with online panel research revealing that 46 per cent of Australians are Adamant Decliners of interest-only home loans according to research from the  Gateway Credit Union. In addition, a further quarter of respondents are Resistant Approvers, acknowledging the benefits of interest-only loans yet choosing not to utilise them. Of the generations, Baby Boomers are most likely to be Adamant Decliners and therefore, less likely to use interest-only products. While Gen Y are most likely to be Enthusiastic Users.

Banks continue to offer attractive rates for new home loans, seeking to pull borrows from competitors. Westpac for example, announced a series of mortgage rate cuts to attract new borrowers, as it seeks to continue to grow its portfolio, leveraging lower funding costs, and the war chest it accumulated earlier in the year from back book repricing, following APRA’s tightening of underwriting standards and restrictions on interest only loans. Rates for both new fixed rate loans and variable rate loans were reduced.  For example, the bank has also increased the two-year offer discount on its flexi first option home for principal and interest repayments from 0.84% p.a. to 1.00% p.a. putting the current two-year introductory rate at 3.59% p.a.

The RBA released their latest Bulletin  and it contained an interesting section on Housing Accessibility For First Time Buyers.  They suggest that in many centers, new buyers are able to access the market, thanks to the current low interest rates. But the barriers are significantly higher in Melbourne, Sydney and Perth. They also highlight that FHBs (generally being the most financially constrained buyers) are not always able to increase their loan size in response to lower interest rates because of lenders’ policies. Indeed, the average FHB loan size has been little changed over recent years while the gap between repeat buyers and FHBs’ average loan sizes has widened. They also showed that in aggregate, rents have grown broadly in line with household incomes, although rent-to-income ratios suggest housing costs for lower-income households have increased over the past decade.

Housing affordability has improved somewhat  across all states and territories, allowing for a large increase in the number of loans to first-home buyers, according to the September quarter edition of the Adelaide Bank/REIA Housing Affordability Report. The report showed the proportion of median family income required to meet average loan repayments decreased by 1.2 percentage points over the quarter to 30.3 per cent. The result was decrease of 0.6 percentage points compared with the same quarter in 2016. However, Housing affordability is still a major issue in Sydney and Melbourne they said.  In addition, over the quarter, the proportion of median family income required to meet rent payments increased by 0.3 percentage points to 24.6 per cent.

Our own Financial Confidence Index for November fell to 96.1, which is below the 100 neutral metric, down from 96.9 in October 2017. This is the sixth month in succession the index has been below the neutral point. Owner Occupied households are the most positive, scoring 102, whilst those with investment property are at 94.3, as they react to higher mortgage repayments (rate rises and switching from interest only mortgages), while rental yields fall, and capital growth is stalling – especially in Sydney.  Households who are not holding property – our Property Inactive segment – will be renting or living with friends or family, and they scored 81.2. So those with property are still more positive overall. Looking at the FCI score card, job security is on the improve, reflecting rising employment participation, and the lower unemployment rate.  Around 20% of households feel less secure, especially those with multiple part time jobs. Savings are being depleted to fill the gap between income and expenditure – as we see in the falling savings ratio. As a result, nearly 40% of households are less comfortable with the amount they are saving. This is reinforced by the lower returns on deposit accounts as banks seek to protect margins. More households are uncomfortable with the amount of debt they hold with 40% of households concerned. The pressure of higher interest rates on loans, tighter lending conditions, and low income growth all adds to the discomfort. More households reported their real incomes had fallen in the past year, with 50% seeing a fall, while 40% see no change.  Only those on very high incomes reported real income growth.

Finally, we also released the November mortgage stress and default analysis update. You can watch our video counting down the most stressed postcodes in the country. But in summary, across Australia, more than 913,000 households are estimated to be now in mortgage stress (last month 910,000) and more than 21,000 of these in severe stress, the same as last month. Stress is sitting on a high plateau. This equates to 29.4% of households. We see continued default pressure building in Western Australia, as well as among more affluent household, beyond the traditional mortgage belts across the country. Stress eased a little in Queensland, thanks to better employment prospects. We estimate that more than 52,000 households risk 30-day default in the next 12 months, similar to last month. We expect bank portfolio losses to be around 2.8 basis points, though with losses in WA rising to 4.9 basis points.

So, the housing market is being supported by first time buyers seeking to gain a foothold in the market, but despite record low interest rates, and special offer attractor rates, many will be committing a large share of their income to repay the mortgage, at a time when income growth looks like it will remain static, costs of living are rising, and mortgage rates will rise at some point. All the recent data suggests that underwriting standards are still pretty loose, and household debt overall is still climbing. This still looks like a high risk recipe, and we think households should do their own financial assessments if they are considering buying at the moment – for home prices are likely to slide, and the affordability equation may well be worse than expected. Just because a lender is willing to offer a large mortgage, do not take this a confirmation of your ability to repay. The reality is much more complex than that. Getting mortgage underwriting standards calibrated right has perhaps never been more important than in the current environment!

And that’s the Property Imperative to 9th December 2017. If you found this useful, do leave a comment, sign up to receive future research and check back next week for the latest update. Many thanks for taking the time to watch.

APRA welcomes finalisation of Basel III bank capital framework

APRA has welcomed the Basel III announcement and expects to commence consultation on revisions to the ADI capital framework in early 2018.

Despite the 2022 date, APRA also reaffirmed that Australian banks should be following strategies to increase their capital strength to exceed the unquestionably strong benchmarks by 1 January 2020.

The Australian Prudential Regulation Authority (APRA) today welcomed the announcement that the Basel Committee on Banking Supervision had finalised the Basel III bank capital framework.

The announcement confirms the final set of measures designed to address deficiencies in the internationally-agreed capital framework following the global financial crisis and are primarily focused on addressing undue variability in risk-weighted assets, and therefore capital requirements, across banks.

Key elements of the final framework include changes to the standardised approach to credit risk capital for real estate, restrictions on modelled risk estimates by banks using the internal ratings-based (IRB) approach to credit risk capital, and the removal of provisions for banks to use internal models to determine their operational risk capital requirements. The Basel Committee has also agreed to introduce a ‘floor’ to limit the reduction in capital requirements available to banks using capital models relative to those using the standardised approaches.

APRA Chairman Wayne Byres said APRA’s ADI capital framework, including the adjustments made to IRB risk weights in 2016, is well-equipped to accommodate the final Basel III framework. APRA has been involved in the international work to agree the final Basel III reforms.

“We welcome the finalisation of these measures which represent the final stage of a decade’s financial reform work aimed at building resilience in the financial system following the global financial crisis.

“Importantly for Australian ADIs, these final Basel III reforms will be accommodated within the targets APRA set in July this year in our assessment of the quantum and timing of capital increases for Australian ADIs to achieve unquestionably strong capital ratios,” Mr Byres said.

The Basel Committee has agreed to an implementation timetable commencing in 2022 for the final Basel III reforms. APRA will consider the appropriate effective date for revisions to the ADI prudential standards in light of the Basel Committee’s announcement and expects to commence consultation on revisions to the ADI capital framework in early 2018. However, consistent with its July 2017 announcement, APRA reaffirms its expectation that ADIs should be following strategies to increase their capital strength to exceed the unquestionably strong benchmarks by 1 January 2020.

The 2018 consultation will be based on the final Basel III framework but with appropriate adjustments to reflect APRA’s approach and Australian conditions, most notably adjustments to capital requirements for higher risk residential mortgage lending, consistent with the achievement of unquestionably strong capital ratios.

Basel III Agreed [Finally]

The Bank for International Settlements has released the now agreed Basel III framework. Many of the measures will have a 2022 target implementation data. They will tend to lift capital requirements higher, and reduce the potential advantage of adopting advanced IRB models.  Investment mortgage lending will attract higher weights.

APRA will, we assume take account of this framework when their paper on capital is issued, now expected in the new year (presumably to take account of the BIS announcement).

Here is a quick summary, of some of the main take outs. However, the new revisions makes the Basel framework ever more complex.

The Basel III framework is a central element of the Basel Committee’s response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.

The initial phase of Basel III reforms focused on strengthening the following components of the regulatory framework:

  • improving the quality of bank regulatory capital by placing a greater focus on going-concern loss-absorbing capital in the form of Common Equity Tier 1 (CET1) capital;
  • increasing the level of capital requirements to ensure that banks are sufficiently resilient to withstand losses in times of stress;
  • enhancing risk capture by revising areas of the risk-weighted capital framework that proved to be acutely miscalibrated, including the global standards for market risk, counterparty credit risk and securitisation;
  • adding macroprudential elements to the regulatory framework, by: (i) introducing capital buffers that are built up in good times and can be drawn down in times of stress to limit procyclicality; (ii) establishing a large exposures regime that mitigates systemic risks arising from interlinkages across financial institutions and concentrated exposures; and (iii) putting in place a capital buffer to address the externalities created by systemically important banks;
  • specifying a minimum leverage ratio requirement to constrain excess leverage in the banking system and complement the risk-weighted capital requirements; and
  • introducing an international framework for mitigating excessive liquidity risk and maturity transformation, through the Liquidity Coverage Ratio and Net Stable Funding Ratio.

The Committee’s now finalised Basel III reforms complement these improvements to the global regulatory framework. The revisions seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios by:

  • enhancing the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment (CVA) risk and operational risk;
  • constraining the use of the internal model approaches, by placing limits on certain inputs used to calculate capital requirements under the internal ratings-based (IRB) approach for credit risk and by removing the use of the internal model approaches for CVA risk and for operational risk;
  • introducing a leverage ratio buffer to further limit the leverage of global systemically important banks (G-SIBs); and
  • replacing the existing Basel II output floor with a more robust risk-sensitive floor based on the Committee’s revised Basel III standardised approaches.

Banks on the standard approach will need to incorporate mortgage risk weights depend on the loan-to-value (LTV) ratio of the mortgage and different risks for investment property.

They also changed the risk weights on commercial real estate and will reducing mechanistic reliance on credit ratings.

The financial crisis highlighted a number of shortcomings related to the use of internally modelled approaches for regulatory capital, including the IRB approaches to credit risk. These shortcomings include the excessive complexity of the IRB approaches, the lack of comparability in banks’ internally modelled IRB capital requirements and the lack of robustness in modelling certain asset classes.

To address these shortcomings, the Committee has made the following revisions to the IRB approaches: (i) removed the option to use the advanced IRB (A-IRB) approach for certain asset classes; (ii) adopted “input” floors (for metrics such as probabilities of default (PD) and loss-given-default (LGD)) to ensure a minimum level of conservativism in model parameters for asset classes where the IRB approaches remain available; and (iii) provided greater specification of parameter estimation practices to reduce RWA variability.

The Financial Stability Board welcomed the announcement.

The Financial Stability Board (FSB) welcomes the announcement by the Group of Central Bank Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, that agreement has been reached on the finalisation of Basel III. The agreement improves the comparability of banks’ risk-weighted assets and reinforces the credibility of the bank capital framework. Agreement on these final elements means that one of the key reforms pursued to address the causes of the global financial crisis has been completed and can be fully implemented.

Australian Debt Servicing Ratios Higher and More Risky

The Bank for International Settlements released their updated Debt Service Ratio (DSR) Benchmarks overnight. A high DSR has a strong negative impact on consumption and investment.

Australia (the yellow dashed line) is second highest after the Netherlands. We are above Norway and Denmark, and the trajectory continues higher. Further evidence that current regulatory settings in Australia are not correct. As the BIS said yesterday, such high debt is a significant structural risk to future prosperity.

The DSR reflects the share of income used to service debt and has been found to provide important information about financial-real interactions. For one, the DSR is a reliable early warning indicator for systemic banking crises.

The DSRs are constructed based primarily on data from the national accounts. The BIS publishes estimated debt service ratios (DSRs) for the household, the non-financial corporate and the total private non-financial sector (PNFS) using standardised data inputs for 17 countries.

BIS Special Feature On Household Debt

The Bank for International Settlements has featured the issues arising from high household debt in its December 2017 Quarterly Review. They call out the risks from high mortgage lending, high debt servicing ratios, and the risks to financial stability and economic growth.  All themes we have already explored on the DFA Blog, but it is a well argued summary. Also note Australia figures as a higher risk case study.  Here is a summary of their analysis.

Central banks are increasingly concerned that high household debt may pose a threat to macroeconomic and financial stability.  This special feature seeks to highlight some of the mechanisms through which household debt may threaten both macroeconomic and financial stability.

Australia is put in the “High and rising” category.  The debt ratio now exceeds 120% in both Australia and Switzerland.  Mortgages make up the lion’s share of debt (between 62 and 97%).  In Australia mortgage debt has risen from 86% of household debt in 2007 to 92% in 2017.

High household debt can make the economy more vulnerable to disruptions, potentially harming growth. As aggregate consumption and output shrink, the likelihood of systemic banking distress could increase, since banks hold both direct and indirect credit risk exposures to the household sector.

They say  the size of household debt burdens matters too. This is best measured by the ratio of interest payments and amortisation to income – the debt service ratio (DSR).   They say that rising household debt can reflect either stronger credit demand or an increased supply of credit from lenders, or some combination of the two. In Australia, for instance, heightened
competition among lenders seems to have resulted in a relaxation of lending standards.  In addition, the interest rate sensitivity of a household’s debt service burden is likely to matter. High debt (relative to assets) can make a household less mobile, and hence less able to adjust by finding a new or better job in another town or region. Homeowners may be tied down by mortgages on properties that have depreciated in value, especially those that are underwater (ie worth less than the loan balance).

These household-level observations have implications for aggregate demand and aggregate supply. From an aggregate demand perspective, the distribution of debt across households can amplify any drop in  consumption. Notable examples include high debt concentration among households with limited access to credit (ie close to borrowing constraints) or less scope for self-insurance (ie low liquid balances).

Since poorer households are more likely to face these credit and liquidity
constraints, an economy’s vulnerability to amplification can be assessed by looking at the distribution of debt by income and wealth.  In Australia, households in the top income brackets tend to have substantially higher debt ratios than those at the bottom of the distribution (eg in 2014, the top two quintiles had debt ratios of about 200%, while the bottom two had ratios of about 50%. [Note this is based on OLD 2014 HILDA data, and debt to higher income households has risen further since then!]

In countries where household debt has risen rapidly since the crisis, and where the majority of mortgages are adjustable rate, DSRs are already above their historical average, and would be pushed yet further away by higher interest rates.

From an aggregate supply perspective, an economy’s ability to adjust via labour reallocation across different regions can weaken if household leverage grows over time. In such an economy, a fall in house prices – as may be associated with interest rate hikes – would saddle a number of households with mortgages worth less than the underlying property. A share of these “underwater” homeowners might also lose their jobs in the ensuing contraction. In turn, their unwillingness to realise losses by selling their property at depressed prices may prolong their spell of unemployment by preventing them from taking jobs in locations that would require a house move.

Elevated levels of household debt could pose a threat to financial stability, defined here as distress among financial institutions. These exposures relate not only to direct and indirect credit risks, but also to funding risks. There is some evidence that this may be occurring in Australia, where high-DSR households are more likely to miss mortgage payments.

The indirect exposure to household debt arises from any increase in credit risk linked to households’ expenditure cuts. These are bound to have a broader impact on output and hence on credit risk more generally. Deleveraging by highly indebted households could induce a recession so that banks’ non-household loan assets are likely to suffer. Financial stability may also be threatened by funding risks . The network of counterparty relationships could become a channel for the transmission of stress, as any decline in the value of one bank’s cover pool could rapidly affect that of all the others.

They conclude:

Central banks and other authorities need to monitor developments in household debt. Several features of household indebtedness help to shape the behaviour of aggregate expenditure, especially after economic shocks. The level of debt and its duration – as well as whether debt has financed the acquisition of illiquid assets such as housing – all play a role in determining how far an individual household will cut back its consumption. Aggregating up, the distribution of debt across households can amplify these  adjustments. In turn, such amplification is more likely if debt is concentrated among households with limited access to credit or less scope for selfinsurance. Since these households are also likely to be poorer households, keeping track of the distribution of debt by income and wealth can help indicate an economy’s vulnerability to amplification.

Australian Home Price Growth Still At The Top; The Shadow Of A Fall Hangs Long

The latest BIS data series on home prices trends has been published to Q2 2017. Here is a selected range, which shows Australia is near the top in terms of trend growth, relative to other western countries, including UK, USA, Canada and New Zealand.

Norway and Sweden are slightly higher. The fastest rate of growth is in South Africa, which has reached a heady 700!

There is an important lesson in this data. If prices do crash it can take significant time to recover. Look at home prices in Ireland (the yellow solid line), which peaked in 2007, and 10 years later is still well below the peak – a salutatory warning.  USA prices have now just passed their pre-GFC peak and the UK achieved this in 2014!

The fallout from home price falls cast a long shadow.  Importantly, the fall in prices took on average 5 years from their peak to the subsequent trough. A warning that if Australian prices start to slide, they could do so for many years.

For many years, the BIS has promoted analysis of the long-term movements in residential property prices that are particularly important for financial stability research and policy.  A data set of long historical time series of nominal residential property prices in 13 advanced economies was presented for the first time in 1994. Interest in this data set has steadily increased among researchers as well as policymakers and private sector practitioners.

The research data set on long series on residential property prices presented here currently includes quarterly time series for 18 advanced economies going back as far as 1970 or 1971 or even earlier, and quarterly time series for five emerging market economies with starting dates between 1966 and 1991. This work has been undertaken by the BIS in close coordination with national authorities with the aim of providing the most accurate data whenever possible. However, these long series are imperfect. They have been constructed from a variety of sources, including central banks, national statistical offices, research institutes, private companies and academic studies. The methodologies they employ, and the types of geographical areas and dwellings they cover, are likewise varied. Although significant efforts have been made recently to harmonise and improve the comparability of house price indices across countries, the discrepancies in the compilation methods are quite large and may hamper the usability of the data set.

Wallowing In Debt

The long comparative data series from the Bank for International Settlements provides a useful and well documented relative comparisons across countries and over time.  They are careful to compare like with like!

The data on household debt relative to GDP is one of the most significant – “Credit to Households and NPISHs from All sectors at Market value – Percentage of GDP – Adjusted for breaks”.  Here is a set comparing Australian Household Debt with USA, Canada, New Zealand and Hong Kong and Ireland. Australian households are wallowing in debt (no wonder mortgage stress is so high), even relative to Canada (where home prices have now started to fall), Hong Kong (where prices are in absolute terms higher), and New Zealand (where the Reserve Bank there has been much more proactive in tacking the ballooning debt). See also the plunge in debt in Ireland, still trying to deal with the collapse which followed the GFC in 2007.

If we then add in the range of other economies (which I accept makes the chart more complex), we find that only Switzerland has a higher ratio. Even those Scandinavian countries with high ratios and high home prices are below Australia. Interesting then that household wealth, according to the recent survey, was highest in Switzerland, then Australia, thanks to high home values (but of course supported by very high debt).

We appear to have settings which simply are allowing this debt to continue to accumulate – and over the weekend the QLD election campaign included promises of yet more assistance to first time buyers worth $30m, further stoking the debt pyre.

Basel III Implementation Status In Australia

The Basel Committee published its latest status report on Basel III implementation to end-September 2017 – the 13th progress report. This includes a status report on Australia:

There are areas (in red) where the deadline has passed, and as yet plans are not announced. Many other countries have red marks, but it is worth noting the Euro area is ahead of many other regions. Disclose is a major gap in Australia according to the committee.

APRA provided comments on the status.

It also, once again, highlights the complexity in the Basel framework. Here the overall Basel Committee statement summary.

As of end-September 2017, all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force. 26 member jurisdictions have issued final rules for the countercyclical capital buffers and for domestic systemically important banks (D-SIBs) frameworks.

With regard to the global systemically important banks (G-SIBs) framework, all members that are home jurisdictions to G-SIBs have final rules in force. 21 member jurisdictions have issued final or draft rules for margin requirements for non-centrally cleared derivatives and 22 have issued final or draft rules for monitoring tools for intraday liquidity management.

With respect to the standards whose agreed implementation date passed at the start of 2017, 20 member jurisdictions have issued final or draft rules of the revised Pillar 3 framework (as published in January 2015, ie at the end of the first phase of review), 19 have issued final or draft rules of the standardised approach for measuring counterparty credit risk (SA-CCR) and capital requirements for equity investments in funds, and 18 have issued final or draft rules of capital requirements for bank exposures to central counterparties (CCPs).

Members are now striving to implement other Basel III standards. While some members reported challenges in doing so, overall progress is observed since the previous progress report (as of end-March 2017) in the implementation of the interest rate risk in the banking book (IRRBB), the net stable funding ratio (NSFR), and the large exposures framework. Members are also working on or turning to the implementation of TLAC holdings, the revised market risk framework, and the leverage ratio. The Committee will keep on monitoring closely the implementation of these standards so as to keep the momentum in implementing the comprehensive set of the Committee’s post-crisis reforms.

Regarding the consistency of regulatory implementation, the Committee has published its assessment reports on all 27 members regarding their implementation of Basel risk-based capital and LCR standards.

Rising US Rates Will Clip Home Prices Here

Interesting research is contained in a BIS Working Paper “Interest rates and house prices in the United States and around the world“.

They show that home prices are indeed connected to interest rates, and changes in rates do have a flow on effect to prices, and that there are spillover effects, especially relating to interest rates in the USA.

This means that as the FED lifts rates, as is now well signalled, we should expect prices to fall here and in other countries. There may be some delay, the modelling is complex, and the relationships are not straight forward. But it is is worth remembering that in the US real house prices fell by as much as 31% over the course of 2007–09!

This paper estimates the response of house prices in 47 advanced and emerging market economies (EMEs) to changes in short- and long-term interest rates. Our study has four novel aspects. First, we analyse in some detail the impact of short-term interest rates on house prices. Second, we look at the responsiveness of house prices around the world to US interest rates. Third, we use a unique data set on house prices compiled by the BIS in cooperation with national statistical and monetary authorities. And fourth, our empirical framework tries to capture the important role of inertia in house prices.

One striking feature of house price growth is its persistence. With the exception of Germany, Portugal and Switzerland, advanced economies have seen real house prices growing by an average of at least 6% per year for 40 years or longer. In the United States, for instance, this resulted in a 13-fold increase in real house prices over a period of 47 years; in Norway, in a 77-fold increase over 66 years. And in South Africa, real house prices increased nearly 150 times over half a century.

Another way to appreciate the persistence of house prices is to contrast the length of their upswings and downswings. We define an upswing (downswing) as a period of house price increases (decreases) sustained in an individual country for three years or more. Based on this definition, periods of upswing accounted for nearly 80% of the advanced economy sample. The upswings lasted on average 13 years; with the longest one, in Australia, still continuing after half a century. By contrast, downswings accounted for only 8% of the advanced economy sample; they lasted on average five years, and the longest one, in Japan, lasted 13 years. In EMEs, upswings accounted for two thirds of the sample. They lasted on average eight years, and the downswings four years.

The surge in house prices has been particularly pronounced since the turn of the millennium. Between 2000 and 2015, real house prices increased by 100% or more in half the economies in our sample.  Most countries experienced a housing boom before 2007 (light bar segments). But many have also seen very rapid house price growth since 2007 (dark bar segments). These included Australia, Austria, Canada, the Netherlands, Norway, Sweden and Switzerland among advanced economies; and Brazil, Hong Kong SAR, Israel, Malaysia and Peru among EMEs.

Our focus on short-term interest rates is motivated by their link to monetary policy. As a house is a long-lived asset, the interest rate appropriate for relating the service flow from a house to its price is arguably a long-term rate. However, house prices also depend importantly on ease of access to credit, which is in turn significantly affected by the monetary policy stance. Bernanke and Blinder (1992), for instance, showed that changes in the US federal funds rate were associated with changes in lending by US banks, an effect that has become known as the bank lending channel of monetary policy. Short-term interest rates, which are more closely related to the stance of monetary policy, might therefore be just as important a “fundamental” for house prices as longer-term rates. Indeed, we find a surprisingly important role for short-term interest rates as drivers of house prices, especially outside the United States. Our interpretation is that this reflects an important role for the bank lending channel of monetary policy, especially in countries where securitisation of home mortgages is less prevalent.

The motivation for looking at the responsiveness of house prices around the world to not only domestic but also US interest rates is that the latter have become a key measure of the global cost of financing. We do find spillover effects from US interest rates, both short and long ones, on house prices outside the United States.

Our study draws on the BIS residential property price statistics and, in particular, the “preferred” house price series as identified by national statistical offices or central banks. We compiled over 1,000 annual observations on house prices for the non-US countries in our sample from these series and about a half century of quarterly house prices for the United States. We use these data to estimate the dynamic impact of changes in interest rates and other explanatory variables on real house prices around the world.

Most empirical studies assume that short-term interest rates do not influence house price growth other than through the domestic cost of borrowing, ie by their influence on long-term interest rates. The findings in this paper suggest that this view might be mistaken: changes in short-term interest rates seem to have a strong and persistent impact on house price growth.

Moreover, global, ie US short-term interest rates – not just domestic ones – seem to matter, both in advanced economies and EMEs. We interpret the relative importance of short-term interest rates in driving house prices as indicating an important role for the bank lending channel of monetary policy in determining housing financing conditions, especially outside the United States, where securitisation of home mortgages is less prevalent.

The larger effect of interest rates on house prices we find reflects in part the use in our regressions of a long distributed lag of interest rate changes. For the United States, our estimates for the period from 1970 to the end of 1999 suggest that a 100 basis-point fall in the nominal short-term rate, accompanied by an equivalent fall in the real short-term rate, generated a 5 percentage point rise in real house prices, relative to baseline, after three years. We find an even larger effect if we include the data through end-2015. For other advanced economies and EMEs, we estimate that a 100 basis-point fall in domestic short-term interest rates, combined with an equivalent fall in the US real rate, generates an increase in house prices of up to 3½ percentage points, relative to baseline, after three years. Another reason we find larger interest rate effects is by allowing for inertia in house price movements. We find strong evidence against the random walk hypothesis: real house prices around the world tend to move in the same direction for about a year after being hit by a disturbance, then exhibit a modest reversal.

We think that this inertia in house prices reflects the large search and transaction costs associated with trading residential real estate and shifting between owner-occupied and rental housing. These costs are ignored in the user cost model, which predicts a fairly high interest rate sensitivity for house prices.

Our findings also suggest a potentially important role for monetary policy in countering financial instability. While higher short-term interest rates alone cannot significantly dampen the demand for housing, slower house price growth can give supervisors more time to implement measures to strengthen the financial system. At the same time, the finding that house prices adjust to interest rate changes gradually over time suggests that modest cuts in policy rates are not likely to rapidly fuel house
price bubbles.

 

 

 

 

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.