April 2016 – Page 3 – Digital Finance Analytics (DFA) Blog

A digital crack in banking’s business model

Mckinsey says low-cost attackers are targeting customers in lucrative parts of the banking sector. The rewards for digital success are huge. Capturing even a tiny fraction of banking’s more than $1 trillion profit pool could generate massive returns for the owners and investors of “fintech” start-ups. Little wonder there are more than 12,000 on the prowl today.

The rise of digital innovators in financial services presents a significant threat to the traditional business models of retail banks. Historically, they have generated value by combining different businesses, such as financing, investing, and transactions, which serve their customers’ broad financial needs over the long haul. Banks offer basic services, such as low-cost checking, and so-called sticky customer relationships allow them to earn attractive margins in other areas, including investment management, credit-card fees, or foreign-exchange transactions.

To better understand how attackers could affect the economics of banks, we disaggregated the origination and sales component from the balance-sheet and fulfillment component of all banking products. Our research (exhibit) shows that 59 percent of the banks’ earnings flow from pure fee products, such as advice or payments, as well as the origination, sales, and distribution component of balance-sheet products, like loans or deposits. In these areas, returns on equity (ROE) average an attractive 22 percent. That’s much higher than the 6 percent ROE of the balance-sheet provision and fulfillment component of products (for example, loans), which have high operating costs and high capital requirements.Digital start-ups (fintechs)—as well as big nonbank technology companies in e-retailing, media, and other sectors—could exploit this mismatch in banking’s business model. Technological advances and shifts in consumer behavior offer attackers a chance to weaken the heavy gravitational pull that banks exert on their customers. Many of the challengers hope to disintermediate these relationships, slicing off the higher-ROE segments of banking’s value chain in origination and sales, leaving banks with the basics of asset and liability management. It’s important that most fintech players (whether start-ups or China’s e-messaging and Internet-services provider Tencent) don’t want to be banks and are not asking customers to transfer all their financial business at once. They are instead offering targeted (and more convenient) services. The new digital platforms often allow customers to open accounts effortlessly, for example. In many cases, once they have an account, they can switch among providers with a single click.

Platforms such as NerdWallet (in the United States) or India’s BankBazaar.com aggregate the offerings of multiple banks in loans, credit cards, deposits, insurance, and more and receive payment from the banks for generating new business. Wealthfront targets fee-averse millennials who favor automated software over human advisers. Lending Home targets motivated investment-property buyers looking for cost-effective mortgages with accelerated time horizons. Moneysupermarket.com started with a single product springboard—consumer mortgages—and now not only offers a range of financial products but serves as a platform for purchases of telecom and travel services, and even energy.

Across the emerging fintech landscape, the customers most susceptible to cherry-picking are millennials, small businesses, and the underbanked—three segments particularly sensitive to costs and to the enhanced consumer experience that digital delivery and distribution afford. For instance, Alipay, the Chinese payments service (a unit of e-commerce giant Alibaba), makes online finance simpler and more intuitive by turning savings strategies into a game and comparing users’ returns with those of others. It also makes peer-to-peer transfers fun by adding voice messages and emoticons.

From an incumbent’s perspective, emerging fintechs in corporate and investment banking (including asset and cash management) appear to be less disruptive than retail innovators are. A recent McKinsey analysis showed that most of the former, notably those established in the last couple of years, are enablers, serving banks directly and often seeking to improve processes for one or more elements of banking’s value chain.

Many successful attackers in corporate and investment banking, as well as some in retail banking, are embracing “coopetition,” finding ways to become partners in the ecosystems of traditional banks. These fintechs, sidestepping banking basics, rely on established institutions and their balance sheets to fulfill loans or provide the payments backbone to fulfill credit-card or foreign-exchange transactions. With highly automated, scalable, software-based services and no physical-distribution expenses (such as branch networks), these attackers gain a significant cost advantage and therefore often offer more attractive terms than banks’ websites do. They use advanced data analytics to experiment with new credit-scoring approaches and exploit social media to capture shifts in customer behavior.

Attackers must still overcome the advantages of traditional banks and attract their customers. Most fintechs, moreover, remain under the regulatory radar today but will attract attention as they reach meaningful scale. That said, the rewards for digital success are huge. Capturing even a tiny fraction of banking’s more than $1 trillion profit pool could generate massive returns for the owners and investors of these start-ups. Little wonder there are more than 12,000 of them on the prowl today.

BIS Updates Standards For Interest Rate Risk In The Banking Book

The Basel Committee on Banking Supervision has today issued standards for Interest Rate Risk in the Banking Book (IRRBB). The key enhancements to the 2004 Principles include:

More extensive guidance on the expectations for a bank’s IRRBB management process in areas such as the development of interest rate shock scenarios, as well as key behavioural and modelling assumptions to be considered by banks in their measurement of IRRBB;
Enhanced disclosure requirements to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. This includes quantitative disclosure requirements based on common interest rate shock scenarios;
An updated standardised framework, which supervisors could mandate their banks to follow or banks could choose to adopt; and
A stricter threshold for identifying outlier banks, which is has been reduced from 20% of a bank’s total capital to 15% of a bank’s Tier 1 capital.

The document runs to 50 pages but here is a summary of the main points:

Interest rate risk in the banking book (IRRBB) is part of the Basel capital framework’s Pillar 2 (Supervisory Review Process) and subject to the Committee’s guidance set out in the 2004 Principles for the management and supervision of interest rate risk (henceforth, the IRR Principles). The IRR Principles lay out the Committee’s expectations for banks’ identification, measurement, monitoring and control of IRRBB as well as its supervision.
IRRBB refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions. When interest rates change, the present value and timing of future cash flows change. This in turn changes the underlying value of a bank’s assets, liabilities and off-balance sheet items and hence its economic value. Changes in interest rates also affect a bank’s earnings by altering interest rate-sensitive income and expenses, affecting its net interest income (NII). Excessive IRRBB can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately.
Three main sub-types of IRRBB are defined for the purposes of these Principles:
- Gap risk arises from the term structure of banking book instruments, and describes the risk arising from the timing of instruments’ rate changes. The extent of gap risk depends on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).
- Basis risk describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.
- Option risk arises from option derivative positions or from optional elements embedded in a bank’s assets, liabilities and/or off-balance sheet items, where the bank or its customer can alter the level and timing of their cash flows. Option risk can be further characterised into automatic option risk and behavioural option risk.
All three sub-types of IRRBB potentially change the price/value or earnings/costs of interest rate-sensitive assets, liabilities and/or off-balance sheet items in a way, or at a time, that can adversely affect a bank’s financial condition
The Committee has decided that the IRR Principles need to be updated to reflect changes in market and supervisory practices since they were first published, and this document contains an updated version that revises both the Principles and the methods expected to be used by banks for measuring, managing, monitoring and controlling such risks.
These updated Principles were the subject of consultation in 2015, when the Committee presented two options for the regulatory treatments of IRRBB: a standardised Pillar 1 (Minimum Capital Requirements) approach and an enhanced Pillar 2 approach (which also included elements of Pillar 3 – Market Discipline). The Committee noted the industry’s feedback on the feasibility of a Pillar 1 approach to IRRBB, in particular the complexities involved in formulating a standardised measure of IRRBB which would be both sufficiently accurate and risk-sensitive to allow it to act as a means of setting regulatory capital requirements. The Committee concludes that the heterogeneous nature of IRRBB would be more appropriately captured in Pillar 2.
Nonetheless, the Committee considers IRRBB to be material, particularly at a time when interest rates may normalise from historically low levels. The key updates to the Principles under an enhanced Pillar 2 approach are as follows:

Greater guidance has been provided on the expectations for a bank’s IRRBB management process, in particular the development of shock and stress scenarios (Principle 4) to be applied to the measurement of IRRBB, the key behavioural and modelling assumptions which banks should consider in their measurement of IRRBB (Principle 5) and the internal validation process which banks should apply for their internal measurement systems (IMS) and models used for IRRBB (Principle 6).

The disclosure requirements under Principle 8 have been updated to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. Banks must disclose, among other requirements, the impact of interest rate shocks on their change in economic value of equity (∆EVE) and net interest income (∆NII), computed based on a set of prescribed interest rate shock scenarios.

The supervisory review process under Principle 11 has been updated to elaborate on the factors which supervisors should consider when assessing the banks’ level and management of IRRBB exposures. Supervisors could also mandate the banks under their respective jurisdictions to follow the standardised framework for IRRBB (eg if they find that the bank’s IMS does not adequately capture IRRBB). The standardised framework has been updated to enhance risk capture.

Supervisors must publish their criteria for identifying outlier banks under Principle 12. The threshold for the identification of an “outlier bank” has also been tightened, where the outlier/materiality test(s) applied by supervisors should at least include one which compares the bank’s ∆EVE with 15% of its Tier 1 capital, under a set of prescribed interest rate shock scenarios. Supervisors may implement additional outlier/materiality tests with their own specific measures. There is a strong presumption for supervisory and/or regulatory capital consequences, when a review of a bank’s IRRBB exposure reveals inadequate management or excessive risk relative to a bank’s capital, earnings or general risk profile.

Consistent with the scope of application of the Basel II framework, the proposed framework would be applied to large internationally active banks on a consolidated basis. Supervisors have national discretion to apply the IRRBB framework to other non-internationally active institutions.
The document is structured as follows. Section I provides an introduction to IRRBB. Section II presents the revised Principles, which replace the 2004 IRR Principles for defining supervisory expectations on the management of IRRBB. Principles 1 to 7 are of general application for the management of IRRBB, covering expectations for a bank’s IRRBB management process, in particular the need for effective IRRBB identification, measurement, monitoring and control activities. Principles 8 and 9 set out the expectations for market disclosures and banks’ internal assessment of capital adequacy for IRRBB respectively. Principles 10 to 12 address the supervisory approach to banks’ IRRBB management framework and capital adequacy. Section III states the scope of application and Section IV sets out the standardised framework which supervisors could mandate their banks to follow, or a bank could choose to adopt. The Annexes provide a set of terminology and definitions that will provide a better understanding of IRRBB to both banks and supervisors and further details on the standardised interest rate shocks.
The banks are expected to implement the standards by 2018.

Foreign Investors in Victoria Get Stamp Duty Hit

The 2016/17 Victorian Budget will increase the stamp duty surcharge on foreign buyers of residential real estate from 3 per cent to 7 per cent, and apply to contracts signed on or after 1 July 2016. The land tax surcharge on absentee owners will also rise from 0.5 per cent to 1.5 per cent from the 2017 land tax year. The measures are expected to raise $486 million over the next four years. Treasurer Tim Pallas said “No Victorians will pay these surcharges. This is about ensuring foreign owners pay their fair share.”

The Andrews Labor Government is taking action to ensure foreign buyers of residential real estate contribute their fair share to the liveability of our state.

It is only fair that foreign buyers – who do not pay taxes such as payroll tax and GST – fairly contributed to the maintenance and development of government services and infrastructure, just like Victorian taxpayers do.

There have been sustained and strong levels of foreign purchasing of residential real estate in recent years. This increase will ensure a fair and equitable contribution is made by foreign purchasers of Victorian real estate.

Victoria’s surcharges on foreign owners of residential real estate have been in operation since 1 July 2015 and have had little impact on foreign demand for Victorian dwellings.

Where to With Melbourne Home Prices?

Continuing our econometric modelling of home prices trends, today we examine Melbourne. As we discussed our model takes account of a range of factors and runs a series of future scenarios out to mid 2018. We look at prices both within Melbourne and also across the state and split the analysis into houses and units.

In our base case to mid 2018, we expect to see the average house price in Melbourne rise by 2.8% to $639,000 and the average unit in Melbourne fall by 15.1% to $429,000. In regional areas, the average house price will rise 3.5% to $321,000 and units will fall by 0.4% to $260,000. The oversupply of units in the CBD explain the projected price falls.

If economic momentum becomes stronger, to mid 2018, the average house price in Melbourne will rise by 5.1% to $653,000 and the average unit in Melbourne will fall by 5.7% to $476,000. In regional areas, the average house price will rise 3.4% to $337,000 and units will rise by 7.9% to $282,000. The rise in Melbourne will continue despite lower demand for investment property and static incomes. Over supply of units in the CBD will depress unit prices.

If economic momentum falls, to mid 2018, we expect to see the average house price in Melbourne fall by 11.6% to $549,000 and the average unit in Melbourne fall by 25.2% to $378,000. In regional areas, the average house price will fall 10.6% to $277,000 and units will fall by 12.6% to $228,000. In this scenario, growth remains low, unemployment moves higher, incomes remain flat, and demand for property slows.

If economic momentum falls significantly, to mid 2018, we expect to see the average house price in Melbourne fall by 29.2% to $439,000 and the average unit in Melbourne fall by 38.4% to $311,000. In regional areas, the average house price will fall 28% to $223,000 and units will fall by 18.8% to $221,000. In this scenario, cash interest rates are cut further, unemployment rises, income falls in real terms, and demand for property falters. This is our Armageddon scenario.

We see that the main area of risk centres on units in Melbourne, especially those within the CBD and surrounds. Supply is rising fast, at a time when demand is not matched.

And a caveat, this modelling will be wrong, but it does give an indication of relative sensitives. Next time we will look at Brisbane and QLD.

Unintended Consequences of Macroprudential

An IMF working paper, just released examines the impact of macroprudential policy. They conclude that implementing macroprudential does reduce the expansion of bank credit, but this is offset by a growth in non-bank credit and foreign bank lending, so the overall braking effect is less severe than expected. This substitution effect needs to be incorporated into the policy settings to deliver the desired credit growth management. Here is a summary.

Macroprudential policy is alive and kicking. It is being used actively both in emerging market economies and—following the global financial crisis—in advanced economies. It includes measures that apply directly to lenders, such as countercyclical capital buffers or capital surcharges, and restrictions that apply to borrowers, such as loan-to-value (LTV) and loan-to-income (LTI) ratio caps. Most macroprudential measures activated around the globe between 2000 and 2013 apply to the banking sector only, including borrower-based measures.

The widespread use of macroprudential policy is aimed at reducing systemic risks. Yet the use of national sector-based measures may be subject to a boundary problem, causing substitution flows to less regulated parts of the financial sector. Specifically, macroprudential policy may have the consequence of shifting activities and risks both to: (i) foreign entities (e.g., bank branches and cross-border lending); and (ii) nonbank entities (e.g., shadow banking, also referred to as market-based financing). Whereas several papers have estimated intended effects of macroprudential policies (MaPs) on variables such as credit growth and housing prices, and whether measures leak to foreign banks, cross-sector substitution effects have—to the best of our knowledge—not yet been tested empirically.

This paper aims to fill this gap. It investigates whether macroprudential policies lead to substitution from bank-based financial intermediation to nonbank intermediation. In addition, it uses event study methodology to shed light on the timing of the effects of policy measures on bank and nonbank intermediation around activation dates. Moreover, we contribute to the literature by distinguishing between the effects of quantity versus price-based instruments and lender versus borrower-based instruments, given that the effects may differ. We also check whether results differ for advanced economies (AEs) versus emerging market economies (EMEs) and bank versus market-based financial systems.

Our results support the hypothesis that macroprudential policies reduce bank credit growth. In our sample, in the two years after the activation of MaPs, bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure. This effect is much stronger in EMEs than in AEs. Beyond this, our results suggests that quantity-based measures have much stronger effects on credit growth than price-based measures, both in advanced and emerging market economies. In cumulative terms, quantity measures slow bank credit growth by 8.7 percentage points over two years relative to the counterfactual of no policy change.

Our main contribution to the literature relates to substitution effects: we find that the effect of MaPs on bank credit is always substantially higher than the effect on total credit to the private sector. Whereas bank credit growth falls on average by 7.7 percentage points relative to the counterfactual of no measure, total credit growth falls by 4.9 percentage points on average. The reason for this is the increase in nonbank credit growth. We also find significant differences between country groups and instruments. First, substitution effects are stronger in AEs. This is in line with expectations given their more developed financial systems, with a larger role for market-based finance. Second, substitution effects are much stronger in the case of quantity restrictions, which are more constraining than price-based measures. Finally, we find strong and statistically significant effects on specific forms on nonbanking financial intermediation, such as investment fund assets.

Our paper builds on a rapidly expanding literature. While the concept of macroprudential policy can be traced back at least to the late 1970’s, it has become a common part of the policy lexicon in the first decade of this millennium. The global financial crisis has led not only to much more interest in the macroprudential approach, but also to active use of macroprudential instruments around the world.

The active use of instruments has spawned a growing empirical literature on the effectiveness of macroprudential policies, in individual country, regional and global settings. The most comprehensive study, who uses an IMF survey to document macroprudential policies in 119 countries over the 2000–13 period. They find that the implementation of such instruments is generally associated with the intended lower impact on credit, but that the effects are weaker in financially more developed and open economies.

In addition, to its intended effects, macroprudential policy may leak. Macroprudential policy may also increase crosssector substitution. A recent study by the IMF finds that more stringent capital requirements are associated with stronger growth of shadow banking. Our paper uses both net flow measures and an event study methodology to shed light on the size and timing of cross-sector substitution effects. Our empirical framework builds on work that has sought to explain credit growth, for instance to understand credit rationing and the monetary transmission mechanism. We control for macroeconomic fundamentals to filter out effects of policy on credit growth in a crosscountry panel setting.

Our results do not allow us to assess whether substitution effects reduce or increase systemic risks. A lowering of systemic risks may be expected, as risks may shift to institutions that are less leveraged and less subject to maturity mismatch. But this need not be the case, as market failures and systemic risks may also arise outside the regulated banking sector.

Overall, our findings underline the relevance of such a broad approach to monitoring and addressing systemic risks, especially for advanced economies. Earlier findings on cross-border leakages indicate that macroprudential policy should not take a narrow national perspective, as this would fail to internalize cross-border substitution effects. Our results on cross sector substitution complement these findings, and suggest that macroprudential policy should not take a narrow sectoral perspective.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Stronger role for ombudsman is the key to protecting bank customers

From The Conversation.

The federal government responded to calls for a banking royal commission with a raft of changes to the Australian Securities and Investment Commission (ASIC) but for consumers, who bore the brunt of the recent financial scandals, it is further potential changes to the Financial Ombudsman Service (FOS) that may matter the most.

The media has focused on recommendation for change at ASIC, where the majority of recommendations announced yesterday were outcomes of the ASIC Capability Review. The review was itself was recommended by the 2015 Financial System Inquiry, which commenced began back in 2014.

It is good to see movement on these recommendations, though some of the fine points such as the user-pays funding model and ASIC’s new recommended internal governance structure may remain subject to debate.

Equally if not more important for consumers is the government’s new review – also announced yesterday – of the Financial Ombudsman Service (FOS) and other external dispute resolution schemes. This is where average Australians takes up cases of carelessness, wrongdoing, negligence and fraud every day. According to reports, the FOS alone received 30,000 complaints last year. It is the coal face.

The FOS, itself operating under ASIC’s regulatory guidance, is the natural place for consumers to find their voice. It is an independent body for dispute resolution, keeping cases away from the courts with the aim of enabling consumers to win remedial action at lower cost and in less time. There are reported issues around about the response time of staff at the FOS, and the overall resources available to support work volumes and complexity, but the need for a strong FOS appears to be undisputed.

Submissions to the original Financial System Inquiry in early 2014 attest to the role of the FOS, and hint at its potential effectiveness. In one submission, the Consumer Credit Legal Centre in NSW provides case study after case study of consumers who went to the FOS seeking help for unpaid insurance claims, fraudulent mortgages and irresponsible lending practices.

In an ideal world, these circumstances would not arise – but no system is perfect, or immune from abuses. The submission of consumer group Choice to the inquiry also recognised the role of external dispute resolution schemes for both consumers and the benefit of the overall system.

In light of ongoing issues and scandals in the financial sector, it might be reasonable to consider further beefing up the resources and powers of the FOS. Policing a system through high level surveillance is one way to detect problems; gathering intelligence from the grassroots is another.

But the system is messy. In addition to the FOS, the external dispute resolution landscape includes the Credit and Investment Ombudsman and the Superannuation Complaints Tribunal, each with their own guidelines of where and how they can get involved in a case. This is a confusing menu of options for the consumer, even after the 2008 consolidation that brought the number of schemes down from eight to three.

The role, powers and governance of these bodies will now be the subject of another independent review, with an expert panel to be convened and asked to report back by the end of this year. Among other items, this review might consider removing these bodies from ASIC.

Such a separation would leave ASIC free to concentrate on its core role: ensuring market integrity through surveillance and enforcement. It would relieve ASIC of the responsibility for consumer protection in financial services – the only industry where ASIC instead of the ACCC has a mandated role in relation to consumer protection.

A suggestion to relocate responsibility for consumer protection in financial services from ASIC to ACCC was one of the suggestions made by Alex Erskine, in a paper submitted to the Financial Services Inquiry and published by the Australian Centre for Financial Studies in 2014. In the paper, Erskine argues that ASIC suffers from being charged with six policy objectives and insufficient tools – thus failing the Tinbergen Principle that holds that every single policy objective needs to have at least one policy tool if it is to be realised.

This analysis merits careful consideration. In every other industrial sector in Australia, the ACCC is charged not only with consumer protection, but also competition.

The importance of competition in promoting efficiency and encouraging satisfactory consumer outcomes was a theme that carried through the findings and recommendations of the Financial Services Inquiry, and remains a subject of great public debate in relation to the financial services sector.

ACCC holds sufficient power to investigate any matter of unconscionable conduct, whether within a single firm or on an industry-wide level. It is also the competition regulator. These activities sit within its core mandate and institutional expertise. What is the role of this regulator in Australia’s financial system?

The opus magnum of the Financial System Inquiry continues to be written, as the industry now awaits the outcome of another highly significant review.

Author: Amy Auster, Executive Director, Australian Centre for Financial Studies

Could gambling be the secret to saving when rates are so low?

From The Conversation.

Many interest rates in the U.S. are close to zero and even negative in some parts of the world, like Japan.

Not unexpectedly, U.S. savings rates are also quite low as individuals ask themselves: “Why save a lot of money at a bank if I get no return?”

This situation has many commentators wringing their hands because low savings rates are a problem for many reasons.

Individuals who don’t save face spending their golden years of retirement in poverty, instead of plenty. In addition, people with no savings face financial problems and potential ruin when unexpected large expenses occur and cannot help out their children with large bills like college or a down payment on a first home.

In the absence of a rapid increase in interest rates, which appears unlikely, is there anything we can do to change this problem and get people to save more?

As odd as it may sound, gambling could be part of the answer.

A simple solution: prize-linked accounts

One innovative idea for boosting low savings rates is through prize-linked savings accounts, also known as lottery-linked deposits.

The idea of prize-linked accounts is simple. Instead of receiving the full amount of interest on their savings, most people are given less money than they would otherwise and the remainder is distributed as prizes awarded randomly to some savers chosen by a lottery.

Pretend the average person receives US$2 each month in interest on a standard savings account. A bank offering a prize-linked account might instead give the account holder $1 of interest plus a small chance – slightly better than scratch tickets – to win $10,000. The bank would gather the $10,000 prize money by pooling the extra dollars of interest held back from many savings accounts.

These lottery savings accounts are an innovative idea because interest rates today are very low and offer little or no incentive for people to save money. Low savings rates cause people to abandon traditional savings accounts and lead some people to seek higher rates of return in very risky investments.

Prize-linked accounts have the advantage of ensuring savers never lose their initial funds, unlike other forms of gambling where losers can go home empty-handed.

One example of how prize-linked accounts work is the save-to-win program, promoted by a nonprofit with a mission to boost financial security among the poor. Savers deposit their money in a special 12-month account. Every $25 deposited gets the saver one more lottery ticket. Each month some prizes are awarded, and in some locations there is also an annual grand prize of $10,000 for those people who kept money in the bank for all 12 months.

These rules encourage people to open accounts, leave money untouched and build savings. Evaluations of these accounts since they began in 2009 suggest they are effective at boosting savings especially among the poor.

History of prize-linked accounts

Prize-linked savings accounts are not a new invention. The first lottery savings account was created in England in 1693 to help fund the Nine Years’ War against France.

It was a great success and raised a million British pounds for the government, which was about one-sixth of all public spending that year. Savers bought tickets for £10 each. Each ticket had a chance to win a grand prize of £1,000 per year for 16 years.

Tickets that won nothing in the lottery, however, paid interest of £1 per year for 16 years, providing the English Crown with a medium-term loan whose proceeds were used to fight a war. This was a huge success for savers because each £10 ticket returned a total of £16, plus a chance of winning a jackpot.

Controversy

Controversy has surrounded prize-linked accounts ever since their introduction in 1693. Initially, criticism was leveled against the accounts because they encouraged people to gamble, which many people viewed as immoral.

More recently, governments have been against the accounts because they divert funds from state-sanctioned lotteries. South Africa’s First National Bank created a very successful account in which winners received a maximum payout of about $150,000. This program boosted savings by the poor and unbanked in South Africa. However, that country’s Supreme Court ruled the accounts were illegal after the state lottery commission complained that its own sales were reduced as a result.

While many other countries have created prize-linked savings accounts, the idea is relatively new in the U.S. The first prize-linked savings accounts were created in Michigan in 2009.

The successful introduction of these accounts in other states like Nebraska resulted in President Barack Obama signing into law in December 2014 the “American Savings Promotion Act,” which enabled credit unions and banks to offer these accounts across the country. President Obama and Congress needed to revise the laws, because prior to the bill it was illegal for banks to engage in risky activities such as sponsoring a lottery.

States, however, also have to change their laws for this program to become widespread. One of the most recent states is Oregon, which passed legislation in June 2015 enabling banks to offer the accounts this year.

Very interesting but preliminary research is being done by University of Colorado Finance Professor Tony Cookson, who examined people in Nebraska and found that the introduction of lottery-linked savings leads consumers to reduce casino gambling. This means that these lottery-style accounts can not only boost savings rates but also encourage people to gamble less in casinos. While this is a win for consumers, it is problematic for states that are dependent on casino and lottery revenue to balance their books.

A ‘special’ boost

Prize-linked savings accounts are not the complete solution to low savings problems in the U.S. and elsewhere. Nevertheless, these accounts can help.

Encouraging people to save and build an emergency cushion for a rainy day is important. Prize-linked savings accounts are one way to do this.

My bank recently sent me a mailing trumpeting the fact that because I am a long-term “valued” customer, my savings account got a special interest rate boost to encourage me to save more. Even with the “special” boost, I earned a grand total of $1.27 in interest for the month. This tiny sum gives me no incentive to spend less and save more.

However, a prize-linked savings account that did away with all of my paltry interest but gave me a small chance at earning enough money to actually buy something of value would definitely encourage me, and likely many others, to save more.

Author: Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University

Banks Act to Strengthen Community Trust

In response to the recent discussions on bank culture, and regulation, Australia’s banks have announced they will begin to implement comprehensive new measures to protect consumer interests, increase transparency and accountability and build trust and confidence in banks. Of note is a review of product sales commissions, enhanced complaints procedures, and whistle blower procedures. They will publish quarterly reports on progress.

“This package aims to address consumer concerns about remuneration, the protection of whistleblowers, the handling of customer complaints and dealing with poor conduct,” Australian Bankers’ Association Chief Executive Steven Münchenberg said.

“Customers expect banks to keep working hard to make sure they have the right culture, the right practices and the right behaviours in place.

“That’s why the banks will immediately establish an independent review of product sales commissions and product based payments, with a view to removing or changing them where they could result in poor customer outcomes,” he said.

“Banks will also improve their protections for whistleblowers to ensure there is more support for employees who speak out against poor conduct.

“This plan delivers immediate action to make it easier for customers to do business with banks, including when things go wrong. For example, improved complaints handling and better access to external dispute resolution, as well as providing compensation to customers when needed,” he said.

The plan, parts of which are subject to regulatory approval or legislative reform, will be overseen by an independent expert.

“We recognise the importance of having an impartial third party to oversee this process,” Mr Münchenberg said.

“The industry has appointed Gina Cass-Gottlieb, Gilbert + Tobin Lawyers, to lead the work on establishing the governance arrangements around the implementation of the plan, the review process, public reporting, and the selection of an independent expert to oversee implementation of this initiative.

“The banks also support the Federal Government’s review of the Financial Ombudsman Service, who is the independent umpire for customer complaints, to ensure it has the power and scope required to deal with a variety of issues that currently fall outside its thresholds,” he said.

“Trust is at the centre of banking and is critical for the stability of our financial system. The strength of our banking sector got us through the global financial crisis. Since then banks have done a lot of work in improving customer satisfaction, strengthening their balance sheets, and making it easier for customers to do their banking wherever and whenever they want.

“The plan also responds to a range of expert reports and public inquiries that have identified key areas of reform, including the Financial System Inquiry.

“Banks recognise the importance of the community discussion about the delivery of banking and financial services, and are pleased to put forward this plan,” Mr Münchenberg said.

A copy of the industry statement is below.

Industry Statement

Australia’s banks understand that trust is critical to a strong and stable banking and financial services sector. We acknowledge that we have a privileged role in the economy. Our customers, shareholders, employees and our communities rightly expect the behaviour of banks to meet high ethical standards as we look after their financial needs.

For some years now banks have been responding to community feedback to improve customer service and our industry’s contribution to the community more broadly. This has been largely successful. While all banks have customer satisfaction ratings above 80%, we acknowledge there is more to do. We continue to implement wide ranging reforms that have already been agreed through the inquiries, reviews and consultations undertaken over recent years.

Subject to regulatory approval, we are committing to a further six actions to make it easier for customers to do business with us and to give people confidence that when things go wrong, we will do the right thing.

We understand the importance of independence and transparency. To ensure this, the industry has appointed Gina Cass-Gottlieb, Gilbert + Tobin Lawyers, to lead the work on establishing the governance arrangements around the implementation of the plan, the review process, public reporting, and the selection of an independent expert to oversee implementation of this initiative. This initial stage will take a month. We will publish public quarterly reports on our progress, with the first report within three months of this announcement.

We believe these actions will further lift standards and transparency across the banking and financial services sector and bolster the existing strength of the regulatory framework.

1. Reviewing product sales commissions

Building on the ‘Future of Financial Advice’ reforms, we will immediately establish an independent review of product sales commissions and product based payments with a view to removing or changing them where they could lead to poor customer outcomes. We intend to strengthen the alignment of remuneration and incentives and customer outcomes. We will work with regulators to implement changes and, where necessary, seek regulatory approval and legislative reform.

Each bank commits to ensure it has overarching principles on remuneration and incentives to support good customer outcomes and sound banking practices.

2. Making it easier for customers when things go wrong

We will enhance the existing complaints handling processes by establishing an independent customer advocate in each bank to ensure retail and small business customers have a voice and customer complaints directly relating to the bank, and the third parties appointed by the bank, are appropriately escalated and responded to within specified timeframes.

We support a broadening of external dispute resolution schemes. We support the Government’s announcement to conduct a review into external dispute resolution, including the Financial Ombudsman Service conducting a review of its terms of reference with a view to increasing eligibility thresholds for retail and small business customers.

We will work with ASIC to expand its current review of customer remediation programs from personal advice to all financial advice and products.

We will evaluate the establishment of an industry wide, mandatory last resort compensation scheme covering financial advisers. We support a prospective scheme being introduced where consumers of financial products who receive a FOS determination in their favour would have access to capped compensation where an adviser’s professional indemnity insurance is insufficient to meet claims.

3. Reaffirming our support for employees who ‘blow the whistle’ on inappropriate conduct

We will ensure the highest standards of whistleblower protections by ensuring there is a robust and trusted framework for escalating concerns. We will standardise the protection of whistleblowers across banks, including independent support, and protection against financial disadvantage. As part of this, we will work with ASIC and other stakeholders.

4. Removing individuals from the industry for poor conduct

We will implement an industry register which would extend existing identification of rogue advisers to any bank employees, including customer facing and non-customer facing roles. This will help prevent the recruitment of individuals who have breached the law or codes of conduct.

5. Strengthening our commitment to customers in the Code of Banking Practice

We will bring forward the review of the Code of Banking Practice. The Code of Banking Practice is the banking industry’s customer charter on best practice banking standards, disclosure and principles of conduct. The review will be undertaken in consultation with consumer organisations and other stakeholders, and will be completed by the end of the year.

6. Supporting ASIC as a strong regulator

We support the Government’s announcement to implement an industry funding model. We will work with the Government and ASIC to implement a ‘user pays’ industry funding model to enhance the ability for ASIC to investigate matters brought to its attention.
We will also work with ASIC to enhance the current breach reporting framework.

Econometric House Price Modelling

Given the near $6 trillion of residential real estate, and the near $1.6 trillion of loans on these properties, future house price dynamics are important for households, banks, regulators and the wider economy. So it is worth thinking about where house prices might go. There is no rule that house prices can only rise. In the US they fell up to 40% and in the UK up to 25% post the GFC. Domain today reported falls in many states in the past few months. In Australia, prices are way above long term trends.

Any modelling of future outcomes will be wrong. However we have been developing an econometric model which draws current data from our segmented household surveys and using a range of relationships we seek to estimate average house and unit prices by state, for properties in the main urban areas, and separately in the regional areas. Averages across Australia mask too many differences to be useful. Having used the model to track events over the past year, we feel confident enough of the algorithms to share some of the results. But to stress, this model is only a guide, and its results are wrong!!

Our point of departure is data from the ABS on house and unit prices. We overlay our survey data with a range of factors to drive our modelling from a range of sources. These include:

Supply of property by type (building approvals and construction)
Demand for property by type (from the DFA survey)
Population growth and demography (combination of DFA survey and ABS)
Income growth (from ABS)
Unemployment rate (from ABS)
Inflation rate (from ABS)
GDP Growth rate (from ABS)
Demand for finance (from the survey)
Supply of finance (RBA and ABS data)
Interest rates (RBA)
Mortgage interest margins (RBA and DFA analysis)
Mortgage underwriting interest rate floors (APRA)
Choice modelling between investment types (DFA survey)
Choice modelling between property types (DFA survey)
Tax breaks (DFA survey and ATO)
Mortgage default rates (Various, including DFA survey)
Lender mortgage write-downs (Company results)
Penetration of Lenders Mortgage Insurance (DFA surveys and analysis)

We have six scenarios:

Strong recovery
Mild up turn
Base case (no changes from current settings)
Mild down turn
Severe down turn
Armageddon

Over the coming days we will discuss some of the initial analysis we have completed. Today, we look at NSW.

In our base case to mid 2018, we expect to see the average house price in Sydney fall by 5.5% to $860,000 and the average unit in Sydney fall by 1.2% to $400,000. In regional areas, the average house price will fall 2.5% to $395,000 and units will fall by 10.6% to $309,000.

If economic momentum becomes stronger, to mid 2018, the average house price in Sydney will still fall a little, by 1.4% to $897,000 and the average unit in Sydney will fall by 1.1% to $677,000. In regional areas, the average house price will rise 3.3% to $418,000 but units will fall by 9.3% to $313,000. The falls in Sydney will continue given the previous strong run, lower demand for investment property and static incomes.

If economic momentum falls, to mid 2018, we expect to see the average house price in Sydney fall by 17.5% to $751,000 and the average unit in Sydney fall by 16.3% to $573,000. In regional areas, the average house price will fall 14.6% to $346,000 and units will fall by 21.9% to $269,000. In this scenario, growth remains low, unemployment moves higher, incomes remain flat, and demand for property slows.

If economic momentum falls significantly, to mid 2018, we expect to see the average house price in Sydney fall by 26.1% to $672,000 and the average unit in Sydney fall by 28.4% to $490,000. In regional areas, the average house price will fall 25.2% to$303,000 and units will fall by 34.5% to $226,000. In this scenario, cash interest rates are cut further, unemployment rises, income falls in real terms, and demand for property falters. This is our Armageddon scenario.

Our conclusion is that in NSW, there is more down side than upside in property at the moment and this will continue for some time to come. How severe the correction will be depends on the economic and growth outcomes.

Results are rather different in other states, and we will explore these scenarios in the next few days.

Commonwealth Bank tightens criteria on home loans for foreigners

From Australian Broker.

The nation’s largest mortgage lender, the Commonwealth Bank of Australia (CBA), has announced that it is tightening its criteria for home loans for foreigners.

The CBA will no longer approve applications for home loans that cite self-employed foreign income, according to a note sent to mortgage brokers this week.

The bank also says it will no longer accept the foreign-currency income of temporary Australian residents. These individuals can also only borrow up to 70% of a property’s value, compared with the previous rate of 80%.

Home loan applications from foreigners make up a “significantly low proportion of our total home loan applications” according to a CBA statement, adding, “We constantly review and monitor our home loan portfolio to ensure we are maintaining our prudent lending standards and meeting our customers’ financial needs.”

The fact that home loans for foreigners make up a relatively small segment of the market means CBA’s new policy should not have major consequences for mortgage brokers, according to principal at Ocean Home Loans, Brad Kirwan.

“This is a very small part of the overall market,” he told Australian Broker. “Self-employed foreign investors are an even smaller part of that market. Most lenders won’t accept foreign self-employed income anyway – I’d suggest that CBA are aligning their policy with the other major banks so as not to be over-exposed to one particular type of applicant.”

When asked what steps brokers might take in response to CBA’s changes, Kirwan added, “There are several large brokerages that focus entirely on the Chinese market and have done very well over the past few years, they will obviously have to reassess how they do business in the future, for the majority of mortgage brokers it will be business as usual.”