Household Wealth Up (and Down)

The ABS released their latest Household Finance and Wealth Statistics to March 2019.

The falls in property values were offset by rises in stock markets (for those with shares/superannuation). Residential land and dwellings experienced real holding losses for a fifth consecutive quarter.

Household debt to assets ratio increased from 19.3% to 19.4%, as growth in household debt (0.7%) outweighed the increase in total assets (0.3%).

The mortgage debt to residential land and dwellings ratio increased from 28.1% to 29.0% and is the largest quarterly increase since September quarter 2011.

A fall in gross disposable income was driven by falls in compensation of employees and gross mixed income.

Household wealth (net worth) increased 0.2% in the March quarter 2019, a positive turn around from the decline of 2.1% recorded in the previous quarter. A rebound in the Australian stock market drove increases in real holding gains on financial assets ($147.8b), recovering the real holding losses ($146.2b) in the previous quarter. Positive revaluations on reserves of pension funds (superannuation) accounted for 68.0% of holding gains on household financial assets, reflecting the 70% of investment of total pension fund assets in shares which in turn was helped by the rebound in the Australian stock market. Residential land and dwellings experienced real holding losses for a fifth consecutive quarter and offset the gains on financial assets during the quarter. Through the year, household wealth decreased 0.7%, reflecting continued falls in residential property prices.

The percentage point contributions to the change in household wealth were:

Financial assets contributed 1.8 percentage points
Financial liabilities detracted 0.2 percentage points
Land and dwellings detracted 1.5 percentage points.

Graph 1. Net worth and residential land and dwellings year-on-year growth

Graph 1 shows Net worth and residential land and dwellings year-on-year growth

Household wealth per capita decreased for a third consecutive quarter to $404,556.4, falling $1,511.9. This follows a record $9,992.7 fall in household wealth per capita in the previous quarter, and reflects the continued holding losses on residential land and dwellings.

Real holding gains on financial assets drove a 0.3% increase in total household assets, following a 1.5% fall in the previous quarter. Household liabilities grew 0.7%, with through the year growth at 3.7%, which is its lowest rate since March quarter 2013. This weakness is driven by soft growth in long term loans, which account for 92.0% of household liabilities.

Household transactions in net worth were $28.9b. The largest component at $23.0b, was the net acquisition of financial assets ($36.0b), with superannuation reserves the main contributor, followed by shares and other equity. Net capital formation at $6.0b was driven by net acquisitions of land and dwellings ($7.9b). These were offset by net incurrence of liabilities ($13.0b), driven by transactions in long term loans.

Household debt to assets ratio increases

The household debt to assets ratio gives an indication of the extent to which the overall household balance sheet is geared. Household debt to assets ratio increased from 19.3% to 19.4%, as growth in household debt (0.7%) outweighed the increase in total assets (0.3%).

The mortgage debt to residential land and dwellings ratio increased from 28.1% to 29.0% and is the largest quarterly increase since September quarter 2011. The rise in ratio reflects the fall in the value of residential land and dwellings (2.6%) together with an increase in mortgage debt (0.6%). Despite the large increase in the ratio, it is predominantly driven by the continued fall in the value of residential land and dwellings, as growth in mortgage debt has reduced to its slowest pace since September quarter 2013.

The household debt to liquid assets ratio reflects the ability of households to quickly extinguish debts using liquid assets (currency and deposits, short and long term debt securities, and equity). The household debt to liquid asset ratio decreased from 113.9% to 112.5%. The decrease in the debt to liquid assets ratio indicates growth in household liquid assets (2.0%) outweighed growth in household debt (0.7%). Growth in liquid assets was driven by increases in equity and deposits of 3.2% and 1.0% respectively, while the slow growth in debt reflects weak growth in household loan borrowing.

Graph 2. Risk ratios

The wealth effect

Household net saving increased $6.8b to $9.5b, driven by a decrease in final consumption expenditure ($17.7b), partly offset by a decrease in gross disposable income ($10.6b) and an increase in consumption of fixed capital ($0.3b). The fall in gross disposable income was driven by falls in compensation of employees and gross mixed income.

Household gross disposable income adjusted for other changes in real net wealth (wealth effect) increased $263.5 from $18.9b to $282.5b, reflected by real holding gains on financial assets. Household net saving adjustment for other changes in real net wealth increased to -$10.4b, from -$291.3b in the previous quarter. The $280.9b increase in household net saving plus other changes in net wealth reflects the real holding gains on financial assets, however the household sector remains in a dis-saving position for third consecutive quarter due to the continued real holding losses on residential land and dwellings.

Graph 3. Net saving plus other changes in real net wealth, original

Graph 3 shows Net saving plus other changes in real net wealth, original

Australia continued to borrow from overseas to fund investment, borrowing $1.0 billion from non-residents during the March quarter as national investment exceeded national saving. In seasonally adjusted terms, Australia has been a net borrower from overseas since the September quarter 1975.

National investment decreased $22.2b in March quarter 2019 to $100.9b. The fall comes off the back of a record high in the December quarter 2018 and, despite the decrease, remains at high levels.

Graph 1. Total capital formation, current prices

Graph 1 showsTotal capital formation, current prices

Private non-financial corporations invested $39.5b over the quarter, down $8.5b from December. Investment in machinery and equipment was down this quarter, while the decline in mining investment continued as significant LNG projects move into the production phase.

Households invested $36.4b, down $9.6b from the previous quarter. The decrease was driven by falls in dwelling investment and ownership transfer costs, reflecting the weak conditions in the residential housing market.

Australia’s borrowing narrows to $1 billion

National net borrowing of $1.0b in March quarter 2019 was the lowest since December quarter 1983. The $1.0b worth of lending by the rest of the world was derived by repayments of their liabilities ($18.2b) being larger than the disposal of their financial assets ($17.2b).

During the quarter, rest of the world acquired $15.1b of private non-financial corporations’ shares and other equity but these were offset by maturities of their holdings of bank one name paper ($21.3b) and settlements of their bank derivative contracts ($17.1b). On the liabilities side, rest of the world borrowed $11.1b of short term loans from banks and other private non-financial corporations, and paid off their long term bank loans ($24.0b) and settled their derivative contracts with banks ($16.8b).

Graph 2. Net financial investment (net lending (+) / net borrowing (-))

Graph 2 shows Net financial investment (net lending (+) / net borrowing (-))

Net borrowing by non-financial corporations was $13.8b driven by loan borrowing of $17.5b and net issuances of equity of $13.2b.

The general government was a net lender of $956m this quarter driven by maturities of long-term debt securities of $5.1b.

Households were net lenders of $23.0b, accruing $18.8b in net equity in reserves of pension funds (superannuation) and $10.0b of deposits. These were offset by their loan borrowing of $9.9b.

Credit market rebounds on valuation increases in equities and bonds

Credit market outstanding of the non-financial domestic sectors rose 2.8% in March quarter 2019, following last quarter’s fall of 0.7%. Valuation increases in the equity of other private non-financial corporations drove the result, aided by valuation increases in government bonds as yields fell.

Graph 1. Credit market outstandings

Graph 1 shows Credit market outstandings.

Demand for credit was subdued as the government repays debt

National general government demand for credit fell $4.0b this quarter. Debt repayment outweighed new issuance of bonds for the first time since June quarter 2013, as the government’s net saving position continues to improve.

Credit was raised mainly in the loan market by other private non-financial corporations ($13.7b) and households ($9.9b). However, through the year growth in household borrowing continues to slow due to tighter lending conditions and falling investor demand in the residential property market.

Equity raised by other private non-financial corporations was $12.0b after a subdued December quarter 2018 which reflected the share buy backs of major mining companies.

Graph 2. Total demand for credit

Bank of England’s Plans To Accelerate Digital Disruption

On 20 June, the Bank of England announced plans to facilitate the UK economy’s adoption of new technology through a more open financial infrastructure, via Moody’s. Although many of these plans would ultimately enable faster adoption of new technology with broader and cheaper access to financial services, they would likely be an overall credit negative for incumbent banks, which generate profits thanks in part to high barriers to entry and privileged access to data.

The Bank of England’s announcements include a variety of proposals including better infrastructure to improve payments, easier access to finance for small and midsize enterprises (SMEs), smoothing the transition to a lower-carbon economy, reducing the regulatory burden on the financial industry, and facilitating the adoption of cloud-based technologies to increase operational resilience.

Some of these initiatives will directly benefit incumbent banks. The introduction of a climate stress test will help banks reposition their credit portfolios in anticipation of the transition to a less carbon-intensive economy and thus avoid the credit risk in so-called stranded assets. The Bank of England will also explore ways of using machine learning and artificial intelligence to reduce the need for regulated financial firms to supply it with large amounts of data and to automate part of its own analytical work. These efforts should reduce regulatory costs for banks. And, a new policy on the use by banks of cloud technology and the automation of more post-trade processes will help firms adopt a cheaper and more robust infrastructure.

However, these benefits for banks are likely to be outweighed by the effect of proposals to further open up financial services provision in the UK and reduce barriers to entry.

In the payments system, the Bank of England notes that while payments via card systems are convenient for customers, these processes entail friction and inertia that result in costs for the real economy. For example, fees can consume between 0.5% and 2% per transaction, while the eventual transfer of funds between buyer and seller can take several days to complete (with fees and delays being typically greater for international transactions). In response, the UK government announced a review of payments systems, which will likely lead to further initiatives to further boost the ability of providers of newer and cheaper forms of direct payment to access the
wider market.

For its part, the Bank of England will continue to open up its real time gross settlement payment system to non-bank payment service providers. The central bank will also consult on whether to allow more firms beyond a small group of systemically important banks to access its balance sheet. Such moves, while apparently cautious at this stage, will intensify competition and lead to further margin pressure on incumbent UK banks. In addition, the Bank of England will explore ways to support new digital currencies such as that announced by Facebook, which are also likely to disintermediate established banks.

Meanwhile, the central bank will also promote greater competition in SME financing. Currently, the vast majority of SME lending in the UK is conducted through the largest four banking groups, and new entrants face significant barriers to entry, typically lacking the customer account data which helps banks make their credit decisions. The Bank of England suggests further promoting the existing principles of “open banking,” which allows customers to take control of their data and share them securely with alternative providers, helping SMEs create a “portable credit file.” Doing so would aim to reduce barriers to entry and stimulate competition, thus adding to margin pressure on banks.

Since the open banking initiative began in early 2018, there has been little effect on market shares in retail banking in the UK. But over time, the above measures mean that incumbent banks would likely experience margin declines in some of their traditionally more profitable activities of commercial lending.

NZ Reserve Bank Holds Cash Rate

The Official Cash Rate (OCR) remains at 1.5 percent. Given the weaker global economic outlook and the risk of ongoing subdued domestic growth, a lower OCR may be needed over time to continue to meet our objectives.

Domestic growth has slowed over the past year. While construction activity strengthened in the March 2019 quarter, growth in the services sector continued to slow. Softer house prices and subdued business sentiment continue to dampen domestic spending.

The global economic outlook has weakened, and downside risks related to trade activity have intensified. A number of central banks are easing their monetary policy settings to support demand. The weaker global economy is affecting New Zealand through a range of trade, financial, and confidence channels.

We expect low interest rates and increased government spending to support a lift in economic growth and employment. Inflation is expected to rise to the 2 percent mid-point of our target range, and employment to remain near its maximum sustainable level.

Given the downside risks around the employment and inflation outlook, a lower OCR may be needed.

Meitaki, thanks.

Summary record of meeting

The Monetary Policy Committee agreed that the outlook for the economy has softened relative to the projections in the May 2019 Statement.

The Committee noted that inflation remains slightly below the mid-point of the inflation target and employment is broadly at its maximum sustainable level. The Committee agreed that a lower OCR may be needed to meet its objectives, given further deterioration in the outlook for trading-partner growth and subdued domestic growth.

Relative to the May Statement, the Committee agreed that the risks to achieving its consumer price inflation and maximum sustainable employment objectives are tilted to the downside.

The members noted that global economic growth had continued to slow. They discussed the recent falls in oil and dairy prices, and that several central banks are now expected to ease monetary policy to support demand.

The Committee discussed the ongoing weakening in global trade activity. A drawn out period of tension could continue to suppress global business confidence and reduce growth. Resolution of these tensions could see uncertainty ease.

The Committee discussed the trade, financial, and confidence channels through which slowing global growth and trade tensions affect New Zealand. The members noted in particular the dampening effect of uncertainty on business investment. Some members noted that lower commodity prices and upward pressure on the New Zealand dollar could see imported inflation remain soft.

While global economic conditions had deteriorated, the Committee noted that domestic GDP growth had held up more than projected in the March 2019 quarter. The members discussed disparities in growth across sectors of the economy, with construction strong and services weak. The members also discussed whether some of the factors supporting growth in the quarter would continue.

The members noted two largely offsetting developments affecting the outlook for domestic growth: softer house price inflation and additional fiscal stimulus.

The Committee noted that recent softer house prices, if sustained, are likely to dampen household spending. The Committee also noted the recent falls in mortgage rates and the Government’s decision not to introduce a capital gains tax.

The Committee noted that Budget 2019 incorporated a stronger outlook for government spending than assumed in the May Statement. The members discussed the impact on growth of any increase in government spending being delayed, for example due to timing of the implementation of new initiatives and current capacity constraints in the construction sector.

The members discussed the subdued nominal wage growth in the private sector and the apparent disconnect from indicators of capacity pressure in the labour market. The Committee discussed the possibility of this relationship re-establishing. Conversely, the continuing absence of wage pressure could indicate that there is still spare capacity in the labour market. Some members also noted that reduced migrant inflows could see wage pressure increase in some sectors.

The Committee discussed whether additional monetary stimulus was necessary given continued falls in global growth and subdued domestic demand. The members agreed that more support from monetary policy was likely to be necessary.

The Committee discussed the merits of lowering the OCR at this meeting. However, the Committee reached a consensus to hold the OCR at 1.5 percent. They noted a lower OCR may be needed over time.

IMF Says New Zealand Faces Downside Risks, But Migration May Help To Mitigate Them

The IMF just published their concluding Statement of the 2019 Article IV Consultation Mission to New Zealand.

They conclude:

New Zealand’s economic expansion lost momentum recently. The near-term growth outlook is expected to improve on the back of a timely increase in macroeconomic policy support. Downside risks to the growth outlook have increased but New Zealand has the policy space to respond should such risks materialize.

Macroeconomic policy settings are broadly appropriate, while macroprudential policy settings are attuned to macrofinancial vulnerabilities in the household sector, which have started to decline but remain elevated.

Financial sector reform in the context of the Review of the Capital Adequacy Framework and the Review of the Reserve Bank of New Zealand Act should provide for a welcome further strengthening of the resilience of the financial system and regulatory framework.

The government’s structural policy agenda appropriately focuses on reducing infrastructure gaps, increasing human capital, and lifting productivity, while seeking to make growth more inclusive and improve housing affordability.

Within the statement they warn that:

Risks to the outlook are increasingly tilted to the downside. On the domestic side, the fiscal stimulus could be less expansionary if policy implementation were to be more gradual than expected, and the domestic housing market cooling could morph into a downturn, either because of external shocks or diminished expectations. On the external side, global financial conditions could be tighter and dairy prices could be lower. Risks to global trade and growth from rising protectionism have increased, and this could have negative spillovers to the New Zealand economy, including through the impact on China and Australia, two key trading partners. High household debt remains a risk to economic growth and financial stability, and it could amplify the effects of large, adverse shocks. On the upside, in the near term, growth could be stronger if net migration were to decrease more slowly than expected or if the terms of trade were to be stronger.

With regard to macroprudnetial they warn:

The scope for easing macroprudential restrictions is limited, given still-high macrofinancial vulnerabilities. The shares of riskier home loans in bank assets (those with very high LVRs, high debt-to-income, and investor loans) has moderated due to the combined impact of the LVR settings and tighter bank lending standards. However, with the RBNZ’s recent easing of the LVR restrictions, improvements in some macroprudential risk factors such as credit growth have recently stalled or started to reverse. Further easing of LVR restrictions should consider the possible impact on banks’ prudential lending standards, as well as the risks to financial stability from elevated household debt.

Fed Chair On Economic Outlook and Monetary Policy Review

Jerome H. Powell spoke at the Council on Foreign Relations, New York.

He said when the FOMC met at the start of May, tentative evidence suggested economic crosscurrents were moderating, so they left the policy rate unchanged. But now, risks to their favorable baseline outlook appear to have grown with concerns over trade developments contributing to a drop in business confidence. That said, monetary policy should not overreact to any individual data point or short-term swing in sentiment.

They are also formally and publicly opening their decisionmaking to suggestions, scrutiny, and critique.

It is a pleasure to speak at the Council on Foreign Relations. I will begin with a progress report on the broad public review my Federal Reserve colleagues and I are conducting of the strategy, tools, and communication practices we use to achieve the objectives Congress has assigned to us by law—maximum employment and price stability, or the dual mandate. Then I will discuss the outlook for the U.S. economy and monetary policy. I look forward to the discussion that will follow.
During our public review, we are seeking perspectives from people across the nation, and we are doing so through open public meetings live-streamed on the internet. Let me share some of the thinking behind this review, which is the first of its nature we have undertaken. The Fed is insulated from short-term political pressures—what is often referred to as our “independence.” Congress chose to insulate the Fed this way because it had seen the damage that often arises when policy bends to short-term political interests. Central banks in major democracies around the world have similar independence.
Along with this independence comes the obligation to explain clearly what we are doing and why we are doing it, so that the public and their elected representatives in Congress can hold us accountable. But real accountability demands more of us than clear explanation: We must listen. We must actively engage those we serve to understand how we can more effectively and faithfully use the powers they have entrusted to us. That is why we are formally and publicly opening our decisionmaking to suggestions, scrutiny, and critique. With unemployment low, the economy growing, and inflation near our symmetric 2 percent objective, this is a good time to undertake such a review.
Another factor motivating the review is that the challenges of monetary policymaking have changed in a fundamental way in recent years. Interest rates are lower than in the past, and likely to remain so. The persistence of lower rates means that, when the economy turns down, interest rates will more likely fall close to zero—their effective lower bound (ELB). Proximity to the ELB poses new problems to central banks and calls for new ideas. We hope to benefit from the best thinking on these issues.
At the heart of the review are our Fed Listens events, which include town hall–style meetings in all 12 Federal Reserve Districts. These meetings bring together people with wide-ranging perspectives, interests, and expertise. We also want to benefit from the insights of leading economic researchers. We recently held a conference at the Federal Reserve Bank of Chicago that combined research presentations by top scholars with roundtable discussions among leaders of organizations that serve union workers, low- and moderate-income communities, small businesses, and people struggling to find work.
We have been listening. What have we heard? Scholars at the Chicago event offered a range of views on how well our monetary policy tools have effectively promoted our dual mandate. We learned more about cutting-edge ways to measure job market conditions. We heard the latest perspectives on what financial and trade links with the rest of the world mean for the conduct of monetary policy. We heard scholarly views on the interplay between monetary policy and financial stability. And we heard a review of the clarity and the efficacy of our communications.
Like many others at the conference, I was particularly struck by two panels that included people who work every day in low- and middle-income communities. What we heard, loud and clear, was that today’s tight labor markets mean that the benefits of this long recovery are now reaching these communities to a degree that has not been felt for many years. We heard of companies, communities, and schools working together to bring employers the productive workers they need—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We heard that many people who, in the past, struggled to stay in the workforce are now getting an opportunity to add new and better chapters to their life stories. All of this underscores how important it is to sustain this expansion.
The conference generated vibrant discussions. We heard that we are doing many things well, that we have much we can improve, and that there are different views about which is which. That disagreement is neither surprising nor unwelcome. The questions we are confronting about monetary policymaking and communication, particularly those relating to the ELB, are difficult ones that have grown in urgency over the past two decades. That is why it is so important that we actively seek opinions, ideas, and critiques from people throughout the economy to refine our understanding of how best to use the monetary policy powers Congress has granted us.
Beginning soon, the Federal Open Market Committee (FOMC) will devote time at its regular meetings to assess the lessons from these events, supported by analysis by staff from around the Federal Reserve System. We will publicly report the conclusions of our discussions, likely during the first half of next year. In the meantime, anyone who is interested in learning more can find information on the Federal Reserve Board’s website.¹
Let me turn now from the longer-term issues that are the focus of the review to the nearer-term outlook for the economy and for monetary policy. So far this year, the economy has performed reasonably well. Solid fundamentals are supporting continued growth and strong job creation, keeping the unemployment rate near historic lows. Although inflation has been running somewhat below our symmetric 2 percent objective, we have expected it to pick up, supported by solid growth and a strong job market. Along with this favorable picture, we have been mindful of some ongoing crosscurrents, including trade developments and concerns about global growth. When the FOMC met at the start of May, tentative evidence suggested these crosscurrents were moderating, and we saw no strong case for adjusting our policy rate.
Since then, the picture has changed. The crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy. Our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. For example, the limited available evidence we have suggests that investment by businesses has slowed from the pace earlier in the year.
Against the backdrop of heightened uncertainties, the baseline outlook of my FOMC colleagues, like that of many other forecasters, remains favorable, with unemployment remaining near historic lows. Inflation is expected to return to 2 percent over time, but at a somewhat slower pace than we foresaw earlier in the year. However, the risks to this favorable baseline outlook appear to have grown.
Last week, my FOMC colleagues and I held our regular meeting to assess the stance of monetary policy. We did not change the setting for our main policy tool, the target range for the federal funds rate, but we did make significant changes in our policy statement. Since the beginning of the year, we had been taking a patient stance toward assessing the need for any policy change. We now state that the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.
The question my colleagues and I are grappling with is whether these uncertainties will continue to weigh on the outlook and thus call for additional policy accommodation. Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened. But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty to the outlook. We will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.

Bank requirement leaves brokers “entirely exposed”

A professional indemnity (PI) specialist has expressed grave concern over new requirements for brokers to confirm that there are no signs of financial abuse when they assist clients in securing a loan; via Australian Broker.

The action has been taken by the banks in response to the Australian Banking Association’s updated code of practice requiring a higher standard for dealing with vulnerable customers. However, Darren Loades, the FBAA’s dedicated PI insurance specialist for Queensland and the Northern Territory, has questioned the sudden announcement, the lack of clarity as to what the agreement entails, and the days-long timeframe before the 1 July implementation.

“Do you think that’s by accident? I sure don’t,” said Loades.

“The main point is that it’s been rushed through, no one has actually seen the details, and it could have very far-reaching and onerous implications for brokers. Do not sign anything for the moment.”

Loades highlighted the serious liability concerns of signing an agreement that could likely take brokers out of their current coverage and leave them “entirely exposed.”

“Professional indemnity policies only respond to claims made under common law. Signing one of these declarations could incur contractual liabilities, over and above the liabilities a broker would owe at common law,” he explained.

“The standard PI policy out there on the market will not pick up any liabilities owed under contract. Brokers could potentially be left exposed and not insured at all.”

Last week, FBAA managing director Peter White expressed concern that “PI insurance could increase tenfold to cover a declaration like this.”

“To try and ram this through with little notice is not only ridiculous and ill-conceived, but creates massive risks for brokers with almost no benefit to borrowers,” he added.

As White expressed last week, Loades finds it suspect that the agreements the banks are asking brokers to sign have yet to be made accessible.

He continued, “But knowing the banking industry, the documents are going to be pretty far-reaching with some nasty little clauses in there along the lines of, ‘If you drop the ball in this area, you agree to indemnify the bank against any losses.’ Otherwise, why would they be going to this trouble?

“This seems to be a push from the banks to transfer their liability onto the broker, which isn’t all that fair or realistic.”

While Loades does acknowledge that brokers are the ones to have face-to-face interaction with the borrower, he has serious doubts that a set of written guidelines provided by the bank could translate to brokers being able to identify signs of abuse in real life stations.

“That’s a whole different ballgame. Brokers aren’t qualified or licenced to provide advice in this area of financial abuse,” he said.

“What happens if the broker happens to innocently miss a situation where there is financial abuse? The bank is going to rely on this document to say, ‘Well, you signed off. You’re the one who is liable.’”

Credit resurgence could have ‘undesirable’ impact

The fall in interest rates and an easing of lending standards will “breathe life” into the property market, but not without consequences, according to Moody’s Analytics, via The Adviser.

Financial intelligence agency Moody’s Analytics has released its Second Quarter 2019 Housing Forecast Report, in which it has noted its outlook for the Australian housing market.

Drawing on CoreLogic’s Hedonic Home Value Index, the research agency noted the correction in residential property prices, which it said was “a long time coming” after a “strong run-up” in values across more densely populated markets, particularly in Sydney and Melbourne.

However, Moody’s has observed that while residential home prices have moderated from their peak in September 2017, the decline has not led to a “material” improvement in housing affordability, with values still 20 per cent higher than during the pre-boom period in 2013.

Nonetheless, Moody’s has reported that it expects the Reserve Bank of Australia’s (RBA) cut to the official cash rate and proposals to ease home loan serviceability guidelines from the Australian Prudential Regulation Authority (APRA) to rekindle demand for credit and spark activity in the housing market.

“An important driver of the slowdown in Australia’s housing market has been tighter credit availability, partly as a consequence of the regulator – the Australian Prudential Regulation Authority – tightening lending conditions, which has made it relatively more difficult to purchase a property, particularly for investors,” Moody’s noted.

“These serviceability requirements were eased in May.

“Expectations of further lending reductions flowing on from RBA cash rate reductions will also breathe life into the property market and add weight to our view that the national housing market will reach a trough in the third quarter of 2019 and gradually improve thereafter.”

However, Moody’s warned that a resurgence in the housing market activity could further expose the economy to risks associated with high levels of household debt.

“This could see the household leverage-to-GDP ratio climb, making Australia stand out further amongst its peers,” Moody’s stated.

“This is an undesirable position to be in, particularly given the questions around sustainability of the potentially rising debt load.”

Moreover, recent changes in the regulatory landscape have been interpreted by some observers as as a sign that the economy could be at risk of falling into recession amid growing internal and external headwinds.

Treasurer Josh Frydenberg recently acknowledged that “international challenges” could pose a threat to the domestic economy.

Fears of a looming recession have prompted some observers, including the CEO of neobank Xinja, Eric Wilson, to encourage borrowers to pocket mortgage rate cuts passed on following the RBA’s decision to lower the cash rate.

Mr Wilson claimed that resisting the urge to accrue more debt would help borrowers build a buffer against downside risks in the economy.

The Australian Bureau of Statistics’ (ABS) Australian National Accounts data for the quarter ending March 2019, reported GDP growth of 0.4 per cent, with annual growth slowing to 1.8 per cent – the weakest since September 2009.

However, Moody’s economist Katrina Ell has said she expects the RBA’s monetary policy agenda to help revive the economy.

“The combination of increased monetary policy stimulus, expectations of the housing market reaching a trough in the third quarter of 2019, and fiscal policy playing a relatively supportive role including via income tax cuts should boost GDP growth to 2.8 per cent in 2020,” Ms Ell said.

NZ Reserve Bank Says Deposit Insurance To Happen

In the Phase 2 document released today, Deposit Insurance, funded by a bank levy is proposed. Unlike the Australian $250k scheme (which is not activated until the Government says so, and is taxpayer funded initially), the NZ scheme is for a lower amount with a protection limit in the range of $30,000 – $50,000. Implementation will probably take at least two years.

One question so far not answered is the interaction with the deposit bail-in. Generally bail-in stops a failing bank from failing, whereas deposit guarantees are activated on failure. So bail-in might stop deposit guarantees even being called on…

Depositor Protection

Why is a range of $30,000 – $50,000 for the proposed depositor protection scheme proposed?

Available data suggests that a protection limit in the range of $30,000 – $50,000 could fully protect from loss more than 90 percent of individual bank depositors in New Zealand, while leaving the majority of banks’ deposit funding exposed to risk. This would strike the right balance between protecting small depositors from loss and enhancing public confidence in the banking system on the one hand, while maintaining private incentives to monitor bank risk taking on the other. It would also be broadly consistent with international schemes in terms of the share of deposits and depositors that would be fully protected (albeit relatively low in terms of the absolute dollar value of protections).

More work will be required to choose the limit within this range that is the best for advancing the public policy objectives chosen for the protection scheme. The consultation seeks feedback on these choices.

The Reserve Bank is proposing high capital requirements for banks which should reduce the risk of bank failure. Why is depositor protection required if the risk of bank failure is small?

Even with high capital requirements, banks can still fail for a variety of reasons. Regulation, supervision, resolution, and deposit protection all make up a ‘financial safety net’ that supports a stable and resilient financial system and protects society from the damage caused by bank failures. The safety net tools interact and overlap, which can make it seem that not all of the tools are necessary. However, if the safety net is incomplete, it will be difficult to find effective solutions for dealing with serious problems in the banking system. This means that capital tools that help to keep banks safe and sound at the ‘top of the cliff’, must be complemented by robust tools to deal with banks that may still fall to the bottom.

The OECD and IMF have warned that, without depositor protection, New Zealand is vulnerable to contagious bank runs. Bank runs can escalate into banking crises that destroy social and financial capital. For New Zealand’s safety net to be effective in good times and bad, the tools within the net must each be strong in its own right, and work well together.

How will the risks associated with moral hazard be addressed in the proposed depositor protection scheme?

Moral hazard arises when people are protected from the consequences of their risky behaviour. If deposit protection is introduced, depositors may take less care when assessing the risks associated with their banks, and banks may take less care with depositors’ money. Moral hazard costs are part of the reason why New Zealand has until now chosen not to have a depositor protection regime.

There is considerable international experience on how to design an effective deposit protection scheme, within the broader financial safety net, that mitigates moral hazard. International experience demonstrates that strong regulatory monitoring of deposit-takers’ corporate governance and risk management systems goes a long way to addressing the moral hazard of depositor protection. Maintaining private monitoring incentives is also important, and can be achieved through carefully calibrating the protection scheme’s scope of coverage. For example, setting the protection limit at a level that fully covers most household and small business depositors, but leaves large institutional depositors exposed to risk, will support private monitoring incentives. In conjunction, having effective resolution tools (that make it more credible investors’ money is at risk should their institution fail) can sharpen monitoring by institutional investors.

International practice and guidance, as well as the views of experts and the public, will inform the design of New Zealand’s depositor protection scheme.

What are the costs of funding the proposed depositor protection scheme and who will bear these costs?

A primary tool of the protection scheme will be insurance. Deposit insurance transfers the risks and costs of bank failures away from depositors onto an insurance scheme. This will come with upfront costs of establishing a deposit insurer, and ongoing operational costs.

Modern deposit insurance schemes are normally funded by levies on member banks, supported (where necessary) by temporary lending paid for by taxpayers. If the insurance scheme is accompanied by a depositor preference, this might also increase banks’ non-deposit funding costs as risks are transferred from depositors onto institutional investors.

Details of the scheme, including costs, are still to be worked out in the next phase of the work programme. To the extent that depositor protection increases banks’ average costs, this might be passed on to customers through higher mortgage rates or lower deposit rates. Alternatively, costs might be absorbed by banks’ own margins and retained earnings. The extent to which costs are shared between banks and their customers depends on competition and contestability in the sector.

A fuller cost-benefit analysis will follow as we learn more about the specific design features of New Zealand’s depositor protection scheme.

When will the depositor protection scheme be introduced?

A work programme running alongside the Reserve Bank Review process will develop a depositor protection scheme that is best for New Zealand. The work programme will be guided by a framework setting out some key design principles for an effective scheme, and will draw (where relevant) on international standards and best practice. The work programme will determine the:

mandates and powers
governance and decision making structure
coordination arrangements with other safety net providers
membership and coverage arrangements
funding and pay-out mechanics, and
design features to mitigate moral hazard

that are appropriate for New Zealand’s protection scheme. The Review Team’s discussions with the global coordinating body for deposit insurers indicates that the path from policy recommendations to scheme implementation will probably take at least two years.

18 US Banks pass Federal Reserve stress test

On 21 June, the US Federal Reserve (Fed) published the results of the 2019 Dodd-Frank Act stress test (DFAST) for 18 of the largest US banking groups, all of which exceeded the required minimum capital and leverage ratios under the Fed’s severely adverse stress scenario; via Moodys’.

These results are credit positive for the banks because they show that the firms are able to withstand severe stress while continuing to lend to the economy. In addition, most firms achieved a wider capital buffer above the required minimum than in last year’s test, indicating a higher degree of resilience to stress. The 2019 results support our view of the sector’s good capitalization and benefit banks’ creditors.

The median stressed capital buffer above the required Common Equity Tier 1 (CET1) ratio increased to 5.1% from 3.5% last year, a substantial change. However, the 18 firms participating in 2019 were far fewer than the 35 that participated in 2018, helping lift the results this year. This is because passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act in May 2018 resulted in an extension of the stress test cycle to two years for 17 large and non-complex US bank holding companies, generally those with $100-$250 billion of consolidated assets, which pose less systemic risk.

This is the fifth consecutive year that all tested firms exceeded the Fed test’s minimum CET1 capital requirement. As in prior years, the banks’ Tier 1 leverage and supplementary leverage ratios had the slimmest buffers of 2.8% and 2.4%, respectively, above the required minimums as measured by the aggregate.

Under DFAST, the Fed applies three scenarios – baseline, adverse and severely adverse – which provide a forward-looking assessment of capital sufficiency using standard assumptions across all firms. The Fed uses a standardized set of capital action assumptions, including common dividend payments at the same rate as the previous year and no share repurchases. In this report, we focus on the severely adverse scenario, which is characterized by a severe global recession accompanied by a period of heightened stress in commercial real estate markets and corporate debt markets.

This year’s severely adverse scenario incorporates a more pronounced economic recession and a greater increase in US unemployment than the 2018 scenario. The 2019 test assumes an 8% peak-to-trough decline in US real gross domestic product compared with 7.5% last year and a peak unemployment rate of 10% that, although the same as last year, equates to a greater shock because the starting point is now lower (the rise to peak is now 6.2% compared with 5.9% last year).

The severely adverse scenario also includes some assumptions that are milder than last year: housing prices drop 25% and commercial real estate prices drop 35%, compared with 30% and 40% last year; equity prices drop 50% compared with 65% last year; and the peak investment grade credit spread is 550 basis points (bp), down from 575 bp last year. We consider this exercise a robust health check of these banks’ capital resilience.

Finally, the three-month and 10-year Treasury yields both fall in this year’s severely adverse scenario, resulting in a mild steepening of the yield curve because the 10-year yield falls by less. As a result banks’ net interest income faces greater stress than in last year’s scenario, which assumed unchanged treasury yields and a much steeper yield curve.

How RBA Monetary Policy Works

In the June RBA Bulletin, there was an article which describes how the RBA executes its market interventions to effect a cash rate change. It is important to understand these inner workings, despite it appearing complicated on first blush.

And consider this, this tool box is being used by many central banks around the world to direct the financial system.

In summary, the RBA’s operations in domestic markets support the implementation of monetary policy. The most important tool to guide the cash rate to the target set by the Board is the interest rate corridor. To support this, the RBA pursues daily open market operations in order to keep the pool of exchange settlement (ES) balances at the appropriate level for the cash market to function smoothly. The daily market operations are conducted to offset the effects on liquidity of the many transactions between the banking system and the Australian Government. Open market operations are primarily conducted through repos and FX swaps. These provide flexibility for liquidity management and also help to manage risk for the RBA’s balance sheet.

The cash rate is a key determinant of interest rates in domestic financial markets and hence underpins the structure of the interest rates that influence economic activity and financial conditions more generally.

This helps to explain the sharp falls in the BBSW rates, which are now around 87 basis points lower than the recent peak. Such a fall has been engineered.

The cash rate is an effective instrument for implementing monetary policy because it affects the broader interest rate structure in the domestic financial system. The cash rate is an important determinant of short-term money market rates, such as the bank bill swap rate (BBSW), and retail deposit rates (Graph 1). These rates – as well as a number of other factors – then influence the funding costs of financial institutions and the lending rates faced by households and businesses. As a result, the cash rate influences economic activity and inflation, enabling the RBA to achieve its monetary policy objectives. However, while changes in the cash rate are very important, they are not the only determinant of market-based interest rates. Other factors, such as expectations, conditions in financial markets, changes in competition and risks associated with different types of loans are also important.

The Cash Market and the Interest Rate Corridor

The RBA implements monetary policy by setting a target for the cash rate. This is the interest rate at which banks lend to each other on an overnight unsecured basis, using the exchange settlement (ES) balances they hold with the RBA. ES balances are at-call deposits with the RBA that banks use to settle their payment obligations with other banks. Banks are required to have a positive (or zero) ES balance at all times, including at the end of each day. It is difficult for institutions to predict whether they will have adequate funds at the end of any particular day, which generates the need for an interbank overnight cash market. Those banks that need additional ES balances after they have settled all payment obligations of their customers, borrow from banks with surplus ES balances. The interbank cash market is the mechanism through which these balances are redistributed between participants.

The RBA sets the supply of ES balances to ensure that the cash market functions smoothly by providing an appropriate level of ES balances to facilitate the settlement of interbank payments. The RBA manages the supply of ES balances available to the financial system through its open market operations (see below). Excessive ES balances could lead institutions to lend below the target cash rate, while a shortage might result in the cash rate being bid up above the target.

The interest rate corridor ensures that banks have no incentive to deviate significantly from the cash rate target when borrowing or lending in the cash market. Banks can borrow ES balances overnight on a secured basis from the RBA at a margin set 25 basis points above the cash rate target. As a result, banks have no need to borrow from other banks at a higher rate. Similarly, banks receive interest on their surplus ES balances at 25 basis points below the cash rate target. Therefore, they have no incentive to lend to other banks at a lower rate.

The operation of the interest rate corridor means that there is no need for the RBA to adjust the supply of ES balances to bring about a change in the cash rate (Graph 2 and Graph 3). For example, when the RBA lowered the cash rate target by 25 basis points from 1.5 per cent to 1.25 per cent in early June, the rates associated with the corridor also moved lower, to be 1.0 per cent on overnight deposits and 1.5 per cent on overnight loans (down from 1.25 per cent and 1.75 per cent). A bank that would have previously required a return above 1.25 per cent to lend ES balances in the cash market is, under the new corridor, willing to lend at a lower return. And so a bank wanting to borrow cash pays a lower rate than before. Similarly, if the RBA had instead raised the cash rate by 25 basis points from 1.5 per cent, the corridor would have moved up, to be 1.5 per cent to 2.0 per cent. A bank that would have previously lent surplus ES funds to another in the cash market at 1.50 per cent would, under the new corridor, no longer have an incentive to do so. Indeed, it would require a higher return to lend ES balances, rather than leaving those funds in its ES account and receiving 1.50 per cent from the RBA. Hence, a bank wanting to borrow in the cash market would have to pay a higher interest rate than it did previously.

In other words, interbank transactions automatically occur within the interest rate corridor without the RBA needing to undertake transactions beyond its usual market operations to manage liquidity.

Graph 2: Monetary Policy Easing — Graph 2

Graph 3: Monetary Policy Tightening — Graph 3

The incentives underlying the corridor guide the cash rate to the target and ordinarily all transactions occur at the rate announced by the RBA. The last time there was a small deviation in the published cash rate (which is a weighted average of all transactions in the cash market) from the target (of 1 basis point for two days) was in January 2010 (Graph 4). The lack of deviation of the cash rate from the target has brought about a self-reinforcing market convention where both borrowers and lenders in the cash market expect to transact at the prevailing target rate. This market convention helps to address the uncertainty that banks would otherwise face about the price at which they can borrow sufficient ES balances to cover their payment obligations each day. In 2018, daily transactions in the overnight interbank market were typically between $3 billion and $6 billion.

As in Australia, many other central banks implement monetary policy with an interest rate corridor to guide the policy rate. The width of the corridor tends to differ, typically from 50 to 200 basis points. The choice of the width of the corridor is seen as a reflection of a trade‐off between interest rate control and the desire to avoid the central bank becoming an intermediary in the money market. All other things being equal, cross-country studies suggest that a narrower corridor is preferred by central banks that have a strong preference for low volatility of short-term interest rates, whereas a wider corridor is usually preferred by central banks that seek to encourage more interbank trading activity.

Over the past 10 years, many central banks (other than the RBA) have significantly expanded their balance sheets. This has resulted in significantly more liquidity in their respective systems and so banks typically do not need to borrow funds in the overnight cash market. In these cases, the policy rate typically converges toward the rate on deposits paid by the central bank; this is often referred to as a ‘floor system’. Small changes in liquidity in such a system do not tend to have much effect on the policy rate.

Liquidity Management and Open Market Operations

Transactions between the government (which banks with the RBA) and the commercial banks would, by themselves, change the supply of ES balances on a daily basis. ES balances in accounts of commercial banks increase whenever the government spends out of its accounts at the RBA. Similarly, when the government receives cash into its accounts at the RBA, such as from tax payments or debt issuance, ES balances decline. The RBA monitors and forecasts these changes actively through the day. It offsets (i.e. ‘sterilises’) these changes in ES balances with its daily open market operations so that government receipts and payments do not affect the aggregate level of ES balances. If transactions that affect system liquidity were not offset by the RBA, ES balances would be much more volatile and the payments system would suffer frequent disruptions (Graph 5). Ultimately this is likely to lead to a more volatile cash rate.

Graph 5: Surplus Exchange Settlement Balances — Graph 5

The main tools used in open market operations are repurchase (repo) agreements and foreign exchange swaps. Both repos and foreign exchange swaps involve a first and a second leg (Figures 1 and 2):

The first leg of a typical repo in open market operations (which injects ES balances) involves the RBA providing ES balances to a bank and the bank providing eligible debt securities as collateral to the RBA. Taking collateral safeguards the RBA against loss in the case of counterparty default. The second leg, which occurs at an agreed future date, unwinds the first leg: the bank returns the ES balances and the RBA returns the securities to the bank.
The first leg of a foreign exchange swap designed to inject ES balances into the system involves the RBA providing ES balances to a bank and the bank providing collateral in the form of foreign currency to the RBA (typically US dollars, euros or Japanese yen). The second leg, at the agreed future date, consists of the bank returning the ES balances and the RBA returning the foreign exchange.

Figure 1 Repurchase Agreement — Figure 1

Figure 2: Foreign Exchange Swap — Figure 2

Repos and swaps provide more flexibility for liquidity management than outright purchases or sales of assets since they involve a second leg (when the transaction unwinds) with a date chosen to support liquidity management on that day. It also allows the RBA to accept a much broader range of collateral, such as unsecured bank paper, than it would be willing to purchase outright. By contrast, buying (and then selling) securities outright requires the RBA to take on the price and liquidity risk associated with owning the assets outright. Conducting open market operations by buying and selling government securities outright, while also ensuring that the RBA’s market operations do not affect liquidity in the bond market, would require more government securities than are available in Australia.

The size of daily open market operations is based on forecasts of daily liquidity flows between the RBA’s clients (mainly the Australian Government) and the institutions with ES accounts. In a typical round of market operations, a public announcement is made at 9.20 am that the RBA is willing to auction ES balances against eligible collateral for a certain number of days (ranging from two days to several months, with an average term of around 30 days). Institutions have 15 minutes to submit their bid. The RBA ranks these bids from highest to lowest repo rate and then allocates ES balances to the highest bidders until the amount the RBA intends to auction has been dealt. All auction participants are informed electronically about their allocation. If they have been successful, they will pay the rate at which they bid for the amount allocated. The aggregate results of the auction, including the amount dealt, the average repo rate and the lowest repo rate accepted are published.

Market Operations and the RBA Balance Sheet

The transactions entered into as part of open market operations are reflected in changes in the RBA’s balance sheet. Changes in the size and composition of liabilities (mainly issuance of banknotes and government deposits) may need to be offset via open market operations to ensure that the availability of ES balances remains appropriate for the smooth functioning of the cash market (Graph 6).

Graph 6: Reserve Bank Liabilities — Graph 6

Open market operations affect the asset side of the balance sheet (Graph 7). When the RBA purchases securities under repo, it has a legal claim on the security that was transferred as collateral for the duration of the repo. These claims appear as assets on the balance sheet, along with outright holdings of domestic government securities. When the RBA uses foreign exchange swaps to supply Australian dollars into the local market, the foreign currency-denominated investments associated with the swap are also reflected as assets on the balance sheet. The choice between using repo, foreign exchange swaps or outright purchases to adjust the supply of ES balances is determined by market conditions and pricing. When a large amount of ES balances needs to be supplied or drained, such as when a government bond matures, the RBA might choose to do so using a combination of instruments.

The RBA supplies ES balances not only for monetary policy implementation but also to facilitate the functioning of the payment system. Over recent years, the RBA has been providing more ES balances to banks to enable the settlement of payments outside normal banking hours, such as through direct-entry and the New Payments Platform. These ES balances are supplied under ‘open repos’. An open repo is set up in a similar way to the repo explained in Figure 1, with the initial leg transferring ES balances to banks in return for eligible debt securities as collateral. However, the date of the second leg is not specified, so it is open ended. The ES balances are available (and the claim on securities remain on the RBA’s balance sheet) until the open repo is closed out. These ES balances provided under open repo are held purely to facilitate the effective operation of the payments system after hours and cannot be lent overnight in the cash market. As a result, they have no implications for the implementation of monetary policy. Currently, these balances are around $27 billion. The remainder of ES balances that are available for trading in the cash market are referred to as ‘surplus ES balances’, and are the focus of daily open market operations. Recently, surplus ES balances have been around $2–3 billion. This amount has increased in recent years as demand for balances has risen, partly in response to new prudential regulations on liquidity.