Martin North – Page 1001 – Digital Finance Analytics (DFA) Blog

The Global Implications of Diverging Monetary Policy Settings in Advanced Economies

Panel remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Sixth High Level Conference on the International Monetary System: Monetary Policy Challenges in a Changing World, Zurich, Switzerland, 12 May 2015.

I will focus my remarks on the global implications of U.S. monetary policy normalization – paying particular attention to the potential implications for emerging market economies (EMEs). I put the focus here because these economies were greatly affected in 2013 during the so-called “taper tantrum” and many of these economies have been under stress from the weakness in global commodity prices. As always, what I have to say today reflects my own views and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve.

But before I get to the implications for EMEs and what the Fed should do or not do to mitigate the impact, a few words on the timing of normalization. To be as direct as possible: I don’t know when this will occur. The timing of lift-off will depend on how the economic outlook evolves. Since the economic outlook is uncertain, this means the timing of liftoff must also be uncertain.

At the same time, though, I can be clear about what conditions are needed for normalization to begin. If the improvement in the U.S. labor market continues and the FOMC is “reasonably confident” that inflation will move back to our 2 percent objective over the medium-term, then it would be appropriate to begin to normalize interest rates.

Because the conditions necessary for liftoff are well-specified, market participants should be able to think right along with policymakers, adjusting their views about the prospects for normalization in response to the incoming data. This implies that liftoff should not be a big surprise when it finally occurs, which should help mitigate the degree of market turbulence engendered by lift-off.

Nevertheless, I think it would be naïve not to expect some impact. After more than six years at the zero lower bound, lift-off will signal a regime shift even though policy would only be slightly less accommodative after lift-off than it is before. I expect that this will have implications for global capital flows, foreign exchange valuation and financial asset prices even if it is mostly anticipated when it occurs.

Which leads to the key question I want to address in the remainder of my remarks: What should the Federal Reserve do to minimize the impact?

Like other central banks, our monetary policy mandate has a domestic focus. Our monetary policy actions, though, often have global implications that feed back into the U.S. economy and financial markets, and we need to always keep this in mind.

From one perspective, the unconventional nature of monetary policy around the world adds little that is fundamentally new to the challenges that face EMEs. Today’s monetary policies simply represent a way of easing that was necessitated by hitting the zero lower bound here and elsewhere. Central bankers have managed differences across countries in cyclical positions and policy stances many times in the past. This time should not be fundamentally different.

But, from another perspective, we have less experience operating with unconventional monetary policy, we have been in this regime for a long time and this creates more potential uncertainties. These uncertainties put a premium on clear communication among central bankers as well as between central bankers and market participants. In my view, an important fact is that the large scale asset purchase programs undertaken in the United States and elsewhere have dramatically shrunk the size of bond risk premia globally. This new set of monetary policies affects financial asset prices in a different way compared to changes in short-term interest rates, and we should be humble regarding what we claim to understand about this distinction.

Looking ahead, it seems likely that markets will remain focused on those vulnerabilities that they might have ignored prior to the taper tantrum in 2013. The greater premium on strong fundamentals, policy coherence and predictability will likely remain. Although we will undoubtedly experience further bumps in the road. I think we can remain generally optimistic about the prospects for adjustment. But for this to occur, it will be important for market participants to appropriately discriminate across countries, rather than treating EMEs as a single group.

The good news is that many EMEs generally appear to be better equipped today to handle the Fed’s prospective exit from its exceptional policy accommodation than they were during past tightening cycles. This reflects the fundamental reforms that EMEs have put in place over the past 15 years, as well as the hard lessons learned from past periods of market stress. Among the positives are:

The absence of pegged exchange rate regimes that often came undone violently during periods of acute stress;

Improved debt service ratios and generally moderate external debt levels;

Larger foreign exchange reserve cushions;

Clearer and more coherent monetary policy frameworks, supporting what are now generally low to moderate inflation rates;

Generally improved fiscal discipline; and

Better capitalized banking systems, supported by strengthened regulatory and supervisory frameworks.

Of course, progress has not been uniform across EMEs, and more work remains to further strengthen institutional structures in some countries. In particular, vulnerabilities remain in several important EMEs, and some have been hit by the sharp adverse turn in their terms of trade due to the recent fall in global commodity prices. Still, the fundamental improvements I’ve cited leave many EMEs better positioned than in the past to weather those times in the cycle when the external environment becomes more difficult.

The impact that changes in Fed policy can have beyond our borders has led to calls for us to do more to internalize those impacts, or even further, to internationally coordinate policymaking. As I’ve already noted, we are mindful of the global effects of Fed policy, given the central place of U.S. markets in the global financial system and the dollar’s status as the global reserve currency. Accordingly, we seek to conduct monetary policy transparently and based on clear principles. Promoting growth and stability in the U.S., I believe, is the most important contribution we can make to growth and stability worldwide.

There is, of course, the argument that Fed policy has been too accommodative for too long, creating risks for financial stability worldwide. Here, I think it’s important to consider carefully the counterfactual. Would countries beyond our borders really have been better off with a weaker U.S. economy – an economy that might have required exceptional monetary policy accommodation for a much longer period of time? The fundamental issue is whether U.S. monetary policy has helped support our dual objectives of maximum employment in the context of price stability, and whether this support is consistent with a healthy global economy.

While explicit coordination looks neither feasible nor desirable, there may be more that central banks in general, and the Fed in particular, could do to be better global stewards. As an example, I would emphasize the importance of effective Fed communication. It is clear, in retrospect, that our attempts in the spring of 2013 to provide guidance about the potential timing and pace of tapering confused market participants. Market participants seemed to conflate the prospective tapering of asset purchases with monetary policy tightening, and pulled forward their expectations about the likely timing of liftoff and raised their expected paths for policy rates. Lately, we seem to have done better: the tapering down of the Fed’s asset purchase program went smoothly and market participants now seem to share the assessment embodied in the FOMC’s March Summary of Economic Projections that lift-off is likely to begin sometime later this year.

As you know, we’ve taken a number of steps in recent years to increase transparency and improve our communications. This includes regular press conferences by the Fed chair following FOMC meetings; the publishing of growth, inflation and short-term rate forecasts of FOMC participants; and a concerted attempt to lay out the guideposts that the FOMC will look at to assess progress toward our mandate. We also have explained in considerable detail what tools we will use and how we will likely use them to ensure to ensure a smooth lift-off.

A second area we have focused on is doing a better job safeguarding financial stability. Simply put, we failed to act both early enough and decisively enough to stem the credit excesses that spawned the financial crisis and the Great Recession. The U.S. was not alone in this shortcoming, but given our position in the global financial system, we especially should have done better. We’ve taken important steps through new legislative mandates and a broader effort to rethink our regulatory and supervisory framework. In particular, systemically important banking organizations must now hold amounts of capital and liquidity that are better aligned with their risk profiles. Other changes have also been implemented, such as central clearing of standardized OTC derivatives contracts, that should make the global financial system more resilient and robust.

Although this effort remains very much a work in progress, I think it will enable us to avoid repeating the mistakes of the past decade, and enable us to take a more proactive stance toward mitigating potential future vulnerabilities. Of course, we at the Fed are not alone here. Since the recent financial crisis, central banks worldwide have been engaged in a broad rethinking of how to better fulfill their mandates.

Let me close with a final thought. The largest problems that countries create for others often emanate from getting policy wrong domestically. Recession or instability at home is often quickly exported abroad. Equally important, growth and stability abroad makes all our jobs at home easier. This illustrates the externalities in the work we all do, with more effective fulfillment of our domestic mandates helping to bring us collectively to a better place.

Inquiry On Home Ownership Launched

The House of Representatives Economics Committee has announced a new inquiry into home ownership. The Chair of the Committee, John Alexander, said that ‘home ownership is an issue that lies at the core of the Australian dream and represents the largest investment that most taxpayers will make during their lifetime. The importance of this issue throughout our nation makes it worthy of a detailed inquiry.’

The Committee will inquire into and report on:

current rates of home ownership;
demand and supply drivers in the housing market;
the proportion of investment housing relative to owner-occupied housing;
the impact of current tax policy at all levels; and
opportunities for reform.

The Committee invites submissions to the inquiry by Friday 26 June 2015, and the proposed reporting date is 03 December 2015.

This follows on from the previously released Senate report on Housing Affordability. We wonder if more committee review is an excuse not to tackle the critical issues which need to be addressed! We shall see.

WA Budget Kills First Owner Grants For Established Property

In WA’s 2015 budget, first time buyers wanted to purchase an established property will loose the ability to tap into the $3,000 FHOG. It had already been reduced for established buyers from $7,000 to $3,000 in 2013. However, the FHOG remains unchanged at $10,000 for those wanting to build their first home. Treasure Mike Nahan said the change was in line with the State Government’s policy objective of focusing financial support on residential construction. Cutting the grant for first time buyers purchasing established homes will be a saving of about $109 million for the State Government over four years.

In other changes, whilst stamp duty concessions for first home buyers of both new and established homes remain unchanged, a new $300 flat land tax scale will come into effect in 2015-16 for land with an unimproved value of between $300,000 and $420,000. This new “flatter” land tax scale is expected to raise an additional revenue of $184 million in 2015-16 and about $826 million over the next four years. Those properties with an unimproved value of less than $300,000 will be exempt.

We think FHOG should be abolished entirely because it distorts the market, but the removal from established dwellings makes perfect sense. You can read our background discussion on why FHOG’s are bad news here.

Lending Up Thanks To Housing and Commercial, In March – ABS

The ABS released the Lending Finance data for March 2015 today. Comparing March with February, Housing for owner occupation excluding alterations and additions rose 0.8% in trend terms, and the seasonally adjusted series rose 1.6%. The trend series for the value of total personal finance commitments rose 0.3% although the seasonally adjusted series fell 0.9%. The trend series for the value of total commercial finance commitments rose 2.0% whilst the seasonally adjusted series rose 0.4%. The trend series for the value of total lease finance commitments rose 1.4% in March 2015 and the seasonally adjusted series rose 3.0%, following a rise of 3.6% in February 2015.

Looking at all lending, 43% was for residential property – including investment property loans, and we see a slight downward drift, as lending for other business purposed improved a little.

Looking at all commercial lending (fixed and revolving), we see that 28.8% was for residential investment property purchases, down from a high of 29.9% at the end of last year. This again shows that non-residential property lending to business lifted a little, and could suggest investment lending growth may be slowing a tad. However, investment lending remains at unprecedented levels.

To reinforce this view, we can compare the proportion of all commercial fixed term loans to those relating to housing investment.

The point we make again is that lending for investment property, whilst inflating house prices and bank balance sheets is unproductive. We need more lending to productive businesses to sustain growth, but the banks are finding it easier and more profitable to extend credit to investors, thanks to lower loss experience and capital benefits. This continues to be a significant structural problem, which needs to be addressed.

DFA Household Finance Confidence Index Falls Again In April

The latest DFA Household Finance Confidence Index (FCI) to end April 2015, showed a further slight fall, from 91.97 in March to 91.87 in April, and continues to track below the long term neutral position.

The results are derived from our household surveys, averaged across Australia. We have 26,000 households in our sample at any one time. We include detailed questions covering various aspects of a household’s financial footprint. The index measures how households are feeling about their financial health.

To calculate the index we ask questions which cover a number of different dimensions. We start by asking households how confident they are feeling about their job security, whether their real income has risen or fallen in the past year, their view on their costs of living over the same period, whether they have increased their loans and other outstanding debts including credit cards and whether they are saving more than last year. Finally we ask about their overall change in net worth over the past 12 months – by net worth we mean net assets less outstanding debts.

Looking at the drivers of the index, for all Australia, we see that households are a little more confident about their employment status (+0.28%), but there was overall little change (63.2%). We noted a rotation in confidence towards NSW and away from WA, reflecting the impact of the mining boom coming off.

Looking at confidence with respect to savings, we find that whilst about half of the households scored about the same, there was a further deterioration in those more comfortable (-0.3%) and a rise in those less comfortable (+0.43%). The main factors which are driving this related to ever lower deposit interest rates, and the need to tap into savings as income growth stalls. Males tend to be more confident than Females.

Turning to debt, we see that households are less comfortable about the the amount of debt they hold (-0.9%), this is explained by a growth in the absolute level of debt many households have, and concerns that cash flow is under pressure making it more difficult to repay on time. Lower interest rates have not translated into lower debt costs as many hold balances in credit cards where interest rates remain high.

Turning to real income, some households have seen their incomes rise and were more comfortable (+1.5%), but in contrast more are also less comfortable, as their incomes were eroded in real terms (+1.4%), so as a result, the number who stayed the same fell by 2.2% to 55.8%. Those in part-time work tended to be less confident.

Households whose costs of living rose were up by 1.6% to 37.2%, driven by higher child care costs, garage repair bills, some foods and council rates. 57% of households saw no major change and 4% saw their cost fall, thanks to reductions in fuel costs and some foods. The falling AU$ also had some impact on the results.

Finally, we looked at net worth, 60% of households think their net worth has improved, thanks to higher house prices and paying forward on mortgage repayments, whilst 14% believe their net worth fell. Many of these households live in rented accommodation, and have substantial debts, and relatively few assets. Those not borrowing, but holding substantial savings balances were more likely to see their net worth reduced.

This data is averaged across the states, though we note some significant differences between WA (overall confidence lower) and NSW (overall confidence higher), thanks mainly to differential movements in house prices and employment prospects.

Note, these results were collated before the last RBA interest rate cut, and the budget speech. We will examine the impact of these factors on households next month.

Domestic and Cross-border Spillovers of Unconventional Monetary Policies

Interesting remarks from Benoît Coeuré, Member of the Executive Board of the European Central Bank, at the SNB-IMF Conference “Monetary Policy Challenges in a Changing World”, Zurich today. The discussion centres of the risk of bubbles when interest rates are artificially low, and exacerbated by other unconventional monetary strategies, why investment property is attractive in these conditions, and how macroprudential should be used to manage these unintended consequences in the context of growth. An edited version follows:

In recent years, there has been an intense discussion, both at the national and the international level, about the potential financial market implications of unconventional monetary policies. At the international level, policy makers have been particularly concerned with the surge in capital inflows, and the resulting exchange rate appreciation pressures in emerging markets. More recently, amid monetary policy normalisation in the United States and additional monetary policy easing in the euro area, including through the launch of the public sector purchase programme (PSPP), a new, but conceptually related discussion has emerged on the global financial market implications of diverging monetary policy cycles. At the national level, the main concerns were spillovers to equity and real estate markets, and the worries about the emergence of asset price bubbles as a result of unconventional policy measures.

Monetary policy always has unintended consequences, no matter where it is pursued. By altering short-term interest rates, central banks affect the inter-temporal decisions of households. Inter-temporal redistribution is at the heart of monetary policy that is aimed at ensuring price stability, and it thus has effects on the income distribution of savers and spenders.

But monetary policy also affects the distribution of income along the intra-temporal and spatial (cross-country) dimension. Changes in short-term interest rates affect consumption, savings and wealth in different ways, depending on the characteristics of individual households in different jurisdictions. But all these effects can be considered temporary, indirect and unintended, i.e. a side effect of a strategy that is aimed at ensuring price stability in the economy.

That said, it would be a logical fallacy to conclude that all domestic spillovers are acceptable. Bubbles are a case in point. Bubbles are a possible, but not an inevitable result of unconventional monetary policies. And if they are welcome at all, then only in a severely constrained, second-best world. But in this case, we should ask ourselves how we can overcome the constraints that prevent better policy outcomes, rather than settling for bubbles to temporarily mask the constraints.

Facing the threat of a persistent low-growth and low-inflation environment and a binding floor on standard policy rates, many central banks have resorted to unconventional measures. These measures were aimed at further pushing down nominal interest rates along the maturity spectrum to track the secular decrease in the natural, “Wicksellian” real rate of interest. Thereby, they helped induce firms and households bring forward their investment and consumption spending in comparison with that in a no policy-change scenario and, ultimately, bring the natural rate back to more normal levels.

I am convinced that there is no alternative for us than acting this way in order to deliver on our mandate. Yet, there is a danger associated with the temporary, yet potentially extended period where low interest rates are needed to stimulate investment and consumption. With real interest rates below potential growth, private agents may just borrow to purchase assets in limited or rigid supply (e.g. real estate property). In this dynamically inefficient world with structurally weak growth prospects, this may actually become an attractive way for savers to generate returns on their savings that investments in the productive sector are unable to generate.

In this case, we end up with a “rational bubble”. While unconventional monetary policy is not a necessary condition for this type of bubble to emerge, it may render it more likely – and more violent in the event of its materialising. So what are the consequences of such bubble?

In the short-term, it may indeed generate a temporary boost to the economy. And for a while this boost would be difficult to distinguish from the regular workings of asset purchase programmes, which actually embed asset price increases as a desired effect, which passes on the initial impulse to broader financing conditions via portfolio rebalancing. But this boost would ultimately be very costly. Not only does it does it come with welfare decreasing macroeconomic instability, but it also brings about an arbitrary redistribution of wealth that may, in the worst case, undermine social cohesion and trust that the central bank is acting within its narrow price stability mandate. And moreover, it can create financial stability risks elsewhere, generating negative spillovers from what should otherwise be a normal international adjustment process.

Against this background, it would be wrong to treat bubbles as a welcome replacement therapy to a sustainable growth model. Instead, macroeconomic and structural policies have to set the necessary conditions so that investment in productive sectors becomes attractive again and investment in bubble-prone areas is discouraged, so that total factor productivity is increased and the natural rate of interest ultimately reverts to what is normal.

We take monetary policy decisions with a view to attaining our primary objective of price stability. Thereby, we establish a stable nominal anchor for the private sector, which in turn is a fundamental precondition for overall macroeconomic stability. Without prejudice to this objective, we take financial stability risk seriously and monitor closely whether severe imbalances are emerging in the financial sector. In this context, we consider the financial stability risks related to our policy measures to be contained. Should risks emerge, macro-prudential policy is best suited to safeguard financial stability. Macroprudential instruments can be targeted more efficiently to those sectors and countries where systemic risks may be materialising. Finally, we encourage national authorities to do whatever is in their power to place the euro area on a more dynamic growth path, thereby creating attractive investment projects that generate high, but fundamentally justified, returns. These are the conditions for unconventional monetary policies policies to bring economies back to a stable and sustainable growth path, both at home and abroad.

Housing Market Imbalances Pose Long-term Challenges for Australian Banks – Moody’s

Moody’s Investors Service says that underwriting discipline and capital are key variables in maintaining the health of bank credit profiles in Australia, in the face of rising housing market imbalances.

“Rapid house appreciation, particularly in Sydney, as well as lending imbalances are increasing the risks of a housing market correction,” says Ilya Serov, a Moody’s Vice President and Senior Credit Officer. “This poses long-term challenges to Australian bank credit profiles”.

“We expect that over time the banks will revise up their mortgage risk weights and capital levels to better recognize the rising tail risks embedded in their housing portfolios,” adds Serov .

Moody’s analysis is contained in its just-released report titled “Rising Housing Market Imbalances Pose Long-Term Challenges for Australian Banks,” and is authored by Serov.

Moody’s report points out that dividend policy initiatives announced recently by major Australian banks — including National Australia Bank’s announcement of a capital raising of AUD5.5 billion — represent the start of a capital accumulation phase that is likely to extend well into 2016.

In Moody’s assessment, the risks in Australia’s housing market risks are skewed towards the downside. While over the short run, stability in the housing market will be supported by low interest rates and the healthy state of bank balance sheets, elevated and rising house prices are intensifying imbalances in the housing market.

Moody’s evaluation of the Australian housing market suggests that housing affordability is falling, despite the low interest rate environment. Similarly, lending imbalances, including a decline in the proportion of first-time home buyers and a sharp rise in residential investment activity, pose a further source of risk.

In Moody’s view, Australian banks are well-positioned to adjust their origination practices and capital levels to better recognize the rising tail risks embedded in their housing portfolios.

Moody’s report says likely regulatory changes will see average mortgage risk weights for the major banks in Australia increase to the 20%-25% range, up from the current 15%-20%. It estimates that Australia’s four major banks — National Australia Bank Limited (NAB, rated Aa2 stable, a1), Westpac Banking Corporation (Aa2 stable, a1), Australia and New Zealand Banking Group Limited (Aa2 stable, a1) and the Commonwealth Bank of Australia (Aa2 stable, a1) — are well-positioned to absorb such a change.

However, Moody’s also anticipates a broader increase in regulatory capital requirements, in line with the November 2014 recommendation by Australia’s independent Financial System Inquiry that Australian bank capital ratios should be “unquestionably strong” and rank in the top quartile of internationally active banks. This scenario would necessitate deeper adjustments to the banks’ dividend policies, and potentially the raising of new capital.

Moody’s report points out that the latest regulatory data suggests that Australian banks have become more conservative in their underwriting, as they have curtailed their exposure to high loan-to-value ratio loans. Such moves would help offset the risks posed by the country’s deepening housing market imbalances.

The rating agency sees ongoing adjustment to banks’ underwriting practices to bring them into line with the guidelines released by the Australian Prudential Regulation Authority in December 2014, which include limiting growth in investor housing loans to 10% per annum and specific guidance around stressed debt-service requirements, as supportive of the banks’ high rating levels.

Moody’s report notes that since May 2014, median home prices have risen by 10% nationwide, and by 16% in the core Sydney market . The report further notes that Australian home prices have risen by 23% since the start of the latest interest rate cutting cycle in November 2011.

Overall, Moody’s says that the banks’ asset quality metrics and portfolio quality will remain strong in calendar 2015, supported by Australia’s low interest-rate environment.

Is Europe’s Google Antitrust Probe a ‘War’ Against US Tech?

Published in the The US edition of The Conversation.

Last month, the European Commission (EC) filed a formal antitrust complaint against Google for abusing its dominant market position in internet search.

This complaint alleged that Google had manipulated search results by favoring its own shopping services over rival or unpaid services. Marking the first European Union (EU) antitrust action against the search giant, the complaint concluded a five-year investigation into Google’s search practices.

The EU antitrust probe stands in sharp contrast to a similar investigation by the US Federal Trade Commission (FTC) a few years ago. That investigation was settled in January 2013 after Google agreed to change its advertising and patent licensing practices.

Given the probes’ different outcomes, critics cannot help but wonder whether the recent investigation was caused by Europe’s resentment of the dominance of US tech companies. Some even worry that the investigation represents the opening salvo in a slowly expanding European “war” against Google, Apple, Facebook and Amazon — or what the French have scornfully referred to as “GAFA.”

EU-US antitrust differences

Although marked differences exist in many aspects of EU and US antitrust laws, they do not account for the two investigations’ divergent outcomes. The basic claim for both is essentially the same: Google has allegedly abused its dominant position in the market for general internet search services to restrict competition in the related market for comparison shopping.

Nevertheless, Google has a slightly higher market share in Europe (about 90%) than in the United States (more than two-thirds). Three additional reasons further explain why the EC filed a formal antitrust complaint.

First, Google did not win before the FTC. While the US agency dropped its investigation into the potential bias in Google’s search algorithm, the company did agree in the overall settlement to change its advertising and patent licensing practices. Google could still settle with the EC.

Second, the commission has not made any final decision yet. Despite the formal complaint, known as a Statement of Objections, Google now has ten weeks to respond in writing as well as the right to present evidence in a formal hearing. If the EC finds Google in violation of antitrust laws, Google could still appeal the decision to the Court of Justice of the European Union. The whole process is likely to take years to resolve.

Third, and perhaps most important, EU and US antitrust authorities play different roles in policing the market. The FTC concluded that Google’s decision to “demote” rival shopping sites in its overall ranking of search results actually helped consumers, as it provided a greater variety of hits on the first page. The US agency also noted a similar practice of altering rankings in other search engines, thereby suggesting the existence of legitimate pro-competitive reasons.

By contrast, the EC does not apply a “rule of reason” to excuse otherwise anti-competitive practices. Instead, the commission seems to have taken the position that consumers are entitled to have the best sites listed based on relevance, even though such a listing may result in the first search page dominated by comparison shopping sites.

At issue, then, is who should determine what consumers deem valuable in a web search. Should a search always represent a strict order of relevance? Or should a search engine be able to deviate from that order to provide what it considers a more useful list of search results? After all, if users do not like the results displayed by a particular search engine, they are likely to switch to rival engines.

What’s next for US tech?

Although we do not know how the EU antitrust probe will play out, or whether Google will settle, it is interesting to explore what the current investigation portends for US tech companies.

First, the EC not only filed a complaint concerning the display of comparison shopping sites in internet search. It has also opened a separate antitrust investigation into Google’s conduct concerning mobile operating systems, apps and services, including those used on Android-loaded smartphones and tablets. Thus, even if Google were to settle the current complaint, the commission could still file a new complaint against the company based on anti-competitive practices in other areas.

Second, if critics were correct that the EC targeted Google primarily to protect homegrown tech companies — a charge on which we take no position here — new actions against other major US players such as Apple, Amazon and Facebook are likely to follow. In a recent interview, President Barack Obama already expressed concern that the EU authorities might take “commercially driven” regulatory actions to punish US tech companies.

Third, the EC investigation may open the door for antitrust actions against these companies in other countries. After all, the commission’s antitrust concerns are not unique to European consumers. More importantly, foreign antitrust authorities have already started taking actions against major US tech companies. Only recently, Qualcomm agreed to pay the Chinese antitrust authorities a US$975 million fine to settle its charges over predatory licensing practices.

Finally, it remains unclear how important antitrust actions are in a highly dynamic technological environment. As a New York Times column recently suggested, the decade-old EU and US antitrust actions against Microsoft may, in retrospect, have been unnecessary.

The same may be true for Google. Although today’s consumers still rely on search engines and desktop browsing, a rapidly growing number of consumers have now turned to mobile apps. As this trend continues and accelerates, the anti-competitive effects generated by Google’s search practices will be greatly reduced.

Peter K Yu, Kern Family Chair in Intellectual Property Law at Drake University and John Cross,Grosscurth Professor of Intellectual Property Law and Technology Transfer at University of Louisville.

Bank of England Inflation Report For March – CPI 0%, Please Explain!

In order to maintain price stability, the Government has set the Bank’s Monetary Policy Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%. Subject to that, the MPC is also required to support the Government’s economic policy, including its objectives for growth and employment. The Inflation Report is produced quarterly by Bank staff under the guidance of the members of the Monetary Policy Committee. It serves two purposes. First, its preparation provides a comprehensive and forward-looking framework for discussion among MPC members as an aid to decision-making. Second, its publication allows the MPC to share our thinking and explain the reasons for their decisions to those whom they affect.

GDP growth was robust in 2014, moderating in the second half of the year. Despite the weakness in 2015 Q1, the outlook for growth remains solid. Household real incomes have been boosted by the fall in food, energy and imported goods prices. The absorption of remaining slack and a pickup in productivity growth are expected to support wage growth in the period ahead. Along with the low cost of finance, that will help maintain domestic demand growth. Activity in the United States and a number of emerging markets has slowed but momentum in the euro area appears to have strengthened over the quarter as a whole.

CPI inflation was 0.0% in March 2015 as falls in food, energy and other import prices continued to weigh on the annual rate. Inflation is likely to rise notably around the turn of the year as those factors begin to drop out. Inflation is then projected to rise further as wage and unit labour cost growth picks up and the effect of sterling’s appreciation dissipates. The MPC judges that it is currently appropriate to set policy so that it is likely inflation will return to the 2% target within two years. Conditional on Bank Rate following the path currently implied by market yields — such that it rises gradually over the forecast period — that is judged likely to be achieved.

CPI inflation was 0.0% in March, triggering a second successive open letter from the Governor to the Chancellor of the Exchequer. Around three quarters of the weakness in inflation relative to target, or 1.5 percentage points, was due to unusually low contributions from food, energy and other goods prices, which are judged largely to reflect non-domestic factors. The biggest single driver has been the large fall in energy prices. Falls in global agricultural prices and the appreciation of sterling have also led to lower retail prices for food and other goods. Absent further developments, these factors will continue to drag on the annual inflation rate before starting to drop out around the end of 2015.

The remaining one quarter of the weakness in inflation relative to target, or 0.5 percentage points, is judged to reflect domestic factors. Wage growth remained subdued in Q1, despite a further fall in the unemployment rate. Part of that weakness is likely to reflect the effects of slack in the labour market, although the concentration of recent employment growth in lower-skilled jobs, which tend to be less well paid, is also likely to account for part of it.

Chart 2 shows the Committee’s best collective judgement for the outlook for CPI inflation. In the very near term, inflation is projected to remain close to zero, as the past falls in food, energy and other goods prices continue to drag on the annual rate. Towards the end of 2015, inflation rises notably, as those effects begin to drop out. As the drag from domestic slack continues to fade, inflation is projected to return to target within two years and to move slightly above the target in the third year of the forecast period.

The path for inflation depends crucially on the outlook for domestic cost pressures. A tightening of the labour market and an increase in productivity should underpin wage growth in the period ahead. There is a risk that the temporary period of low inflation may persist for longer — for example, if it affects wage settlements. Alternatively, wages could pick up faster as labour market competition intensifies, which could pose an upside risk to inflation. Inflation will also remain sensitive to further movements in energy and other commodity prices, and the exchange rate.

Another influence on wage and price-setting decisions is inflation expectations. Nearly all measures of inflation expectations have fallen over the past year, with household measures now below pre-crisis average levels. Surveys suggest that employees and firms expect little recovery in pay growth this year. Other measures of inflation expectations are, however, close to historical averages. The MPC judges that inflation expectations remain broadly consistent with the 2% inflation target.

The MPC also noted, however, that, as set out in the February 2014 Report, the interest rate required to keep the economy operating at normal levels of capacity and inflation at the target was likely to continue to rise as the effects of the financial crisis faded further. Despite this, beyond the three-year forecast horizon the yield curve had flattened further over the past year. There was uncertainty about the reasons for this. Given that uncertainty, there was a risk that longer-term yields would move back up over time, for example, in response to a tightening of US monetary policy.

APRA On Lending Standards And Capital

APRA’s Wayne Byres today spoke at the COBA CEO & Director Forum in Sydney. His speech was entitled ‘Sound lending standards and adequate capital: preconditions for long-term success’. He highlights some interesting behaviourial differences between banks when it comes to the appraisal of mortgage loans, and also talks (and reinforces APRA’s position) with regards to capital measures.

I’d like to use my time today to talk about two issues of relevance to all ADIs: credit risk and capital. In the world of banking supervision, these are at the heart of what we do: credit risk because it is far and away the biggest risk that ADIs take on, and capital because it is a critical form of defence for when those risks go awry. Sound lending and adequate capital do not guarantee long-run success, but they are certainly a precondition for it.

Reinforcing sound lending standards

For many of you in the room today, the largest part of your loan portfolios is lending for housing. In that, you are reflective of the broader banking system in Australia. Across all ADIs, the proportion of lending attributable to housing has increased over the past decade from (an already dominant) 55 per cent to a little under 65 per cent today. For credit unions and building societies, the trend is directionally the same, but the dominance of housing even greater (Chart 1).

I have made the point elsewhere that the traditionally low risk nature of Australian housing portfolios has provided important ballast for the Australian banking system – a steady income stream and low loss rates from housing loan books have helped keep the system on a reasonably even keel, despite occasional stormy seas and misadventures elsewhere¹. Much of the ongoing trust and confidence in the system, by Australian depositors and international investors alike, is founded on this history of stability.

It is not something we should place at risk.

The current economic environment for housing lenders is characterised by heightened levels of risk, reflecting a combination of historically low interest rates, high household debt, subdued income growth, unemployment that has drifted higher, significant house price growth, and strong competitive pressures. Many of these features have been emerging over a number of years, and APRA’s supervision has been intensifying in response. In addition to a heightened level of supervisory activity at individual ADIs, APRA has, for example:

increased the level of analysis of mortgage portfolios, including regular review of detailed data on ADI underwriting policies and key risk indicators, to identify outliers;

written to boards of the larger lenders, seeking their written assurances with respect to their oversight of the evolving risks in residential mortgage lending;

issued a prudential practice guide (APG 223) on sound risk management practices for residential mortgage lending; and

completed a stress test of the largest ADIs, with two scenarios focussed on a severe downturn in the housing market.

Not all of you have been directly involved with every one of these initiatives, but I’m sure you will have felt APRA’s presence in some shape or form.

We see this increasing intensity as an example of APRA’s risk-based approach to supervision. As housing-related risks have potentially grown, we have sought to ‘turn up the dial’ of our supervisory scrutiny and, importantly, ensure that Boards and management of ADIs are doing likewise.

Our most recent turning up of the dial was the letter sent to all ADIs in December last year regarding our plans to reinforce sound lending standards². The letter, beyond expressing some of the general concerns I have just touched upon, also set out some more specific areas that APRA supervisors would be focussing on, and how we would respond if we felt our concerns were not being addressed. Similar sentiments have also been included in more recent letters sent to smaller ADIs.

There are a number of additional regulatory and supervisory tools that APRA has available to address emerging risks: additional supervisory monitoring and oversight, supervisory actions involving Pillar 2 capital requirements for individual ADIs, and higher regulatory capital requirements at a system-wide level. Beyond this, there are more direct controls that are increasingly being used in other jurisdictions, such as limits on particular types of lending – what are commonly referred to as macro-prudential controls.

Up to this point, we have opted to stick with traditional micro-prudential tools targeted at individual ADIs and their specific practices, albeit with an eye to financial stability risks as well as the safety and soundness of individual entities. We are not seeking to determine an appropriate level of house prices, or a particular level of household debt. That is beyond our mandate. Our goal is simpler: reinforcing sound lending standards, which is the ‘bread and butter’ work of a banking supervisor.

Credit assessments – room for improvement

Accurately assessing a borrower’s ability to service and ultimately to repay a loan without undue hardship, including under periods of economic stress, is an inherent component of sound credit risk management, particularly for residential mortgage lending.³

One of the interesting challenges of assessing serviceability practices has been that, just as the vast majority of motor vehicle drivers believe they are above average in driving ability, ADIs invariably claim their lending standards are at the more conservative end of the spectrum, and that it is their competitors that are the source of poor practices. As with everyone claiming to be an above-average driver, not every ADI can be right.

To help us get to the bottom of this, we recently undertook a small hypothetical borrower survey. We asked a number of the larger housing lenders (including a few mutuals) to provide their serviceability assessments for four hypothetical borrowers that we invented (two owner-occupiers, and two investors). The outcomes for these hypothetical borrowers helped to put the spotlight on differences in credit assessments and lending standards. The outcomes were quite enlightening for us – and, to be frank, a little disconcerting in places.

Mortgage lending is often thought of as a fairly commoditised product, but in reality there are wide differences in how lenders assessed the risk of a given borrower. The first surprising result from our review was the very wide range of loan amounts that, hypothetically, were offered to our borrowers. It was not uncommon to find the most generous ADI was prepared to lend in the order of 50 per cent more than the most conservative ADI.

More importantly, the exercise also allowed us to explore the key drivers of difference in risk assessments across lenders. Serviceability is obviously multi-dimensional; it depends on how big a loan is extended, relative to a borrower’s income (and the reliability of the various components of that income) and the nature and extent of non-housing obligations that a borrower needs to meet.

One significant factor behind differences in serviceability assessments, particularly for owner occupiers, was how ADIs measured the borrower’s living expenses (Chart 2a and 2b). As a regulator, it is hard to understand the rationale for large differences in what should be a relatively objective, and extremely critical, metric.⁴

Of major concern were a few ADIs who opted to make their credit assessment based on a lower level of living expenses than that declared by the borrower. That is obviously a practice that should not continue, and ADIs should be making reasonable inquiries about a borrower’s living expenses. In fact, best practice (and intuition) would be to apply minimum living expense assumptions that increase with borrower incomes; this was a practice adopted by only a minority of ADIs in our survey.

The treatment of other income sources (such as bonuses, overtime and investment earnings) also played a large role in credit decisions (Chart 3). Common sense would suggest it is prudent to apply a discount or haircut to these types of income, reflecting the fact they are often less reliable means of meeting regular loan repayments. Unfortunately, common sense was sometimes absent.

Another area of interest was the discount or ‘haircut’ applied to declared rental income on an investment property. The norm in the ADI industry seems to be a 20% haircut, but we noted in our exercise that some ADIs based their serviceability assessment on smaller, or even zero, haircuts. Bearing in mind that the cost of real estate fees, strata fees, rates and maintenance can easily account for a significant part of expected rental income, and this does not take into account potential periods of vacancy, the 20% norm itself does not seem particularly conservative. We also came across a few instances in which ADIs were relying on anticipated future tax benefits from negative gearing to get a borrower over the line for a mortgage.

Variations in assessments were also driven by the size of interest-rate buffers applied to the new loan (Chart 4) – something we flagged in our December letter as an area of particular importance. For investor lending, this issue was more pronounced: a major driver of differences across ADIs was whether an interest-rate buffer was applied to both the investor’s existing debts (such as loans outstanding on existing owner-occupied or investment properties), as well as to the proposed new loan. As of earlier this year when the survey was conducted, only about half of the surveyed ADIs applied such a buffer to existing debts (all applied some form of buffer to new debts). I confess to struggling to see the logic of such an approach – after all, any rise in interest rates will at some point in time affect the borrower’s other debts just as they will for the new loan being sought.

The final area I would highlight were differences in the treatment of interest only loans. Our test included one borrower seeking a 30-year loan, with the first 5 years on an interest-only basis. Only a minority of surveyed ADIs calculated the ability to service principal and interest (P&I) repayments over the residual 25 year term. Despite the contractual terms, the majority assumed P&I repayments over the full 30-year term, and hence were able to inflate the hypothetical borrower’s apparent surplus income by, in our particular example, around 5 per cent.

So there is no confusion, let me be clear that Australian ADIs are thankfully well away from the types of subprime lending that have caused so many problems elsewhere (eg lending with an LVR in excess of 100 per cent, at teaser rates, to borrowers with no real capacity to repay). Nevertheless, our overall conclusion from this hypothetical borrower exercise was that there were clearly examples of practice that were less than prudent. As a result, we have shown ADIs that participated in the exercise how they compare to their peers and where their serviceability assessments could be strengthened: in all of the examples above, we expect to see changes to practices across a range of ADIs.

In doing so, we have been asked whether APRA is trying to standardise mortgage risk assessments or impose a common ‘risk appetite’ across the industry. In fact, we do think it important that ADIs adhere to some minimum expectations with respect to, for example, interest-rate buffers and floors, and adopt prudent estimates of borrower’s likely income and expenses. In that regard, to the extent we are reinforcing a healthy dose of common sense in lending standards, greater convergence is probably warranted.

At the same time, we certainly want to see competition between lenders and fully accept that different ADIs can have different risk appetites. And we are not seeking to interfere in ADIs’ ability to compete on price, service standards or other aspects of the customer experience. However, making overly optimistic assessments of a borrower’s capacity to repay does not seem a sensible or sustainable basis on which to attract new customers or retain existing ones. It also runs the risk of adverse selection and an accumulation of higher risk customers who (perhaps quite justifiably) cannot get finance elsewhere. To go back to my opening remarks, it does not fulfil the precondition for long-term success.

I have mentioned all of this for two reasons:

First, because what at first glance might seem prudent practice is not always so. When our December letter was issued, a number of ADIs were quick to point out they were already utilising a floor rate of 7 per cent and a buffer of 2 per cent within their serviceability assessments. Leaving aside that our letter suggested it would be good practice to operate comfortably above those levels, if the buffers are being applied to overly optimistic assessments of income, or only to part of the borrower’s debts, they do not serve their purpose.

Second, because much of the attention given to our December letter has focussed on the 10 per cent benchmark for growth in investor lending. I want to emphasise that our analysis goes much broader than just investor lending growth, and captures ADIs’ lending standards and risk profile across the board. Investor lending aspirations will only be one factor in our consideration of the need for further supervisory action.

This work on lending standards has been intensive and time-consuming for APRA and, no doubt, all of the ADIs involved, but has been well worth it if we have been able to reinforce sound lending standards across the industry. (If you have not yet looked at your own policies in the areas I have outlined, I would encourage you to do so as a matter of priority.) Of course, we will need to keep up our scrutiny and be alert to both subsequent policy changes, and/or substantial policy overrides (ie loan approvals outside policy). The latter will warrant particular attention by both ADIs and APRA: if policies are tightened only for overrides to correspondingly increase, we will have not achieved our objective.

That also applies to business plans and growth aspirations: where we have agreed plans with ADIs, we will obviously be monitoring closely to see that they kick into effect in the second half of the year. We recognise that it takes time for growth plans to alter course, especially given lending pipelines of pre-approved loans (there is also typically slightly stronger growth in the second quarter of the calendar year). However, ADIs have now had long enough to revise their ambitions where needed, and we will be watching carefully to see a moderation in growth in investor lending in the second half of the year as revised plans are implemented.

Developments in capital standards

Let me now turn to capital adequacy.

As most of you know, there were five recommendations from the Final Report of the Financial System Inquiry that relate to ADI capital:

Recommendation 1 – that we set ADI capital standards in such a manner as to ensure ADIs are ‘unquestionably strong’ (with a suggestion this could be met by having Australian banks in the top quartile when measured against the capital ratios of international peers);

Recommendation 2 – that we narrow the differential in risk weights on mortgages between the standardised and internal-ratings based (IRB) approaches (again, with a suggestion of a 25-30 per cent risk weight for the IRB approach);

Recommendation 3 – that we should implement a framework for additional loss absorbing and recapitalisation capacity in line with international practice;

Recommendation 4 – that we develop a reporting template that allows the capital ratios of Australian ADIs to be reported without the impact of APRA adjustments to the Basel minimums; and

Recommendation 8 – that we introduce a leverage ratio as a backstop to the risk-based capital framework.

In addition, the Basel Committee has work underway that will intersect with these recommendations. Most relevantly, it is currently considering:

responses to submissions on proposed revisions to the standardised approach, including, importantly, to housing risk weights;

responses to submissions on proposed revisions to the capital floor for banks using the IRB approach; and

how the IRB framework can be reinforced, given the increasing scepticism towards modelling approaches in light of the excessive variability in capital requirements they are producing.

To repeat what I have said previously, it is to everyone’s benefit that we approach the FSI and Basel proposals in a coordinated manner. But that does not mean waiting until every i is dotted and t is crossed.

The Basel Committee meets again in June to review the way ahead on its various proposals. I do not think it will be too long after that that we are able to announce how we will respond to those issues that are easiest to tackle sooner rather than later (particularly Recommendations 2 and 4). Other items will take a little longer to pin down the precise detail. But the direction is clear, and we fully support the FSI’s recommendation that Australian ADIs should be unquestionably strong. So it also makes sense to start early and move forward in an orderly fashion wherever possible: affected ADIs should, provided they take sensible opportunities to accumulate capital, be well-placed to accommodate these changes when they occur.

What does all of it mean for customer-owned banking organisations? As this audience already knows, the capital ratios of credit unions and building societies stand, on average, well above that of the rest of the banking sector (Chart 5), providing a healthy buffer with which to accommodate any future changes. I suspect that, when looked at in aggregate, mutual ADIs will be less impacted by the collective set of changes to regulatory requirements than other parts of the ADI sector. Of course, within the sector, there are differences from ADI to ADI, so I am wary of making sweeping statements. But there is no doubt that mutual ADIs generally start with high capital ratios vis-à-vis many of their larger competitors, and the impact of changes are likely to be felt more acutely elsewhere.

That said – and I wouldn’t be true to my role as a prudential supervisor if I did not sound a note of caution before I conclude – it doesn’t mean the changes won’t be felt at all, or that changes in the competitive landscape will provide a panacea to the strategic challenges that face smaller organisations in a more demanding environment. Long-standing issues of scale, geographic concentration, technological capacity, and more mobile and demanding customers will not be diminished by regulatory changes. The only suggestion I would offer on these today is that the challenges will be more likely to be overcome if, consistent with the mutual ethos that underpins COBA and its members, the mutual sector works cooperatively together to address them.

Concluding remarks

I opened by setting out two necessary – but not sufficient – preconditions for long-term success: sound lending standards and adequate capital.

Lending standards are important for the stability of the Australian banking system, and given the importance of housing-related lending, it should not be surprising that APRA supervisors are increasingly vigilant on the risks this lending presents. Put simply, if all our eggs are increasingly being placed in one basket, we need to make sure the basket isn’t dropped. ADIs that have continued to adopt sensible practices and prudent credit assessments should welcome this approach, as it strengthens their capacity to compete without being reckless. On the other hand, ADIs with more aggressive practices should fully expect to find APRA increasingly at their doorstep.

When it comes to capital, we will have more to say shortly. But my message today is that we will respond to all of the FSI’s recommendations as soon as we can, bearing in mind the need for a coordinated approach that factors in international work that is still in the pipeline. No one disputes the benefits of having an unquestionably strong banking sector, so where it makes sense to move ahead, we will get on with it. ADIs should adopt a similar approach in their capital planning: to the extent further capital accumulation is needed, there is little to be lost from starting early.

¹ Seeking Strength in Adversity, AB+F Randstad Leaders Lecture Series, 7 November 2014

² Reinforcing Sound Residential Mortgage Lending Practices, 9 December 2014

³ APG223, Residential Mortgage Lending, November 2014. See also Financial Stability Board, Sound Residential Mortgage Underwriting Practices, April 2012.

⁴ Estimated living expenses between the most conservative and the least conservative ADI varied by at least 30 per cent, and in some cases significantly more (depending on the borrower’s characteristics).