Are US Rates Going Higher?

The 10-Year US Bond yield is moving higher.  This is important because it has a knock-on effect in the capital markets and so Australian Bank funding costs, potentially putting upward pressure on mortgage rates.

Whilst the US Mortgage rates were only moderately higher today, the move was enough to officially bring them to the highest levels since the (Northern) Spring of 2017.

So this piece from Moody’s is interesting.  Is the markets view that rates won’t go higher credible?

Earnings-sensitive securities have thrived thus far in 2018. Not only was the market value of U.S. common stock recently up by 4.5% since year-end 2017, but a composite high-yield bond spread narrowed by 23 basis points to 336 bp. The latter brings attention to how the accompanying composite speculative-grade bond yield fell from year-end 2017’s 5.82% to a recent 5.72% despite the 5-year Treasury yield’s increase from 2.21% to 2.39%, respectively.

Thus, the latest climb by the 10-year Treasury yield from year-end 2017’s 2.41% to a recent 2.62% is largely in response to the upwardly revised outlook for real returns that are implicit to the equity rally and the drop by the speculative-grade bond yield. The 10-year Treasury yield is likely to continue to trend higher until equity prices stagnate, the high-yield bond spread widens, interest-sensitive spending softens, and the industrial metals price index establishes a recurring slide. In view of how the PHLX index of housing sector share prices has risen by 4.5% thus far in 2018, investors sense that home sales will grow despite the forthcoming rise by mortgage yields.

Moreover, increased confidence in the timely servicing of home mortgage debt has narrowed the gap between the 30-year mortgage yield and its 10-year Treasury yield benchmark from the 172 bp of a year earlier to a recent 152 bp. The latter is the narrowest such difference since the 150 bp of January 2014, which roughly coincided with a peaking of the 10-year Treasury yield amid 2013-2014’s taper tantrum.

Do suppliers of credit to the high-yield bond market and mortgage market correctly sense an impending top for benchmark Treasury yields? If they are wrong and the 10-year Treasury yield quickly climbs above its 2.71% average of the six-months-ended March 2014, they will regret having acquiesced to the atypically thin spreads of mid-January 2018.

The UK’s “Open Banking” Initiative Went Live Last Saturday

Open Banking, where customers can elect to share their banking transaction information with third parties went live in the UK.

This initiative is designed to lift completion across financial services, and of course in Australia, there are early moves in this direction, though the shape of those here are not yet clear. An issues paper from August 2017 outlines the questions being considered by the Australian Review into Open Banking.

What data should be shared, and between whom?

How should data be shared?

How to ensure shared data is kept secure and privacy is respected?

What regulatory framework is needed to give effect to and administer the regime?

Implementation – timelines, roadmap, costs


The report was due to report end 2017.  So the UK experience is useful.

In essence, consumers (if they choose to) are able to give access to the data on their bank accounts to selected third parties, which allows them potentially to offer new and differentiated banking and financial services products.  In practice, whilst some firms rely on simple (and risky) “screen scraping” the idea is that banks will provide a standard application programme interface (API) to allow selected third parties to access agreed data.  Screen scraping is based on sharing the standard internet banking password and credentials, whilst API’s are more selective, using special passwords, which can time-limit access. This is more secure.

In addition, customers give access by logging on to their bank account, and establishing the data share from there, so again is more secure. Also, in the UK, firms wanting to access the data must be registered, and will be listed on an FCA directory. This is to avoid fraud. In addition, there is some protection for consumers if validly shared credential are misused, unlike the current state of play, where if banking passwords are shared, banks may avoid liability.

It is too soon to know whether this is truly a banking revolution, or something more incremental, but in the light of the emerging Fintech wave, we think the opportunities could be large, and the impact disruptive.

For example, Moody’s says the UK’s Open Banking initiative is credit positive for consumer securitisations.

By directly accessing current accounts, the lenders will gain valuable data about its customers’ disposable income and spending patterns. This data will complement the less detailed data that credit reference agencies provide and will result in stronger underwriting and better risk-adjusted returns when prudently applied.

The improved access to information also will benefit the debt collection process. Data on disposable income provides a realistic picture of a consumer’s debt repayment patterns. A clearer picture of consumers’ repayment patterns increases the probability of successful debt collection while ensuring compliance with the UK’s Financial Conduct Authority’s guidelines on fair treatment of customers.

Of the approximately £32 billion of UK consumer securitisations that we publicly rated in 2017, around half were backed by pools solely originated by non-banks. The exhibit below shows that auto and consumer pools, which will benefit most from improved underwriting, are almost entirely originated by non-banks lenders. We include auto-captive bank lenders in the non-bank category since they do not have a material current account presence.

The nine banks with the largest current accounts market share in the UK that will be obliged to share their data are Allied Irish Banks, Bank of Ireland (UK), Barclays Bank , Danske Bank, HSBC Bank, Lloyds Bank, Nationwide Building Society, The Royal Bank of Scotland and Santander UK plc. Four of the nine banks have been granted an extension of six weeks and the Bank of Ireland has until September to meet the technical requirements.

There is an initial six weeks trial during which only bank staff and third parties will be able to test new services.

Moody’s also notes that “the Open Banking requirements coincide with the European Union’s (EU) Second Payment Services Directive (PSD2), which requires all payment account providers across the EU to provide third-party access. For as long as the UK remains part of the EU, it will need to comply with the EU’s legal framework. However, the regulatory technical standards on customer authentication and secure communication under PSD2 have yet to be agreed, meaning that full data sharing under PSD2 likely will be applied no earlier than third-quarter 2019”.

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.

Will APRA Loosen Lending Standards Next Year?

Interesting economic summary from Moody’s. They recognise the problem with household finances, and low income growth. They also suggest, mirroring the Reserve Bank NZ, that macroprudential policy might be loosened a little next year.

I have to say, given credit for housing is still running at three times income growth, and at very high debt levels, we are not convinced! I find it weird that there is a fixation among many on home price movements, yet the concentration and level of household debt (and the implications for the economy should rates rise), plays second fiddle.

Also, the NZ measures were significantly tighter, and the recent loosening only slight (and in the face of significant political measures introduced to tame the housing market). So we think lending controls should be tighter still in 2018.

It’s strange examining third quarter data when the fourth stanza has almost passed, but the Australian Bureau of Statistics isn’t known for timely national accounts data. Australia is the last major Asia-Pacific economy to release quarterly GDP numbers. Despite the tardiness, the national accounts gives valuable insight, especially on the investment front in the absence of a reliable monthly gauge.

Australia’s GDP growth hit 0.6% q/q in the September quarter following an upwardly revised 0.9% (previously reported as 0.8%) gain in the June stanza. Annual growth accelerated to 2.8% from the prior 1.8% gain. The annual growth figure is now hovering at potential, which we estimate is around 3%. However, momentum is overstated, given low base effects. In the September quarter of 2016, the Australian economy contracted by 0.5% q/q, only the fourth quarterly contraction in 25 years. This was driven by a sharp fall in investment alongside higher imports. During this period, annual growth slowed by 1.3 percentage point to 1.8%.

Private investment booms

Private investment was a bright spot in the third quarter because of a sharp rise in non-dwelling construction, which made the largest contribution to GDP growth at 0.9 percentage point.

Non-dwelling construction has often become a proxy for mining investment, and the third quarter gain is likely due to the installation of two liquefied natural gas platforms in Western Australia and the Northern Territory. LNG exports are expected to pick up late in the fourth quarter amid increased production capacity. The Wheatstone project began production earlier in October after a two-year construction phrase and
shipped its first export to Japan late in the month. Wheatstone is the sixth of eight projects included in a A$200 billion LNG construction boom that is now in its final stretch. Once the remaining two projects are finalized, Australia could topple Qatar as the world’s biggest LNG exporter. Australia has recently become the world’s second largest exporter of LNG.

Public investment didn’t score as well in the third quarter, declining by 7.5% q/q. This is mainly payback after a boost in the June quarter from the acquisition of the Royal Adelaide Hospital from the private sector.

The housing market has cooled in 2017, and price growth is expected to keep decelerating through 2018; this will keep downward pressure on dwelling investment. For instance, dwelling price growth in Sydney was 5% y/y in November, well down from its double-digit growth in 2016 and earlier in 2017.

This is the result of the lagged impact of earlier macroprudential action that has included higher borrowing costs for homebuyers, especially investors or those taking out interest-only loans. The Australian Prudential Regulation Authority has also imposed limits on bank portfolio exposure to new mortgages.

Owner-occupied housing finance commitments tend to track house price growth and are a good gauge of the underlying pulse. Data released this week show October commitments rose just 0.3% m/m on a trend basis. Growth has slowed substantially from earlier in 2017.

An interesting tidbit we have observed in recent years: Housing regulation in New Zealand tends to lead Australia’s by at least a year. The Reserve Bank of New Zealand was on the front foot trying to cool certain heated housing pockets such as Auckland well before the Australian Prudential Regulation
Authority introduced housing-targeted measures, even though both economies were experiencing strong price growth in some areas. Just recently, the RBNZ announced it had eased some macroprudential measures in light of softer house price growth. Now that Australia’s housing market has cooled, APRA may follow suit with minor reversals in the next year.

Households missing in action

At first glance it was a relief that consumption made a positive contribution to GDP growth, but the details were less pleasing, as spending was concentrated on essential items while discretionary purchases suffered. We calculated that nondiscretionary items rose an average 0.6% over the quarter, and discretionary spending fell by 0.7%.

Of the nondiscretionary items, utility spending rose 1.4% q/q, food was up 1%, rent gained 0.6%, and insurance and financial services grew 1.3%. On the discretionary front, clothing spending fell 1% q/q, recreation and culture was down 0.6%, and spending at cafes and restaurants fell by 0.9%.

All told, softness in the consumer sector was largely masked by spending on nondiscretionary items. The monthly retail trade data do not capture nondiscretionary spending as thoroughly as the national accounts; over the third quarter retail volumes were up just 0.1% q/q.

We know from earlier testing that consumer sentiment does not have a causal relationship with retail spending, but incomes do. Sentiment is a symptom of weak income growth, rather than a forward indicator of spending behaviour. The Westpac consumer sentiment index fell to 99.7 in November, below the neutral 100 that indicates optimists equal pessimists. Overall, consumers have been downbeat through most of 2017, concerned about family finances and the economic outlook. At 2% y/y, income growth is hovering near a record low, so it’s little surprise households have pulled
back on discretionary purchases, while other costs such as utilities rose in the third quarter because of seasonal price hikes. The net household saving ratio rose to 3.2% in the third quarter, higher than the decade low of 3% in the June quarter, suggesting that consumers aren’t willing to keep dipping into their savings to fund discretionary purchases. It’s concerning that household consumption is weak, given that it constitutes 75% of GDP.

Businesses are faring better than consumers at the moment. This is reflected in soaring private investment, lofty gains in company profits, and strong employment growth, particularly full-time, through 2017. Unfortunately, this has not yet flowed through to stronger income growth, and there are likely several factors at play. The first is cyclical: Low productivity is mooted as a reason for benign wages in the developed world. More Australia-specific is that underemployment has been very high in
Australia and the correlation with income growth is around -0.88. Underemployment has started to edge lower as full-time positions outpace part-time, and our baseline scenario is for the tighter labour market to yield stronger income growth by mid-2018. Although Australia’s Phillips curve has flattened in the past decade, there is still a reasonable relationship between unemployment and income growth.

Some structural factors: The rise of the gig economy has contributed to the rise in casual employment. These positions are more flexible and more easily adapt to changing demand, but there’s no union representation, which can hurt wage bargaining. Also, as the positions are more flexible, there’s more acceptance that lower wages can be a consequence.

Another structural reason for low incomes could be the higher prevalence of offshoring roles. There’s no reliable industry- or economy-wide data measuring the extent of offshoring, but we know that it is an unrelenting phenomenon, given the disparity in operating costs between Australia and the developed world. Employers are not locally replacing jobs lost offshore, so they are not potentially driving up labour costs to secure the appropriate candidate.

All told, these structural factors suggest that national income growth is unlikely to enjoy a significant rebound but rather gradual and modest improvement in 2018.

How’s the fourth quarter tracking?

Our high-frequency GDP tracker suggests a 2.7% y/y expansion in the December quarter following the barrage of October activity data this week. Retail trade came in at a strong 0.5% m/m, although this was payback for sustained weakness through the third quarter, when retail turnover fell an average 0.3% m/m.

October foreign trade data weren’t inspiring, as merchandise exports fell by 2% m/m amid lower iron ore prices and, to a lesser extent, volumes. The iron ore spot price increased by 22% from its late-October slump to US$71.51 per metric tonne in early December. We expect this will enable iron ore export receipts to improve heading into 2018 as higher global prices are incorporated into contracts; usually the lag is short. It’s too early to determine whether volumes will be adversely affected by higher prices.

We maintain our view that monetary tightening is firmly off the table for at least another year as the central bank sits on the sidelines waiting for consumption to show meaningful signs of a pickup. Our expectation is that the Australian dollar will depreciate around an additional 3% against the U.S. dollar over the next six months, serving to encourage more  consumption onshore and lift export competitiveness and helping core inflation return to and creep through the central bank’s 2% to 3%
target range.

Mortgage arrears to increase in 2018: Moody’s

According to Moody’s “RMBS, ABS and covered bonds – Australia, 2018 outlook – Delinquencies will increase moderately from low levels, report”, delinquencies underlying Australian residential mortgage-backed securities (RMBS) are expected to “moderately” increase in 2018 from their current low levels.

The housing market is expected to ease, and household finances remain under pressure.

Of note is the rise in the relative share of non-bank lending (who are not under the same regulatory control as the banks) and the continued impact from the mining downturn, especially in WA.

We expect mortgage delinquencies in outstanding RMBS deals  to increase moderately from their low levels because of the continued after-effects of weaker conditions in states reliant on the mining industry and less favourable housing market and income dynamics.

With Western Australia and other states reliant on mining pushing up delinquencies this year, this will continue in 2018,

The balance of risks in new RMBS deals will also change, as bank-sponsored RMBS issued in 2018 will include a lower proportion of interest-only, high loan-to-value ratio (LVR) and housing investment loans, following regulatory measures to curb the origination of riskier mortgages.

RMBS issued by the non-banks will include a greater percentage of interest-only and investment loans than has been recorded in the past as these lenders have fallen outside of APRA’s regulatory remit thus far.

China’s Tightens Regulation of Internet-based Consumer Finance

Last Friday, the People’s Bank of China and China Banking Regulatory Commission issued a regulation to rectify excesses in internet-based consumer finance says Moody’s.

The regulation is credit positive for banks because it will help prevent a rapid increase in consumer leverage, strengthen banks’ risk management and limit disorderly competition. Exhibit 1 shows that outstanding internet-based person-to-person (P2P) loans were RMB1.2 trillion ($181.8 billion) at November 2017, 13.4x the amount three years earlier and far outstripping the growth of traditional micro-credit companies (MCCs).


With immediate effect, the regulation stops any unlicensed firms or individuals from making loans. The regulation also temporarily bans internet-based platform companies from making general-purpose unsecured consumer loans and permanently bans loans to finance down payments of housing purchases and loans for purchases of stocks and futures. The permanent ban on affected loans is in line with the authorities’ policy priority of deleveraging the financial system and the real economy.

The regulation curtails funding available to all MCCs, either online platforms or offline traditional entities. MCCs can no longer sell their loans through internet-based or local trading platforms and MCCs must consolidate on their balance sheets loans that have been sold or securitized.

P2P platform companies are particularly prone to liquidity and solvency stresses, as shown in Exhibit 2. The improved risk management of MCCs will help improve the asset quality of banks that lend to MCCs, which would reduce the systemic transmission of risks. The regulation prohibits banks from investing either their on-balance-sheet funds or off-balance-sheet wealth-management products in structured products with underlying assets sourced from the affected loans.

In addition, the regulation prohibits banks’ outsourcing of credit underwriting and risk management functions to internet-based credit service platforms. Banks must validate consumer credit information against centralized databases maintained by the People’s Bank of China and National Internet Finance Association of China. This will discipline banks to strengthen their internal process of managing the use of consumer credit information in originating consumer loans.

Larger banks are likely to benefit most because their brand recognition is more attractive to customers as the regulation reforms the sector. For the 16 listed banks, which account for more than 70% of the country’s commercial banking-sector assets, new retail loans were 54.3% of the increase of the total loan balance in the first half of 2017.


UK’s reduction of stamp duty for first-time homebuyers will benefit RMBS

From Moody’s

On 22 November, the UK government announced a number of measures in its Autumn Budget, including a stamp duty reduction that will benefit 95% of first-time homebuyers, with a maximum saving of £5,000 per buyer. For purchases completed on or after 22 November 2017, first-time buyers do not have to pay stamp duty on properties worth up to £300,000, while for properties worth up to £500,000 they pay £5,000 less. The stamp duty for purchases above £500,000 is unchanged. Such measures will be credit positive for residential mortgage-backed securities (RMBS), allowing first-time buyers to amass the down payment they need to take out a loan faster or allow them to borrow a larger amount, strengthening both housing demand and property prices and lowering market-implied loan-to-value ratios on existing loans.

The stamp duty reduction will help alleviate some of the financial burden on first-time buyers amid stagnant wage growth, proportionally more household cost expenditures, and rising rents (rental price inflation in the UK has slowed recently, but was up 0.9% in October 2017 versus a year ago, according to HomeLet). Nevertheless, first-time buyers, especially in London and surrounding counties, still face relatively high equity layouts compared with other regions. Our recent RMBS pool analysis also showed that compared with non-first-time buyers, first-time buyers start with up to 15% less equity in the property (see exhibit).

The budget also confirmed additional funding under the help-to-buy equity loan scheme, another credit positive because it increases the availability of loans for borrowers, while supporting house prices, which overall we expect will remain flat in 2018. Under the scheme, borrowers can purchase a newly built property with just a 5% deposit. Since its launch, borrowers have purchased 120,864 properties, with 81% of the sales attributable to first-time buyers. In 2017, Halifax Ltd. estimated that first-time buyers accounted for almost half of all mortgage-financed house purchases, an important driver of housing demand.

China to tighten regulations on financial firms’ shareholding

From Moodys

On 16 November, the China Banking Regulatory Commission published for public comment a draft regulation on commercial banks’ shareholding. The draft regulation raises the bar for investor qualification, demands the long-term commitment of significant shareholders’ (those owning a 5% or greater stake) investment, and requires annual disclosures of significant shareholders and related parties. The proposed regulation is credit positive for China’s financial firms because it will limit the systemic transmission of financial risks, improve the quality of the firms’ capital and strengthen their corporate governance.

The draft regulation will serve as a benchmark for regulating non-bank financial institutions including rural credit cooperatives, trust companies, financial leasing companies, automobile and consumer finance companies, and financial asset management companies, which are a type of specialist firm that works out nonperforming financial assets. More stringent investor qualifications include a ban on leveraged acquisition of shares, in line with the authorities’ policy priority of deleveraging the financial system and the real economy. In addition, the draft regulation will limit system interconnectedness by restricting any investor from becoming a significant shareholder of more than two banks or a majority shareholder of more than one bank.

The draft regulation also raises the entry barrier for significant shareholders by setting up a prior-approval process to screen out investors that have overdue bank debts or outstanding court judgments against defaults. Investment pools such as funds, insurance asset-management plans or trust plans cannot own more than 5% of a bank if they are ultimately controlled by a single entity. The higher barrier will diversify the investor base for banks and reduce system interconnectedness. The tighter ownership rules are particularly relevant for rural commercial lenders, which are transforming themselves to commercial banks from mutual institutions of credit cooperatives (see Exhibit 1).

In the banking regulator’s view, there is abundant capital to invest in bank shares, attracted by the sector’s higher profitability. As Exhibit 2 shows, rural commercial banks have had profitability and capital metrics second only to China’s big five banks.


Securing quality capital will improve banks’ creditworthiness. The draft regulation will improve the quality of capital that banks receive from significant shareholders by annually certifying a shareholder’s ability to inject capital into investee firms in times of need. The draft regulation also requires a five-year lockup period of significant shareholders’ investment to protect banks’ ability to create long-term value.

Additionally, the draft regulation tightens the enforcement of existing rules on connected-party transactions by expanding the scope of the rule. Emphasizing a “see-through” principle to improve disclosure on the ultimate beneficiaries of shareholding, the draft regulation specifies connected parties include investors’ controlling shareholder, actual controlling entity, affiliated entities, entities acting in concert and ultimate beneficiaries.

Inclusion of IFRS 9 accounting will toughen EBA’s 2018 banking stress test

Moody’s says on 17 November, the European Banking Authority (EBA) set out its draft methodology for a new round of stress tests that the European Union’s 49 biggest banks must undergo next year. The inclusion of IFRS 9 will lower Tier 1 equity, under stress by an estimated 50-60 basis point.

Similar to the 2016 stress tests, the 2018 exercise will examine banks’ resilience to both base-case and stressed-case scenarios over a three-year horizon, based on a common methodology and prescribed macro-economic scenario parameters. The EBA test will again abstain from setting a minimum capital threshold below which a bank would fail, as in 2014. However, even without set hurdles, the market will benchmark the adverse scenario results, expressed in stressed capital ratios, against banks’ minimum capital requirements, and thereby single out the weaker performers.

The first-time inclusion of International Financial Reporting Standard 9 (IFRS 9), a new accounting rule that takes effect 1 January 2018, will make next year’s stress test tougher than the last one and will likely translate into greater provisioning needs and therefore lower common equity Tier 1 ratios in the prescribed stress-case scenario. The new rules demand that banks set aside higher loan-loss provisions further in advance of default, which is credit positive for banks. While we expect that the initial effect of IFRS 9 will be limited, and therefore digestible for most EU banks, risk provisioning requirements under simulated stressed market conditions will likely be greater using the IFRS 9 rules. However, the size of provisioning will also strongly depend on the macroeconomic scenario assumptions that have yet to be published.

Our expectation of a limited initial effect of IFRS 9 is based on our projection of a 50-60 basis point decline in the ratio of common equity Tier 1 to risk-weighted assets for many European banks. However, we also expect that the initial effect will vary across regions. When additionally taking into account varying stating-point capital levels, capital ratios of banking systems starting from a weak position, including Italy and Portugal, are more at risk of stressed capital ratios falling closer to (or even below) the applicable minimum requirements (see Exhibit 1).

In the EBA’s 2018 stress test, the initial effect on capital ratios will likely be amplified when simulating stressed economic conditions. Europe’s weaker banking systems with relatively large but still performing portfolios that have deteriorated over time will experience greater capital effects under the new rules than banks that benefitted from systemwide asset quality improvements amid benign credit conditions in recent years. Such quality improvements have resulted in low nonperforming exposures in a number or European countries, including France, Germany and the UK (see Exhibit 2).

The objective of the 2018 stress test is to assess the resilience of EU banks and banking systems to shocks. The results will inform the supervisory review and evaluation process, the European Central Bank’s annual in-depth evaluation of each bank’s risk exposure. This evaluation forms the basis of the regulators’ decisions on bank-specific minimum capital requirements for the subsequent year

Australia’s decision to allow Mutuals to issue capital instruments is credit positive

According to Moody’s, last Wednesday’s  Australian government announcement that it would accept all 11 recommendations of the so-called Hammond Review on regulatory and legislative reforms to improve access to capital for co-operative and mutual enterprises, is credit positive for these entities because it provides an alternative to building capital with retained earnings. In particular in the banking sector, the allowance also shows that the government regards mutual authorized deposit-taking institutions (mutual ADIs) as integral to healthy competition in Australia’s banking system.

Mutual ADIs will be able to build capital in case of need by issuing capital instruments as opposed to relying solely on retained earnings to do so. In theory, the ability to issue capital instruments could facilitate a significant increase in mutual ADI loan growth: we estimate that mutual ADIs could raise up to AUD 1.2 billion through the mutual equity interest framework, supporting AUD 24 billion (or 21%) growth in loans.

Our estimate is based on mutual ADIs’ capital as of 30 June 2017, applying a 15% cap on the inclusion of capital instruments in common equity Tier 1 (CET1) capital, and a current CET1 ratio of around 14%. However, we do not expect such strong CET1 issuance because the mutual ADI sector is already strongly capitalized relative to the broader Australian banking sector.

Yet, some mutual ADIs with smaller capital buffers may issue capital instruments to support housing loan growth. Australia’s larger banks have moderated their residential mortgage lending as a result of macro-prudential measures to slow house price growth and steadily increasing capital requirements for banks that utilize the internal rating-based model for determining risk-weighted assets.

Since capital instruments issued by mutual ADIs would be equivalent to ordinary shares, and require dividend payments, some in the market are concerned that they will affect the traditional mutual business model.

Accordingly, the Australian Prudential Regulatory Authority (APRA) has proposed a 15% cap on the inclusion of such instruments in CET1 capital, and a cap on the distribution of profits to investors at 50% of a mutual ADI’s annual net profit after tax. These caps ensure that mutual ADIs continue to prioritize the interests of their existing members and are not incentivized to unduly increase their risk profile to boost returns to their new equity holders.

The government’s actions last week follow the July 2017 “Report on Reforms for Cooperatives, Mutuals and Member-owned Firms,” led by independent facilitator Greg Hammond. The government’s decision also follows a July 2017 proposal by APRA to allow mutual ADI to issue directly CET1-eligible capital instruments through a mutual equity interest framework.