Martin North – Page 1008 – Digital Finance Analytics (DFA) Blog

RBA Statement on Monetary Policy Lowers Growth

The RBA released their statement on monetary policy May 2015, today. In it there is no signal about future interest rate movements, but growth forecasts were lowered, to 2% in June 2015. Beyond that, the economy is now expected to grow to 3.25% in the year ended December 2016 (previously 4%). They expect unemployment to rise further to a peak of 6.5%. Inflation is expected to rise later in 2015, a little, but still within the target band. In an investigation into the cycle of dwelling investment, they find that on balance, strength in dwelling investment is likely to be sustained, supported by low interest rates and relatively strong population growth. However, difficulties in obtaining the necessary production inputs, especially suitable land with development approval in some parts of the country, are likely to limit the extent of any further pick-up in dwelling investment growth above what is currently expected.

Growth of Australia’s major trading partners was around its long-run average in 2014. It appears to have eased slightly in the early months of 2015. Commodity prices have been quite volatile over recent months, notably iron ore and oil prices, which have rebounded somewhat from recent lows. Even so, prices of Australia’s key commodity exports overall have declined since the beginning of 2015 and are well down on levels of a year ago. In large part, the declines reflect growth in the supply of commodities globally, although an easing of growth in China’s demand for some key commodities has also played a role. While there has been a further fall in Australia’s terms of trade, the Australian dollar has appreciated by around 3 per cent against the US dollar and in trade-weighted terms since the previous Statement. In China, economic growth has eased further. The Chinese property market remains a source of weakness in the economy and this is flowing through to weaker demand for steel and other construction related products. Indicators for Japanese economic activity have been somewhat mixed early this year, though labour market conditions remain tight and there are tentative signs that wage growth will rise, which is expected to underpin a pick-up in domestic price pressures. Economic growth in the rest of east. Asia looks to have slowed a little in the March quarter.

Growth in the US economy moderated in the March quarter, largely reflecting the temporary effects of disruptions related to severe weather and industrial action in west coast ports. Meanwhile, the US labour market has continued to improve and wage growth has picked up. Economic activity in the euro area is recovering at a gradual pace.

Despite slightly weaker-than-expected conditions early in 2015, growth of Australia’s major trading partners is expected to remain around its long-run average pace in 2015 and 2016. Growth will continue to be supported by very stimulatory monetary policies in most parts of the world. Core inflation rates are below many central banks’ targets. The Federal Open Market Committee is not expected to start increasing the US policy rate until the second half of 2015, while the People’s Bank of China has recently taken steps to boost liquidity and has adopted a more accommodative monetary policy stance more generally. The European Central Bank and the Bank of Japan continue to expand their balance sheets in line with their previously announced policies. Accordingly, finance remains readily available amid very favourable pricing conditions, notwithstanding the sharp rise in sovereign yields in recent days. Also, the low oil price is providing support to Australia’s trading partners, most of which are net oil importers.

The available data suggest that the domestic economy continued to grow at a below-trend pace in the March quarter. Dwelling investment and resource exports appear to have continued growing strongly and there is evidence that the growth of household consumption has been gaining some momentum over the past six months or so. However, investment in the mining sector is declining noticeably and non-mining business investment remains subdued. Moreover, indicators of nonmining business investment intentions suggest that a significant pick-up is not in prospect over the next year or so.

Conditions in the established housing market remain strong, especially in Sydney and to a lesser extent in Melbourne. Outside these cities, however, housing price growth has declined. Forward-looking indicators, including building approvals, suggest that dwelling investment overall will continue to grow strongly over coming quarters. Housing credit growth has been little changed at a pace that is around the long-term growth of household income. Growth of housing credit for investors remains close to 10 per cent on an annual basis, with no sign of growth either increasing or decreasing in the period ahead. Very low interest rates and increasing housing prices helped to support a pick-up in the growth of household consumption over 2014. More recent retail sales data suggest that consumption growth maintained its pace into the early months of 2015. Measures of consumer sentiment remain a little below average.

Export volumes continue to increase, aided in the March quarter by the absence of substantial weather-related disruptions to mining and shipping operations across the country. Resource export volumes are expected to continue growing as new production capacity for iron ore and liquefied natural gas comes on line over 2015. However, the decline in commodity prices in recent quarters has put pressure on higher-cost producers in the iron ore and coal sectors. While the substantial declines recorded in mining investment have been much as expected, producers have responded to lower commodity prices with further cost-cutting. Some smaller, higher-cost producers of iron ore and coal in Australia have announced the curtailment of production, although the affected mines accounted for only a relatively small share of Australian production in 2014.

Non-mining business investment has remained subdued even though many of the conditions for a recovery have been in place for some time. Access to funding does not appear to be constraining business decisions; lending rates on the outstanding stock of business (and housing) loans have continued to edge lower and business credit growth has been picking up. Also, surveys suggest that business conditions in the non-mining sector are close to average. However, forward-looking measures of business confidence remain a bit below average and non-residential building approvals are relatively subdued. Business liaison suggests that firms have spare capacity and are still waiting to see a more substantial improvement in demand conditions before they commit to major new investment projects. In line with that, surveys of investment intentions do not indicate that there will be much of a pick-up in non-mining capital investment over the next year or so.

There continues to be excess capacity in the labour market, though the most recent labour force data suggest that employment growth has increased over the past six months or more, to be above the rate of population growth. The participation rate has picked up slightly, and the unemployment rate has been stable at about 6¼ per cent since mid 2014. Forward-looking indicators of labour demand, which had picked up somewhat over the past year, have been little changed over recent months and point to modest growth of employment over coming months.

Consumer price inflation declined over the past year, reflecting substantial falls in fuel prices and the repeal of the carbon price, although the recent rebound in fuel prices should add to headline inflation somewhat in the near term. Measures of underlying inflation remained around ½–¾ per cent in the March quarter and 2¼–2½ per cent over the past year. Domestic cost pressures are generally well contained, partly because of the extended period of low growth of wages, with the result that non-tradables inflation was about 1 percentage point below its decade average over the year to March. Consumer prices related to housing increased by marginally more than their historical average, driven by inflation in new dwelling costs, which in turn reflects the strength of dwelling investment. Tradables inflation (excluding volatile items and tobacco) has picked up in response to the depreciation of the Australian dollar over the past two years or so.

Growth in the Australian economy is expected to continue at a below-average pace for a little longer than earlier anticipated and to pick up gradually to an above-average pace over 2016/17. The key forces shaping the outlook are much as they have been for some time. Recent data suggest that consumption growth has continued to pick up gradually, supported by very low interest rates and relatively strong population growth. Forwardlooking indicators continue to suggest that dwelling investment will continue to grow strongly in the near term. The momentum building in household demand will, in time, provide some impetus to nonmining business investment, even though indicators of investment intentions suggest that non-mining business investment is not likely to pick up over coming quarters, as had been expected at the time of the February Statement. Export growth is also expected to continue making a substantial contribution to GDP growth. Mining investment, fiscal consolidation and the falling terms of trade are expected to impart an offsetting restraint on growth over the next couple of years at least. The profile for GDP growth implies that there will be excess capacity in the labour market for longer than previously thought. The unemployment rate is expected to rise gradually and peak a little later than envisaged in the February Statement, before gradually declining towards the end of the forecast period. Wage growth is not expected to increase much from its current low levels over the next two years or so. As a result, domestic labour cost pressures are likely to remain well contained and underlying inflation is expected to be consistent with the inflation target throughout the forecast period.

The risks to the outlook for the global economy appear roughly balanced, other than for China where risks remain tilted to the downside. Weakness in the Chinese property market and constraints on the ability of local governments to fund infrastructure projects continue to represent key sources of uncertainty for China’s economic growth and its demand for commodities. Any significant change in the demand for steel in China would affect the prices of iron ore and coking coal. Also, if high cost producers of iron ore in China were to curtail production significantly, this would place upward pressure on prices. Developments in China and their impact on commodity prices are also likely to affect the outlook for the exchange rate, which is another important consideration for the forecasts for the domestic economy. Further depreciation of the exchange rate seems both likely and necessary, particularly given the significant declines in key commodity prices, although increasingly divergent monetary policies in the major economies are also likely to have an important bearing on exchange rate developments.

Domestically, the forecasts embody a further gradual pick-up in consumption growth and decline in the saving ratio. However, if households respond to changes in interest rates and asset prices to the same degree as they did prior to the global financial crisis, this would support higher consumption growth and imply a lower saving ratio than embodied in the forecasts. Alternatively, if households are less inclined to bring forward their consumption than has been factored into the forecasts, perhaps because they do not wish to increase their leverage, consumption growth would be weaker and the saving ratio higher than forecast.

Business investment remains a significant source of uncertainty. Mining investment is expected to fall significantly, but the size of the fall and the impact of lower-than-expected commodity prices remain uncertain. There are also significant risks to the forecasts for non-mining investment. While the latest capital expenditure survey implies a weaker profile for non-mining business investment over the next year than currently forecast, the first estimate of investment intentions for 2015/16 is subject to considerable uncertainty and the survey covers only about half of actual non-mining business investment. Moreover, many of the preconditions for a recovery in non-mining business investment are in place, so it is possible that the recovery could begin earlier or be stronger than currently forecast. The adjustment to the decline in the terms of trade and mining investment over recent years has resulted in a rise in the unemployment rate and a pronounced decline in wage growth in the economy. The unemployment rate is expected to rise a little further from here, before it begins to decline. It is possible that employment growth will be stronger than expected and the unemployment rate will not increase to the extent anticipated, although this could probably only be achieved with ongoing moderation in wage growth.

The Reserve Bank Board reduced the cash rate by 25 basis points at its February meeting. At its March and April meetings, the Board kept the cash rate steady, but indicated that further easing may be appropriate. Over that period, incoming data have generally provided more confidence that growth in household expenditure is gaining some momentum, consistent with the forecasts presented in the February Statement. However, other information, including the forward-looking indicators of investment, suggested that overall growth will remain below trend for longer than had previously been expected. Accordingly, the economy is likely to be operating with a degree of spare capacity for some time yet and domestic cost pressures are expected to remain subdued and inflation well contained. The Board noted that although financial conditions are very accommodative, the exchange rate continues to offer less assistance than would normally be expected in achieving balanced growth in the economy. It also noted that while housing price growth is very strong in Sydney, it has declined across much of the rest of the country, and there has been little change to the growth of housing credit in recent months. The Bank is working with other regulators to assess and contain risks that may arise from the housing market.

At its May meeting the Board judged that, under these circumstances, it was appropriate to reduce the cash rate by a further 25 basis points to provide some additional support to economic activity. This could be expected to reinforce recent encouraging trends in household demand and is consistent with achieving the inflation target. The Board will continue to assess the outlook and adjust policy as needed to foster sustainable growth in demand and inflation outcomes consistent with the inflation target over time.

APRA Finalises New Disclosure Requirements for ADIs

The Australian Prudential Regulation Authority (APRA) has today released a response to submissions paper and final versions of Prudential Standard APS 110 Capital Adequacy and Prudential Standard APS 330 Public Disclosure, which incorporate new disclosure requirements for a limited number of authorised deposit-taking institutions (ADIs). These standards take effect from 1 July 2015. In most cases, the first set of disclosures will be based on September 2015 reporting dates.

With regard to capital, the Prudential Standard requires an authorised deposit-taking institution (ADI) to maintain adequate capital, on both a Level 1 and Level 2 basis, to act as a buffer against the risk associated with its activities. An ADI must have an Internal Capital Adequacy Assessment Process (ICAAP) that must: (a) be adequately documented, with the documentation made available to APRA on request; and (b) be approved by the Board initially, and when significant changes are made.

An ADI must, on an annual basis, provide a report on the implementation of its ICAAP to APRA (ICAAP report). A copy of the ICAAP report must be provided to APRA no later than three months from the date on which the report has been prepared.

APRA will determine prudential capital requirements (PCRs) for an ADI. The PCRs, expressed as a percentage of total risk-weighted assets, will be set by reference to Common Equity Tier 1 Capital, Tier 1 Capital and Total Capital. PCRs may be determined at Level 1, Level 2 or both.

The minimum PCRs that an ADI must maintain at all times are:

(a) a Common Equity Tier 1 Capital ratio of 4.5 per cent;
(b) a Tier 1 Capital ratio of 6.0 per cent; and
(c) a Total Capital ratio of 8.0 per cent.

APRA may determine higher PCRs for an ADI and may change an ADI’s PCRs at any time.

From 1 January 2016, an ADI must hold a capital conservation buffer above the PCR for Common Equity Tier 1 Capital. The capital conservation buffer is 2.5 per cent of the ADI’s total risk-weighted assets, unless determined otherwise by APRA. The sum of the Common Equity Tier 1 PCR plus the capital conservation buffer determined by APRA will be no less than 7.0 per cent of the ADI’s total risk-weighted assets. Any amount of Common Equity Tier 1 Capital required to meet an ADI’s PCRs for Tier 1 Capital or Total Capital, above the amount required to meet the PCR for Common Equity Tier 1 Capital, is not eligible to be included in the capital conservation buffer.

From 1 January 2016, APRA may require an ADI to hold additional Common Equity Tier 1 Capital, of between zero and 2.5 per cent of total risk-weighted assets, as a countercyclical capital buffer. An ADI with credit exposures in geographic locations outside Australia must calculate any countercyclical capital buffer requirement as the weighted average of the buffers that are applied by the regulatory authorities in jurisdictions in which the ADI has exposures. APRA will inform ADIs of any decision to set, or increase, the level of the countercyclical capital buffer up to 12 months before the date from which it applies. Any decision by APRA to decrease the level of a countercyclical capital buffer will take effect immediately.

An ADI or authorised NOHC (as applicable) must obtain APRA’s written approval prior to making any planned reduction in capital, whether at Level 1 or Level 2.

An ADI or an authorised NOHC (as applicable) must notify APRA, in accordance with section 62A of the Banking Act, of any breach or prospective breach of the capital requirements contained in this Prudential Standard and inform APRA of any remedial actions taken or planned to deal with the breach.

Wall Street’s Thinking About Creating Derivatives on Peer-to-Peer Loans

Interesting article from Bloomberg Business on the continuing morphing of P2P lending into the main stream, and potentially wrapped up into derivatives.

It began with a seemingly wacky idea to reinvent banking as we know it. But no one is scoffing at peer-to-peer lending anymore — least of all, Wall Street. Barely a decade old, “P2P” has gone mainstream and is now being co-opted by some of the big financial players it was supposed to bypass. Investment funds can’t get enough of this business, which involves lending to people over the Internet and hoping they pay you back. Investors are snapping up the loans directly, while the banks are bundling them into securities, much as they did with subprime mortgages.

Now peer-to-peer lending and its Internet enablers like LendingClub Corp., the industry leader, are being pulled into the high-octane world of derivatives. While many hail Wall Street’s growing involvement, others warn investors could get carried away, as they did during the dot-com era and again during the mortgage mania. The new derivatives could help people hedge their risks, but they could also lure speculators into the market.

“It feels like the year 2000 again,” said Frank Rotman, a partner at QED Investors, an Alexandria, Virginia-based venture-capital firm that has invested in Prosper Marketplace Inc., Social Finance Inc. and 13 other P2P lending platforms. “Everyone is chasing ’it,’ but they don’t know what ’it’ is, and that is kind of scary.”

Lured by Yield

It’s easy to see why investors are so enthusiastic. In today’s low-interest-rate world, high-quality P2P loans yield about 7.6 percent. Two-year U.S. Treasuries, by comparison, were yielding a mere 0.6 percent on Friday.

But P2P’s rapid growth also raises questions about the potential risks, including whether the firms involved might lower their standards to stay competitive. During the mortgage boom, Wall Street’s securitization machine fueled questionable lending practices. Derivatives tied to the debt were blamed for spreading their risks around the globe, and then amplifying investors’ losses when the housing market crashed.

Now a firm led by Michael Edman, a veteran of Morgan Stanley, is creating derivatives that will give investors a new way to bet for — or against — peer-to-peer loan performance. Edman has ridden credit booms before: he was a figure in “The Big Short,” Michael Lewis’s best-seller about the buildup to the housing bubble of the 2000s.

“It’s a high-coupon asset that’s had very good returns for the short period of time it’s been around,” Edman said of P2P loans. “I don’t have reason to believe that’s going to change dramatically anytime soon, but there are bad loans out there.”

Satisfying Demand

Derivatives could help satisfy investors’ demand for P2P assets, while also helping others hedge risks on loans they’ve already bought. The instruments could also bring more investors swooping into the market simply to place speculative wagers.

Brendan Dickinson, principal at Canaan Partners, a $4.2 billion asset firm based in New York and Menlo Park, California, is counting on the former.

“If you could create a synthetic product that mimics all the features of a P2P loan and had the same risk and yield tradeoff, there would be a lot of demand to buy that paper,” said Dickinson, whose firm has invested in LendingClub and Orchard Platform and is looking to invest $5 million to $10 million in a firm trying to create derivatives on P2P loans. Other small firms are racing to create P2P derivatives before big banks try to muscle in.

Derivatives Pioneer

Edman, who runs New York-based Synthetic Lending Marketplace, or SLMX, has some high-profile experience. In the early 2000s, he helped invent a kind of credit-default swap that enabled some Wall Street firms to bet against U.S. subprime mortgage bonds.

But Edman sees little resemblance between the boom-era mortgage market of and the current peer-to-peer market. He said his derivatives will help investors hedge their bets and also improve the pricing of the underlying loans.

Indeed, Edman said the ability to short the loans could curb some of the enthusiasm for this asset class before any of the debt sours.

“If derivatives in mortgage-backed securities existed in 1998, we wouldn’t have gotten to the point that we did in terms of the bubble in mortgages,” Edman said. “This keeps a market honest.”

Investors are already showing some skepticism. Less than a year after going public, LendingClub is the sixth-most bet against stock on the New York Stock Exchange.

‘Legitimate Need’

LendingClub chief executive officer Renaud Laplanche said he’s aware of the interest to bet against the market. Derivatives that give investors the ability to protect against losses on the loans the company arranges is just smart risk-management, he said.

Spokeswomen for Prosper and Social Finance declined to comment.

SLMX is still working on documentation for the derivatives, which are likely to take the form of credit-linked notes with total-return swaps, rather than the credit-default swaps some blame for worsening the financial crisis. The firm has teamed up with a broker-dealer, AK Capital LLC, to execute trades and hopes to make its first transaction as early as this year.

Rotman said another firm, PeerIQ, has discussed with him the possibility of creating contracts that would essentially zero in on loans arranged by LendingClub, the industry leader, which has facilitated $7.6 billion of loans since 2006. PeerIQ – – whose financial backers include John Mack, the former CEO of Morgan Stanley and Vikram Pandit, the former CEO of Citigroup Inc. — hasn’t publicly disclosed any plans; a spokesman for the firm declined to comment. Those men recently led a $6 million investment round for the company’s analytics business.

LendingClub’s chief executive officer Laplanche called PeerIQ a third-party partner, no different than other companies seeking to utilize the company’s public data.

“It is a perfectly legitimate need from many of our investors, especially large ones,” Laplanche said.

Macquarie Lifts FY 2015 Profit 27%

Macquarie Group today announced a net profit after tax attributable to ordinary shareholders of $A1,604 million for the full year ended 31 March 2015 (FY15), up 27 per cent on the full year ended 31 March 2014 (FY14) and above expectations. Profit for the second half of the year (2H15) was $A926 million, up 37 per cent on the first half (1H15). The six months to 31 March 2015 saw Macquarie’s annuity-style businesses (Macquarie Asset Management (MAM), Corporate and Asset Finance (CAF) and Banking and Financial Services (BFS)) continue to perform well with combined net profit contribution1 up four per cent on 1H15 and up 29 per cent on 2H14. Macquarie’s capital markets facing businesses (Macquarie Securities Group (MSG), Macquarie Capital and Commodities and Financial Markets (CFM)) also delivered an improved result with combined net profit contribution1 up significantly on 1H15, and up 24 per cent on 2H14. Macquarie’s annuity-style businesses’ FY15 combined net profit contribution1 increased by $A710 million, or 33 per cent, on FY14. Macquarie’s capital markets facing businesses’ FY15 combined net profit contribution1 increased by $A216 million, or 19 per cent, on FY14.

Net operating income of $A9.3 billion for FY15 was up 14 per cent, while total operating expenses of $A6.8 billion were up 12 per cent on the prior year. Key drivers of the change from the prior year were:

A 17 per cent increase in combined net interest and trading income to $A3.8 billion, up from $A3.3 billion in FY14, resulting from loan portfolio growth for both CAF and BFS and improved trading results in CFM and MSG
A 24 per cent increase in fee and commission income to $A4.8 billion, up from $A3.9 billion in FY14, primarily driven by higher base and performance fees in MAM, improved levels of advisory fee income in Macquarie Capital and CFM and higher debt capital markets activity
An 18 per cent decrease in other operating income and charges to $A0.7 billion, from $A0.9 billion in FY14. Increased gains on business and asset sales, predominately in CAF, were offset by higher impairment charges and collective provisions as well as non-recurrence of FY14 items such as the dividend income and gain on disposal of SYD and OzForex
Total operating expenses increased 12 per cent, driven by: an 11 per cent increase in employment expenses resulting primarily from improved Group performance; increased technology costs due to higher development activity to support business growth as well as increased regulatory compliance; increased other operating expenses largely driven by an overall increase in the Group’s operating activity; and the impact of the depreciation of the Australian dollar on offshore expenses.

Staff numbers were 14,085 at 31 March 2015, up from 13,913 at 31 March 2014.

The income tax expense for FY15 was $A899 million, up nine per cent from $A827 million in the prior year. The effective tax rate of 35.9 per cent was down from 39.5 per cent in FY14 driven by the nature and geographic mix of income and tax uncertainties.

Retail deposits increased by 12 per cent to $A37.3 billion at 31 March 2015, with total deposits increasing during the year from $A36.9 billion to $A39.7 billion at 31 March 2015. During FY15, $A21.5 billion of new term funding was raised covering a range of sources, tenors, currencies and product types.

While Macquarie continued to build on the strength of its Australian franchise, its international income accounted for 70 per cent of the Group’s total income for FY15. This reflects the growth of international operations, particularly in the Americas which was the largest contributing region with 36 per cent of total income, as well as the favourable impact of foreign exchange movements.

The effective tax rate for FY15 was 35.9 per cent, down from 39.5 per cent in FY14.

Macquarie’s assets under management (AUM) at 31 March 2015 were $A486.3 billion, up 14 per cent from $A426.9 billion at 31 March 2014 largely due to additional investments and favourable foreign exchange and market movements.

A final ordinary dividend of $A2.00 per share (40 per cent franked), up from the 1H15 ordinary dividend of $A1.30 per share (40 per cent franked) will be paid. The total ordinary dividend payment for the year was $A3.30 per share, up from $A2.60 in the prior year. This represents an annual ordinary dividend payout ratio of 68 per cent. The record date for the final ordinary dividend is 20 May 2015 and the payment date is 2 July 2015.

Macquarie Group remains very well capitalised with APRA Basel III Group capital of $A16.1 billion at 31 March 2015, a $A2.7 billion surplus to Macquarie’s minimum regulatory capital requirement from 1 January 20167. The Bank Group APRA Basel III Common Equity Tier 1 capital ratio was 9.7 per cent at 31 March 2015, slightly up on 31 March 2014.

Macquarie intends to purchase approximately $A390 million of shares on-market to satisfy the requirements of the Macquarie Group Employee Retained Equity Plan (MEREP) for FY15. The buying period for the MEREP will commence on 18 May 2015 and is expected to be completed by 10 July 20159. No discount will apply for the 2H15 Dividend Reinvestment Plan (DRP) and the shares required under the DRP are to be acquired on market.

Outlook

While the impact of future market conditions makes forecasting difficult, it is currently expected that the combined net profit contribution1 from operating groups for the year ending 31 March 2016 (FY16) will be broadly in line with FY15. The FY16 tax rate is currently expected to be broadly in line with 2H15, and down on FY15. Accordingly, the FY16 result for the Group is currently expected to be slightly up on FY15. The Group’s short term outlook remains subject to a range of challenges including: market conditions; the impact of foreign exchange; the cost of our continued conservative approach to funding and capital; and potential regulatory changes and tax uncertainties.

Regulatory update

In August 2014, APRA issued its final rules for Conglomerates with the implementation timing dependent on the outcomes of the Financial System Inquiry. Macquarie continues to work through the application of these rules with APRA and the Group’s current assessment remains that Macquarie has sufficient capital to meet the minimum APRA capital requirements for Conglomerates. Based on finalised Bank for International Settlements (BIS) leverage ratio requirements released in January 2014, the Bank Group is well in excess of the currently proposed Basel III three per cent minimum, with an estimated 6.0 per cent leverage ratio as at 31 March 2015. The leverage ratio applies to the Bank Group only. APRA published draft standards relating to the leverage ratio in September 2014 and is currently undertaking industry consultation regarding its final form.

Liquidity Coverage Ratio (LCR) requirements, which also only apply to the Bank Group, came into effect on 1 January 2015. As at 31 March 2015, the Bank Group’s LCR exceeded 120 per cent. Macquarie has been compliant with the LCR at all times since the ratio became a minimum requirement, with the average LCR for the first quarter of 2015 also exceeding 120 per cent. APRA has recently indicated its intention to deal with the level of capital held against mortgages, perhaps narrowing the mortgage risk weight differential between internal ratings-based (IRB) and standardised approach banks. While it remains unclear if, and to what extent, the gap will be narrowed, if the current APRA standardised approach were to be used instead of Macquarie’s IRB mortgage risk weights, the expected impact on the Bank Group’s Common Equity Tier 1 capital would be less than $A250 million.

Operating group performance

Macquarie Asset Management delivered a net profit contribution1 of $A1,450 million, up 38 per cent on the prior year. The result was driven by strong performance fee income and growth in annuity base fee income from higher assets and equity under management. AUM increased 14 per cent on the prior year to $A484.0 billion. Macquarie Infrastructure and Real Assets (MIRA) raised $A8.3 billion in new equity commitments during the year, invested equity of $A6.2 billion in portfolio assets across the globe and divested assets of over $A2.5 billion. Macquarie Investment Management (MIM) continued its strong investment performance, launched several new products across the fixed income, equities and alternatives asset classes, reached capacity in a number of strategies and continued to expand its global distribution network. Macquarie Specialised Investment Solutions continued to grow the Macquarie Infrastructure Debt Investment Solutions (MIDIS) business reaching second close on the UK Inflation-linked Infrastructure Debt Fund to bring total third party investor commitments to the MIDIS platform to over $A3.3 billion.

Corporate and Asset Finance delivered a net profit contribution1 of $A1,112 million, up 35 per cent on the prior year, including gains on several asset sales. CAF’s asset and loan portfolio increased 13 per cent during the year to $A28.7 billion. The corporate and real estate lending portfolio increased by 24 per cent to $A11.2 billion. There were $A4.7 billion of portfolio additions, comprising $A3.1 billion in new primary financings and $A1.6 billion of loans acquired in the secondary market. CAF’s asset finance portfolio of $A17.5 billion was up six per cent on the prior year due to the impact of the depreciation of the Australian dollar. The aircraft leasing business signed an agreement to acquire an operating lease portfolio of 90 aircraft valued at approximately $US4.0 billion, with acquisition and delivery to be completed during FY16. Throughout the year CAF also saw the continued expansion in the motor vehicle and equipment finance channels, as well as growth in the energy asset portfolio of smart meters in the UK and solar energy assets in Australia. CAF continued its securitisation activities, with $A4.0 billion of motor vehicle and equipment leases and loans securitised during FY15.

Banking and Financial Services delivered a net profit contribution1 of $A285 million, up 10 per cent on the prior year. BFS’ Australian mortgage portfolio grew by 44 per cent to $A24.5 billion, including $A2.5 billion in residential mortgage portfolios acquired during the year. This portfolio represents 1.7 per cent of the Australian mortgage market. Macquarie platform assets under administration increased by 19 per cent during the year to $A48.0 billion, while Macquarie Life inforce risk premiums increased by 17 per cent to $A223 million. Average business banking deposits increased 19 per cent over the year, with the business banking loan portfolio at $A5.2 billion as at 31 March 2015, up 27 per cent from $A4.1 billion in the prior year. Total retail deposits were up 12 per cent to $A37.3 billion. During the year BFS continued to invest in its technology to improve client experience, support growth and simplify, streamline and centralise its product and transactional functions.

Macquarie Securities Group delivered a net profit contribution1 of $A64 million, down from $A107 million in the prior year. Brokerage income remained relatively flat whilst equity capital markets activity increased on the prior year largely driven by initial public offering (IPO) activity in Australia. Certain markets experienced favourable conditions, which benefited the derivatives and trading divisions, however operating expenses (excluding brokerage, commission and trading-related expenses) were up 11 per cent on the prior year, resulting largely from investment in platforms and processes driven by regulatory compliance requirements, as well as restructuring costs from the exit of Structured Products. Macquarie was ranked No.1 in Australia for IPOs and No.2 for Australian equity and equity related deals in calendar year 2014. MSG continued to build on its expertise as one of the largest derivative warrant issuers in the Asia-Pacific region, holding No.1 market share for listed warrants in Singapore and Malaysia, No.3 in Thailand and No.7 in Hong Kong.

Macquarie Capital delivered a net profit contribution1 of $A430 million, up 54 per cent on the prior year. The business advised on 470 transactions worth $A141 billion and was ranked No.1 for announced and completed merger and acquisitions (M&A) deals in Australia in calendar year 2014. During the year, Macquarie Capital advised Freeport LNG on its landmark $US11.0 billion equity and debt raising to project finance its LNG export facility in Texas; was Joint Lead Manager on the $A5.7 billion IPO of Medibank Private, the largest Australian IPO in calendar year 2014 and the second largest Australian IPO ever; advised Emperador on its acquisition of Whyte & Mackay from United Spirits for £430 million; and was sole Sponsor and exclusive Financial Adviser to IHS Lothian for the project finance facilities of £185 million to the Royal Hospital for Sick Children public private partnership project in Edinburgh.

Commodities and Financial Markets delivered a net profit contribution1 of $A835 million, up 15 per cent on the prior year. The improved result reflected a general improvement in market conditions compared to the prior year. The Energy Markets business was a significant contributor to CFM’s overall result with revenues generated across the global energy platform, particularly in Global Oil and North American Gas. The Metals, Mining and Agriculture business had an overall improved result on the prior year, primarily driven by continued growth in the base metals platform across financing, physical execution and hedging activities, however further provisions for impairment were taken on underperforming resources investments and loans. Volatility and volumes improved in foreign exchange, interest rates and futures markets in the second half. US credit markets were mixed, however debt capital markets volumes and fees increased as M&A activity increased. The securitisation and origination businesses experienced continued growth and increased transaction flows, particularly in the UK and Europe.

IMF Regional Economic Outlook Update

The IMF released their Regional Economic Outlook for Asia Pacific to April 2015 today. China’s growth is predicted to fall, Australia’s to rise a little, on a comparative basis, our banks hold lower capital than many across the region, and the IMF stress the importance of macroprudential measures to reign in house prices, and fiscal stimulus to support economic growth. A few selected highlights:

Asynchronous monetary policies in major advanced economies in response to divergent cyclical conditions have contributed to large and rapid exchange rate realignments. Robust growth and the prospect of higher interest rates in the United States, coupled with the start of quantitative easing in the euro area and further monetary stimulus in Japan, have caused the value of the major reserve currencies to diverge sharply. While the dollar has gained substantially against most other currencies, rising about 9½ percent on a trade-weighted basis since the end of June 2014, the yen has fallen by about 10½ percent in nominal effective terms over the same period, and the euro has been broadly unchanged.

Against this backdrop, a number of Asia and Pacific currencies have appreciated in nominal effective terms since mid-2014. This reflects somewhat greater stability of Asian currencies relative to the dollar than implied by the share of the United States in these countries’ gross trade. In contrast, the currencies of commodity exporting Australia, Malaysia, and New Zealand have depreciated in nominal effective terms
(Figure 1.7).

Changes in real effective exchange rates have been broadly in line with changes in their nominal counterparts. However, using weights based on domestic value added in exports, appreciations of most Asian currencies have been less pronounced, suggesting a more modest erosion

Bank balance sheets have strengthened across most of Asia. Bank profitability has been high in many countries and, together with injections of new Basel III–compliant equity, has contributed to an increase in Tier 1 capital (Figure 1.23). Note that Australia is at the lower end of Tier 1.

While still outperforming most other large economies, China’s growth rate is expected to continue to edge lower over the medium term as rebalancing proceeds. Growth is projected to ease to 6.8 percent in 2015 and to 6.3 percent in 2016 as the correction in the residential and related sectors continues to drag on investment.

The downturn in the global commodity cycle will continue to affect Australia’s economy, with related investment coming off historic highs. However, supportive monetary policy and a weaker exchange rate will underpin nonresource activity, helping to edge up growth in 2015 to 2.8 percent, rising to 3.2 percent in 2016 (broadly unchanged from projections in the October 2014 WEO).

In Australia and New Zealand, consumers gain from the oil price windfall while forgone mining receipts and royalties have a negative effect on mining companies and the fiscal accounts.

In addition to strong microprudential supervision and regulation, protecting financial stability will require proactive use of macroprudential policies to increase resilience to shocks and contain the buildup of systemic risk associated with changes in financial conditions. In fact, greater reliance on macroprudential policies may be needed where the fi nancial cycle is not well synchronized with the real economy cycle (Australia, Hong Kong SAR, Korea), which may be more likely in the presence of strong unconventional monetary policies in the major economies. To avert overheating or overinvestment in real estate that could threaten the stability of financial systems, eliminating the preferential tax treatment of real estate (for example, by raising taxes on real estate capital gains) and tightening regulations on credit financing for real estate development and purchase (for example, imposing binding loan-to-value limits and debt-service-to-income ceilings) are advised. Macroprudential policies and capital flow measures should not substitute for appropriate macroeconomic policy reactions to volatile capital flows and asset price swings.

On the other hand, fiscal stimulus, or a slower pace of consolidation, may be appropriate for economies facing temporary adverse terms-of-trade shifts or where output is below the full-capacity level (Australia, Korea). But care should be taken to ensure that stimulus is reversed during cyclical upturns and to avoid conflating weaker potential growth with a temporary growth dip.

NAB 1H 2015 Results – UK Exit, Stage Left – DFA Research Alert

NAB today announced their results for 1H 2015, which completes the updates from the major banks this week. Somewhat similar themes, with volumes up but lending margins down, offset by some deposit repricing and lower provisions. The hand of the regulator can be seen on the Australian home loan business, but significantly NAB outlined an exit path from the UK requiring capital, and other strategic initiatives, and a rights issue. No commentary on the potential demands by higher regulatory capital.

On a statutory basis, net profit attributable to owners of the Company was $3.44 billion, an increase of $584 million or 20.4% compared with March 2014. Cash earnings were $3.32 billion, an increase of $170 million or 5.4% with improved performances across all major businesses. This was in line with expectations. Excluding prior period UK conduct related charges, cash earnings rose 0.3%. Analysis of the results shows a trade off between volume growth and margin.

Revenue increased 3.1%. Excluding gains on the UK Commercial Real Estate (CRE) loan portfolio sale and SGA asset sales, revenue rose 2.2% benefitting from higher lending balances, the impact of changes in foreign exchange rates, stronger Markets and Treasury income and increased NAB Wealth net income. Group net interest margin (NIM) declined 2 basis points over the year and 1 basis point when compared to the September 2014 half year.

Expenses were broadly flat but excluding a fine paid in relation to UK conduct and prior period UK conduct related charges rose 4.0%. The increase mainly reflects the impact of changes in foreign exchange rates, investment in the Group’s priority customer segments and higher technology costs, combined with occupancy and Enterprise Bargaining wage increases.

Improved asset quality resulted in a total charge to provide for bad and doubtful debts (B&DDs) of $455 million, down 13.8%. This primarily reflects lower charges in UK Banking and NAB UK CRE. Compared to the September 2014 half year, the B&DD charge rose 30.4% due to releases from the Group economic cycle adjustment and NAB UK CRE overlay of $104 million in the prior period which were not repeated. Group asset quality metrics continued to improve over the period. The ratio of Group 90+ days past due and gross impaired assets to gross loans and acceptances of 0.85% at 31 March 2015 was 34 basis points lower compared to 30 September 2014 and 67 basis points lower compared to
31 March 2014.

The Group’s Basel III Common Equity Tier 1 (CET1) ratio was 8.87% as at 31 March 2015, an increase of 24 basis points from September 2014. As previously announced, the Group’s CET1 target ratio from 1 January 2016 remains between 8.75% – 9.25%, based on current regulatory requirements. The interim dividend is 99 cents per share (cps) fully franked, unchanged from the prior interim dividend, and below market expectations.

For the March 2015 half year the Group has raised approximately $17.3 billion of term wholesale funding. The weighted average term to maturity of the funds raised by the Group for the March 2015 half year was approximately 5.0 years.

The Group’s quarterly average liquidity coverage ratio as at 31 March 2015 was 118%. The ratio of collective provision to credit risk weighted assets was 1.01% at 31 March 2015 compared to 0.83% at 30 September 2014 with the increase over the period reflecting transition to AASB. The ratio of specific provisions to impaired assets was 35.5% at 31 March 2015, which compares to 35.3% at 30 September 2014 and 34.8% at 31 March 2014.

There were two significant strategic announcements in the results.

UK Exit – this was signalled in October 2014 as a result of the strategy to focus on the Australian and New Zealand franchise. Significant work has since been undertaken on various exit options, in particular public market options which offer increased certainty on the ability to transact and timing. While remaining open to a trade sale, NAB intends to pursue a public market option of a demerger of approximately 70-80% of Clydesdale Bank’s holding company National Australia Group Europe Ltd and its subsidiaries (Listco) to NAB shareholders and a sale of the balance by way of IPO (approximately 20-30%) to institutional investors. A demerger accelerates the full exit of the UK business, as opposed to a prolonged multi-staged public market sell-down, and allows an exit to be targeted by the end of this calendar year, subject to market conditions. The consequences for NAB will be a reduction in cash earnings on separation of Listco with shares in Listco to be received by NAB shareholders, whilst NAB cash ROE should increase on separation; the transaction expected to have a broadly neutral impact on NAB’s capital position excluding the capital support to Listco which will receive capital support of £1.7bn is, from separation, expected to be a full deduction from NAB CET1. Actual losses lower than £1.7bn should result in a capital release for NAB over time. Post separation, future actual conduct cost will be recognised by NAB within discontinued operations outside of cash earnings with no impact on capital (netted against £1.7bn support). No impact on NAB’s credit ratings expected

NAB Wealth today announced it has received APRA approval for its life insurance arm to enter into a reinsurance arrangement with a major global reinsurer for approximately 21% of its in-force retail advised insurance book. The transaction is expected to release approximately $500 million of CET1 capital (13 basis points) to the NAB Group, and represents approximately 15% of NAB Wealth’s life insurance embedded value. This is expected to result in a reduction in NAB Wealth cash earnings of approximately $25 million per annum.

Also, NAB will be undertaking a 2 for 25 fully underwritten pro rata accelerated renounceable rights issue with retail rights trading (the Entitlement Offer) at an offer price of $28.50, to raise approximately $5.5 billion. Approximately 194 million new NAB ordinary shares are to be issued (approximately 8.0% of issued capital). New shares issued under the Entitlement Offer will rank equally with existing shares from the date of allotment. New shares will not however be entitled to the interim dividend for the half year ended 31 March 2015 of 99 cps because they will not be issued before the dividend record date.

Looking at the segmentals, Australian Banking cash earnings were $2,574 million, an increase of 4.0%, with revenue the key driver. Revenue rose 3.9% reflecting a stronger trading performance, combined with higher volumes of housing and business lending, partly offset by weaker margins. Expenses rose 3.8% driven by additional service roles and front line business bankers, combined with Enterprise Bargaining wage increases and higher technology costs. Cost to income rose by 10 basis points to 40.7%. Asset quality metrics continued to improve and B&DD charges of $366 million fell 2.4%, benefitting from lower business impairment activity partly offset by higher collective provision charges including a $49 million overlay for agriculture and resource sectors. NIM declined 3 basis points to 1.60% as a result of asset competition and lending mix impacts.

Although NAB experienced above system growth in mortgages, margins on home lending were squeezed 5 basis points.

Broker volumes grew from 30.2% to 30.9% of loans originated. There was a net 209 increase in brokers across aggregators PLAN, Choice and FAST – currently 3,700 affiliated brokers, and a 31% increase in white label transaction. LVR’s over 80% were circa 20% of transactions, and around 15% of book, with a slight fall above 90%.

Looking at the loan portfolio mix, 28.8% of loans were for investment property (up from 28.2% in Sept 2014), and 35% of loans were interest only. The average balance was $276,000. 90 Day past due was 0.48% and impaired loans 0.14%. The loss rate is 0.03%. Home loan impairment is lower through the broker channels than proprietary channels (opposite to what the regulator says, by the way, but consistent with our own modelling).

Steps are being taken to slow growth in investor mortgage lending to meet APRA’s 10% YoY threshold – currently 13%, and they say they are on track to comply with APRA’s best practice serviceability guidelines by June 2015 – floor rate comfortably above 7.0% and serviceability buffer comfortably above 2.0% (including buffer on existing debt). Interest only lending assessed on a principal and interest basis. This shows the regulator is having an impact and that lending criteria are tightening.

NZ Banking local currency cash earnings rose 4.5% to NZ$418 million with higher revenue given steady growth in lending volumes and improved margins (up 7 basis points, but with a 13 basis fall in lending margin, offset by 10 basis point rise in deposit margin, as well as funding and capital benefits) reflecting lower funding costs and benefits from both higher capital levels and higher earnings on capital. Costs rose 1.8% due mainly to increased personnel expenses, but were broadly flat compared to the September 2014 half year. Cost to income ratio rose 80 basis points to 40.2% B&DD charges were higher over the period with lower collective provision write-backs, but were flat over the six months to 31 March 2015 given the continued benign credit environment.

NAB Wealth cash earnings increased 28.2% to $223 million reflecting improved results from both the investments and insurance businesses, and lower operating expenses. Net income rose 8.0% due to improved insurance claims performance, stable lapses and growth in funds under management (FUM) as a result of strong investment markets, partly offset by lower investment margins related to a change in business mix. Cost to income ratio fell by 7.7% to 67.9%. There was no repeat of the insurance reserve increases seen in prior periods.

UK Banking local currency cash earnings grew 35.6% to £99 million driven by a further material reduction in B&DD charges as the business benefitted from improved economic conditions and loan portfolio shifts. Revenue was slightly weaker despite good growth in home lending volumes with competitive pressures resulting in NIM decline of 11 basis points from lending, points. Costs fell 1.2% (cost to income up 10 basis points to 70.3%) with increased restructuring and marketing spend more than offset by a one-off pension scheme gain in the March 2015 half year and conduct related charges that were incurred only in the March 2014 half year.

High Liquidity Creation and Bank Failures

An IMF working paper published today entitled “High Liquidity Creation and Bank Failures”, suggests that regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

Identifying vulnerabilities which may lead to bank failure is a persistent challenge to regulators of financial systems and market analysts. Regulators seek timely warning of bank failures for an efficient deployment of monitoring resources and for enhancing regulation enforcement, and shareholders and taxpayers want to avoid substantial resolution costs as well as reduce the time involved in loss resolution.

Two hypotheses in the literature on bank fragility explain bank failures: the “Weak Fundamentals Hypothesis” (WFH) and the “Liquidity Shortage Hypothesis” (LSH). Under the WFH, poor bank fundamentals foreshadow an impending bank failure and CAMELS components are often used as the basis for an early warning system. Bank failures are thus information-based, as decaying capital ratios, reduced liquidity, deteriorating loan quality, and depleted earnings signal an increased likelihood of bank failure. In contrast, the LSH assumes that banks are solvent institutions but fragility is due to the irrational behavior of uninformed depositors who are unable to distinguish between liquidity and solvency shocks. According to this hypothesis, bank vulnerability to crises stems from the financing of illiquid assets with liquid liabilities. When exposed to an external shock and under the sequential servicing constraint, first-in-line depositors seek to withdraw all their deposits and, as the bank’s ability to meet deposit withdrawals declines, liquidity shortages become pronounced and the probability of failure increases.

The WFH focuses on asset risk to explain bank fragility and bank risk under the LSH arises from the liability side of the balance sheet. In this paper, we propose that bank vulnerability may result from the interaction between both asset and liability risks. Using new measures on liquidity creation, we postulate that banks’ vulnerability to failure may resultfrom a proliferation in the core activity of liquidity creation. We propose the “High Liquidity Creation Hypothesis” (HLCH) to explain bank failures, complementing the WFH (which identifies banks with weak fundamentals) and the LSH (which focuses on the inability of banks to meet liquidity commitments). According to the HLCH, a bank’s vulnerability increases when the core output measured by liquidity creation reaches high levels compared to other banks’ activities in the system.

To test this, we need a banking system that witnessed a number of bank failures which are unrelated to economic business cycles or triggered by adverse exogenous shocks. In Russia, over 200 banks failed between 2000 and 2007 and many of those failures were not associated with the business cycle. Thus, the banking system in Russia provides a natural field experiment to test as we are able to isolate the reasons for bank fragility independently from exogenous events.

To gauge the impact of high liquidity creation on the probability of bank failures, we perform logit regressions with bank random effects. We use different thresholds to define high liquidity creation in a given quarter, based on the distribution of the entire liquidity creation in the banking system. Our findings confirm the hypothesis that high liquidity creation increases the probability of bank failure, and the results are robust to several validity checks. Rather than suggesting an absolute cut-off value, we propose to screen financial intermediaries based on their liquidity creation ranking in the system. The identification of high liquidity creators allows regulators to at least place these banks on the watch list for enhanced oversight in view of reducing the number of failures in the system and strengthening incumbent institutions.

We propose a screening procedure of banks, ranking them based on their liquidity creation in the system. Specifically, we define high liquidity creators as banks with a liquidity creation level in a given quarter that exceeds the 90th percentile of the distribution. When liquidity creation becomes high, the probability of failure for such a bank increases significantly more than for other banks. Our results are robust to alternative measures of liquidity creation and definitions of bank failure, and controlling for bank location, market concentration, and regulatory changes. They are also in line with the theoretical predictions of Allen and Gale (2004) and empirical results for the U.S. (Berger and Bouwman, 2011).

The HLCH has two main implications. First, it suggests that liquidity creation by banks can be counterproductive when it becomes high. Liquidity creation above a certain threshold increases the probability of bank failure, eventually leading to the disappearance of the high liquidity-creating institution and even a reduction in the volume of aggregate liquidity creation in the economy. Therefore, regulatory authorities may need to give more attention to the liquidity-creating activities by banks when identifying vulnerabilities in the financial system. Second, our main finding provides insight for regulatory authorities to predict bank failures. Specifically, regulators may want to consider incorporating liquidity creation into their early warning systems and subject high liquidity creators to additional oversight to either prevent bank failure or impose an orderly winding-down of the bank and limit taxpayer losses.

Did Abolishing Negative Gearing Push Up Rents? – ABC Fact Check

ABC Fact Check investigates whether abolishing negative gearing in 1985 caused rents to surge. During the period negative gearing was abolished rents notably increased only in Sydney and Perth. Other factors, including high interest rates and the share market boom, were also contributors to rent increases at the time.

As property prices continue to rise across Australian capital cities, in particular Sydney, the debate around how to address housing affordability problems has intensified.

Sydney house prices have jumped more than 6 per cent since the beginning of the year, increasing pressure on first home buyers.

The Reserve Bank has raised concerns that “ongoing strong speculative demand” from property investors will exacerbate the run-up in housing prices and raise the risk of big price falls.

Negative gearing, a tax deduction for rental property investors, is an area of contention.

But Treasurer Joe Hockey says if negative gearing is abolished, there could be other serious consequences.

“If you abolish negative gearing on investment properties, there’s a strong argument that rents would increase,” Mr Hockey said on the ABC’s Q&A.

Mr Hockey said that in the 1980s, when negative gearing was briefly removed, there was a backlash from investors who increased rents to “replace the lost income” negative gearing had provided.

“The net result was you saw a surge in rents,” he said.

Mr Hockey has made similar claims a number of times in the past two months. On April 28 he said: “If you were to remove negative gearing you would see an increase in rents and I think that hurts lower income Australians who may be renting those homes.”

However, during the period that negative gearing was abolished real rents notably increased only in Sydney and Perth – where rental vacancies were at extremely low levels.

This is inconsistent with arguments that negative gearing was a significant factor, with negative gearing likely to have a uniform impact on rents in all capital cities.

At the same time, high interest rates and the share market boom of the mid 1980s increased consumer demand for rental properties, encouraged existing investors to pass on high mortgage costs to renting consumers, and discouraged additional investors from investing in the rental property market.

While the rent increases in two cities did coincide with the temporary removal of negative gearing tax deductions, it is unlikely that change had a substantial impact on rents in any major capital city in Australia.

Mr Hockey’s claim doesn’t stack up.

Link to the ABC video

RBA Rate Cut Increases Need for Greater Macro-Prudential Response – Fitch

Fitch Ratings says the Reserve Bank of Australia’s (RBA) recent interest rate cut is likely to lead to a strengthened macro-prudential response from the Australian Prudential Regulatory Authority (APRA) for the Australian banking system, although implementation will probably remain targeted and occur on a bank-by-bank basis.

Today’s rate cut is likely to further fuel the Australian property market, particularly in Sydney, at a time when the authorities are trying to take the steam out of the market. Macro-prudential tools allow the regulator to influence banks’ risk appetite, preserving asset quality and limiting potential losses in the event of an economic shock. The Australian banking system benefits from strong loss absorption capacity given the banks’ sound profit generation and provision levels, as well as adequate capitalisation. These strengths could be undermined by further increases in property prices and household debt, given mortgages form the largest asset class for Australian banks.

APRA has targeted certain higher risk areas such as investor mortgages, indicating growth in excess of 10% per annum would trigger closer regulatory monitoring and may lead to tougher capital requirements. In addition, APRA could use a set of other macro-prudential tools which may include a combination of debt-servicing requirements, additional capital requirements and/or loan-to-value ratio (LVR) restrictions, depending on each lender. Given the existence of lenders’ mortgage insurance (LMI), which mitigates the banks’ risk of higher LVR mortgages, debt-servicing requirements and higher capital requirements on a bank-by-bank basis are likely to be the preferred options.

Growing risks in the housing market and the banks’ mortgage portfolios could be exacerbated if further macro-prudential scrutiny is not forthcoming. The recent interest rate cut may lead to further house price appreciation, especially in cities such as Sydney and Melbourne, where there has been greater investor activity over the past 12 to 18 months. The first rate cut in February 2015 was followed by increased activity in these housing markets. The growth in house prices exceeded lending growth up to the end of 2014, but this trend could reverse as interest rates are at historical lows. At the same time, it makes borrowers vulnerable to a potential increase in interest rates in the medium term. Australia has one of the highest household debt levels globally, and if low interest rates contribute to higher credit growth, it could drive up household indebtedness from already historically high levels.

Falling interest rates may also result in further growth in potentially higher-risk loan types, such as interest-only and investor loans. These loan types already represent a high proportion of new approvals for Australian banks, as shown in Fitch’s “APAC Banks: Chart of the Month, February 2015”. The proportion of new interest-only mortgages is higher than new investor mortgages, suggesting that owner-occupiers are increasing the use of these types of loans at a time when historically-low interest rates should encourage borrowers to pay off debt. Serviceability testing at Fitch-rated Australian banks may provide some offset to this risk, with loans assessed on a principle and interest basis and at interest rates well above the prevailing market rate.