Martin North – Page 1041 – Digital Finance Analytics (DFA) Blog

Risky Lending In A Low Interest Rate Competitive Environment

Regulators have been concerned about the quality of lending, and have been increasing their supervision, conscious of the potential impact on financial stability. However, a paper from the Bank for International Settlements – Bank Competition and Credit Booms highlight that especially when interest rates are low, and competition intense, banks will naturally and logically drop underwriting standards. This observation is highly relevant to the Australian context, where competition for home loans in particular is leading to heavy discounting from already low rates, and potential lax underwriting. It suggests that lowering rates further will exacerbate the effect.

Greater bank competition and a lower risk-free rate raise the screening costs of lending, which can result in sharp increases in credit supply and deteriorations in average loan quality, which are inefficient for banks. Banks’ incentives to make risky loans can vary despite unchanged capital structure, thus highlighting the role of a risk-taking mechanism. This approach helps explain the existing mixed empirical results on the relationship between bank competition and financial stability. The model can be used to define a neutral interest rate in the context of financial cycles.

There is a growing recognition that the relationship between finance and growth may be unstable in practice. Past financial crises serve as painful reminders that increasing financial access by too much too fast is subject to diminishing returns at best, and can even lead to severe output losses when the financial sector is in disarray. Despite ample evidence for this perverse nonlinearity, there is less understanding about the exact mechanism by which excessive finance that is harmful for stability can arise as an equilibrium phenomenon. Similarly, the role of policy in navigating the trade-o between growth and financial stability, unlike that between growth and inflation, remains a relatively uncharted territory.

This paper proposes a simple model of bank lending decision, where a`credit boom’ could emerge as an equilibrium phenomenon. Two key forces interact to determine the equilibrium. First, banks have an incentive to screen out bad clients by restricting the amount of lending per contract, as riskier firms are known to seek larger loans despite a lower chance of success. Such screening entails costs to both banks and good firms, given that credits are being rationed to meet incentive compatibility conditions. This feature is essentially classic credit rationing.

The second force comes into play when banks enjoy some monopolistic power over their loan market, but can attempt to poach clients from another bank by offering cheaper loan contracts. Lowering prices of loans raises the screening costs, because it necessitates even greater credit rationing if banks were to screen out risky firms. When the degree of bank competition for borrowers is suciently intense, it becomes optimal for banks to stop screening and rush to dominate the market by offering contracts with larger loans to all firms. This new pooling equilibrium is characterised by a low lending interest rate (relative to the average productivity of underlying projects), a larger loan size, and a higher probability of loan defaults.

A lower risk-free rate increases the banks’ incentives to lend by lowering the opportunity cost of funds. But how the credit market equilibrium responds to changes in the risk-free rate also depends on the market structure in which banks operate. In particular, when a bank can gain more market share for a given cut in lending rate, the degree of competiton tends to be higher in equilibrium for any level of risk-free rate. Credit booms are therefore more likely to occur when banks compete more aggressively and/or the risk-free rate is low. In this context, the notion of `financial stability neutral’ monetary policy can be given an explicit denition, namely that which will prevent a pooling equilibrium from occuring. At the same time, the presence of intense bank competition can limit the effectiveness of monetary policy in containing a credit boom and achieving the financial stability objective.

Why A Larger Finance Sector Is Killing The Economy

The Bank for International Settlements released a paper “Why does financial sector growth crowd out real economic growth?” The paper suggests that rather than encouraging a bigger banking sector, we should be careful because a larger finance sector actually kills growth in the real economy. That is an important insight, given that in Australia, the ratio of bank assets to GDP is higher than its ever been, and growing, at a time when economic growth in anemic.

Other countries have significantly higher ratios. The mythology that a bigger banking sector is good for Australia should be questioned. At a time when banks are growing in Australia, thanks to high house prices and lending, inflating their size, we should be looking hard at these findings, because if true, we are on the wrong track.

The purpose of this paper is to examine why financial sector growth harms real growth. We begin by constructing a model in which financial and real growth interact, and then turn to empirical evidence. In our model, we first show how an exogenous increase in financial sector growth can reduce total factor productivity growth. This is a consequence of the fact that financial sector growth benefits disproportionately high collateral/low productivity projects. This mechanism reflects the fact that periods of high financial sector growth often coincide with the strong development in sectors like construction, where returns on projects are relatively easy to pledge as collateral but productivity (growth) is relatively low.

Next, we introduce skilled workers who can be hired either by financiers to improve their ability to lend, increasing financial sector growth, or by entrepreneurs to improve their returns (albeit at the cost of lower pledgeability). We then show that when skilled workers work in one sector it generates a negative externality on the other sector. The externality works as follows: financiers who hire skilled workers can lend more to entrepreneurs than those who do not. With more abundant and cheaper funding, entrepreneurs have an incentive to invest in projects with higher pledgeability but lower productivity, reducing their demand for skilled labour. Conversely, entrepreneurs who hire skilled workers invest in high return/low pledgeability projects. As a result, financiers have no incentive to hire skilled workers because the benefit in terms of increased ability to lend is limited since entrepreneurs’ projects feature low pledgeability. This negative externality can lead to multiple equilibria. In the equilibrium where financiers employ the skilled workers, so that the financial sector grows more rapidly, total factor productivity growth is lower than it would be had agents coordinated on the equilibrium where entrepreneurs attract the skilled labour. Looking at welfare, we are able to show that, relative to the social optimum, financial booms in which skilled labour work for the financial sector, are sub-optimalwhen the bargaining power of financiers is sufficiently large.

Turning to the empirical results, we move beyond the aggregate results and examine industry-level data. Here we focus on manufacturing industries and find that industries that are in competition for resources with finance are particularly damaged by financial booms. Specifically, we find that manufacturing sectors that are either R&D-intensive or dependent on external finance suffer disproportionate reductions in productivity growth when finance booms. That is, we confirm the results in the model: by draining resources from the real economy, financial sector growth becomes a drag on real growth.

Their conclusions are important.

First, the growth of a country’s financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth. In other words, financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources. Second, using sectoral data, we examine the distributional nature of this effect and find that credit booms harm what we normally think of as the engines for growth – those that are more R&D intensive. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems.

Bendigo Bank Results Show Signs Of Home Loan Competition

Bendigo and Adelaide Bank (BEN), Australia’s fifth largest bank, today announced an after-tax statutory profit of $227.3 million for the six months ending 31 December 2014. The results were in line with the consensus expectations. Underlying cash earnings were $217.9 million, a 10.9 per cent increase on the prior half year result. Bad and doubtful debts expense was $30.1 million, down 29.5% on the prior corresponding period. NIM was maintained at 2.24%. Cash earnings per share were 48.1 cents, an increase of 3.4 per cent.

The interim fully franked dividend of 33 cents per share is up 2 cents on the 2014 interim dividend.

Basel III CET1 ratio increased by 12bps half on half to8.14% and an $292m additional Tier 1 capital issued in October. $600m RMBS was issued in December 2014. Total capital increased 80bps half on half to 12.19%.

Looking at the segmentals, Retail banking was up 14.2% from Jun 2014 ($128m to $146m), Third party banking was down 4.6% from Jun 2014 ($95.8m) to $91.4m, Wealth fell 37.5% from $19.5m to $12.0m and Rural rose 73.3% from $24.3m to $42.1m including the Rural Finance acquisition – in In July 2014, Bendigo finalised its $1.78 billion acquisition of Rural Finance Corp. from Victoria’s state government which has grown its agricultural lending. Overall, home lending grew at just 3.2% compared with system growth of 7.1%, whilst arrears were around 0.5%. There was strong competition through the broker originated channel.

They grew business lending by 19.7% compared with system of 7.4%. Business loan arrears were around 1.4%. Deposit growth was 1.5%, compared with system of 9.1%. Bendigo had an 8 basis point squeeze on lending margins thanks to competitive pressures and as a result they reduced term deposit pricing to help partly offset this so the net interest margin remained unchanged. Customer satisfaction remains higher than the majors, highlighting their unique position in the market.

The market reacted negatively to the results, because the growing business lending sector may imply higher loss rates, pressure on home lending margin and share, and reduced provisioning.

Is More Securitisation A Good Thing?

Prior to the 2007 Financial Crisis, securitisation was seen as a tool to support economic growth and financial stability by enabling issuers and investors to diversify and manage risk. By transforming a pool of illiquid assets into tradable securities, securitisation frees up bank capital, allowing banks to extend new credit to the real economy, and support the transmission of monetary policy. However, it has the capacity to amplify the flow of credit inside or outside the banking system, increase leverage, exacerbate misaligned incentives in the financial intermediation chain, and, thus, ultimately amplify systemic risk. It was right at the heart of the GFC. Now, Regulators and Bankers are looking for ways to resurrect securitisation, and there are signs of momentum beginning to grow in some markets.

In a recent speech, Dame Clara, External Member of the Financial Policy Committee, Bank of England, noted that whilst it is important to recognise that market-based finance can also present systemic risk, a more balanced financial system should emerge in the long-term. This should make both the real economy and banking system more resilient to economic shocks, as well as help central banks step back from “last resort” measures and allow private markets to operate more widely and efficiently. She also highlighted the important role of investment banks in helping this balance to be achieved. Firstly, by facilitating equity and bond issuance, and secondly by ensuring liquidity in the secondary market for those assets.

In the US and Europe, Securitisation issues fell from 2007 onwards, but are showing signs of recovery (chart shows billions of US dollars)

In Australia, where momentum started in mid 1990’s, we saw a similar collapse post the GFC. But again, we are seeing the first signs of a lift in volumes, as the mortgage market has grown.

But, is this a good thing? It certainly enables Banks to lend more. Changes to the capital rules will however mean these methods are less effective from a capital efficiency view point than prior to the GFC. In December 2014, the Basel Committee on Banking Supervision published “Revisions to the Securitisation Framework”. This framework, which will come into effect in January 2018, forms part of the Committee’s broader Basel III agenda to reform regulatory standards for banks in response to the global financial crisis and thus contributes to a more resilient banking sector. The new concept aims to make capital requirements more prudent and risk-sensitive, reduce mechanistic reliance of the industry on external credit ratings, and reduce cliff effects. In all the proposed approaches a risk-weight floor of 15 percent for any securitization tranche is suggested. Net, net however, securitisation will still be capital efficient.

The IMF recently released a discussion paper on Securitisation, the Road Ahead, where the role of securitisation was discussed, and some ideas laid out as to how to allow securitisation to be used, without the overlay of complex risks. They suggest that:

Placing private securitisation markets back on a firm and sustainable footing has never been more important. Financial risk-taking has resurfaced, but securitisation has yet to retake its instrumental role in rekindling credit flows and diversifying risks. Clearly, securitisation must be managed in a way that supports financial stability rather than posing risks to it. Many reforms have focused on mitigating these risks. They need to be complemented by further policy actions to secure a thriving financial ecosystem for securitisation.

Proposed reforms along the four-stage financial intermediation chain should be strengthened. First, the quality of underlying loan origination practices should be further beefed up to restore the appetite for securitisation. Second, securitisation intermediaries must be encouraged to develop structures that are transparent, straightforward to value, and primarily designed to finance the real economy. Legal ambiguities related to the rights and obligations of servicers, trustees, and investors should be avoided. Establishing the secure, transparent, and cost-effective transfer of claims on collateral will be paramount. Third, credit ratings can be put to better use. Standardised definitions of securitisation characteristics and full disclosure of the rating process would increase transparency and confidence. The practice of rating shopping should be disclosed and the removal of references to external ratings in regulations accelerated. Fourth, investors can be galvanised by ensuring consistent application of capital charges across asset classes and borders. It will be beneficial to avoid large step-changes in charges (the so-called “cliff effects”) between classes of securitised assets that do not differ much in underlying quality.

More granular application of industry standards for the classification of risk would preserve the benefits of those standards while mitigating due diligence problems encountered during the crisis. A single aggregate label for risk tends to act as a credit rating, encouraging investors to shirk on their due diligence. Changes in the rating can create forced buying and selling pressure independent of the variation in investor tolerances for risk. Proposals for a binary (high-low quality) aggregate classification system risk creating a fragmented market with significant pricing discontinuities. Instead, standardisation across individual risk factors (i.e., duration, prepayment risk, collateral fungibility, track record of credit performance, etc.) could mitigate these concerns.

Finally, securitisation markets would be strengthened by fostering a diversified nonbank institutional investor base with a long time horizon. In the case of Europe, for instance, the development of a suitable nonbank investor base will likely require the pan-European harmonization of loan-level reporting standards, documentation standards, insolvency regimes, and taxation treatment of securitisations. Regulatory, institutional, and product design obstacles will also need to be overcome to encourage greater sponsorship from European insurers and pension funds, both of which are underutilized potential sources of patient, long-term capital. These efforts could also contribute to the broader aim of diversifying the sources of financing for the European economy.

So regulators are trying to figure out the best mix of regulation and control to allow securitisation to become more main stream again. We agree significant changes would be required across the securitisation value chain, but are less convinced of the merits to allowing such financial engineering to be drive the market. It remains a complex and relatively opaque funding method, designed to leverage capital harder. The risk is however is that other more exotic alternatives are also being explored and as indicated earlier, more open securitisation mechanisms may be lower risk from a financial stability perspective than some others – the question is, is this sufficient reason to encourage a resurgence?

90% of additional Tier 1 instruments issued by banks globally in 4Q14 were for large Chinese banks

According to Fitch, nearly 90% of additional Tier 1 (AT1) instruments issued by banks globally in 4Q14 were issued by large Chinese banks. This resulted in Chinese banks, which were not present in the growing AT1 market before 4Q14 becoming the third-largest issuers of AT1 instruments behind UK and Swiss banks and accounting for around 20% of the USD131bn AT1 and other capital-trigger instruments.

Overall, banks issued around USD29bn in AT1 bonds in 4Q14, the second-strongest quarter after 2Q14. Fitch expects issuance volumes in 1H15 to remain dominated by Chinese banks which are likely to issue around USD50bn AT1 instruments in the short-term, mostly in local currency in their domestic market.

However, with the year-end results season under way and following tax status clarifications of AT1 instruments in several European countries, issuance from European banks will also likely remain solid, provided market conditions are conducive. This was evidenced by a EUR1.5bn issue by Netherlands-based Rabobank Group in January 2015.

Overall coupon omission and write-down/conversion risk in the AT1 market remained broadly stable in 4Q14. The write-down/conversion TDA (the issue size-weighted distance between the applicable common equity Tier 1 ratio of the issuer and the contractual write-down or conversion trigger) increased by a negligible 14bps to 679bps at end-4Q14, indicating marginally lower average write-down/conversion risk. In absolute terms, the write-down/conversion TDA widened to USD39.2bn at end-4Q14 from USD26.5bn at end-3Q14 largely as a result of the above-average size (in absolute terms) of the new Chinese issuers.

When Are Banks Too Big To Fail?

The Bank of England just published a research paper “Financial Stability Paper 32: Estimating the extent of the ‘too big to fail’ problem – a review of existing approaches – Caspar Siegert and Matthew Willison”.

The disorderly failure of a large financial institution could cause widespread disruption to the financial system. Because of this, authorities have often in the past been reluctant to see large institutions fail and preferred to use public funds to save them. To the extent that this is anticipated by a bank’s debt holders, these ‘too big to fail’ (TBTF) institutions may benefit from funding costs that are artificially low and insensitive to risk, a form of implicit subsidy from the government. Implicit subsidies could lead to resource misallocation in the economy because institutions are incentivised to choose excessively high levels of risk since their funding costs do not fully reflect the level of risk-taking. Moreover, banks that are not yet TBTF may have incentives to grow to being inefficiently large, in order to boost their chances of receiving government support.

First, the share price increase would reflect a TBTF bank’s lower debt costs since shareholders hold a residual claim on the bank’s profits. If an increase in the expectation that a bank will be bailed out reduces debt costs and these benefits are not fully passed on to the bank’s customers or employees this will increase expected profits and hence raise a bank’s share price. Thus, share price reactions could be an indirect measure of the impact of TBTF expectations on debt costs. But cross-sectional studies that compare TBTF and non-TBTF banks should fail to find this effect if they control for bank profitability.
Second, a capital injection into a bank that would otherwise have failed may mean that shareholders’ claims are diluted rather than being wiped out entirely as they would be if the bank became insolvent. If existing shareholders are not wiped out entirely they are partially insured in case of failure and will demand lower expected returns in order to invest into the bank. Consequently, share prices will be higher for a TBTF bank than for a non-TBTF bank for a given level of bank profitability.

The existence of the TBTF problem is now widely accepted by academics, politicians and regulators across the world. In 2009, G20 leaders called on the Financial Stability Board (FSB) to propose measures to reduce the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs). The FSB has developed a framework for addressing the TBTF problem that includes:

Methodologies to identify institutions that are systemically important (for banks see Basel Committee on Banking Supervision (2013), for insurers see International Association of Insurance Supervisors (2013), and for non-bank,
non-insurer financial institutions see Financial Stability Board and International Organization of Securities Commissions (2014));
Policies to reduce the likelihood of SIFIs failing such as additional capital requirements (eg Basel Committee on Banking Supervision (2013)) and enhanced supervision (Financial Stability Board (2012));
Policies to reduce the impact of SIFIs failing by ensuring arrangements are in place to effectively resolve those institutions (see Financial Stability Board (2011)).

As part of its work on reducing the impact of the failure of a global systemically important bank (G-SIB) the FSB is currently consulting on policy proposals to ensure that G-SIBs have sufficient capacity to absorb losses in resolution without requiring public support or threatening financial stability (Financial Stability Board (2014)). The policy proposals on such ‘total loss-absorbing capacity’ were welcomed by the G20 leaders at their Brisbane summit in November 2014.

But it raises the question, how big is the ‘too big to fail’ (TBTF) problem? Different approaches have been developed to estimate the impact being perceived as TBTF might have on banks’ costs of funding. One approach is to look at how the values of banks’ equity and debt change in response to events that may have altered expectations that banks are TBTF. Another is to estimate whether debt costs vary across banks according to features that make them more or less likely to be considered TBTF. A third approach is to estimate a model of the expected value of government support to banks in distress. They review these different approaches, discussing their pros and cons. Policy measures are being implemented to end the TBTF problem. Approaches to estimating the extent of the problem could play a useful role in the future in evaluating the success of those policies. With that in mind, the report concludes by outlining in what ways they think approaches need to develop and suggest ideas for future research.

ASIC issues stop order on pre-prospectus publications by Bitcoin Group Limited

ASIC has placed a stop order prohibiting Bitcoin Group Limited (a proposed Bitcoin ‘miner’ in Australia) from publishing any statements concerning its intention to make an initial public offering of its shares until the lodgement of a prospectus.

ASIC’s concerns relate to publications posted by the company via a social media application ‘Wechat’ seeking expressions of interest from potential investors to subscribe for shares if there is a proposed listing on the Australian Securities Exchange. The publications were made before Bitcoin Group Limited was registered as an Australian company by ASIC and before the lodgement of a formal disclosure document (e.g. a prospectus). ASIC’s understanding is that the company particularly targeted potential investors from the Chinese community.

ASIC Commissioner John Price said, ‘ASIC will often review pre-prospectus advertising or publicity to ensure legal requirements are being met. This is because any statements made about a potential offer may influence the investment decisions of consumers who will not have the benefit of all material information that would be included in a prospectus.’

‘ASIC expects companies to be fully aware of their obligations regarding advertising or publicity that occurs before making a regulated disclosure document available to investors. If they do not observe these requirements, then ASIC will take necessary action so that investment decisions are made in a confident and fully informed environment.’

ASIC has taken the step of issuing a media release given the publicity raised by Bitcoin Group in relation to their intention to list on the ASX. In normal circumstances, the issuing of a stop order is made public on our website and in reference to the fundraising documents lodged with ASIC. On this occasion, no documents have yet been lodged with ASIC so we have issued a media release outlining our concerns and subsequent action.

ASIC’s action relates just to this company rather than Bitcoin generally.

Banks More Leveraged Into Housing Than Ever

Putting together data from the recent ABS releases, we can view some important data which shows that today Banks in Australia are deeper into property than ever they have been. As a result they are more leveraged (thanks to capital adequacy rules) and more exposed if prices were to turn. Meantime, other classes of commercial lending continues to decline.

To show this, we look first at the share of commercial lending which is investment housing related. These are the monthly flows, not the overall stocks of loans on book. On latest trend data, around 33 per cent of monthly lending is for investment housing. Its normal range was 20-25 percent, but thanks to a spike in investment for housing, and a fall in other commercial lending categories it has broken above 30 percent. From a capital and risk perspective, lending for investment housing is adjudged as less risky than other commercial lending categories.

Now, lets look at all lending for property, including owner occupied lending, investment lending, and alterations, again from a flow perspective. Now we find that 47 per cent of all monthly flows are property related, again, higher than it has traditionally been.

Finally, in our earlier analysis we highlighted the relative stock of different loan types. Overall, only 33% of all lending is productive finance for business purposes. Household and consumer debt continues to rise strongly. Housing Lending is driving the outcomes.

This is unproductive lending, simply feeding the debt beast, and inflating property to boot. It also means the banks have strong interests in keeping the beast fed, and the RBA, conscious of the need for financial stability, will continue to support the current mix. As Murray pointed out the government is guaranteeing the banks and if there was a failure the tax payer would pick up the tab.

Lending Growth In December Only Supported By Housing

The ABS published their lending finance data for December. Only Housing Lending increased. All other categories declined. We know that investment housing lending grew the fastest.

Comparing December, with November, the total value of owner occupied housing commitments excluding alterations and additions rose 0.9% in trend terms, and the seasonally adjusted series rose 3.8%.

The trend series for the value of total personal finance commitments fell 0.1%. Revolving credit commitments fell 0.4%, while fixed lending commitments rose 0.1%. The seasonally adjusted series for the value of total personal finance commitments fell 2.5%. Revolving credit commitments fell 5.2% and fixed lending commitments fell 0.4%.

The trend series for the value of total commercial finance commitments fell 2.9%. Revolving credit commitments fell 5.1% and fixed lending commitments fell 2.2%. The seasonally adjusted series for the value of total commercial finance commitments rose 0.4%. Revolving credit commitments rose 4.3%, while fixed lending commitments fell 0.9%.

The trend series for the value of total lease finance commitments fell 3.8% in December 2014 and the seasonally adjusted series fell 11.2%, following a fall of 6.7% in November 2014.