The RBA On Least Cost Routing

The RBA’s Tony Richards, Head of Payments Policy spoke at the Australian Payment Summit 2017 and discussed the vexed issue of Least Cost Routing for EFTPOS transactions, especially when using Tap-and-Go. Until very recently, acquirers have indicated reluctance to provide least-cost routing to their merchant customers. This is partly due to the expected systems work, including to reprogram terminals.  But pressure is mounting, as for example, the recent House of Reps report.

He says indications are that all four of the major banks are moving to providing least-cost routing if requested by merchants, though in some cases they have indicated this could occur on a fairly extended timetable.

So, merchants, do yourself a favour, and ask! You may save on your transaction costs!

Given that payment costs are a significant item for merchants, it is not surprising that merchants pay attention to them. Just as merchants are keen to hold down other business costs, they are also keen to hold down their payment costs. Recently, they have drawn attention to a particular issue that is driving up their cost of payments.

The majority of debit cards issued in Australia are now dual-network cards, which means that authorisation of cardholders’ debit transactions can occur through different networks – the domestic eftpos network or the debit networks of the international MasterCard or Visa schemes. If you look at your debit or ATM card, there is a good chance it will have an international scheme logo on one side and the eftpos logo on the other.

Traditionally, cardholders have determined how their debit transactions are processed, by pressing either the CHQ or SAV buttons for eftpos or the CR button for the international network, before entering their PIN. However, with the shift to contactless or ‘tap-and-go’ transactions, the processing of debit transactions has been shifting to the international networks. This initially reflected the fact that contactless payments were only available for the international schemes. Most cards and terminals are now also activated for eftpos contactless functionality. However, when card-issuing banks send out dual-network debit cards they are programmed with the international scheme as the first-priority network for contactless use and the eftpos network as second priority.

Most cardholders are indifferent about which network processes their contactless transactions. Both networks can link to the same debit account and cardholders do not directly bear the costs of the transactions. Moreover, there are typically no rewards programs associated with debit transactions, and customers receive similar protections from fraud and disputed transactions, based on the ePayments Code and the chargeback policies of the three schemes.

However, many merchants have a preference for transactions to be processed via the eftpos network, because it is typically less expensive for them. Accordingly, many merchants have been calling for their acquirer banks to provide them with ‘least-cost routing’, i.e., terminal functionality that sends contactless debit transactions via the lower-cost network. Terminals might be programmed to always send dual-network card transactions via a particular network or they might use dynamic rules which identify the lower-cost network for each transaction.

The Bank has had discussions with consumer organisations and staff from the Australian Competition and Consumer Commission (ACCC) as to how least-cost routing might be implemented. We consider that it would be desirable for a merchant implementing least-cost routing to disclose this to customers. Depending on how terminals were actually programmed, this could be by a sign that the merchant will typically send tap-and-go debit card transactions via a certain network, but noting that customers wishing to send transactions via a different network could insert or dip their cards and push the button or keypad for their preferred network. A sign such as this would provide consumers with the opportunity to override the merchant’s preferred network if they wished. Such a framework would seem to be a reasonable balance between the rights of merchants and consumers, and it is likely that consumers would quickly become used to the idea that their transactions could be sent via different networks at different merchants.

The Reserve Bank has taken an interest in dual-network card issues because of the Payments System Board’s mandate to promote competition and efficiency. As the Bank and other observers of the payments system have frequently noted, the nature of competition in the payment card market is often such that it tends to drive up costs to merchants, as schemes increase their interchange fees to persuade issuers to issue their cards. Merchants have typically had little ability to offset these pressures (in the absence of regulatory intervention to cap interchange fees or remove schemes’ no-surcharge rules). However, dual-network cards can potentially offset the pressures for payment costs to rise, because the merchant may be able to steer the consumer to use the lower-cost of the two networks on a card. Accordingly, the Bank has indicated that it supports the issue of such cards in Australia, because they are convenient for cardholders and allow stronger competition between networks at the point of sale, facilitating both consumer and merchant choice.

Some disputes over dual-network debit cards emerged between the debit schemes in 2012-13. However, after a series of discussions with the Bank, in August 2013 the three debit schemes made voluntary undertakings to the Bank that addressed some policy concerns. These included commitments:

  • to work constructively to allow issuers to include applications from two networks on the same card and chip, where issuers wished to do this;
  • not to prevent merchants from exercising choice in the networks they accept, in both the contact and contactless environments; and
  • not to prevent merchants from exercising their own transaction routing priorities when there are two contactless debit applications on one card.

As noted above, most terminals and eftpos cards are now enabled for tap-and-go eftpos transactions. Given the Bank’s views about the potential competition and efficiency benefits of dual-network cards, as well as the earlier commitments by the three debit schemes, the Bank has been liaising with a range of stakeholders over recent months to encourage the provision of least-cost routing functionality to merchants.

However, until very recently, acquirers have indicated reluctance to provide least-cost routing to their merchant customers. This is partly due to the expected systems work, including to reprogram terminals.

In addition, some merchants have expressed concern to the Bank that the international schemes might resist the implementation of least-cost routing. To the extent that transactions via the international schemes are currently more expensive to merchants, a possible outcome of least-cost routing becoming available would be for the international schemes to reduce scheme or interchange fees so that merchants have little incentive to send transactions via another network. However, some merchants are concerned about other possible responses, including that the international schemes might respond to a merchant’s decision to implement least-cost routing of debit transactions by increasing the interchange rates that apply to the merchant’s credit transactions. They have also noted that the international schemes might try to preclude least-cost routing by attempting to persuade issuers to stop issuing dual-network cards. The ACCC is aware of these concerns, and is closely monitoring the situation. With the passage of the Harper reforms, which came into effect in November this year, the ACCC now has even stronger powers to investigate and take action in relation to conduct by the international schemes that might hinder competitive conduct by a lower-cost provider.

The Payments System Board has discussed issues involving dual-network cards in recent meetings. At its 17 November meeting, the Board strongly supported calls from a range of stakeholders for acquirers to provide merchants with least-cost routing functionality for contactless transactions using dual-network debit cards. It requested the Bank staff to continue to engage with the payments industry on this issue, noting that ‘a prompt industry solution was preferable to regulation’.

More recently, the Review of the Four Major Banks by the House of Representatives Standing Committee on Economics has made the following recommendation:

“The committee recommends that banks be required to give merchants the ability to send tap-and-go payments from dual-network debit cards through the channel of their choice.

Merchants should be able to choose whether to route these transactions through eftpos or another channel, noting that consumers may override this merchant preference if they choose to do so.

If the banks have not facilitated this recommendation by 1 April 2018, the Payments System Board should take regulatory action to require this to occur.”

Recent indications are that all four of the major banks are moving to providing least-cost routing if requested by merchants, though in some cases they have indicated this could occur on a fairly extended timetable. We expect that some of the smaller acquirers may be able to move more quickly.

Accordingly, the Bank expects that by early in 2018 there will be concrete indications that a critical mass of acquirers are moving to provide least-cost routing and that the international schemes are not attempting to prevent this. However, if this expectation is not met, I expect that the Payments System Board will consider consulting on a regulatory solution that deals with all the relevant considerations. While of course the measures that could be consulted on will be determined by the Board, I can imagine that this could involve considering whether some or all of the following measures might be in the public interest:

  • a requirement that acquirers must provide merchants with least-cost routing functionality for contactless dual-network debit card transactions
  • a requirement for enhanced transparency in contractual pricing of acquiring services to merchants
  • requirements that schemes publish explicit criteria for any preferred or strategic interchange fees and that any such criteria may not be related to acceptance decisions relating to other payment systems
  • anti-avoidance provisions that ensure adherence to the spirit, as well as the letter, of any standard.

Why the RBA is unlikely to cut interest rates

From Business Insider.

Australia’s housing market is cooling after years of rollicking price growth.

Annual price growth has halved since May, auction clearance rates sit at multi-year lows in Sydney and Melbourne and investor housing credit is declining, coinciding with tougher restrictions on interest-only lending from APRA, Australia’s banking regulator, introduced in March.

The slowdown in the housing market, coming on top of weakness in Australia’s household sector seen in Australia’s recent GDP report, has got many people questioning whether the Reserve Bank of Australia (RBA) should hike interest rates given the current set of circumstances, especially with inflationary pressures close to non-existent.

Rather than hiking interest rates, some have even floated the idea that the RBA may consider cutting interest rates given the sharp deceleration in the housing market.

George Tharenou and Carlos Cacho, Economists at UBS, played devils advocate on that front earlier this month, pointing to the chart below to show that when house prices weakened by a similar amount in the past, it has almost always resulted in the RBA cutting official interest rates.

The pair note that national price growth on a six-month annualised basis is currently running at just 0.7%, an important consideration given that over the past 30 years “when house prices over a 6-month period weakened towards flat or negative, the RBA cut within a few months in 7 of 9 cycles”.

While that’s not UBS’ official call, forecasting instead that the RBA will hike rates in late 2018 with the risks slanted towards a later move, it does pose the question as to whether the current weakness in the housing market will see history repeat.

To ANZ Bank’s Australian economics team, led by David Plank, the answer to that question is almost certainly no.

 “There has been quite a lot of focus on the current downturn in house price inflation, with some commentators pointing out that similar downturns in the past have been followed by RBA rate cuts,” the bank says.

“While this might be true, it ignores the key differences between this cycle and previous downturns.

“In particular, previous downturns in house prices followed a succession of RBA rate increases, which pushed mortgage rates sharply higher. Given that RBA tightening cycles typically impact a lot more across the economy than just house prices, we think it is difficult to argue that the slowdown in house price inflation was the primary reason for eventual rate cuts.

“We think a rising unemployment rate was far more important,” it says.

One look at the charts below adds credence to that view.

The first looks at the relationship between annual house price growth and mortgage rates. The latter, shown in orange, has been inverted and advanced by six months.

As opposed to what has been seen previously when house prices tended to decline following a series of interest rate hikes, in recent times, price growth has slowed despite mortgage rates remaining near the lowest levels on record, coinciding with tighter macroprudential restrictions on investor and interest-only lending from APRA.

“The current downturn in house prices has not come after a tightening cycle. Instead we think the most likely cause was the tightening in credit, though with a lag and interrupted by the impact of RBA rate cuts in 2016,” ANZ says.

In comparison, this next chart shows the relationship between the annual change in Australia’s unemployment rate to movements in the cash rate.

While not perfect by any stretch, when unemployment starts to lift, the RBA tends to cut the cash rate, and vice versus.

Australia’s unemployment rate has recently fallen to 5.4%, leaving it at the lowest level in close to five years, going someway to explaining why ANZ is forecasting that the RBA will lift the cash rate to 2% by the end of next year despite the slowdown in the housing market.

“In our view, a [housing] cycle driven by credit is likely to play out very differently from one driven by higher interest rates,” it says.

“Expecting the current housing cycle to play out like those caused by movements in interest rates, strikes us as likely to end in disappointment.”

Indeed, outside of the recent price deceleration caused by credit rather than mortgage rates, ANZ points to a variety of other housing market indicators that suggest there’s little need for the RBA to cut rates.

“The most recent data on auction clearance rates suggest some stability after a period of decline. If this broadly continues then we would expect house annual price inflation to stabilise in the low-to-mid single digits in 2018,” it says.

“Our forecasts have nationwide house price inflation slowing to zero in 2018, but this also includes the impact of the two RBA rate hikes we expect in 2018. If these don’t take place then we would expect less of a slowdown in housing inflation, probably to the low-to-mid single digits mentioned above.”

ANZ says recent strength in Australian building approvals data, supporting the view that credit cycles play out differently from rate hike cycles, provides further evidence why RBA rate cuts are not required on this occasion.

“In late 2016, when approvals were falling sharply, there were a number of dire predictions about what that would mean for housing construction and employment. But it has been clear for some time that the downturn in building approvals was shallower than in previous cycles,” it says.

“We think this is because this cycle was not triggered by higher interest rates. Instead, we think a more likely cause was the tightening in credit that began in 2015.”

According to the ABS, Australian building approvals rose by 0.9% to 19,074 in seasonally adjusted terms in October, leaving the increase on a year earlier at 18.4%. Private sector approvals for houses and other dwellings stood at 10,063 and 8,683, up 6.2% and 37.6% respectively from 12 months earlier.

Given the absence of weakness in other areas of the housing market, differing it from periods in the past when interest rates were cut, it helps explain why ANZ and the vast majority of forecasters believe that the next move in the cash rate will be higher, albeit not for many months.

Yes, Finance For Small Business IS a Problem

Christopher Kent, RBA Assistant Governor (Financial Markets), spoke at the 30th Australasian Finance and Banking Conference on The Availability of Business Funding, a subject which was featured in the recent RBA Bulletin.

While his speech covered the gamut of business finance, his comments on small business are important. He acknowledged the need for, and difficulty of getting funding in this sector. Something we have highlighted in our SME Report series, and which are still available. Whilst alternative lenders (Fintechs for example) have a role to play, (and there is massive opportunity in the SME sector in our view), most SME’s still go to the banks, where they have to pay more, for poor products and service. Indeed, if you are a business owner seeking to borrow, without a property to secure against, the options are limited. This is because the banks’ view is, correctly, unsecured risks are higher than secured, and in any case, they prefer to lend to mortgage holders more generally, as the capital required to do so is lower. Therefore many SME’s are at a structural disadvantage, and often end up having to pay very higher interest rates, if they can get finance at all.

There is much to do, in my view, to address the funding needs of SMEs, and this is a critical requirement if we are to seen sustained real economic growth. As Kent suggests, perhaps Open Banking will assist, eventually!

The challenge of obtaining finance has been a consistent theme of the Small Business Finance Advisory Panel. In this context, it is important to distinguish between two types of small businesses. First, there are the many established small businesses that are not expanding. Their needs for external finance are typically modest. Second, there are small businesses that are in the start-up or expansion phase. They are not generating much in the way of internal funding. Accordingly, those businesses have a strong demand for external finance. I’ll focus my comments on the issues relevant to this second group of small businesses.

I should emphasise again that access to finance for small businesses is important because they generate employment, drive innovation and boost competition in markets. Indeed, small businesses in Australia employ almost 5 million people, which is nearly half of employment in the (non-financial) business sector. They also account for about one-third of the output of the business sector.

Compared with larger, more established firms, smaller, newer businesses find it difficult to obtain external finance since they are riskier on average and there is less information available to lenders and investors about their prospects. Lenders typically manage these risks by charging higher interest rates than for large business loans, by rejecting a greater proportion of small business credit applications or by providing credit on a relatively restricted basis.

The reduction in the risk appetite of lenders following the global financial crisis appears to have had a more significant and persistent effect on the cost of finance for small business than large business. After the crisis, the average spread of business lending rates to the cash rate widened dramatically. The increase was much larger and more persistent, though, for small business loans (Graph 9). In part, this increase owed to the larger increase in non-performing loans for small businesses than for large business lending portfolios (Graph 10). It’s not clear, however, whether the increase in interest rates being charged on small business loans relative to those charged on large business loans (over the past decade or so) reflects changes in the relative riskiness of the two types of loans.[11]

Graph 9
Graph 9: Interest Rate Spreads on Business Debt
Graph 10
Graph 10: Business Lending Default Probabilities

Over recent years, there has been strong competition for large business lending, which has resulted in a decline in the interest rate spread on large business loans. Part of the competition from banks for large business loans has been driven by an expansion in activity by foreign banks. Large businesses also have access to a wider array of funding sources than small businesses, including corporate bond markets and syndicated lending.

In contrast, competition has been less vigorous for small business lending. Indeed, some providers of small business finance were acquired by other banks or exited the market following the onset of the crisis. Also, the interest rates on small business loans have remained relatively high. This difference in competitive pressures is evident in the share of lending provided to small business by the major banks, which is relatively high at over 80 per cent. This compares with a share of around two-thirds in the case of large businesses. Small businesses continue to use loans from banks for most of their debt funding because it is often difficult and costly for them to raise funds directly from capital markets.

The RBA’s liaison has highlighted that if small business borrowers are able to provide housing as collateral, it significantly reduces the cost and increases the availability of debt finance. Lenders have indicated that at least three-quarters of their small business lending is collateralised and they only have a limited appetite for unsecured lending. However, there are a number of reasons why entrepreneurs find it difficult to provide sufficient collateral for business borrowing via home equity:

  • they may actually not own a home, or have much equity in their home if they are relatively young;
  • similarly, they may not have sufficient spare home equity if they’ve already borrowed against their home to establish a business and now want to expand their business;
  • and even if they have plenty of spare home equity, using their homes as collateral concentrates the risk they face in the event of the failure of the business.

Many entrepreneurs have limited options for providing alternative collateral, since banks are far more likely to accept physical assets (such as buildings or equipment), rather than ‘soft’ assets, such as software and intellectual property.

Given the higher risk associated with small businesses, particularly start-ups, equity financing would appear to be a viable alternative to traditional bank finance. However, small businesses often find it difficult to access equity financing beyond what is issued to the business by the founders. Small businesses have little access to listed equity markets, and while private equity financing is sometimes available, its supply to small businesses is limited in Australia, particularly when compared with the experience of other countries (Graph 11). Small businesses also report that the cost of equity financing is high, and they are often reluctant to sell equity to professional investors, since this usually involves relinquishing significant control over their business.

Graph 11
Graph 11: Venture Capital Funding

Innovations Improving Access to Business Finance

There are several innovations that could help to improve access to finance by: providing lenders with more information about the capacity of borrowers to service their debts, and connecting risk-seeking investors with start-up businesses that could offer high returns.

Comprehensive credit reporting

Comprehensive credit reporting will provide more information to lenders about the credit history of potential borrowers. The current standard only makes negative credit information publicly available. When information about credit that has been repaid without problems also becomes available publicly, the cost of assessing credit risks will be reduced and lenders will be able to price risk more accurately; this may enhance competition as the current lender to any particular business will no longer have an informational advantage over other lenders. It may also reduce the need for lenders to seek additional collateral and personal guarantees for small business lending, particularly for established businesses. Indeed, the use of personal guarantees is more widespread in Australia than in countries that have well-established comprehensive credit reporting regimes, such as the United Kingdom and the United States.

For several years, the finance industry has attempted to establish a voluntary comprehensive credit reporting regime in Australia. Participation has so far been limited.[13] However, several of the major banks have committed to contribute their credit data in coming months. The Australian Government has announced that it will legislate for a mandatory regime to come into effect mid next year.

Open banking

The introduction of an open banking regime should make it easier for entrepreneurs to share their banking data (including on transactions accounts) securely with third-party service providers, such as potential lenders. When assessing credit risks, lenders place considerable weight on evidence of the capacity of small business borrowers to service their debts based on their cash flows. For this reason, making this data available via open banking would reduce the cost of assessing credit risk. A review is currently being conducted with a view to introducing legislation to support an open banking regime.

Large technology companies

Technology firms can use the transactional data from their platforms to identify creditworthy borrowers, and provide loans and trade credit to these businesses from their own balance sheets. This could supply small innovative businesses that are active on these online platforms with a new source of finance. Amazon and Paypal are providing finance to some businesses that use their platforms. For example, Amazon identifies businesses with good sales histories and offers them finance on an invitation-only basis. Loans are reported to range from US$1 000 to US$750 000 for terms of up to a year at interest rates between 6 and 14 per cent. Repayments are automatically deducted from the proceeds of the borrower’s sales.

Alternative finance platforms

Alternative finance platforms, including marketplace lending and crowdfunding platforms, use new technologies to connect fundraisers directly with funding sources. The aim is to avoid the costs and delays involved in traditional intermediated finance.

While alternative financing platforms are growing rapidly, they are still a very minor source of funding for businesses, including in Australia. The largest alternative finance markets are in China, followed by the United States and the United Kingdom. But even these markets remain small relative to the size of their economies (Graph 12).

Graph 12
Graph 12: Alternative Financing for Businesses

Marketplace lending platforms provide debt funding by matching individuals or groups of lenders with borrowers. These platforms typically target personal and small business borrowers with low credit risk by attempting to offer lower cost lending products and more flexible lending conditions than traditional lenders. Data collected by the Australian Securities and Investments Commission indicate that most marketplace lending in Australia is for relatively small loans to consumers at interest rates comparable to personal loans offered by banks (Graph 13).

Graph 13
Graph 13: Marketplace Lending in Australia

It is unclear whether marketplace lending platforms are significantly reducing financial constraints for small businesses. Unlike innovations such as comprehensive credit reporting, which have the potential to improve the credit risk assessment process, marketplace lenders do not have an information advantage over traditional lenders. As a result, they need to manage risks with prices and terms in line with traditional lenders. Nevertheless, these platforms could provide some competition to traditional lenders, particularly as a source of unsecured short-term finance, since they process applications quickly and offer rates below those on credit cards.

Crowdfunding platforms have the potential to make financing more accessible for start-up businesses, although their use has been limited to date. Crowdsourced equity funding platforms typically involve a large number of investors taking a small equity stake in a business. As a result, entrepreneurs can receive finance without having to give up as much control as expected by venture capitalists. Several legislative changes have been made to facilitate growth in these markets, including by allowing small unlisted public companies to raise crowdsourced equity.

Digital Disruption And The AU$

RBA Governor Philip Lowe spoke at the 2017 Australian Payment Summit and explored some of the disruption in the payments system, including falling cash transactions, an eAUD, electronic bank notes and distributed ledger systems.  He also said that a convincing case for issuing Australian dollars on the blockchain for use with limited private systems has not yet been made.

A clear lesson from history is that as people’s needs change and technology improves, so too does the form that money takes. Once upon a time, people used clam shells and stones as money. And for a while, right here in the colony of New South Wales, rum was notoriously used. For many hundreds of years, though, metal coins were the main form of money. Then, as printing technology developed, paper banknotes became the norm. The next advance in technology – developed right here in Australia – was the printing of banknotes on polymer.

No doubt, this evolution will continue. Though predicting its exact nature is difficult. But as Australia’s central bank, the RBA has been giving considerable thought as to what the future might look like. We are the issuer of Australia’s banknotes, the provider of exchange settlement accounts for the financial sector, and we have a broad responsibility for the efficiency of the payments system, so this is an important issue for us.

Today I want to share with you some of our thinking about this future and to address a question that I am being asked increasingly frequently: does the RBA intend to issue a digital form of the Australian dollar? Let’s call it an eAUD.

The short answer to this question is that we have no immediate plans to issue an electronic form of Australian dollar banknotes, but we are continuing to look at the pros and cons. At the same time, we are also looking at how settlement arrangements with central bank money might evolve as new technologies emerge.

As we have worked through the issues, we have developed a series of working hypotheses. I would like to use this opportunity to outline these hypotheses and then discuss each of them briefly. As you will see, we have more confidence in some of these than others.

  • There will be a further significant shift to electronic payments, but there will still be a place for banknotes, although they will be used less frequently.
  • It is likely that this shift to electronic payments will occur largely through products offered by the banking system. This is not a given, though. It will require financial institutions to offer customers low-cost solutions that meet their needs.
  • An electronic form of banknotes could coexist with the electronic payment systems operated by the banks, although the case for this new form of money is not yet established. If an electronic form of Australian dollar banknotes was to become a commonly used payment method, it would probably best be issued by the RBA and distributed by financial institutions, just as physical banknotes are today.
  • Another possibility that is sometimes suggested for encouraging the shift to electronic payments would be for the RBA to offer every Australian an exchange settlement account with easy, low-cost payments functionality. To be clear, we see no case for doing this.
  • It is possible that the RBA might, in time, issue a new form of digital money – a variation on exchange settlement accounts – perhaps using distributed ledger technology. This money could then be used in specific settlement systems. The case for doing this has not yet been established, but we are open to the idea.

So these are our five working hypotheses. I would now like to expand on each of these.

1. The Shift to Electronic Payments

An appropriate starting point is to recognise that most money is already digital or electronic. Only 3½ per cent of what is known as ‘broad money’ in Australia is in the form of physical currency. The rest is in the form of deposits, which, most of the time, can be accessed electronically. So the vast majority of what we know today as money is a liability of the private sector, and not the central bank, and is already electronic.

With most money available electronically, there has been a substantial shift to electronic forms of payments as well. There are various ways of tracking this shift.

One is the survey of consumers that the RBA conducts every three years. When we first conducted this survey in 2007, we estimated that cash accounted for around 70 per cent of transactions made by households. In the most recent survey, which was conducted last year, this share had fallen to 37 per cent (Graph 1).

Graph 1
Graph 1: Number of Cash Payments


A second way of tracking the change is the decline in cash withdrawals from ATMs. The number of withdrawals peaked in 2008 and since then has fallen by around 25 per cent (Graph 2). This trend is likely to continue.

Graph 2
Graph 2: Number of ATM Withdrawals


The third area where we can see this shift is the rapid growth in the number of debt and credit card transactions and in transactions using the direct entry system. Since 2005, the number of transactions using these systems has grown at an average annual rate of 10 per cent (Graph 3). This stands in contrast to the decline in the use of cash and cheques.

Graph 3
Graph 3: Transactions per Capita


The overall picture is pretty clear. There has been a significant shift away from people using banknotes to making payments electronically. Most recently, Australia’s enthusiastic adoption of ‘tap-and-go’ payments has added impetus to this shift. In many ways, Australians are ahead of others in the use of electronic payments, although we are not quite in the vanguard. It is also worth pointing out, though, that despite this shift to electronic payments, the value of banknotes on issue is at a 50-year high as a share of GDP (Graph 4). Australians are clearly holding banknotes for purposes other than for making day-to-day payments.

Graph 4
Graph 4: Australia – Currency to GDP


This shift towards electronic payments, and away from the use of banknotes for payments, will surely continue. This will be driven partly by the increased use of mobile payment apps and other innovations. At the same time, though, it is likely that banknotes will continue to play an important role in the Australian payments landscape for many years to come. For many people, and for some types of transactions, banknotes are likely to remain the payment instrument of choice.

2. Banks are likely to remain at the centre of the shift to electronic payments

In Australia, the banking system has provided the infrastructure that has made the shift to electronic payments possible. In some other countries, the banking system has not done this. For example, in China and Kenya non-bank entities have been at the forefront of recent strong growth in electronic payments. A lesson here is that if financial institutions do not respond to customers’ needs, others will.

At this stage, it seems likely that the banking system will continue to provide the infrastructure that Australians use to make electronic payments. This is particularly so given the substantial investment made by Australia’s financial institutions in the NPP. The new system was turned on for ‘live proving’ in late November and the public launch is scheduled for February. It will allow Australians to make payments easily on a 24/7 basis, with recipients having immediate access to their money. The RBA has built a critical part of this infrastructure to ensure interbank settlement occurs in real time. Payments will be able to be made by just knowing somebody’s email address or mobile phone number and plenty of information will be able to be sent with the payment. This system has the potential to be transformational and will allow many transactions that today are conducted with banknotes to be conducted electronically.

Importantly, the new system offers instant settlement and funds availability. It provides this, while at the same time allowing funds to be held in deposit accounts at financial institutions subject to strong prudential regulation and that pay interest. This combination of attributes is not easy to replicate, including by closed-loop systems outside the banking system.

However, the further shift to electronic payments through the banking system is not a given. It requires that the cost to consumers and businesses of using the NPP is low and that the functionality expands over time. If this does not happen, then the experience of other countries suggests that alternative systems or technologies might emerge.

One class of technology that has emerged that can be used for payments is the so-called cryptocurrencies, the most prominent of which is Bitcoin. But in reality these currencies are not being commonly used for everyday payments and, as things currently stand, it is hard to see that changing. The value of Bitcoin is very volatile, the number of payments that can currently be handled is very low, there are governance problems, the transaction cost involved in making a payment with Bitcoin is very high and the estimates of the electricity used in the process of mining the coins are staggering. When thought of purely as a payment instrument, it seems more likely to be attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions. So the current fascination with these currencies feels more like a speculative mania than it has to do with their use as an efficient and convenient form of electronic payment.

This is not to say that other efficient and low-cost electronic payments methods will not emerge. But there is a certain attraction of being able to make payments from funds held in prudentially regulated accounts that can earn interest.

3. Electronic banknotes could coexist with the electronic payment system operated by the banks

In principle, a new form of electronic payment method that could emerge would be some form of electronic banknotes, or electronic cash. The easiest case to think about is a form of electronic Australian dollar banknotes. Such banknotes could coexist with the electronic account-to-account-based payments system operated by the banks, just as polymer banknotes coexist with the electronic systems today.

The technologies for doing this on an economy-wide scale are still developing. It is possible that it could be achieved through a distributed ledger, although there are other possibilities as well. The issuing authority could issue electronic currency in the form of files or ‘tokens’. These tokens could be stored in digital wallets, provided by financial institutions and others. These tokens could then be used for payments in a similar way that physical banknotes are used today.

In thinking about this possibility there are a couple of important questions that I would like to highlight.

The first is that if such a system were to be technologically feasible, who would issue the tokens: the RBA or somebody else?

The second is whether the RBA developing such a system would pass the public interest test.

In terms of the issuing authority, our working hypothesis is that this would best be done by the central bank.

In principle, there is nothing preventing tokenised eAUDs being issued by the private sector. It is conceivable, for example, that eAUD tokens could be issued by banks or even by large non-banks, although it is hard to see them being issued as cryptocurrency tokens under a bitcoin-style protocol, with no central entity standing behind the liability. So, while a privately issued eAUD is conceivable, experience cautions that there are significant difficulties and dangers associated with privately issued fiat money.

The history of private issuance is one of periodic panic and instability. In times of uncertainty and stress, people don’t want to hold privately issued fiat money. This is one reason why today physical banknotes are backed by central banks. It is possible that ways might be found to deal with this financial stability issue – including full collateralisation – but these tend to be expensive. This suggests that if there were to be an electronic form of banknotes that was widely used by the community, it is probably better and more likely for it to be issued by the central bank.

If we were to head in this direction, there would be significant design issues to work through. The tokens could be issued in a way that transactions could be made with complete anonymity, just as is the case with physical banknotes. Alternatively, they might be issued in a way in which transactions were auditable and traceable by relevant authorities. We would also need to deal with the issue of possible counterfeiting. Depending upon the design of any system, we might be very reliant on cryptography and would need to be confident in the ability to resist malicious attacks.

This brings me to the second issue here: is there a public policy case for moving in this direction?

Such a case would need to be built on electronic banknotes offering something that account-to-account transfers through the banking system do not. We would also need to be confident that there were not material downsides from moving in this direction.

Our current working hypothesis is that with the NPP there is likely to be little additional benefit from electronic banknotes. This, of course, presupposes that the NPP provides low-cost efficient payments. One possible benefit of electronic banknotes for some people might be that they could have less of an ‘electronic fingerprint’ than account-to-account transfers, although this would depend upon how the system was designed. But having less of an electronic fingerprint hardly seems the basis for building a public policy case to issue an electronic form of the currency. So there would need to be more than this.

Among the potential downsides, the main one lies in the area of financial stability.

If we were to issue electronic banknotes, it is possible that in times of banking system stress, people might seek to exchange their deposits in commercial banks for these banknotes, which are a claim on the central bank. It is likely that the process of switching from commercial bank deposits to digital banknotes would be easier than switching to physical banknotes. In other words, it might be easier to run on the banking system. This could have adverse implications for financial stability.

Given these various considerations, we do not currently see a public policy case for moving in this direction. We will, however, keep that judgement under review.

4. Exchange settlement accounts for all Australians?

Another possible change that some have suggested would encourage the shift to electronic payments would be for the central bank to issue every person a bank account – for each Australian to have their own exchange settlement account with the RBA. In addition to serving as deposit accounts, these accounts could be used for low-cost electronic payments, in a similar way that third-party payment providers currently use accounts at the RBA to make payments between themselves. Some advocates of this model also suggest that the central bank could pay interest on these accounts or even charge interest if the policy rate was negative.

On this issue, we have reached a conclusion, rather than just develop a hypothesis. The conclusion is that we do not see it as in the public interest to go down this route.

If we did go down this route, the RBA would find itself in direct competition with the private banking sector, both in terms of deposits and payment services. In doing so, the nature of commercial banking as we know it today would be reshaped. The RBA could find itself not just as the nation’s central bank, but as a type of large commercial bank as well. This is not a direction in which we want to head.

A related consideration is the same financial stability issue that I just spoke about in terms of electronic banknotes. In times of stress, it is highly likely that people might want to run from what funds they still hold in commercial bank accounts to their account at the RBA. This would make the remaining private banking system prone to runs.

The point here is that exchange settlement accounts are for settlement of interbank obligations between institutions that operate third-party payment businesses to address systemic risk – something that is central to our mandate. A decision to offer exchange settlement accounts for day-to-day use would be a step into a completely different policy area.

5. New settlement systems based on distributed ledger technology and central bank money?

One final possibility is for the RBA to issue Australian dollars in the form of electronic files or tokens that could be used within specialised payment and settlement systems. The tokens could be exchanged among members of a private, permissioned distributed ledger, separate from the RBA’s Real-time Gross Settlement (RTGS) system, but with mechanisms for the tokens to be exchanged for central bank deposits when required. Such a system might allow the payment and settlement process to become highly integrated with other business processes, generating efficiencies and risk reductions for private business. As part of this, the tokens might also be able to be programmed and sit alongside smart contracts, enabling multi-stage transactions with potentially complex dependencies to take place securely and automatically. This seems to be the general model that some people have in mind when they talk about ‘putting AUD on the blockchain’, although other technologies might be able to achieve similar outcomes.

Whether a strong case for the development of these types of systems emerges remains an open question. We need to better understand the potential efficiencies for private business and why it would be preferable for such a settlement system to be provided by the central bank, rather than the private sector; why privately issued tokens or files could not do the job. We would also need to understand why any efficiency improvement could not be obtained by using the existing Exchange Settlement Accounts and the NPP.

We would also need to understand whether and how risk in the financial system would change as a result of such a system. It remains unclear which way this could go. On the one hand, these types of processes could use a very different technology from the current system, which is based on account-to-account transfers, so they could add to the resilience of the overall payments system. But there would be a whole host of new technology issues to manage as well.

The RBA on ATM’s

The recently published RBA Bulletin included an article “Recent Developments in the ATM Industry”. The article shows that the number of ATMs in Australia is very high relative to population, thanks to significant growth in third party fee for service machines. Now that the banks have announced they will not charge for foreign withdrawals, the RBA says third party players – like owners of petrol stations and convenience stores may see a decline in income, and that overall declines in transaction volumes are likely to reduce the number of machines available, especially in regional areas.  That said, many independently owned ATMs are in convenience locations not serviced by bank ATMs (such as pubs and clubs) and so they may be shielded somewhat from this competitive pressure. But many consumers will end up paying even higher fees to use these machines, which may be the only options for some.

The ATM industry in Australia is undergoing a number of changes. Use of ATMs has been declining as people use cash less often for their  transactions, though the number of ATMs remains at a high level. The total amount spent on ATM fees has fallen, and is likely to decline further as a result of recent decisions by a number of banks to remove their ATM direct charges. This article discusses the implications of these changes for the competitive landscape and the future size and structure of the industry.

By international standards, we have a large number of ATMs per capita (though not corrected for geographic size).

As at September 2017, there were 32 275 ATMs, only slightly below the peak of nearly 32 900 in December 2016. This represents over 1 300 ATMs per million inhabitant.

The share of the national ATM fleet owned by independent deployers has been rising over the past decade. Independent deployers operate standalone ATM networks that are not affiliated with any financial institution and which are often focused on convenience locations like petrol stations and licensed venues. They rely on the revenue generated by charging fees on all transactions, irrespective of the cardholder’s financial institution, to support their networks.

As at June 2017, 57 per cent of ATMs in Australia were independently owned, up from 55 per cent in mid 2015 and 49 per cent in 2010. The remaining 43 per cent were owned by financial institutions. The increase in the independent deployers’ share reflects strong growth in their ATMs, while the number of bank-owned ATMs has declined over the past few years.

A small number of ATMs that carry financial institutions’ branding but are owned and operated by an independent deployer are recorded in data for independent deployers; other similar arrangements may be recorded under financial institutions. (b) In late 2016, DC Payments acquired First Data’s Cashcard ATM business. (c) NAB, Cuscal and Bank of Queensland, along with a number of other smaller financial institutions, are part of the rediATM network, which allows customers of member institutions to access about 3 000 ATMs (as at June 2017) within that network on a fee-free basis. From August 2017, Suncorp also joined the rediATM network. (d) In November 2017, Stargroup was placed in administration after it was unable to complete a restructure of its debt.

There has been significant consolidation in the independent deployer market over recent years. Cardtronics, an independent deployer, had the largest fleet in Australia in June at nearly 10 500 ATMs, which is around one-third of all ATMs. Cardtronics is part of a US-based group that is also the largest deployer of ATMs globally. It entered the Australian market around the start of 2017 when it acquired DC Payments, which was the largest domestic independent deployer at the time. DC Payments had itself acquired a number of smaller independent networks over earlier years, including First Data’s Cashcard ATM business in late 2016. Other large independent deployers, such as Banktech and Next Payments, have also expanded their ATM fleets since 2015, partly through acquisitions.

Despite the increase in the share of independently owned ATMs, most Australian cardholders have had access to large networks of fee-free ATMs provided by their financial institutions. As at June 2017, three of the four major banks each had fleets of at least several thousand ATMs; NAB had the smallest fleet among the majors, but it is also part of the rediATM network, which means its customers had access to about 3 000 ATMs in that network on a fee-free basis.

A number of the banks, including all the majors, have recently removed the ATM withdrawal fees they used to charge non-customers. This means Australian cardholders can now generally access cash free of charge at around 11 000 financial institution ATMs across the country, which is a significant increase in access to fee-free ATM services.

However, following the removal of withdrawal fees by various banks, the distribution has changed significantly: there is now no charge for foreign withdrawals at around one-third of ATMs, whereas most of these ATMs had previously charged $2.00. But Independent deployer ATMs have the greatest variation in ATM fees; as at June this year, their withdrawal fees ranged from zero to $8.00, though most were around $2.50 to $3.00.

With the removal of withdrawal fees providing a much larger network of fee-free ATMs, it will now be even easier for cardholders to avoid paying fees. As a result, those ATM deployers that continue to charge withdrawal fees – particularly independent deployers, who typically charge the highest average fees – may face additional competitive pressure, especially where they have ATMs in close proximity to fee-free bank ATMs. That said, many independently owned ATMs are in convenience locations not serviced by bank ATMs (such as pubs and clubs) and so they may be shielded somewhat from this competitive pressure.

For those banks that eliminated their withdrawal fees, the direct reduction in their revenue will be relatively small, especially given the decline in ATM use over recent years. In particular, based on the Bank’s survey, it is estimated that withdrawal fees paid at ATMs owned by the major banks in 2016/17 totalled around $50 million. As noted earlier, the bulk of ATM fees has been paid at independent deployer ATMs rather than bank-owned ATMs.

Given that cardholders can now effectively use most bank ATMs on a fee-free basis, it is likely that having a large ATM fleet will be viewed as less of a source of competitive advantage to banks than it was in the past. With ATM use declining rapidly and the costs of ATM deployment continuing to rise, the removal of ATM fees may strengthen the case for deployers to reduce the size of their ATM fleets. Having multiple bank ATMs side-by-side or in close proximity (as can often be seen in shopping centres, for example) will make less economic sense now that all or most of those ATMs are fee-free.

Fleet rationalisation could occur in a number of ways. Some banks (and possibly independent deployers) might look to better optimise their own fleets by removing ATMs in low-density or low-use areas. Banks may look to pool part or all of their fleets with other banks under generically branded, shared service or ‘utility’ ATM models as a way to improve efficiency, while still maintaining adequate access for cardholders.

A pooled network may enable the participants to remove ATMs that are co-located or in close proximity, which would reduce costs and help them sustain, and possibly grow, their joint network coverage. Indeed, before the recent announcements on direct charges, some banks had been in discussions about pooling their ATM fleets into a shared utility.

Facing similar downward trends in cash and ATM use, a number of other countries, particularly in northern Europe, have successfully implemented or are considering shared ATM models. For example, bank ATMs in Finland were outsourced to a single operator in the mid 1990s, while Sweden’s five largest banks adopted a utility model earlier this decade. The large Dutch banks are currently looking to set up a joint ATM network to help ensure the continued wide availability of ATMs in the Netherlands even as cash use is decreasing.

While it is too early to assess the full impact of the recent announcements by the major banks, it is likely that they will focus attention on the growing disparity between the number of ATMs in Australia and the demand for ATM services.

Some consolidation seems likely, and may even be desirable for the efficiency and sustainability of the ATM network, though it will be important that adequate access to ATM services is maintained, particularly for people in remote or regional locations, where access to alternative banking services is often limited.



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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The RBA On Housing Affordability

The RBA released their latest Bulletin today  and it contained an interesting section on Housing Accessibility For First Time Buyers.  They suggest that in many centers, new buyers are able to access the market, at the current low interest rates. But the barriers are significantly higher in Melbourne, Sydney and Perth.

They also highlight that FHBs (generally being the most financially constrained buyers) are not always able to increase their loan size in response to lower interest rates because of lenders’ policies. Indeed, the average FHB loan size has been little changed over recent years while the gap between repeat buyers and FHBs’ average loan sizes has widened.

The article starts with an analysis of housing price-to-income ratios.

In Australia, the housing price-to-income ratio has increased since the early 1990s, and has increased particularly rapidly over the past five years to reach its highest level on record. At face value, this suggests that housing affordability is at a record low. However, this masks significant differences across states. The recent trend increase in the housing price-to-income ratio is largely due to increases in the ratios in New South Wales and Victoria (Graph 2). The housing price-to-income ratios have increased by less in other states in recent years and suggest that housing affordability in those states is at a similar level to the mid 2000s.

This housing affordability measure accounts for changes in average housing prices and household income. However, it ignores the effect of changes in interest rates on borrowing costs and other financial factors that may affect a household’s purchasing capacity and therefore their ability to purchase a home.

If interest rates fall, households can afford to repay a larger mortgage, all other things being equal. This would be reflected in a lower mortgage debt-servicing ratio, and would imply greater affordability. There is no role for changes to the deposit burden in the mortgage debt-servicing ratio, as the LVR is considered to be fixed. Looking at the trends over time, the aggregate mortgage debt-servicing ratio has risen over the
past year or so and is currently above the average of the inflation-targeting period but below historical peaks

There are significant state variations.

A shortcoming of the conventional estimates of housing affordability is that, by focussing on the average home price and average household income, they measure affordability for the average household. But the typical FHB is not the same as the average household – they tend to be younger and less wealthy. Also, if most FHBs buy homes that are cheaper than the average, then measures that focus on the average home will provide a poor guide to the ability of FHBs to purchase their first home (i.e. housing accessibility). To address these shortcomings, we construct a housing accessibility index that specifically focuses on the purchasing capacity of potential FHBs

This measure combines information from household surveys with data on all housing sale transactions in Australia. It shows housing accessibility is around the long-run average in aggregate in Australia, with the median potential FHB being able to afford around one-third of all homes sold in 2016, although this share is significantly lower in Sydney, Melbourne and Perth. Moreover, the quality of homes that potential FHBs can afford has fallen over time, as measured by location and the number of bedrooms. This measure also shows accessibility is lower in capital cities, particularly in areas close to the CBD.

The cost of renting is also an important component of housing affordability and the number of households renting has trended up over the past few decades. In aggregate, rents have grown broadly in line with household incomes, although rent-to-income ratios suggest housing costs for lower-income households have increased over the past decade.

RBA Holds Cash Rate For The 16th Time

The RBA has kept the cash rate steady, as widely expected.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

Conditions in the global economy have improved over 2017. Labour markets have tightened and further above-trend growth is expected in a number of advanced economies, although uncertainties remain. Growth in the Chinese economy continues to be supported by increased spending on infrastructure and property construction, although financial conditions have tightened somewhat as the authorities address the medium-term risks from high debt levels. Australia’s terms of trade are expected to decline in the period ahead but remain at relatively high levels.

Wage growth remains low in most countries, as does core inflation. In a number of economies there has been some withdrawal of monetary stimulus, although financial conditions remain quite expansionary. Equity markets have been strong, credit spreads have narrowed over the course of the year and volatility in financial markets is low. Long-term bond yields remain low, notwithstanding the improvement in the global economy.

Recent data suggest that the Australian economy grew at around its trend rate over the year to the September quarter. The central forecast is for GDP growth to average around 3 per cent over the next few years. Business conditions are positive and capacity utilisation has increased. The outlook for non-mining business investment has improved further, with the forward-looking indicators being more positive than they have been for some time. Increased public infrastructure investment is also supporting the economy. One continuing source of uncertainty is the outlook for household consumption. Household incomes are growing slowly and debt levels are high.

Employment growth has been strong over 2017 and the unemployment rate has declined. Employment has been rising in all states and has been accompanied by a rise in labour force participation. The various forward-looking indicators continue to point to solid growth in employment over the period ahead. There are reports that some employers are finding it more difficult to hire workers with the necessary skills. However, wage growth remains low. This is likely to continue for a while yet, although the stronger conditions in the labour market should see some lift in wage growth over time.

Inflation remains low, with both CPI and underlying inflation running a little below 2 per cent. The Bank’s central forecast remains for inflation to pick up gradually as the economy strengthens.

The Australian dollar remains within the range that it has been in over the past two years. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.

Growth in housing debt has been outpacing the slow growth in household income for some time. To address the medium-term risks associated with high and rising household indebtedness, APRA has introduced a number of supervisory measures. Credit standards have been tightened in a way that has reduced the risk profile of borrowers. Nationwide measures of housing prices are little changed over the past six months, with conditions having eased in Sydney. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Rent increases remain low in most cities.

The low level of interest rates is continuing to support the Australian economy. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Mortgage Growth Only Easing A Bit: A Policy Vacuum

The latest data from the RBA, to end October 2017 ,  shows that lending for housing rose 0.5% in the month, and 6.5% for the past year (three times inflation!).  Lending to business rose 0.3% to 4% over the past year and personal credit was flat, and fell 0.9% over the past year. Another $1.2 billion of housing loans were reclassified in the month, making $60 billion in total, this is more than 10% of the total investment loan book! The proportion of investor loans fell slightly again, down to 34.2% of portfolio

Total mortgage lending is now above $1,7 trillion, with owner occupied loans up 0.6% or $6.6 billion to $1.12 trillion, and investor loans up 0.2% or $1.2 billion to $584 billion. Comparing this with the APRA data, out today, we see continued relative growth in the non-bank sector.

Here is the monthly growth plots, which even seasonally adjusted are noisy.   The smoother annual plots shows a slowing trend across the mortgage sector, but with investor sector still growth at 6.9%, ahead of the owner occupied sector at 6.5%, or business at 4%.  Further evidence the settings are wrong.

There is simply no excuse to allow home lending to be running at more than three times inflation or wage growth at the current dizzy price and leverage levels.  Still too much focus on home lending and not enough on productive growth enabling business lending. This is something which the Royal Commission is unlikely to touch, as it is a policy, not a behaviourial issue.

The RBA says:

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $60 billion over the period of July 2015 to October 2017, of which $1.2 billion occurred in October 2017. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

Next Move In Rates Will Be Up, But Not Yet – RBA

RBA Governor Philip Lowe spoke at the Australian Business Economists Annual Dinner.  Essentially, the conundrum of low inflation and wage growth, despite better employment means the cash rate will stay lower for longer, though the next move is likely up. High household debt is less about risks to the banking system and more about medium term financial stability, especially as rates rise.  Household spending will remain muted. GDP is forecast to be higher because the fall in mining investment has ended, even if other business investment is still low.

This is a better read than the bland RBA minutes which also came out today!

Here is the speech:

There are three sets of questions that have occupied much of our time over the past year.

The first is how the final stages of the transition to lower levels of mining investment would play out.

The second is the degree to which an improving labour market would translate into a pick-up in wage growth and inflation.

And the third is the nature of risks stemming from high and rising levels of household debt and how to deal with those risks.

I will talk about each of these three issues and then conclude with how they have influenced the Reserve Bank Board’s decisions on monetary policy over the past year or so.

The End of the Transition

For a number of years we have been describing the economy as being in transition: a transition from very high levels of mining investment to something more normal.

It is now time, though, to move to a new narrative. The wind-down of mining investment is now all but complete, with work soon to be finished on some of the large liquefied natural gas projects. Mining investment, as a share of GDP, is now back to something more normal (Graph 1). This means that, as I talked about in a recent speech, it’s time to open a new chapter in Australia’s economic history.

Graph 1
Graph 1: Mining Investment

Over recent times, our judgement has been that this transition to lower levels of mining investment was masking an underlying improvement in the Australian economy. The decline in mining investment generated substantial negative spillovers to the rest of the economy. These spillovers were most evident in Queensland and Western Australia, where, for a while, growth in employment, investment and income were all quite weak.

The good news is that these negative spillovers from lower levels of mining investment are now fading. This was first evident in Queensland, where the labour market began to improve in 2015 (Graph 2). It is now evident too in Western Australia, where conditions in the labour market have improved noticeably since late last year. Elsewhere, there has been steady growth in employment for a number of years.

Graph 2
Graph 2: Employment Growth


The fading of the negative spillovers is one reason why growth in the Australian economy is expected to strengthen over the period ahead. Another is the higher volume of resource exports as a result of all the mining investment. We expect GDP growth to pick up to average a bit above 3 per cent over 2018 and 2019 (Graph 3). If these forecasts are realised, it would represent a better outcome than has been achieved for some years now.

Graph 3
Graph 3: GDP Growth


This more positive outlook is being supported by an improving world economy, low interest rates, strong population growth and increased public spending on infrastructure. All these things are helping.

Encouragingly, the outlook for business investment has brightened. For a number of years, we were repeatedly disappointed that non-mining business investment was not picking up. Part of the explanation was the negative spillover effects that I just spoke about, although, as my colleague Guy Debelle spoke about last week, there were other factors at work as well.  Now, though, a gentle upswing in business investment does seem to be taking place and the forward indicators suggest that this will continue. It’s too early to say that animal spirits have returned with gusto. But more firms are reporting that economic conditions have improved and more are now prepared to take a risk and invest in new assets. This is good news for the economy.

The improvement in the business environment is also reflected in strong employment growth. Over the past year, the number of people with jobs has increased by around 3 per cent, the fastest rate of increase for some time (Graph 4). This pick-up in jobs is evident across the country and has been strongest in the household services and construction industries. It is also leading to a pick-up in labour force participation, especially for women.

Graph 4
Graph 4: Employment Growth


Business is feeling better than it has for some time and it is lifting capital spending and creating more jobs.

At the same time, though, growth in consumer spending remains fairly soft. Indeed, for a number of years consumption growth has been weaker than we had originally forecast. This is evident in this chart, which shows our forecasts for consumption growth at various points in time as well as the actual outcomes (black line) (Graph 5). The picture is pretty clear. For some years, consumption growth has been weaker than forecast and it has not exceeded 3 per cent for quite a few years.

Graph 5
Graph 5: Consumption Growth Forecasts


The most likely explanation for the ongoing subdued consumption outcomes is the combination of weak growth in real household income and the high level of household debt. Given the persistence of these factors, our latest forecasts have incorporated a flatter profile for consumption growth than has been the case in previous forecasts.

An important issue shaping the future is how these cross-cutting themes are resolved: businesses feel better than they have for some time, but consumers feel weighed down by weak income growth and high debt levels.

Our central scenario is that the increased willingness of business to invest and employ people will lead to a gradual increase in growth of consumer spending. As employment increases, so too will household income. Some increase in wage growth will also support household income. Given these factors, the central forecast is for consumption growth to pick up to around the 3 per cent mark. This would be above the average growth of consumption for the current decade, but below the average for the period prior to the financial crisis.

Labour Market, Wages and Inflation

I would like to turn to the second question that has occupied us over much of the past year: the degree to which an improving labour market will translate into a pick-up in wage growth and inflation.

A distinguishing feature of Australia’s recent economic performance has been the slow growth in wages. The Wage Price Index has increased by just 2 per cent over the past year. Whereas in earlier years, Australians had got used to average wage increases of around the 3½–4 per cent mark, 2–2½ per cent is now the norm (Graph 6). Growth in average hourly earnings has been weaker still: in trend terms it is running at the lowest rate since at least the 1960s. Not only are wage increases low, but some people had been moving out of high-paying jobs associated with the mining sector into lower-paying jobs. We have heard from our liaison program that there has been downward pressure on non-wage payments, including allowances, and an increase in the proportion of new employees hired on lower salaries than their predecessors.

Graph 6
Graph 6: Labour Costs


As I noted earlier, subdued growth in wages is also occurring in a number of other countries. Understanding this is a major priority. Low growth in wages means low inflation, which means low interest rates, which means high asset valuations. So a lot depends on understanding the reasons for slow growth in nominal and real wages. The answer is likely to be found in a combination of cyclical and structural factors.

In Australia, we are still some way short of our estimates of full employment of around 5 per cent, so it is not surprising that wage growth is below average.

But structural factors are likely to be at work as well. Foremost among these are perceptions of increased competition.

Many workers feel there is more competition out there, sometimes from workers overseas and sometimes because of advances in technology. In the past, the pressure of competition from globalisation and from technology was felt most acutely in the manufacturing industry. Now, these same forces of competition are being felt in an increasingly wide range of service industries. This shift, together with changes in the nature of work and bargaining arrangements, mean that many workers feel like they have less bargaining power than they once did.

But this is not the full story. It is likely that there is also something happening on the firms’ side as well. In other advanced economies where unemployment rates are below conventional estimates of full employment, the normal tendency for firms to pay higher wages in tight labour markets appears to be muted. Businesses are not bidding up wages in the way they might once have. This is partly because business, too, feels the pressure of increased competition.

One response to this competitive pressure is to have a laser-like focus on containing costs. Over recent times there has been a mindset in many businesses, including some here in Australia, that the key to higher profits is to reduce costs. Paying higher wages can sit at odds with that mindset.

Given these various effects, it is plausible that, at least for a while, the economy is less inflation prone than it once was. Both workers and firms feel more competition, and it is plausible that the wage- and price-setting processes are adjusting in response.

This, of course, does not mean that the normal forces of supply and demand have been abandoned. Tighter labour markets should still push up wages and prices, even if it takes a little longer than we are used to. We are starting to see some hints of this in the Australian labour market. Business surveys report that firms are having more difficulty finding suitable labour than they have for some time (Graph 7). In the past, when firms found it difficult to find suitable labour, higher growth in wages resulted. Consistent with this, we are hearing reports through our liaison program that in some pockets the stronger demand for workers is starting to push wages up a bit. We expect that as employment growth continues, these reports will become more common.

Graph 7
Graph 7: Wage Pressures


Another factor that has a significant bearing on the outlook for inflation is the increased competition in the retail industry. I spoke a few moments ago about how, globally, increased competition is affecting pricing dynamics. Australian retailing provides a very good example of this. Competition from new entrants is putting pressure on margins and is forcing existing retailers to find ways to lower their cost structures. Technology is helping them to do this, including by automating processes and streamlining logistics. The result is lower prices.

For some years now, the rate of increase in food prices has been unusually low. A large part of the story here is increased competition. The same story is playing out in other parts of retailing. Over recent times, the prices of many consumer goods – including clothing, furniture and household appliances – have been falling (Graph 8). Increased competition and changes in technology are driving down the prices of many of the things we buy. This is making for a tough environment for many in the retail industry, but for consumers, lower prices are good news.

Graph 8
Graph 8: Retail Inflation


A question we are grappling with here is how much further this process has to run. It is difficult to know the answer, but our sense is that the impact of greater competition on consumer prices still has some way to go as both retailers and wholesalers adjust their business models. So this is likely to be a constraining factor on inflation for a while yet.

Putting all this together, we expect inflation to pick up, but to do so only gradually (Graph 9). By the end of our two-year forecast period, inflation is expected to reach about 2 per cent in underlying terms, and a little higher in headline terms because of planned increases in tobacco excise. Underpinning this expected lift in inflation is a gradual increase in wage growth in response to the tighter labour market.

Graph 9
Graph 9: Inflation

High and Rising Household Debt

The third question we have focused on over recent times is the implications of the high and rising level of household debt.

The growth in household debt has been outpacing the very low growth in household incomes for a few years now. As a result, the household debt-to-income ratio has risen, although if account is taken of the increased balances held in offset accounts the rise is less pronounced (Graph 10). The low level of interest rates means that even though debt levels are higher, the share of household income devoted to paying mortgage interest is lower than it has been for some time. Perhaps reflecting this, as well as the recent decline in the unemployment rate, aggregate indicators of household financial stress remain quite low.

The central issue here is how the high levels of debt affect the stability of the economy over the medium term. Our concern has not been the stability of the banking system; the banks are strong and they are well capitalised. Rather, the concern has been that as the household sector takes on ever-more debt relative to its income, the risk of medium-term problems increases. This is especially so when this debt is taken on in an unusually low-interest rate environment.

Graph 10
Graph 10: Household Debt Indicators


It is difficult to be precise about exactly how much this risk has increased, but our judgement has been that, should earlier trends have continued, the risk of future problems would have continued to increase. A scenario we have focused on is the possibility of a future shock that causes households to abruptly reassess their past borrowing decisions. In this scenario, consumption might be wound back sharply to put balance sheets on a sounder footing. If this occurred, it could turn an otherwise manageable shock into something more serious.

One way of guarding against this risk is for lenders to maintain strong lending standards. The various steps taken by the Australian Prudential Regulation Authority (APRA) – with the strong support of the Council of Financial Regulators – have worked in this direction. Growth in lending to investors has slowed, fewer loans are being made with very high loan-to-valuation ratios, debt-servicing tests have been tightened and fewer interest-only loans are being made. The latest data suggest that the banks have more than succeeded in reducing interest-only lending to below the 30 per cent benchmark (Graph 11). These are all positive developments but it is an area we, together with the Council of Financial Regulators, continue to watch closely.

Graph 11
Graph 11: Interest-only Housing Loan Approvals


Recently, we have also seen some cooling in the Sydney property market. This reflects a combination of factors, including increased supply of new dwellings, some tightening of credit conditions, higher interest rates on loans to investors and some reduction in offshore demand. The increasing unaffordability of prices for many people has also probably played a role. In Melbourne, where the population is growing very strongly, housing prices are still increasing faster than incomes, although the rate of increase has slowed. Elsewhere, housing prices have been little changed over recent months. Conditions are subdued in Brisbane, where the supply of apartments has increased significantly, and remain weak in Perth, owing to slowing population growth following the unwinding of the mining investment boom.

It is important to be clear that the RBA does not have a target for housing prices. But a return to more sustainable growth in housing prices does reduce the medium-term risks. These risks have not gone away, but the fact that they are not building at the rate they have been is a positive development.

Monetary Policy

I would like to conclude with what all this has meant for monetary policy over the past year or so.

As you are aware, the Reserve Bank Board has kept the cash rate unchanged at 1.5 per cent since August last year.

In the early part of that period, a central issue was balancing the need to support the economy in the final days of the transition to lower levels of mining investment against the risks stemming from rising household debt. Lower interest rates might have provided a bit more support, but would have done so partly by encouraging people to borrow yet more money, thus adding to the risks. The Board’s judgement was this would not have been consistent with its broad mandate for economic stability. Accordingly, with the economy expected to pick up and the unemployment rate to come down gradually as the mining investment transition came to an end, the Board judged it appropriate to hold the cash rate at 1.5 per cent. We were prepared to be patient in the interests of medium-term economic stability.

As the year progressed, we became somewhat more confident that the expected pick-up in growth would materialise. The strengthening in the global economy has helped here. So too has the lift in employment and the better outlook for investment. This improvement meant that the case for lower interest rates weakened over the year.

Also, as the year progressed, one issue the Board paid increasing attention to was the persistently weak growth in wages and household incomes and the implications for consumption. A related issue is the effect of increased competition on the wage and price dynamics in the economy. As I said earlier, we are still trying to understand this. It does, though, look increasingly likely that these factors will mean that inflation remains subdued for some time yet. We still expect headline inflation to move above 2 per cent on a sustained basis, but it is taking a bit longer to get there than we had earlier expected.

So, in summary, over the past year or so there has been progress in moving the economy closer to full employment and in having inflation return to the 2 to 3 per cent range. Both of these are positive developments and suggest a more familiar normal is still in sight. Progress on these fronts has been made while also containing the build-up of risks in household balance sheets.

We still, though, remain short of full employment, and inflation is expected to pick up only gradually and remain below average for some time yet. This means that a continuation of accommodative monetary policy is appropriate. If the economy continues to improve as expected, it is more likely that the next move in interest rates will be up, rather than down. But the continuing spare capacity in the economy and the subdued outlook for inflation mean that there is not a strong case for a near-term adjustment in monetary policy. We will, of course, continue to keep that judgement under review.