Australia Still High Up The Private Sector To GDP Metric

The Bank For International Settlements has released their latest data series of credit to GDP for more than 40 countries. It is a reasonably accurate benchmark.

I have selected some relevant analogues to show that private debt to GDP ratios in Australia remain high, well above USA Canada and UK. Denmark and New Zealand are higher.  Australia is the dotted yellow line.

Relevant given my recent post of the impact of credit on Australia!

You can watch my video blog where we discuss todays releases.

Early warning indicators of banking crises: expanding the family

The Bank for International Settlements has just published a special report on Early Warning Indicators Of Banking Crises.

Household and international debt (cross-border or in foreign currency) are a potential source of vulnerabilities that could eventually lead to banking crises. We explore this issue formally by assessing the performance of these debt categories as early warning indicators (EWIs) for systemic banking crises. We find that they do contain useful information. In fact, over the more recent subsample, for household and cross-border debt indicators the information is similar to that of the more commonly used aggregate credit variables regularly monitored by the BIS. Confirming previous work, combining these indicators with property prices improves performance. An analysis of current global conditions based on this richer information set points to the build-up of vulnerabilities in several countries.

Early warning indicators (EWIs) of banking crises are typically based on the notion that crises take root in disruptive financial cycles. The basic intuition is that outsize financial booms can generate the conditions for future banking distress. The narrative of financial booms is well understood: risk appetite is high, asset prices soar and credit surges. Yet it is difficult to detect the build-up of financial booms in real time and with reasonable confidence. It is here that EWIs come in.

Table 4 takes a closer look at the status of the various indicators as of June 2017. Cells are marked in red if the indicator has breached the threshold for predicting at least two thirds of the crises. Those marked in amber correspond to the lower threshold required to predict at least 90% of the crises. This avoids a false sense of precision and captures the very gradual build-up in vulnerabilities. Asterisks indicate that the corresponding combined credit-cum-property price indicator has breached its critical threshold. The picture that emerges is a varied one.

Aggregate credit indicators point to vulnerabilities in several jurisdictions Canada, China and Hong Kong SAR stand out, with both the credit-to-GDP gap and the DSR flashing red. For Canada and Hong Kong, these signals are reinforced by property price developments. The credit-to-GDP gap also flashes red in Switzerland, whereas the total DSR flashes red in Russia and Turkey.

Credit conditions are also quite buoyant elsewhere. Credit-to-GDP gaps and/or the total DSR send amber signals in some advanced economies, such as France, Japan and Switzerland, as well as in several emerging market economies (EMEs). In Indonesia, Malaysia and Thailand, as well as some other countries, property price gaps underscore this signal.

Some jurisdictions also exhibit some signs of high household sector vulnerabilities. In Korea, Russia and Thailand, the household sector DSR flashes red (Table 4, third column). In Thailand, the red signal for the household DSR is underlined by the property price indicator. Property prices have also been in elevated in Sweden and Canada, which exhibit an amber signal for the household DSR.

The cross-border claims indicator supports the risk assessment for several countries and flags some potential external vulnerabilities for others (Table 4, fourth column). The indicator flashes red for Norway, and is amber for a number of economies.

While providing a general sense of where policymakers may wish to be especially vigilant, these indicators need to be interpreted with considerable caution. As always, they have been calibrated based on past experience, and cannot take account of broader institutional and economic changes that have taken place since previous crises. For example, the much more active use of macroprudential measures should have strengthened the resilience of the financial system to a financial bust, even if it may not have prevented the build-up of the usual signs of vulnerabilities. Similarly, the large increase in foreign currency reserves in several EMEs should help buffer strains. The indicators should be seen not as a definitive warning but only as a first step in a broader analysis – a tool to help guide a more drilled down and granular assessment of financial vulnerabilities. And they may also point to broader macroeconomic vulnerabilities, providing a sense of the potential slowdown in output from financial cycle developments should the outlook deteriorate.

Money in the digital age: what role for central banks?

Where do Crypto-curriences fit it? A Central Banker’s view.

Via The Bank For International Settlements. Lecture by Agustín Carstens
General Manager, Bank for International Settlements House of Finance, Goethe University Frankfurt.

One of the reasons that central bank Governors from all over the world gather in Basel every two months is precisely to discuss issues at the front and centre of the policy debate. Following the Great Financial Crisis, many hours have been spent discussing the design and implications of, for example, unconventional monetary policies such as quantitative easing and negative interest rates.

Lately, we have seen a bit of a shift, to issues at the very heart of central banking. This shift is driven by developments at the cutting edge of technology. While it has been bubbling under the surface for years, the meteoric rise of bitcoin and other cryptocurrencies has led us to revisit some fundamental questions that touch on the origin and raison d’être for central banks:

  • What is money?
  • What constitutes good money, and where do cryptocurrencies fit in?
  • And, finally, what role should central banks play?

The thrust of my lecture will be that, at the end of the day, money is an indispensable social convention backed by an accountable institution within the State that enjoys public trust. Many things have served as money, but experience suggests that something widely accepted, reliably provided and stable in its command over goods and services works best. Experience has also shown that to be credible, money requires institutional backup, which is best provided by a central bank. While central banks’ actions and services will evolve with technological developments, the rise of cryptocurrencies only highlights the important role central banks have played, and continue to play, as stewards of public trust. Private digital tokens posing as currencies, such as bitcoin and other crypto-assets that have mushroomed of late, must not endanger this trust in the fundamental value and nature of money.

The money flower highlights four key properties on the supply side of money: the issuer, the form, the degree of accessibility and the transfer mechanism.

  • The issuer can be either the central bank or “other”. “Other” includes nobody, that is, a particular type of money that is not the liability of anyone.
  • In terms of the form it takes, money is either electronic or physical.• Accessibility refers to how widely the type of money is available. It can either be wide or limited.
  • Transfer mechanism can either be a central intermediary or peer-to-peer, meaning transactions occur directly between the payer and the payee without the need for a central intermediary.

In conclusion, while cryptocurrencies may pretend to be currencies, they fail the basic textbook definitions. Most would agree that they do not function as a unit of account. Their volatile valuations make them unsafe to rely on as a common means of payment and a stable store of value.

They also defy lessons from theory and experiences. Most importantly, given their many fragilities, cryptocurrencies are unlikely to satisfy the requirement of trust to make them sustainable forms of money.

While new technologies have the potential to improve our lives, this is not invariably the case. Thus, central banks must be prepared to intervene if needed. After all, cryptocurrencies piggyback on the institutional infrastructure that serves the wider financial system, gaining a semblance of legitimacy from their links to it. This clearly falls under central banks’ area of responsibility. The buck stops here. But the buck also starts here. Credible money will continue to arise from central bank decisions, taken in the light of day and in the public interest.

In particular, central banks and financial authorities should pay special attention to two aspects. First, to the ties linking cryptocurrencies to real currencies, to ensure that the relationship is not parasitic. And second, to the level playing field principle. This means “same risk, same regulation”. And no exceptions allowed.


Fintech’s Digital Disruption In Five Scenarios

The BIS task force has developed five scenarios which highlight how Fintech disruption might play out, in a 50 page report “Implications of fintech developments for banks and bank supervisors.”  Bankers will find it uncomfortable reading!

Under the The Bank For International Settlements (BIS) five scenarios, the scope and pace of potential disruption varies significantly, but ALL scenarios show that banks will find it increasingly difficult to maintain their current operating models, given technological change and customer expectations.

The fast pace of change in fintech makes assessing the potential impact on banks and their business models challenging. While some market observers estimate that a significant portion of banks’ revenues, especially in retail banking, is at risk over the next 10 years, others claim that banks will be able to absorb or outcompete the new competitors, while improving their own efficiency and capabilities.

The task force used a categorisation of fintech innovations. Graph 1 depicts three product sectors, as well as market support services. The three sectors relate directly to core banking services, while the market support services relate to innovations and new technologies that are not specific to the financial sector but also play a significant role in fintech developments.

The analysis presented in this paper considered several scenarios and assessed their potential future impact on the banking industry. A common theme across the various scenarios is that banks will find it increasingly difficult to maintain their current operating models, given technological change and customer expectations. Industry experts opine that the future of banking will increasingly involve a battle for the customer relationship. To what extent incumbent banks or new fintech entrants will own the customer relationship varies across each scenario. However, the current position of incumbent banks will be challenged in almost every scenario.

1. The better bank: modernisation and digitisation of incumbent players

In this scenario the incumbent banks digitise and modernise themselves to retain the customer relationship and core banking services, leveraging enabling technologies to change their current business models.

Incumbent banks are generally under pressure to simultaneously improve cost efficiency and the customer relationship. However, because of their market knowledge and higher investment capacities, a potential outcome is that incumbent banks get better at providing services and products by adopting new technologies or improving existing ones. Enabling technologies such as cloud computing, big data, AI and DLT are being adopted or actively considered as a means of enhancing banks’ current products, services and operations.

Banks use new technologies to develop value propositions that cannot be effectively provided with their current infrastructure. The same technologies and processes utilised by non-bank innovators can also be implemented by incumbent banks, and examples may include:

  • New technologies such as biometry, video, chatbots or AI may help banks to create sophisticated capacities for maintaining a value-added remote customer relationship, while securing transactions and mitigating fraud and AML/CFT risks. Many innovations seek to set up convenient but secure customer identification processes.
  • Innovative payment services would also support the better bank scenario. Most banks have already developed branded mobile payments services or leveraged payment services provided by third parties that integrate with bank-operated legacy platforms. Customers may believe that their bank can provide a more secure mobile payments service than do non-bank alternatives.
  • Banks may also be prone to offer partially or totally automated robo-advisor services, digital wealth management tools and even add-on services for customers with the intention of maintaining a competitive position in the retail banking market, retaining customers and attracting new ones.
  • In this scenario, digitising the lending processes is becoming increasingly important to meet the consumer’s demands regarding speed, convenience and the cost of credit decision-making. Digitisation requires more efficient interfaces, processing tools, integration with legacy systems and document management systems, as well as sophisticated customer identification and fraud prevention tools. These can be achieved by the incumbent by developing its own lending platform, purchasing an existing one, white labelling or outsourcing to third-party service providers. This scenario assumes that current lending platforms will remain niche players.
    While there are early signs that incumbents have added investment in digitisation and modernisation to their strategic planning, it remains to be seen to what extent this scenario will be dominant.

2. The new bank: replacement of incumbents by challenger banks

In the future, according to the new bank scenario, incumbents cannot survive the wave of technology-enabled disruption and are replaced by new technology-driven banks, such as neo-banks, or banks instituted by bigtech companies, with full service “built-for-digital” banking platforms. The new banks apply advanced technology to provide banking services in a more cost-effective and innovative way. The new players may obtain banking licences under existing regulatory regimes and own the customer relationship, or they may have traditional banking partners.

Neo-banks seek a foothold in the banking sector with a modernised and digitised relationship model, moving away from the branch-centred customer relationship model. Neo-banks are unencumbered by legacy infrastructure and may be able to leverage new technology at a lower cost, more rapidly and in a more modern format.

Elements of this scenario are reflected in the emergence of neo- and challenger banks, such as Atom Bank and Monzo Bank in the United Kingdom, Bunq in the Netherlands, WeBank in China, Simple and Varo Money in the United States, N26 in Germany, Fidor in both the United Kingdom and Germany, and Wanap in Argentina. That said, no evidence has emerged to suggest that the current group of challenger banks has gained enough traction for the new bank scenario to become predominant.

Neo-banks make extensive use of technology in order to offer retail banking services predominantly through a smartphone app and internet-based platform. This may enable the neo-bank to provide banking services at a lower cost than could incumbent banks, which may become relatively less profitable due to their higher costs. Neo-banks target individuals, entrepreneurs and small to medium-sized enterprises. They offer a range of services from current accounts and overdrafts to a more extended range of services, including current, deposit and business accounts, credit cards, financial advice and loans. They leverage scalable infrastructure through cloud providers or API-based systems to better interact through online, mobile and social media-based platforms. The earnings model is predominantly based on fees and, to a lesser extent, on interest income, together with lower operating costs and a different approach to marketing their products, as neo-banks may adopt big data technologies and advanced data analytics. Incumbent banks, on the other hand, may be impeded by the scale and complexity of their current technology and data architecture, determined by factors such as legacy systems, organisational complexity and historical acquisitions. However, the customer acquisitions costs may be high in competitive banking systems and neo-banks’ revenues may be offset by their aggressive pricing strategies and their less-diverse revenue streams.

3. The distributed bank: fragmentation of financial services among specialised fintech firms and incumbent banks

In the distributed bank scenario, financial services become increasingly modularised, but incumbents can carve out enough of a niche to survive. Financial services may be provided by the incumbents or other financial service providers, whether fintech or bigtech, who can “plug and play” on the digital customer interface, which itself may be owned by any of the players in the market. Large numbers of new businesses emerge to provide specialised services without attempting to be universal or integrated retail banks – focusing rather on providing specific (niche) services. These businesses may choose not to compete for ownership of the entire customer relationship. Banks and other players compete to own the customer relationship as well as to provide core banking services.

In the distributed bank scenario, banks and fintech companies operate as joint ventures, partners or other structures where delivery of services is shared across parties. So as to retain the customer, whose expectations in terms of transparency and quality have increased, banks are also more apt to offer products and services from third-party suppliers. Consumers may use multiple financial service providers instead of remaining with a single financial partner.

Elements of this scenario are playing out, as evidenced by the increasing use of open APIs in some markets. Other examples that point towards the relevance of this scenario are:

  • Lending platforms partner and share with banks the marketing of credit products, as well as the approval process, funding and compliance management. Lending platforms might also acquire licences, allowing them to do business without the need to cooperate with banks.
  • Innovative payment services are emerging with joint ventures between banks and fintech firms offering innovative payment services. Consortiums supported by banks are currently seeking to establish mobile payments solutions as well as business cases based on DLT for enhancing transfer processes between participating banks (see Box 4 for details of mobile wallets).
  • Robo-advisor or automated investment advisory services are provided by fintech firms through a bank or as part of a joint venture with a bank.

    Innovative payment services are one of the most prominent and widespread fintech developments across regions. Payments processing is a fundamental banking operation with many different operational models and players. These models and structures have evolved over time, and recent advances in technological capabilities, such as in the area of instant payment, have accelerated this evolution. Differences in types of model, technology employed, product feature and regulatory frameworks in different jurisdictions pose different risks.

The adoption by consumers and banks of mobile wallets developed by third–party technology companies – for example, Apple Pay, Samsung Pay,12 and Android Pay – is an example of the distributed bank scenario. Whereas some banks have developed mobile wallets in-house, others offer third-party wallets, given widespread customer adoption of these formats. While the bank continues to own the financial element of the customer relationship, it cedes control over the digital wallet experience and, in some cases, must share a portion of the transaction revenue facilitated through the third-party wallets.

Innovation in payment services has resulted in both opportunities and challenges for financial institutions. Many of the technologies allow incumbents to offer new products, gain new revenue streams and improve efficiencies. These technologies also let non-bank firms compete with banks in payments markets, especially in regions where such services are open to non-bank players (eg the Payment Service Directives in the European Union and the Payment Schemes or Payment Institutions Regulation in Brazil).

4. The relegated bank: incumbent banks become commoditised service providers and customer relationships are owned by new intermediaries

In the relegated bank scenario, incumbent banks become commoditised service providers and cede the direct customer relationship to other financial services providers, such as fintech and bigtech companies. The fintech and bigtech companies use front-end customer platforms to offer a variety of financial services from a diverse group of providers. They use incumbent banks for their banking licences to provide core commoditised banking services such as lending, deposit-taking and other banking activities. The relegated bank may or may not keep the balance sheet risk of these activities, depending on the contractual relationship with the fintech company.

In the relegated bank scenario, big data, cloud computing and AI are fully exploited through various configurations by front-end platforms that make innovative and extensive use of connectivity and data to improve the customer experience. The operators of such platforms have more scope to compete directly with banks for ownership of the customer relationship. For example, many data aggregators allow customers to manage diverse financial accounts on a single platform. In many jurisdictions consumers become increasingly comfortable with aggregators as the customer interface. Banks are relegated to being providers of commoditised functions such as operational processes and risk management, as service providers to the platforms that manage customer relationships.

Although the relegated bank scenario may seem unlikely at first, below are some examples of a modularised financial services industry where banks are relegated to providing only specific services to another player who owns the customer relationship:

  • Growth of payment platforms has resulted in banks providing back office operations support in such areas as treasury and compliance functions. Fintech firms will directly engage with the customer and manage the product relationship. However, the licensed bank would still need to authenticate the customer to access funds from enrolled payment cards and accounts.
  • Online lending platforms become the public-facing financial service provider and may extend the range of services provided beyond lending to become a new intermediary between customers and banks/funds/other financial institutions to intermediate all types of banking service (marketplace of financial services). Such lending platforms would organise the competition between financial institutions (bid solicitations) and protect the interests of consumers (eg by offering quality products at the lowest price). Incumbent banks would exist only to provide the operational and funding mechanisms.
  • Banks become just one of many financial vehicles to which the robo-advisor directs customer investments and financial needs.
  • Social media such as the instant messaging application WeChat13 in China leverage customer data to offer its customers tailored financial products and services from third parties, including banks. The Tencent group has launched WeBank, a licensed banking platform linked to the messaging application WeChat, to offer the products and services of third parties. WeBank/WeChat focuses on the customer relationship and exploits its data innovatively, while third parties such as banks are relegated to product and risk management.

5. The disintermediated bank: Banks have become irrelevant as customers interact directly with individual financial services providers.

Incumbent banks are no longer a significant player in the disintermediated bank scenario, because the need for balance sheet intermediation or for a trusted third party is removed. Banks are displaced from customer financial transactions by more agile platforms and technologies, which ensure a direct matching of final consumers depending on their financial needs (borrowing, making a payment, raising capital etc).

In this scenario, customers may have a more direct say in choosing the services and the provider, rather than sourcing such services via an intermediary bank. However, they also may assume more direct responsibility in transactions, increasing the risks they are exposed to. In the realm of peer-to-peer (P2P) lending for instance, the individual customers could be deemed to be the lenders (who potentially take on credit risk) and the borrowers (who may face increased conduct risk from potentially unregulated lenders and may lack financial advice or support in case of financial distress).

At the moment, this scenario seems far-fetched, but some limited examples of elements of the disintermediation scenario are already visible:

  • P2P lending platforms could manage to attract a significant number of potential retail investors so as to address all funding needs of selected credit requests. P2P lending platforms have recourse to innovative credit scoring and approval processes, which are trusted by retail investors. That said, at present, the market share of P2P lenders is small in most jurisdictions. Additionally, it is worth noting that, in many jurisdictions, P2P lending platforms have switched to, or have incorporated elements of, a more diversified marketplace lending platform business model, which relies more on the funding provided by institutional investors (including banks) and funds than on retail investors.
  • Cryptocurrencies, such as Bitcoin, effect value transfer and payments without the involvement of incumbent banks, using public DLT. But their widespread adoption for general transactional purposes has been constrained by a variety of factors, including price volatility, transaction anonymity – raising AML/CFT issues – and lack of scalability.

In practice the report highlights that a blend of scenarios is most likely.

The scenarios presented are extremes and there will likely be degrees of realisation and blends of different scenarios across business lines. Future evolutions may likely be a combination of the different scenarios with both fintech companies and banks owning aspects of the customer relationship while at the same time providing modular financial services for back office operations.

For example, Lending Club, a publicly traded US marketplace lending company, arguably exhibits elements of three of the five banking scenarios described. An incumbent bank that uses a “private label” solution based on Lending Club’s platform to originate and price consumer loans for its own balance sheet could be characterised as a “distributed bank”, in that the incumbent continues to own the customer relationship but shares the process and revenues with Lending Club.

Lending Club also matches some consumer loans with retail or institutional investors via a relationship with a regulated bank that does not own the customer relationship and is included in the transaction to facilitate the loan. In these transactions, the bank’s role can be described as a “relegated bank” scenario. Other marketplace lenders reflect the “disintermediated” bank scenario by facilitating direct P2P lending without the involvement of a bank at any stage.

Warnings On The Profitability Of Global Banks, Excessive Risk-taking and Leverage

The Committee on the Global Financial System  at The Bank for International Settlements (BIS) has published an important report “Structural changes in banking after the crisis“.

The report highlights a “new normal” world of lower bank profitability, and warns that banks may be tempted to take more risks, and leverage harder in an attempt to bolster profitability. This however, should be resisted. They also underscore the issues of banking concentration and the asset growth, two issues which are highly relevant to Australia.

The report highlights that in some countries the 2007 banking crisis brought about the end of a period of fast and excessive growth in domestic banking sectors.  Worth noting the substantial growth in Australia, relative to some other markets and of particular note has been the dramatic expansion of the Chinese banking system, which grew from about 230% to 310% of GDP over 2010–16 to become the largest in the world, accounting for 27% of aggregate bank assets.

They also call out the concentration banking to a smaller number of larger players since the crisis.  The number of banks has fallen in most countries
over the past decade. Post-crisis reductions in bank numbers have been mainly among smaller institutions, aside from a handful of distressed large banks in the euro area and the retreat of some international banks from specific foreign markets. Concentration has also risen in some countries that were less affected by the crisis and where bank numbers have
continued to expand or remained steady (Australia, Brazil, Singapore).

The decade since the onset of the global financial crisis has brought about significant structural changes in the banking sector. The crisis revealed substantial weaknesses in the banking system and the prudential framework, leading to excessive lending and risk-taking unsupported by adequate capital and liquidity buffers. The effects of the crisis have weighed heavily on economic growth, financial stability and bank performance in many jurisdictions, although the headwinds have begun to subside. Technological change, increased non-bank competition and shifts in globalisation are still broader environmental challenges facing the banking system.

Regulators have responded to the crisis by reforming the global prudential framework and enhancing supervision. The key goals of these reforms have been to increase banks’ resilience through stronger capital and liquidity buffers, and reduce implicit public subsidies and the impact of bank failures on the economy and taxpayers through enhanced recovery and resolution regimes. At the same time, the dynamic adaptation of the system and the emergence of new risks warrant ongoing attention.

In adapting to their new operating landscape, banks have been re-assessing and adjusting their business strategies and models, including their balance sheet structure, cost base, scope of activities and geographic presence. Some changes have been substantial and are ongoing, while a number of advanced economy banking systems are also confronted with low profitability and legacy problems.

This report by the CGFS Working Group examines trends in bank business models, performance and market structure, and assesses their implications for the stability and efficiency of banking markets.

The main findings on the evolution of banking sectors are as follows:

  1. Changes in banking market capacity and structure. The crisis ended a period of strong growth in banking sector assets in many advanced economies. Several capacity metrics point to a shrinking of banking sectors relative to economic activity in several countries directly impacted by the crisis. This adjustment has occurred mainly through a reduction in business volumes rather than the exit of firms from the market. Banking sectors have expanded in countries that were less affected by the crisis, particularly the large emerging market economies (EMEs). Concentration in banking systems has tended to increase, with some exceptions.
  2. Shifts in bank business models. Advanced economy banks have tended to reorient their business away from trading and more complex activities, towards less capital-intensive activities, including commercial banking. This pattern is evident in the changes in banks’ asset portfolios, revenue mix and increased reliance on customer deposit funding. Large European and US banks have also become more selective and focused in their international banking activities, while banks from the large EMEs and countries less affected by the crisis have expanded internationally.
  3. Trends in bank performance. Bank profitability (return on equity) has declined across countries and business model types from the historically high rates seen before the crisis. At least in part, this reflects lower leverage induced by the regulatory reforms. In addition, many advanced economy banks, in particular banks in some European countries, are facing sluggish revenues and an overall cost base that has been resistant to cuts, including, in some cases, legacy costs associated with past investment decisions and misconduct.

The main findings regarding the impact of post-crisis structural change for the stability of the banking sector are related to three areas:

  1. Bank resilience and risk-taking. Banks globally have enhanced their resilience to future risks by substantially building up capital and liquidity buffers. The increased use of stress testing by banks and supervisors since the crisis also provides for greater resilience on a forward-looking basis, which should help support credit flows in good and bad times. In addition, advanced economy banks have shifted to more stable funding sources and invested in safer and less complex assets. Some of these adjustments may be driven partly by cyclical factors, such as accommodative monetary policy, and hence may diminish as conditions change. Qualitative evidence
    indicates that banks have considerably strengthened their risk management and internal control practices. Although these changes are hard to assess, supervisors point to significant scope for further improvements, in particular because of the inherent uncertainties about the future evolution of risks.
  2. Market sentiment and future bank profitability. Despite a recovery in marketbased indicators of investor sentiment towards larger institutions in recent years, equity investors remain sceptical towards some banks with low profitability. Simulation analysis carried out by the Working Group suggests that some institutions need to implement further cost-cutting and structural adjustments.
  3. System-wide effects. Assessing the impact of structural change on system-wide stability is harder than in the case of individual banks because of complex interactions within the system. Nonetheless, a number of changes are consistent with the objectives of public authorities and the reform process. First, banks appear to have become more focused geographically in their international strategy and tend to intermediate more of their international claims locally. Second, direct connections between banks through lending and derivatives exposures have declined. Third, some
    European banking systems with relatively high capacity have made progress with consolidation. Fourth, while the effect of less business model diversity arising from the repositioning of many banks towards commercial banking cannot be assessed yet, this trend has been accompanied by a shift towards more stable funding sources (such as deposits). A range of other reforms has also enhanced systemic stability (eg money market mutual fund reforms) and further progress has been made on resolution and recovery frameworks.


Changes in banking sector resilience have to be measured against the impact on the services provided by the sector. The main findings regarding the impact of changes on the efficiency of financial intermediation services are:

  1. Provision of bank lending to the real economy. Trends in bank-intermediated credit have been uneven over time and across countries, reflecting differences in their crisis experience and related overhang of credit. Credit declined significantly relative to economic activity in advanced economies that bore the brunt of the crisis, and in most countries started to recover only from 2015. But the adjustment is still ongoing
    in others, reflecting in part a legacy of problem bank assets that continues to hamper the growth of fresh loans. By comparison, advanced economy banking systems not significantly affected by the crisis continued to report solid loan growth, notwithstanding tighter regulations.Recognising the difficulty of disentangling demand and supply drivers, the
    evidence gathered by the group does not suggest a systematic change in the
    willingness of banks to lend. But, in line with the objectives of regulatory reform, lenders have become more risk-sensitive and more discriminating across borrowers. In contrast to many advanced economies, bank lending has expanded strongly in EMEs, raising sustainability concerns and prompting the use of macroprudential measures and the tightening of certain lending standards more recently.
  2. Capital market activities. Crisis-era losses combined with regulatory changes have motivated a significant reduction in risk and scale in the non-equity trading and market-making businesses of a number of global banks.
  3. International banking was one of the areas most affected by the crisis. Aggregate foreign bank claims have seen a significant decline since the crisis, driven particularly by banks from the advanced economies most affected by the crisis, especially from some European countries. By contrast, banks from other non-crisis countries have expanded their foreign activities, in some cases quite substantially, resulting in a significant change in the country composition of global banking assets.

The report highlights four key messages for markets and policymakers:

  1. Post-crisis, a stronger banking sector has resumed the supply of
    intermediation services to the real economy, albeit with some changes in
    the balance of activities.
    – Bank credit growth remains below its excessive pre-crisis pace in advanced economies but without indications of a systematic reduction in the supply of local credit. Lending to some sectors and borrowers has seen reductions, however, as banks have adjusted their risk profile, and policymakers should remain attentive to potential unintended gaps in the flow of credit.
    – Experience from crisis countries underscores the benefits of acting early in addressing problems associated with non-performing loans (NPLs).
    – The withdrawal of some banks from capital markets-related business has
    coincided with signs of fragile liquidity in some markets, although causality
    remains an open question.
  2. Longer-term profitability challenges require the attention of banks and
    supervisors, as they may signal risk-taking incentives and overcapacity. Low profitability partly reflects cyclical factors but also higher capitalisation and more resilient bank balance sheets. As such, banks and their investors need to adapt to a “new normal”. Market concerns about low profitability may deprive banks of an important source of fresh capital, or encourage risk-taking and leverage by banks, thus placing a premium on robust risk management, regulation and supervision. In some cases, low profitability might also signal the existence of excess capacity and structural impediments to exit for individual banks, requiring decisive policy action to apply relevant rules.
  3. Consolidation and preservation of gains in bank resilience requires ongoing
    surveillance, risk management and a systemic perspective. Key indicators
    show areas of improvement since the crisis, but also areas which are still a work in progress. Authorities and market participants should not become complacent. The system is adapting to a variety of changes, the interaction of which is difficult to predict. Authorities should monitor the ongoing adaptation and evolution in the nature and locus of risk-taking within the banking sector and the financial system more broadly. In this regard, the group sees scope for the international supervisory community to undertake a post-crisis study of bank risk management practices. In addition, ample buffers remain critical to coping with unexpected losses from new risks.
  4. Better use and sharing of data are critical to enhanced surveillance of
    systemic risk. Surveillance is crucial, given that the financial sector evolves
    dynamically and because future risks will likely differ from past ones. Although data availability has improved, there is a need to make better use of existing data to assess banking sector structural adjustment and related risks. This effort will likely require additional conceptual work, building on the data sets of national authorities and the international financial institutions. Areas that warrant further analysis include the potential for increased similarities in the exposure profile of banks to correlated shocks, the growing role and implications of fintech, and the migration of activity and risk to the non-bank sector.


Unconventional Monetary Policies And Persistently Low Interest Rates

A working paper from the BIS – “Effectiveness of unconventional monetary policies in a low interest rate environment” examines the connection between low interest rates and unconventional monetary policy, and their findings suggest the “neutral” rate is likely to rise much faster than many are currently expecting, with significant potential economic impact. Indeed, Central Banks are “behind the curve” and that the assumed lower “neutral interest rate may in fact be wrong.

A reliance on balance sheet tools can, for example, result in resource misallocations, disruptive risk-taking behaviour and political economy challenges. These costs, among others, would have to be weighed against the benefits when considering the appropriate role for central bank balance sheets in the new normal era as well as in future crisis periods.

They suggest that unconventional monetary policies (UMPs) became less effective in the post-GFC period, but not for the reasons typically given. The explanation is nuanced and emerges from careful assessment of the various links in the monetary transmission mechanism.

Post the GFC, major central banks in advanced economies cut policy rates sharply and, then when the room for manoeuvre closed, resorting to a range of unconventional monetary policies (UMPs) that exploited the financial firepower of central bank balance sheets. The lacklustre recovery that followed has naturally raised questions about the effectiveness of these new tools. This paper uses extensive modelling to investigate the links, and the results are troubling.  Not least, they  find evidence supporting the hypothesis that the economy did not become less interest-sensitive in the aftermath of the GFC, once changes in the “natural” rate of interest are taken into account. They conclude that UMPs had a declining impact on economies over time. Looking forward, the results suggest that the normalisation of balance sheet policies could be accompanied by an increase in the conventionally estimated “natural” rate, which if not taken into account would increase the risk that central banks will find themselves falling behind the curve.

They conclude:

We find that unconventional monetary policies were effective in providing some stimulus to economies at the perceived lower bound for policy rates. The responsiveness of the economy to private sector interest rates remained remarkably stable in our sample. However, it must also be noted that the overall effectiveness fell for two key reasons. First, the “bang for the buck” of central bank balance sheet stimulus declined over time. Larger and larger programmes were necessary to achieve a given change in sovereign yields. Second, the “natural” rate tended to decline with (unexpected) expansionary unconventional monetary policies. This suggests that monetary policy decisions have influenced the perceived “natural” rate, contrary to what is implied by the conventional wisdom. This correlation may also help to explain why monetary policy appears to have had been less stimulative than expected in the past decade, and may indicate that monetary policy could prove to be more stimulative than expected during the normalisation with no change in the conventional wisdom.

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.

China implements Basel Committee framework for controlling large exposures, curtailing bank risk

From Moody’s.

Last Friday, the China Banking Regulatory Commission published for public comment a draft regulation of commercial banks’ large exposure management in accordance with the Basel Committee on Banking Supervision’s framework. The draft regulation is credit positive for banks because it will quantifiably curtail the shadow-banking practice of investing in structured products without risk-managing the underlying exposures and will limit the concentration risk in traditional non-structured loan portfolios.

For the first time, regulators are introducing binding and quantifiable metrics to implement the look-through approach when measuring credit exposures of investments in structured products, as emphasized in a series of recent steps to tighten shadow banking activities.  A bank must aggregate unidentified counterparty risk in a structured investment’s underlying assets as if the credit exposures relate to a single counterparty (i.e., the unknown client) and reduce that aggregate exposure to below 15% of the bank’s Tier 1 capital by the end of 2018. Any investment in structured products above the capped amount must identify counterparty risks associated with underlying assets so that investing banks can manage the risks accordingly.

The draft regulation’s measure of the unknown client limit will discipline banks’ implementation of the look-through approach to their investment portfolio to address opaque bank investment categories such as “investment in loans and receivables” that have been originated by other financial institutions. For the 16 listed banks that we rate, which account for more than 70% of the country’s commercial banking-sector assets, total investment in loans and receivables was slightly more than 100% of Tier 1 capital as of 30 June 2017. This implies a forced look-through approach will be applied to more than 85% of this segment of banks’ investment portfolios (see exhibit).

For the concentration risk in traditional non-structured loan portfolios, the draft regulation reiterates the current rule limiting a bank’s loans to a single customer to 10% of the bank’s Tier 1 capital, and extends the limit to include non-loan credit exposure to a single customer at 15% of Tier 1 capital. For a group of connected customers, either through corporate governance or through economic dependence, the draft regulation caps a bank’s total credit exposure at 20% of Tier 1 capital.

For a group of connected financial-institution counterparties, the draft regulation caps a bank’s total credit exposure at 100% of Tier 1 capital by 30 June 2019 and steadily lowers the cap to 25% by the end of 2021. In the case of credit exposures between global systemically important banks (G-SIBs), the cap is 15% of Tier 1 capital within a year of the bank’s designation as a G-SIB.

Macroeconomic Blindspot and Zombie Firms

Interesting Panel remarks by Claudio Borio Head of the BIS Monetary and Economic Department, who argues that a core assumption implicit in policy setting is that macroeconomics can treat the economy as if it produced a single good through a single firm. The net effect of this assumption is to drag down interest rates and productivity.

The truth is much more complex, and within the economy there are “zombie firms”where resources are effectively misallocated, leading to reduced productivity and lower than expected economic outcomes, which will cast a long shadow through the economic cycle.

In my remarks today, I would like to suggest that the link between resource misallocations and macroeconomic outcomes may well be tighter than we think. Ignoring it points to a kind of blind spot in today’s macroeconomics.

It would thus be desirable to bridge the gap, investigate the nexus further and explore its policy implications. Today’s conference is a welcome sign that the intellectual mood may be changing.

As an illustration, I will address this question from one specific angle: the role of finance in macroeconomics. As we now know, the Great Financial Crisis (GFC) has put paid to the notion that finance is simply a veil of no consequence for the macroeconomy – another firmly and widely held notion that has proved inadequate. I will first suggest, based on some recent empirical work, that the resource misallocations induced by large financial expansions and contractions (financial cycles) can cause material and long-lasting damage to productivity growth. I will then raise questions about the possible link between interest rates, resource misallocations and  productivity. Here I will highlight the interaction between interest rates and the financial cycle and will also present some intriguing empirical regularities between the growing incidence of “zombie” firms in an economy and declining interest rates. I will finally draw some implications for further analysis and policy.

Their research shows first, credit booms tend to undermine productivity growth as they occur and second, the subsequent impact of the labour reallocations that occur during a financial boom is much larger if a banking crisis follows.

For a typical credit boom, a loss of just over a quarter of a percentage point per year is a kind of lower bound (Graph 1, lefthand column). The key mechanism is the credit boom’s impact on labour shifts towards lower productivity growth sectors, notably a temporarily bloated construction sector. That is, there is an economically and statistically significant relationship between credit expansion and the allocation component of productivity growth (compare the left-hand panel with the right-hand panel of Graph 2). This mechanism accounts for slightly less than two thirds of the overall impact on productivity growth (Graph 1, left-hand column, blue portion).

Second, the subsequent impact of the labour reallocations that occur during a financial boom is much larger if a banking crisis follows. The average loss per year in the five years after a crisis is more than twice that during the boom, around half a percentage point per year (Graph 1, right-hand column). Indeed, as shown in the simulation presented in Graph 3, the impact of productivity growth in that case is very long-lasting. The reallocations cast a long shadow.

Let me conclude by highlighting the key takeaways of my remarks for analytics and policy.

I believe we need to go beyond the stark distinction between resource allocation and aggregate macroeconomic outcomes often implicit in current analysis and debates – a kind of blind spot in today’s macroeconomics. There is a lot to be learned from studying their interaction as opposed to stressing their independence. I have illustrated this with a focus on the long-neglected link between finance and macroeconomic fluctuations. The financial cycle can cause first-order and long-lasting damage to productivity growth through its impact on resource misallocations. And we need to understand much better also the possible link between interest rates and such misallocations.

Policy, too, needs to be much better aware of these interactions. Some lessons are well understood, if not always put into practice. For instance, one such example is the need to tackle balance sheet repair head-on following a banking crisis so as to lay the basis for a strong and sustainable recovery. Such a strategy is also important to relieve pressure on monetary policy. Doing so, however, has proved quite difficult in some jurisdictions following the GFC . Other aspects need to be better incorporated into policy considerations. The impact of persistently low rates is one of them. How well all of this is done may well hold one of the keys to the resolution of the current policy challenges.

Why Are Interest Rates So Low? – Blame Central Banks

Current statements from central bankers around the world argue that current low real interest rates reflect a change in the “neutral” rate, and is linked to demographic shifts, investment patterns and globalisation.  In other words, monetary policy is NOT to blame – they are simply reacting.

However, an interesting (and complex) working paper Why so low for so long? A long-term view of real interest rates?  from the Bank for International Settlement raises serious questions about the assumption which Central Banks are working with. In fact, their analysis suggests that monetary policy is the cause of the low rates, not a reaction to them and this has long range impact. This turns current thinking on its head. Central Bankers policy have driven rates lower!

Global real (inflation-adjusted) interest rates, short and long, have been on a downward trend throughout much of the past 30 years and have remained exceptionally low since the Great Financial Crisis (GFC). This has triggered a debate about the reasons for the decline. Invariably, the presumption is that the evolution of real interest rates reflects changes in underlying saving-investment determinants. These are seen to govern variations in some notional “equilibrium” or natural real rate, defined as the real interest rate that would prevail when actual output equals potential output, towards which market rates gravitate.

Prevailing explanations of the decline in real interest rates since the early 1980s are premised on the notion that real interest rates are driven by variations in desired saving and investment.

But based on data stretching back to 1870 for 19 countries, our systematic analysis casts doubt on this view. The link between real interest rates and saving-investment determinants appears tenuous. While it is possible to find some relationships consistent with the theory in some periods, particularly over the last 30 years, they do not survive over the extended sample. This holds both at the national and global level. By contrast, we find evidence that persistent shifts in real interest rates coincide with changes in monetary regimes. Moreover, external influences on countries’ real interest rates appear to reflect idiosyncratic variations in interest rates of countries that dominate global monetary and financial conditions rather than common movements in global saving and investment. All this points to an underrated role of monetary policy in determining real interest rates over long horizons.

Overall, our results raise questions about the prevailing paradigm of real interest rate determination. The saving-investment framework may not serve as a reliable guide for understanding real interest rate developments. And inflation may not be a sufficiently reliable signal of where real interest rates are relative to some unobserved natural level. Monetary policy, and financial factors more generally, may have an important bearing on persistent movements in real interest rates.

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.





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.