Martin North – Page 518 – Digital Finance Analytics (DFA) Blog

How Resilient Will Consumption Growth Be If Income Growth Stays Weak?

RBA Assistant Governor (Economic) Luci Ellis spoke at the ABE Conference “Three Questions About the Outlook“.

The section on the impact of weak income growth is significant, because it examines why households are under financial pressure, and the impact of this. She says “continued weak income growth presents a particular risk to the consumption outlook in the context of high household indebtedness”.

One aspect of recent developments where Australia’s experience differs, though, relates to household income and consumption. As we discussed in the Statement, consumption growth in the major advanced economies has been quite robust, supported by strong growth in employment. In Australia, we’ve also had especially strong employment growth over the past year – more than double the rate of growth in the working-age population. But that hasn’t translated into strong consumption growth. Household income growth has been weak for a number of years, and that has weighed on consumption growth (Graph 4). Consumption growth hasn’t slowed as much as income growth. This is what you’d expect, given that households generally try to smooth their consumption through episodes of income volatility. But there’s a real question of how long that could continue if income growth stays weak. This clearly has implications for how we think about the risks to our consumption forecasts.

Graph 4: Household Consumption and Income — *Graph 4*

The weakness in incomes goes beyond the downward pressure on wage growth that I’ve already spoken about. Yes, growth in the wage price index (WPI) has stepped down. But the WPI captures a fixed pool of jobs. It abstracts from compositional change. Average earnings as measured in the national accounts have been even weaker than the WPI (Graph 5). This has not occurred because workers shifted between industries; it is also seen within industries. It might be partly driven by the end of the mining investment boom, as workers moved out of mining-related work, including in the construction and business services industries. But it seems to have been broader than that. Our central forecast is that this weakness will end as the drag from the end of the boom dissipates and spare capacity is absorbed, such that average earnings growth recovers. There is no guarantee of this, though, and therein lies the risk.

Graph 5: WPI and AENA by Sector — *Graph 5*

The living cost pressures that many households feel have therefore been an income story, not a price inflation story. Although utilities prices did increase significantly in some states in recent quarters, much of households’ regular spending has seen relatively little in the way of price increases for a number of years.

Weak income growth can run below consumption growth for a time, but not forever. If households start to see this weakness in income growth as permanent, they are likely to change their spending patterns in response. We might be seeing this in the details of the consumption figures: growth in spending on discretionary items, like travel and eating out, has slowed while growth in spending on essentials has held up (Graph 6).

Graph 6: Household Consumption — *Graph 6*

Continued weak income growth presents a particular risk to the consumption outlook in the context of high household indebtedness. Households do not just wake up one day and collectively decide to pay down their debt. But if incomes turn out weaker than they expect, or some other adverse news should arise, the households carrying the most debt might feel they have to rein in their spending quite a bit.

No legal barriers for royal commission witnesses

From Investor Daily.

The initial hearing of the royal commission into banking, superannuation and financial services was held in Melbourne yesterday, and commissioner Kenneth Hayne QC had a stark warning for institutions.

All four of the major banks have confirmed they will waive non-disclosure agreements that could stop people from testifying to the royal commission.

But in comments during the hearing, Mr Hayne confirmed that even if they were not waived, confidentiality agreements (or ‘non-disparagement’ clauses) would not be a “reasonable excuse” to avoid a question in a hearing of the royal commission.

“It seems to me to follow that answering a notice or a summons would not amount to a breach of any confidentiality or non-disparagement clause,” Mr Hayne said.

Furthermore, under s6M of the Royal Commission Act 1902, no injury can be done to a person who gives evidence or produces a document under a notice or summons, he said.

“Suing the person would almost certainly fall within that prohibition,” Mr Hayne said.

“An institution which sought any form of legal redress against a member of the public or a whistle blower seeking to volunteer information to the commission in anticipation of the possible exercise of the the commission’s coercive powers would be taking a step which would very likely provoke two immediate consequences.”

First, the commission would be “very likely indeed” to exercise its compulsory powers to secure the information in question, Mr Hayne said.

“Second, the very fact that an institution sought to prohibit or prevent the disclosure of the information would excite the closest attention not only to the lawfulness of that conduct by the institution, but also what were the institution’s motives for seeking to prevent the commission from having that information,” he said.

Public submissions to the royal commission via the online form on its website are “very important to our work”, he said.

Indeed, the royal commission will be closely comparing the industry participant submissions about misconduct with public submissions, Mr Hayne said.

“One of the consequences of our adopting this sequence of action – of first asking industry participants to identity misconduct and conduct falling short of community standards and expectations and then asking the public to make submissions – is that it may help us to identify whether there is a gap between what industry participants now say is relevant conduct and what member of the public see as being relevant,” he said.

The royal commission made initial requests for information of industry participants on 15 December 2017, which were delivered on 29 January.

Further requests limited to events of misconduct identified over the past five years were made on 2 February, with answers sought by 13 February.

In A Banking Crisis, Are Bank Deposits Safe?

There were several well publicised Government bail-out’s of banks which got into problems after the GFC. For example, the UK’s Royal Bank of Scotland was nationalised. This costs tax payers dear, so there were measures put in place to try to manage a more orderly transition when a bank gets into difficulty.

In October 2011, the Financial Stability Board (FSB) issued its Key Attributes
of Effective Resolution Regimes for Financial Institutions (Key Attributes). These Key Attributes set out the ‘core elements that the FSB considers to be necessary for an effective resolution regime. There followed legislation in a number of jurisdictions.

For example, the EU introduced the Bank recovery and resolution – Directive 2014/59/EU, the US The Dodd-Frank Title II Overview: Orderly Liquidation Authority and in New Zealand the Open Bank Resolution (not to be confused with Open Banking, which we discussed last week). This is a summary from New Zealand.

But note the chilling words “the bank closes temporarily and some money is frozen. Bank re-opens under statutory manager. Customers can access non-frozen portion of their money, which is now Government protected. Frozen money can be used to help resolve the bank’s issues. Resolution of issues completed. Un-used portion of frozen money is returned to customers”.

Or in other words, customers money, held as savings in the bank are able to be grabbed to assist in the resolution. This is of course what happened to people with bank deposits in Cyprus a few years back.

The thinking behind it is simple. Banks need an exit strategy in case of a problem, and Government bail-outs should not be an option. So a manager can be appointed to manage through the crisis. They can use bank capital, other instruments, like hybrid bonds and deposits to create a bail-in. This approach to rescuing a financial institution on the brink of failure makes its creditors and depositors take a loss on their holdings. This is the opposite of a bail-out, which involves the rescue of a financial institution by external parties, typically governments using taxpayers money.

So, given the New Zealand position (and the tight relationship between banking regulators in Australia and New Zealand), we should look at the position in Australia. Are deposit funds in Australia likely to be “bailed-in”?

As it happens there has been a long running discussion on this in Australia, and on 16 November 2017, the Senate referred the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 [Provisions] to the Economics Legislation Committee for inquiry and report by 9 February 2018. They just reported back.

It all centered on the powers which were to be given to APRA to deal with a banking collapse. “The bill seeks to strengthen the powers of the Australian Prudential Regulation Authority (APRA) to facilitate the orderly resolution of an authorised deposit-taking institution (ADI) or insurer so as to protect the interests of depositors and policyholders, and to protect the stability of the financial system in case of crisis”. The Treasurer had argued that by “affording APRA the power to work with ADIs and insurers in order to plan for economic stress events, the cost to the taxpayer will be significantly
reduced in the event of a financial crisis”.

The Senate review and consultation elicited a significant number of submissions, and they made two main points in opposition to the bill: firstly, they believed that this bill gives APRA the power to ‘bail-in’ depositors’ savings to stabilise a failing financial institution; secondly, in place of the bill, the Australian Parliament should legislate a Glass-Steagall style separation of the banks.

Specifically, Dr Wilson Sy, a former analyst with APRA, considered that the bill was not clear enough on the topic of depositors’ savings. Dr Sy suggested that deposit protection is to be balanced against financial system stability, without the law clearly stating which has higher priority’. Dr Sy claimed that the bill is ‘designed to confiscate bank deposits to ‘bail-in’ insolvent banks to save the financial system.

It came down to the meaning of “any other instrument” in the draft bill. Treasury said, “the use of the word ‘instrument’ in paragraph (b) is intended to be wide enough to capture any type of security or debt instrument that could be included within the capital framework in the future. It is not the intention that a bank deposit would be an ‘instrument’ for these purposes”. Treasury confirmed that because deposits are not classified as capital instruments, and do not include terms that allow for their conversion or write-off, they cannot be ‘bailed-in’.

The committee concluded:

The committee believes that the protection of depositors’ interests is paramount and does not consider that the bill would allow the ‘bail-in’ of Australians’ savings and deposits. The stability of the financial system depends on its depositors having confidence in its financial institutions. By ensuring the security of depositors’ savings, the overall protection of the financial system can be ensured.

But there are a few questions to consider.

Why not expressly exclude deposits from the bill, the current vague wording appears to leave the door open for a deposit grab in case of financial instability? We may have some reassuring words from the regulators, but is it enough?
How does this fit with the NZ model, where deposits can be targeted, especially, as the regulators in the two countries are closely aligned, and in fact most banking in New Zealand is provided by Australian Bankers. In case of failure would customers of a bank operating in both countries be different?

And two wider questions.

The NZ model expressly says depositors should weight up the risks of placing money with specific lenders but can savers really do this?
The issue of hybrid bonds needs more careful consideration, in that in Australia (unlike some other countries) these bonds have been sold to retail investors, people looking to savings with good returns, and who probably do not understand the bail-in risks they may face. So even if deposits are excluded there is a risk that investors in hybrids will get a nasty shock.

Seems to me this is a messy area, and I for one cannot be 100% convinced savings will never be bailed-in. And that’s a worry!

I recall the Productivity Commission comment last week, that financial stability had taken prime place compared with competition (and so customer value) in financial services. The issue of bail-in of deposits appears to be shaping the same way.

Auction Clearances A Little Higher, Perhaps

CoreLogic has published their preliminary auction clearance results for last Saturday.

This week across the combined capital cities, auction volumes continued to increase with 1,464 homes taken to auction returning a preliminary clearance rate of 67.7 per cent, increasing from 62.0 per cent across 790 auctions last week, although this is likely to revise down over the week. Over the same week last year 1,591 auctions were held, while the clearance rate was a stronger 73.2 per cent. Adelaide and Perth were the only cities to see clearance rates fall over the week, while volumes increased everywhere except Adelaide. The strongest preliminary clearance rate was recorded in Melbourne (72.5 per cent), followed by Adelaide (68.9 per cent).

Reality Bites on Interest Rates for Global Economy

World growth prospects remain very strong for 2018 and are unlikely to be derailed by recent financial market volatility, but the balance of inflation risks is shifting, with implications for monetary policy, says Fitch Ratings in its latest Global Economic Update report.

Data released since Fitch’s December 2017 Global Economic Outlook (GEO) show world growth to have recovered even more rapidly than previously thought in 2017 and confirm that momentum has been maintained in early 2018, supported by rising investment, buoyant world trade, loose financial conditions and pro-cyclical fiscal easing.

“Economic slack is diminishing rapidly, and against a backdrop of an even stronger global recovery last year than we thought, market concerns over inflation and forthcoming monetary policy adjustments have risen. This has sparked a rise in global bond yields and significant equity market volatility. But we see this primarily as a correction to an overly sanguine view on the US interest rate outlook rather than signalling any serious threat of a sharp economic slowdown,” said Brian Coulton, Fitch’s Chief Economist.

The rise in oil prices in the aftermath of the extension of OPEC quota reductions, sharp falls in Venezuela’s oil production and declining global crude inventories also adds risks to headline inflation. While we still expect the strong supply response from US shale producers to continue, there are upside risks to our USD52.5/bbl (Brent) oil price forecast for 2018.

The Fed looks increasingly likely to raise rates four times in 2018 following upgrades to its growth forecasts. Concerns about low core inflation have eased and will be further assuaged by the recent pick-up in US wage inflation to an eight-year high of 2.9%. The ECB is sounding much more confident about economic recovery and has acknowledged the recent acceleration in wages, even though core CPI inflation remains below the bank’s comfort zone at 1%. Net asset purchases at EUR30 billion per month through September 2018 are still the base case, but the chances of any extension or upscaling are diminishing and ECB forward guidance is likely to start reflecting this in March. Better-than-expected UK growth increases the chance of a further Bank of England rate increase this year as low unemployment reduces the bank’s tolerance for above-target inflation.

US GDP grew by 2.5% annualised in 4Q17, broadly in line with our GEO forecast. Private domestic demand growth now exceeds 3% on an annual basis, led by a pick-up in business investment. The capex recovery is boosting US imports, imparting a drag on GDP growth from net trade. Nevertheless, with the final tax package worth 0.7% of GDP in its first year, domestic demand is likely to accelerate this year and there are modest upside risk to the GEO growth forecast of 2.5%.

Eurozone GDP grew by 0.6% in 4Q17, in line with our GEO forecast. However, upward revisions to previous quarters saw the 2017 annual outturn hit 2.5%, the strongest growth rate since 2007. PMI surveys remain at very elevated levels, and the ECB’s January bank lending survey showed increasing loan demand from firms. The latter is consistent with an increasingly buoyant outlook for eurozone capex as conditions for SMEs improve, bank lending picks up, and economic and political uncertainties subside.

The strength of the eurozone economy was an important factor supporting UK growth in 4Q17, when GDP expanded by a faster-than-expected 0.5%, taking 2017 annual GDP growth to 1.8%, 0.2pp faster than anticipated. Japan’s 4Q17 GDP data has yet to be released, but upward revisions to earlier quarters and buoyant monthly data point to 2017 growth having beaten the GEO estimate of 1.5% and to upside risks for 2018.

China’s economy grew by 6.8% yoy and by 1.6% qoq in 4Q17. These rates were in line with our GEO forecasts, but upward revisions to preceding quarters pushed 2017 annual growth up to 6.9%, the first incremental increase since 2010. The slowdown in credit and housing sales in late 2017 was consistent with weakening sequential GDP growth through the year (from 1.9% qoq in 2Q17) and points to some mild further slowing ahead.

Bendigo and Adelaide Bank 1H18 Results

Bendigo and Adelaide Bank announced their 1H18 results, with an after tax statutory profit of $213.7 million, up $22.7m. Underlying earnings were $225.3 million, which is a 10.7% increase on pcp. It is a story of tight management, a boost to NIM from asset repricing, which may not be repeated, and an uplift in commercial property lending provisions plus a rise in bad and doubtful debts. Capital benefited from weighted risk asset adjustments and so was stronger than expected. But being a regional bank remains a tough gig.

The results were supported by strong margin growth, but were impacted by reduced trading income and lower ATM and transaction fees.

Cash earnings per share were 46.8 cents a 3.3% increase on the pcp. A dividend of 35 cents per share, up 1 cent on the pcp.

They reported an exit net interest margin of 2.38% a margin expansion of 18 basis points, driven by mortgage and deposit repricing. They also warn that front book discounts will challenge their margin in 2H18.

Growth in Owner Occupied home loans was up 13% pcp, whilst total loans were up 0.7% (implying a fall in investor loan, flows down 59%). Interest only loans flows were down 41%.

76% of their home lending portfolio was at or below 80% (or around a quarter of the book is above 80%).

Home safe proceed to completed contracts continue to exceed pre-overlay values. The overlay assumes a 3% rise in property prices for the next 18 months, then rising back to 6%. This may be optimistic!

Arrears appear benign, though with a small rise on past 90-day due home loans. WA remains the most trouble state. But in value terms, past due 90 day loans were down $57.2m (10.7%).

Total impaired assets were down $11.9m to $288.8m. Great Southern past due 90 days fell down $40.5m to $62.7m.

Specific provisions were $113.2 million, with business lending showing the largest move, mainly relating to commercial property lending. B&DD stood at $46 million, which is higher than expected.

Cost to income ratio moved down 220 basis points to 54.2%. Software amortisation was up $4.5% (50%) on 1H17 and staff costs up 0.7% pcp.

Their CET1 ratio was 8.61%, up 64 basis points and they expect to be able to meet the “unquestionably strong” benchmark.

Progress toward Advanced Accreditation awaits APRA’s release of new guidelines. 79.6% of funding comes from retail customers

The liquidity ratio was 128.8% and NSFR around 111%.

Banking Royal Commission Will Investigate Lending Practice First

The first round of public hearings for the Banking Royal Commission will focus on lending, including mortgages, credit cards and car loans; we heard today during the opening session.

The Commission highlighted the large size of the lending market, and the significant number of submissions they have already received on misconduct in this area, including relating to intermediaries, commission and advice.

In addition, as part of the opening address, we were told that some of the major players were unable to provide the full range of misconduct information that Commission requested. Some players offered a few case studies, and were then asked to provide more detail over the past 5 years (as opposed to 10) but said they could not meet the required deadline.

This Is Why Markets Have Gotten Jumpy

Back in April 2017, the IMF released a Financial Stability Report update which said that “in the United States, if the anticipated tax reforms and deregulation deliver paths for growth and debt that are less benign than expected, risk premiums and volatility could rise sharply, undermining financial stability”.

They said that more than 20% of US firms would find it hard to service their debts, if rates rose – and yes, now rates are rising! This puts pressure on companies, and on their banks. This is no “flash crash”, it’s structural!

Under a scenario of rising global risk premiums, higher leverage could have negative stability consequences. In such a scenario, the assets of firms with particularly low debt service capacity could rise to nearly $4 trillion, or almost a quarter of corporate assets considered.

The number of US firms with very low interest coverage ratios—a common signal of distress—is already high: currently, firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (Panel 5).

This figure doubles to 20 percent of corporate assets when considering firms that have slightly higher earnings cover for interest payments, and rises to 22 percent under the assumed interest rate rise. The stark rise in the number of challenged firms has been mostly concentrated in the energy sector, partly as a result of oil price volatility over the past few years. But the proportion of challenged firms has broadened across such other industries as real estate and utilities. Together, these three industries currently account for about half of firms struggling to meet debt service obligations and higher borrowing costs (Panel 6).

Royal commission points to big bank dominance

From Investor Daily.

On Friday morning, commissioner Kenneth Hayne QC published a background paper titled Some Features of the Australian Banking Industry.

The paper points to the role of authorised-deposit taking (ADI) institutions, which hold 55 per cent of the total assets of Australian financial institutions.

It also points to declining competition in the the banking sector, with the number of credit unions falling due to consolidation and the major banks holding 75 per cent of total assets held by ADIs in Australia.

The paper notes that five of the 20 listed companies that make up the ASX20 are banks, noting that the major banks have “generally achieved higher profit margins than other types of ADIs”.

“The major banks earned a profit margin of 36.4 per cent in the June quarter 2017. Major banks’ net profit after tax in the June quarter 2017 was $7.8 billion,” noted the paper.

While the commission noted that precise international comparisons are difficult, it found that Australia’s major banks are “comparatively more profitable (as assessed by net income as a percentage of total assets) than some of their international peers in Canada, Sweden, Switzerland and the UK”.

“Similar conclusions can be reached for international comparisons for Australian major banks’ return on equity,” said the paper.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, will hold its initial public hearing at 10am this morning in Melbourne. The hearing will be streamed lived through the Royal Commission’s website.

Banks and financial providers one step ahead of consumers who struggle with personal bias

From The Conversation.

There’s more than 30 years of research showing financial consumers have behavioural biases that can lead to poor decisions. Financial providers and banks have known this too, and have designed some products to take advantage of consumer habits rather than benefit them.

Legislation soon to be introduced to parliament is intended to curb these practices, but credit products are being left out to consumer detriment.

Regulators have relied on two strategies to help consumers with this problem. Disclosure of the nature and prospects of the products providers offer. Also, encouraging consumers to seek financial advice.

Neither of these has worked well. The Financial System Inquiry in 2014 recognised that disclosure hasn’t closed the gap in consumer capability. Worse, the providers of these products may have incentives through remuneration which may not serve the customer’s interest and only about 25% of financial consumers seek advice.

The Productivity Commission’s report on competition in financial services, illustrates many of these points in arguing for regulation of mortgage brokers. Brokers are supposed to be the customer’s agent to scout for and advise on the best mortgage terms and cost. Instead they are remunerated by mortgage providers (like the banks), take commissions and, according to the Productivity Commission, generally cost more than loans directly from a bank.

Bias in financial decision-making

Consumers are prone to a range of biases which may also impair their financial decisions. For example overconfidence may cause them to ignore new information or hold unrealistic views about how high returns will be.

As we age or as our circumstances change, our tolerance for risk also changes. As we get older our tolerance for risk decreases, while having a higher income increases it. Men are also more risk tolerant than women.

Consumers may also give too much weight to recent events and things they know already and can be unduly influenced by the opinions of friends and family.

This sort of consumer decision-making is no match for providers’ knowledge of financial conditions and product features. Banks and other financial service providers have learned from experience, but most of all their own command of consumer behaviour research.

The latter leaves providers able to design and sell products that benefit from consumers not overcoming mistakes, or at times, exacerbating mistakes.

Helping customers make better choices

In a bill soon to be before the Australian parliament, those selling financial products will have to make a “target market determination”. This records and describes the market for a product (those who would buy it). It must also set out any conditions under which the product must be distributed, for example that it can only be sold with advice.

It’s designed so that financial products meet the needs and financial situation of the people acquiring them.

There are criminal and civil penalty sanctions for failing to make and ensure products are sold in accordance with a determination. Also, for failure to revise and reissue it, if circumstances change.

Twinned with this requirement are new intervention powers for the Australian Securities and Investments Commission (ASIC). ASIC will be able to make interim rules, effectively prohibiting sales or imposing conditions, if continued sale would result in “significant detriment” to financial consumers.

The purpose of product regulation is clearly to allow ASIC to be more active and reduce over-reliance on ineffective disclosure, conflicted advice and drawn out dispute resolution.

Product regulation is no panacea. This version has a large gap, as credit products (for example credit cards or mortgages) do not require a target market determination. It’s not difficult to read the politics of regulation in this omission. There is also a risk that target market determinations will become pro-forma and add to compliance and not to consumer benefit. Although a description of the target market must be in the advertising, it’s not clear it must be in formal disclosure, so consumers may never read it.

Product intervention powers apply across investment, insurance and credit products but it will never be easy for ASIC to prove the risk of “significant consumer detriment”. Intervention orders also expire in 18 months unless made permanent by parliament.

The regulation of product design and distribution in the spirit of consumer safety has been commonplace (if imperfectly realised) in car, pharmaceuticals and other consumer markets, for decades. There are modest grounds for optimism that in Australia financial product safety might catch on too, but the government needs to include credit products as well.

Authors: Dimity Kingsford Smith, Professor of Law, UNSW