Economics and Banking – Page 391 – Digital Finance Analytics (DFA) Blog

The Euro Zone’s Inflation Problem

Dr Jens Weidmann, President of the Deutsche Bundesbank, highlighted the low inflation expectations within the Euro Zone, predicting no more than a gradual increase in inflation to 1.6 % this year, with 1.7 % growth assumed for each of the coming two years.

The global economy is on a moderate growth path. Though its momentum is weaker now than we had expected a little over half a year ago, the fears that prevailed in the financial markets every now and then did not materialise. However, right now we are seeing a shift in the dynamics of growth. In the emerging markets, where the situation had clouded over perceptibly at the beginning of the year, the situation is stabilising to a degree. The recessionary tendencies plaguing Russia have died down, although a sustainable recovery is not yet in sight. In China, growth prospects repeatedly required downward revisions in the past. The shift in growth seen thus far, though, is consistent with China’s transition to a more services-oriented, domestically driven economic model; if we look at it that way, we have no cause for anxiety.

And those countries which derive a large proportion of their value added from commodity exports are likely to benefit from the latest recovery of commodity prices, especially the significant increase in oil prices. By contrast, the United States and United Kingdom recently saw a slight deceleration of growth, with US growth being curbed by the oil industry delaying investment, amongst other factors. Private consumption was also on the weak side in both countries.

On the other hand, the euro area got off to a good start in 2016. Gross domestic product grew by a healthy 0.6 % on the quarter. Lively domestic demand, which benefited from low oil prices and the accommodative monetary policy, was a pillar of the upturn. However, another decisive factor was the surprisingly mild weather at the start of the year, which boosted, above all, the construction sector. The strong first-quarter growth should therefore not be extrapolated to the year as a whole.

On aggregate, the euro-area economy’s growth path is still only tepid at present. The latest Eurosystem staff projection has the euro-area economy growing by 1.6 % this year, with 1.7 % growth assumed for each of the coming two years.

Economic growth in Germany is looking relatively similar, even though the situation – seen, for instance, in terms of capacity utilisation and labour market indicators – is significantly better than in the rest of the euro area. Our country did, after all, post respectable first-quarter growth of 0.7 %. However, even in Germany, aggregate economic growth will peter out somewhat as the year progresses. Bundesbank economists are expecting growth of 1.7 % this year. Owing to the difficult external environment, growth is projected to decelerate temporarily to 1.4 % for 2017 before then climbing back up to 1.6 % in 2018.

Monetary policy

For us as central bankers, macroeconomic analysis is, of course, not an end in itself. After all, our mandate is not to steer the economy but instead to maintain price stability. Economic growth, however, is one determinant of enterprises’ capacity utilisation and their scope for raising prices. It also indicates how much leeway wage bargainers have in wage negotiations.

Inflation rates have been very low for some time now in many currency areas, and the euro area is no exception. Here, inflation is even in negative territory; in May, prices were down by 0.1 % on the year. In the past two years, it was mainly the sharp fall in commodity prices, particularly oil prices, which pushed inflation down. However, the impact of a change in oil prices will automatically be washed out of the inflation rate over time. And the recent rise in oil prices is helping to speed up this process somewhat.

However, the low inflation rates in the euro area are not just an outcome of the fall in oil prices. Core inflation, i.e. the price index adjusted to exclude energy and food prices, is likewise relatively low. The muted domestic price pressures measured in this manner also show that some euro-area economies are recovering only gradually and that unemployment levels in those countries are still very high.

Seeing as the euro-area economic recovery is only tepid, the Eurosystem projections foresee no more than a gradual increase in inflation to 1.3 % next year and 1.6 % in 2018.

In view of this muted price outlook, an accommodative monetary policy is appropriate at present, though reasonable people can disagree about the specific design of the non-standard measures. There is one thing I would like to stress, though: Our definition of price stability requires the target inflation rate to be achieved over the medium term. This will give us enough time to see how the adopted monetary policy measures will impact on price movements, especially since, as I have been pointing out time and again, the Eurosystem is still something of a novice when it comes to applying non-standard monetary policy, and the risks and side-effects of the ultra-accommodative monetary policy are growing over time.

McKinsey’s Asia–Pacific Banking Review 2016

McKinsey has just released its latest banking annual report “Weathering the storm” which finds an industry facing challenges to maintain its growth, but significant opportunities remain.

Over the past decade, the Asia–Pacific region has propelled global banking. Of the industry’s $1.1 trillion global profits in 2015, some 46 percent came from the region, up from just 28 percent in 2005. The bulk of this increase was the result of growth linked to dynamic economies throughout Asia–Pacific, especially China, which accounted for about half of the region’s banking-revenue pool in 2015.

Yet our annual report, Weathering the storm: Asia–Pacific Banking Review 2016, finds that the momentum from this golden decade is already fading. Margins and returns on equity are shrinking—for instance, the Asia–Pacific banking industry’s ROE slipped to 14 percent in 2014, from 15 percent a year earlier. The region and its financial industry seem to be settling into a new era of slower growth and greater challenges in generating economic profit.

They say slowing macroeconomic growth, disruptive attackers from outside the financial-services sector and weakening balance sheets may come together in a powerful storm that could cripple ROEs by 2018. Indeed, banks already see the impact of the changing environment. Their analysis of 328 banks in the region showed that while 39 percent posted an economic profit in the period from 2003 to 2006, only 28 percent did so from 2011 to 2014.

They conclude that although the coming storm is a potent and clear threat to most banks in the Asia–Pacific region, it may also provide the kind of significant industry disruption that creates opportunities for those that recognize it. The most aggressive banks will not merely survive the turbulence but also be strengthened by it.

Income, Credit and Home Prices Out of Kilter

In this post we combine the latest data from the RBA and ABS, and our own analysis to look at the relationship, at a state level, between income growth, home price growth and credit growth. These three elements should logically be closely meshed, yet in the current environment, they are not. We think this is an important leading indicator of trouble ahead as these three factors will come back eventually to a more normal relationship, signalling potential falls in home values and credit volumes in a low income growth environment.

The latest data from the ABS shows that home prices fell slightly in the past quarter. The Residential Property Price Index (RPPI) fell 0.2 per cent in the March quarter 2016, the first fall since the September quarter 2012. Attached dwellings, such as apartments, largely drove price falls in the RPPI. The attached dwellings price index fell 0.8 per cent in the March quarter 2016. Falls were recorded in Melbourne (-1.3 per cent), Sydney (-0.6 per cent), Perth (-1.1 per cent), Canberra (-1.1 per cent) and Adelaide (-0.4 per cent). Brisbane (+0.7 per cent), Hobart (+2.3 per cent) and Darwin (+0.1 per cent) recorded rises. Established house prices for the eight capital cities was flat (0.0 per cent). The total value of Australia’s 9.7 million residential dwellings increased $15.4 billion to $5.9 trillion. The mean price of dwellings in Australia is now $613,900.

The RBA minutes also out today had a couple of interesting comments.

Dwelling investment had continued to grow strongly over the year, consistent with the substantial amount of work in the pipeline noted in previous meetings. Members observed that private residential building approvals had increased strongly in April, to be close to peaks seen earlier in 2015. Although these data are quite volatile from month to month, the trend for building approvals had been stronger than expected of late and the pipeline of residential work yet to be done had remained at high levels. This implied that growth in new dwelling investment would continue to add to the supply of housing over the next year or so, particularly in the eastern capitals.

In established housing markets, prices increased significantly in Sydney and Melbourne over April and May and, to a lesser extent, in a number of other capital cities. Auction clearance rates and the number of auctions increased in May, but remained lower than a year earlier. At the same time, the monthly data available for April showed that there had been a further easing in housing credit growth and the total value of housing loan approvals, excluding refinancing, had fallen in the month. Members noted that the divergence in the trends in housing price and credit growth was not expected to persist over a long period of time.

We already know that income growth is static.

So this got us thinking about the relationship between income, home price growth and credit growth. To look at this, we drew data from our surveys, and also the ABS and RBA data-sets, to map the relative cumulative growth of average household income, home price growth and credit growth. The results are interesting. We used 2006 as a baseline and measured the relative cumulative growth since then, by state.

First, here is the average across Australia. The growth of credit since 2006 (the yellow line) is significantly stronger than home prices and income. Income is notably the slowest. This is course confirms what we know, households are more leveraged (highest in the western world), and home prices are higher relative to income, supported by credit availability and more recently low interest rates. Note also the recent slowing in credit growth.

Looking at the state variations is really insightful. In the ACT credit growth is very strong, but home prices and incomes are moving at a similar trajectory. This is partly because of the micro-economic climate supported by well paid public servants.

In NT, home price growth is higher than credit and income growth, but the growth is beginning to slow, in response to the mining slow down. Home prices are significantly extended relative to incomes.

In TAS, home prices are tracking incomes, whilst credit has been growing more slowly, thanks to lower price growth and local demographics.

In WA, we see significant home price momentum through the mining boom years, but it is now adjusting, and credit which has been strong has been easing in the past 12 months. Home price growth is now tracking income growth.

In SA, credit is quite strong now, and we are seeing home prices moving ahead of incomes, as they did in 2010, but only slightly.

In QLD, credit is growing faster now, and home prices are moving faster than incomes, there is an interesting dip in 2011-12, thanks to some “local political difficulties!”

VIC holds the award for the strongest credit growth in recent time, and as a result we see home prices moving ahead of income growth, a trend which can be traced back to before the GFC.

Finally, in NSW, we see a dramatic run up in credit and home prices, especially since 2013. Both are growing faster than incomes. Prior to this, income growth and home prices were more aligned.

So a few observations. Incomes and home prices, and credit are disconnected, significantly. This is a problem because credit has to be repaid from income, in some way, at some time. Next, there are strong correlations in some states between credit growth and home prices, in other states it is less clear. NSW and VIC have the largest gaps between income and prices. So it reconfirms the property markets are not uniform. Finally, and importantly, we think that home price and credit growth will have to come back to income growth – and as incomes will be static for some time, downward pressure on home prices and credit will build, especially if the costs of borrowing were to rise.

The Changing Face of the Non-Bank Sector

The prospective sale of Firstmac underscores the dilemma for Non-Banks operating in the current environment. Pre-GFC, most were able to work a very effective Residential Mortgage Backed Securitisation (RMBS) model where bundles of loans were packaged up and sold to investors, many of whom were offshore. Then the GFC hit. As a result the securisation markets froze and funding all but stopped. It has hardly recovered.

In this chart we compared the assets of securitised pools with the total mortgage loan growth in Australia, and it starkly shows the changes post the GFC. We used data from RBA and ABS to generate the data. As a result, the share of mortgages written by banks have lifted from 70% to well above 90%. Banks also have looked at other funding routes, (for example Bendigo Bank have moved from 20% to 6% RMBS, and this has created a capital headwind, so they will most likely focus on senior funding), because costs of securitising is still higher than before the GFC, when the Non-Banks had a significant funding advantage. Banks also are now subject to tighter capital rules for securitised pools.

Here is the latest data on issuance from Macquarie.

In addition, most deals which are done are in Australia, as the global demand for securitised paper is still well down as shown by this chart. Most deals now done to institutional investors in Australia, in long term instruments. We also see a rise in direct placements.

So, Non-Banks need alternative models to make their business work. Those who survive do so on the back of funding from investors, (which include some of the major banks, as well as retail super funds and sophisticated individuals). They also find it hard to compete in the current low interest rate environment making “meat and potato” loans, because the margins are compressed. As a result they will be looking for niche markets, such a low documentation loans, jumbo loans, investment loans, and credit impaired loans. Here they have an advantage as they are not under the APRA 10% speed limit for investment loans, and do not have to hold capital against these loans under the Basel III arrangements. They are merely answerable to ASIC.

So we expect Non-Banks to operate in niche markets, funding their business from investors. We also expect to see more sales and consolidation.

Firstmac For Sale

According to MPA,

Non-bank lender Firstmac is for sale, with Goldman Sachs looking for a strategic investor or a buyer to snap up the whole company, according to the Australian Financial Review. Firstmac is owned by Brisbane businessman Kim Cannon and has about $8 billion in mortgages under management.

Goldman has turned its attention to potential buyers such as banks, private equity firms and offshore strategic players to generate interest before a two-part auction takes place. According to the AFR, Firstmac could be worth up to $500 million and hits about $20 million in annual profits.

Cannon is considering selling a 30% to 40% stake in the business or the whole company and has reportedly been approached over the years by interested parties, including the big banks.

US Banks To Tighten Credit Impairment Reporting

US companies including banks, will have to reassess how financial statements report credit risks, and expected losses in current statements and future outlooks due to changes in accounting standards which were published last week and will be effective in 2020. The changes may also have an impact of capital requirements and reporting. This is another step in the tighter regulation of the banking sector.

According to Moody’s, the US Financial Accounting Standards Board (FASB) published its Current- Expected-Credit-Loss model (CECL), a controversial and long-awaited expected-credit-loss model for financial instruments. CECL better aligns the recognition of credit losses with the economics of lending and investing. Additionally, the overall principle for CECL is easy to understand, reducing complexity in financial statements.

Although CECL applies to all companies that report under US generally accepted accounting principles (GAAP), it has the most material effect on bank financial statements because of the size of their loan portfolios. As of 31 March 2016, the loan portfolio of US commercial banks totaled $8.7 trillion. Banks will need to reassess the credit risk inherent in these loans to comply with CECL, in some cases requiring significant systems changes to incorporate forward-looking information.

When a bank first reports under CECL, provisions will significantly increase, reducing bank capital. In subsequent periods, however, provisions will only reflect changes to the bank’s estimated expected credit losses. US regulators supported CECL throughout its development, but it remains to be seen whether the new rules will affect regulatory capital requirements and nonperforming loan disclosures.

The main changes are:

Incurred versus expected credit losses. An expected-credit-loss model improves the usefulness of information in financial statements for investors. Currently, banks must wait until credit losses are probable or incurred before recognizing provisions for contractual cash flows that will not be collected on loans. On the day a loan is originated, CECL requires banks to recognize in earnings a provision that reflects management’s expectation of lifetime credit losses incorporating all reasonable and supportable information, including forward-looking information. Therefore, under CECL, the carrying value of loans measured at amortized cost on the balance sheet will reflect the net amount a bank expects to collect.

CECL has been heavily criticized because it requires a loss to be recognized upon loan origination, which many believe is counterintuitive since credit risk is typically considered in pricing. For credit analysis, however, we believe this is appropriate for banks: history has shown that in a pool of performing loans, not all contractual cash flows will be collected.

Detailed and transparent credit quality disclosures. Along with the CECL model, the FASB’s new credit loss standard published Thursday expands current credit quality disclosures by requiring banks to disaggregate their loans and receivables not only by class and credit characteristics but also by vintage.

These disclosures will be particularly helpful in understanding how credit quality has changed from period to period.

US GAAP and International Financial Reporting Standards (IFRS) have different expected credit loss models, a negative for users of financial statements. Although both CECL and the new IFRS impairment model are expected-credit-loss models, their principles are not fully aligned, which does not aid in global comparability of bank financial statements. IFRS 9, the financial instruments standard published in July 2014,4 requires recognition of lifetime expected credit losses once financial assets exhibit a significant increase in credit risk. For performing financial assets, an amount equal to 12-month expected credit losses is recognized. As such, CECL results in earlier recognition of credit losses on performing loans compared with IFRS 9. In addition, financial reporti g under CECL will be easier to understand because provisions in each reporting period will only reflect changes in the bank’s estimate of lifetime expected credit losses. Provisions under IFRS 9 will include a cliff effect for loans that exhibit credit deterioration but were previously performing.

What sort of Reserve Bank governor will Philip Lowe be?

From The Conversation.

Glenn Stevens’ ten year stewardship of the Reserve Bank of Australia has been characterised by remarkable challenges. Yet, if the Australian economy has shown considerable resilience over this troubled decade, particularly during the global financial crisis, part of the credit certainly goes to the RBA.

When Stevens’ deputy, Philip Lowe succeeds him in September, he will need to continue to shepherd Australian prosperity through the challenges of global deflation and faltering global economic growth.

What direction will he take with the country’s monetary policy?

Glenn Stevens’ Legacy

Under Stevens, inflation has remained relatively stable and predictable, which is the main target for a central bank like the RBA. The repercussions of the financial crisis in North America and Europe have been mostly avoided thanks to the solidity of the Australian financial system, which is also a key responsibility of the RBA.

Sure enough, the exchange rate has experienced some wide fluctuations. But in an economy where the central bank targets inflation and there is no external anchor, these fluctuations are inevitable. In fact, the flexibility of the exchange regime has been another important factor driving Australia’s resilience.

Finally, the RBA has maintained its strong reputation and credibility both domestically and internationally; and in the current context where central banks in many industrial countries are blamed for poor macroeconomic management (well beyond their actual faults), this is no little achievement.

A solid background

A graduate from the University of New South Wales, Lowe holds a PhD from the Massachusetts Institute of Technology. He began his career with the RBA in 1980 and, until 1997, occupying a various positions in the International Department and Economic Group, before becoming Head of the Economic Research Department in 1997-98 and then the Financial Stability Department in 1999-2000.

In 2000-02 he was Head of Financial Institutions and Infrastructure Division at the Bank for International Settlements. After returning to the RBA, he headed the Domestic Markets and Economic Analysis Departments.

In 2004 he was appointed Assistant Governor (Financial System), then Assistant Governor (Economic) from 2009 until 2012, when he assumed his current position as Deputy Governor. This already impressive curriculum is enriched by several academic publications.

Lowe’s on monetary policy and financial stability

The RBA operates with an inflation target; that is, its objective is to use monetary policy to stabilise inflation at around 2%-3% on average over the business cycle. The pursuit of the inflation target requires the RBA to respond to demand pressures that can eventually lead to undesirable fluctuations in inflation and consumer prices.

In a low inflation environment such as Australia, these demand pressures can manifest themselves in rapid credit and asset prices growth, which in turn trigger episodes of financial instability.

In some of his academic work, Lowe has documented these links, showing that inflationary pressures are likely to become evident in asset prices before they show up in goods and services prices.

Taken to the operational level, this means that the emergence of an asset-price bubble calls for a deflationary intervention of the RBA before the further enlargement of the bubble threatens financial and monetary stability.

We can therefore expect Lowe’s RBA to be watching credit and asset markets closely and be prepared to respond to fluctuations on such markets as a way to prevent a more general increase in consumer prices. To use an economist’s jargon, credit and asset markets become part of the monetary policy reaction function of the RBA.

But even under an inflation target regime, monetary policy should concern itself with the cycles of the “real” economy (that is, cycles of gross domestic product and employment). Provided that the inflation target is not compromised, monetary policy should be adjusted to stabilise cyclical changes in production and labour market conditions.

In fact, the RBA has never been the type of excessively hard-nosed central bank that exclusively pays attention to monetary stability. Even recently, monetary policy has been significantly accommodating, meaning that interest rates have been kept low as a way to support the cyclical recovery of the Australian economy.

This approach to monetary policy is very likely to continue under Lowe. For instance, in a recent address to Urban Development Institute of Australia (UDIA), he indicated that “[this] low inflation outlook provides scope for easier monetary policy should that be appropriate in supporting demand growth in the economy.”

In this regard, the challenge for him will be twofold. For one thing, as interest rates continue to decline, the effectiveness of further interest rate cuts in stimulating the real economy is likely to weaken. For another, a debt-obsessed government might end up relying too much on monetary policy and too little on fiscal policy to stimulate the economy.

This would then place the RBA in a difficult position, with Lowe having to protect the independence and autonomy of his institution.

Lowe’s on the long term prosperity of Australia

What else can monetary policy do for Australians? Someone might be tempted to argue that monetary policy should deliver long-term growth and prosperity.

In a sense, any public policy should aim at the greater good of the community. Monetary policy does that by delivering stable financial and monetary environment and by helping the economy to recover from short-term cyclical fluctuations.

But beyond that, prosperity becomes a matter of long term productivity growth and innovation, which in turn call for actions that fall largely outside the realm of monetary policy.

Sustaining productivity requires reforms to enhance competition, investment in transport infrastructure and in high quality education. Similarly, innovation stems from interventions that specifically support new entrepreneurial activities while preventing the distortions of old-school import substitution policies.

Active labour market policies are required to support the process of structural transformation of the economy and to guarantee that workers can relocate from declining to emerging sectors.

The RBA, or any central bank for that matter, is not meant to provide all that. In fact, expecting the RBA to do all (or even only some) of the above would tantamount to compromising its fundamental functions, throwing the Australian economy towards an era of financial and monetary instability and low economic growth.

In his October address to the CFA’s Australia Investment Conference, Lowe explicitly acknowledged that, ultimately, the rate at which living standards improve is unlikely to be driven by the actions of the central bank.

The hope is that the government will listen to him and take responsibility for bringing the Australian economy into a new era of prosperity.

Author: Fabrizio Carmignani, Professor, Griffith Business School, Griffith University

IMF On UK’s Financial Stability

The latest IMF Report on the Financial System Stability Assessment on the United Kingdom warns on the impact of a Brexit, and underscored concerns that 16 per cent of the residential property market are investors (remember in Australia, our is more than double, at 35 per cent!). The review assess the stability of the financial system as a whole and not that of individual institutions and was completed in June 2016 from visits to United Kingdom in November 2015 and in January-February 2016.

Property Sector

U.K. residential property prices reflect mostly long-standing supply-demand imbalances. While annual house-price growth slowed substantially between mid-2014 and mid-2015, it has accelerated again more recently, outpacing the growth of nominal GDP. This price growth largely reflects the realignment of relative prices of housing in light of tight supply constraints and growing demand. There is little evidence of a credit-fueled boom: the growth of mortgage lending and the number of housing transactions still remain well below their pre-crisis levels.At the same time, two particular segments of the property market show signs of overheating. First, lending in the buy-to-let sector has grown from 4 percent of mortgage stock in 2002 to 16 percent in mid-2015. In view of this, the FPC requested powers of direction over this sector. As the FPC already has these powers over the buy-to-own market, this would level the regulatory playing field for residential mortgages.

Second, the commercial real estate (CRE) market, has also been buoyant, with annual price growth around 10 percent as of mid-2015, although it has slowed somewhat in early 2016. The prices of prime U.K.—and especially prime London—CRE properties have grown rapidly since 2013. Although a recent analysis by the BoE shows that the overvaluation of CRE properties is limited to certain prime locations, continued rapid price growth could further reduce rental yields and increase the probability of price reversals. Credit risks to domestic banks from a CRE price reversal are reduced in comparison to the run-up to the 2008 crisis: U.K. banks have reduced their commercial real estate exposure, and international investors now account for more than half of CRE financing flows. But the sector can pose a macroeconomic risk since the majority of small and medium firms rely on CRE as collateral.

Their Overall Observations.

Since the last FSAP, the U.K. financial system has put the legacy of the crisis behind it and has become stronger and more resilient. Five years ago, the financial system had stabilized but still faced major residual weaknesses. This FSAP found the system to be much stronger and thus better able to serve the real economy. Like all systems, the U.K. financial system is exposed to risks. Given its size, complexity, and global interconnectedness, if these risks were to materialize they could have a major impact not only on the U.K. but also on the global financial system. Financial stability in the U.K. is thus a global public good. At the same time, understanding, mitigating, and staying a step ahead of the evolving risks in such a complex system is a constant analytical and policy challenge for U.K. policy-makers and regulators.

Its position as a global hub exposes the U.K. financial system to global risks. Regardless of the trigger, global shocks, such as a negative growth shock in emerging markets, a rapid hike in global risk premia, or renewed tensions in the eurozone, would impact significantly U.K. banks and, more broadly, the financial system as a whole. Moreover, as the domestic credit cycle matures while interest rates remain at historic lows, trends in some segments of the U.K. property market—notably buy-to-let and commercial real estate—could become financial stability risks.

In addition, the uncertainties associated with the possibility of British exit from the EU weigh heavily on the outlook. A vote in favor of leaving would usher in a period of uncertainty and financial market volatility during the negotiation of the terms of British exit, which could take years. And the eventual exit deal would have profound effects on trade and the real economy, the “passporting” arrangements for financial institutions, and the location decisions of major international financial firms now headquartered in London. Though highly uncertain, these effects would have major long-term implications for the U.K. financial sector, its contribution to the domestic economy, and its global standing. Needless to say, these economic aspects are only one element of the decision that is for British voters to make.

The main parts of the U.K. financial system appear resilient. At the core of the system, banks have more than doubled their risk-weighted capital ratios from pre-crisis levels, strengthened liquidity, and reduced leverage. Stress tests by both the BoE and the FSAP show that the largest banks would be able to meet regulatory requirements and sustain the capacity to finance the economy in the face of severe shocks. The possible impact of Brexit, however, though potentially significant, is inherently difficult to quantify and has not been covered in the stress tests. U.K. insurers, asset managers, and central counterparties (CCPs) also appear resilient, based on assessments by the BoE, FCA, European financial authorities, and the FSAP.

Despite the apparent resilience of individual sectors, interconnectedness across sectors has the potential to amplify shocks and turn sector-specific distress systemic. New patterns of interconnectedness are emerging due to structural market shifts and new entrants in some markets. These changes are not, by themselves, inherently risky. But they create a major challenge for the supervisors, who should upgrade their capacity and tools to connect the dots across sectors.

This resilience reflects to a large extent a wave of regulatory reforms since the crisis, which are now near completion. These were aimed at strengthening regulation and supervision, thus reducing the probability of failures; and lowering the cost of failures and safeguarding the taxpayer. They are aligned with the global regulatory reform agenda, where the U.K. has played a leading role, and were complemented by steps to enhance the governance and conduct of financial firms, as well as the decision to ring-fence retail banking and related services from riskier activities of U.K. banks. Many of these reforms correspond to the recommendations of the 2011 FSAP (Appendix I).

The first major plank of the reforms was to overhaul financial sector oversight and focus it on systemic stability. The new macroprudential framework provides clear roles and responsibilities, adequate powers and accountability, and promotes coordination across agencies. Its track record to-date, albeit short, is encouraging. Microprudential and conduct oversight have also become more rigorous and hands-on. The focus of supervisory effort and resources on the resilience of the most important firms is appropriate from a systemic perspective, but it inevitably implies less individual attention to small and mid-size companies, for which supervisors rely more on data monitoring, thematic reviews, and outlier analysis. This tradeoff warrants constant vigilance, because the business models of smaller firms tend to be correlated and, regardless of their systemic impact, failures of even small firms can be a source of reputational risk for the supervisor. In view of the downward trend of the ratio of risk-weighted to total assets and methodological inconsistencies across banks, internal models should be reviewed closely. A new, sophisticated framework for annual stress tests of major banks is a key link between the microprudential and macroprudential frameworks, but further investment is needed to ensure it can deliver on its ambitious goals.

The BoE’s new liquidity framework is a key shock absorber, and attendant risks seem adequately managed. By ensuring the Bank is “open for business” in the event of distress, the BoE’s flexible framework can help stop the propagation of a shock through liquidity contagion. Access by a broader range of entities, including broker-dealers and CCPs, is a major plus, made possible by the fact that all entities with access to the framework are supervised by the BoE and PRA. Because the relative ease of access to BoE liquidity risks distorting over time the incentives of participating firms, the BoE needs to monitor their behavior for signs of moral hazard or regulatory arbitrage.

The other major plank of the agenda was to ensure that the failure of a financial firm, regardless of its size, would not compromise financial stability or burden the taxpayer. The transposition of the EU Bank Recovery and Resolution Directive has completed the reform of the U.K.’s Special Resolution Regime for banks, which is now broadly aligned with global standards. The resolution powers, tools, and coordination arrangements for crisis management domestically and cross-border are now much stronger. The key challenge now is to complete the process that will facilitate the resolvability of U.K. financial firms. This is a complex, multi-year task that involves, inter alia, the implementation of ring-fencing and Minimum Requirements for Own Funds and Eligible Liabilities (MREL). The authorities should also build on current arrangements to develop operational principles for funding of firms in resolution and establish an effective resolution regime for insurance companies whose failure could be systemic. Finally, given the systemic role played by U.K. banks in smaller jurisdictions that are not part of the Crisis Management Groups (CMGs), the U.K. authorities should develop appropriate cooperation arrangements with such host countries.

Are Broker Commission Trails At Risk?

From Australian Broker.

Banning trail commissions would have dire consequences on the mortgage broking industry, brokers have proclaimed, with some admitting they would consider leaving the sector.

Kim Hall, director of Smart & Simple Mortgage and Finance Consulting on NSW’s Central Coast, who attended the FBAA National Tour yesterday, told Australian Broker she is concerned by Steve Weston’s caution that trail commissions could be banned under ASIC’s remuneration review. Especially because she doesn’t believe upfront commission will be adjusted as a result.

“At present, broker remuneration is a mix of upfront commission and trail commission. Abolishing trail commission would essentially be a cut to total remuneration, as I don’t believe there is any proposal on the table to increase upfront commissions to compensate for the amount of trail that would be lost if it were banned,” Hall said.

“I think it’s fair to say that an overall cut to remuneration would be a concern for anyone regardless of which industry they’re in.”

Mardee Thomas, mortgage broker at 1st Street Home Loans in Sydney said axing trail commissions would have harmful effects on consumer outcomes.

“I think the biggest issue will be that it will promote mortgage churning, whereby brokers will move a client from one lender to another for the purpose of obtaining additional remuneration, with little-to-no regard for what is in the client’s best interests,” she told Australian Broker.

But because of this, however, Thomas said she doesn’t believe ASIC will ban trail.

According to Hall, there is a false perception that trail commission is income for nothing.

“Unfortunately there is a perception that trail is money for nothing, it’s not, it’s deferred remuneration paid on a monthly basis for continuing to look after that client on an ongoing basis.

“Good brokers invest a lot into the ongoing client relationship, they are often at the client’s beck and call well after the loan settles, and they also invest a lot into their business to continually improve the client experience.”

Hall told Australian Broker she would even consider leaving the industry if there were any drastic changes recommended by the review.

“Depending on the actual outcome of the review, exiting is a possibility if the numbers no longer stack up. But that’s the same as any industry; people do not stay in business if it’s no longer viable,” she said.

Thomas told Australian Broker that she would consider adopting a fee-for-service model to remain in the industry.

“I definitely wouldn’t consider leaving the industry as I really enjoy what I do and work with a wonderful group of people, though I believe we would then have to implement a fee-for-service for our clients’ requirements regarding ongoing support.”

Bank Fees Rose More than 3% Over The Year

According to the Australian Bankers Association, total bank fees paid by households and businesses were $12.5 billion in 2015. This is an increase of 3.4 per cent over the year, (which is significantly higher than inflation). The ABA report, Fees for banking services, was released, on the same day as the latest analysis from the RBA.

The mix of fees has changed, with more drawn from loans and payments, whilst fees on transaction accounts – a product used by virtually every household – are now at the lowest level in 15 years. Fees have fallen by $1 billion or 51 per cent since the peak in 2008, yet the number of transactions has increased by around 60 per cent over that same time.” “Households are paying an average of $9 a week in bank fees – the same as what we were paying in 2004”

The ABA highlighted the increased volumes of products and services accessed. “Banks provide around six million housing loans and last year alone approved more than 900,000 new home loans. The number of credit card accounts also increased last year by more than half a million to 13.5 million. So, the growth in fees paid on home loans and credit cards is low given many more of these products are in the market”

The RBA data, contained in the latest Bulletin, shows overall growth of 3.5%.

Banks’ fee income from households grew by 2.9 per cent in 2015, the third consecutive year of positive growth. Higher fee income largely reflected growth in fee income from credit cards, which grew strongly for the second consecutive year. Growth in housing and personal lending fees was moderate, while fee income from deposit products declined in 2015. Fee income from credit cards, the largest single source of fee income from households, increased strongly in 2015. The increase in fee income from credit cards was due to both more instances of fees being charged and an increase in unit fees on some products. An increase in currency conversion fees incurred by households for overseas purchases was largely a result of an increase in the number of foreign currency transactions, with only a small increase in average unit fees. Banks increased some unit fees during 2015, in particular those relating to credit card annual fees and cash advances. Several banks also increased fee income from credit cards through the acquisition of existing credit cards from other providers.

The main drivers of modest growth in fee income on personal lending were higher unit fees and increased turnover. Some banks also increased lending volumes, resulting in higher establishment and loan registration fee income. Exception fees and transaction fees on personal lending declined. Growth in fee income from housing loans was consistent with housing credit growth during 2015. Higher fee income was due to a higher volume of new loans, more instances of early repayment fees and, to some extent, higher unit fees on home loan packages. The major banks and large regional banks recorded the highest growth in housing loan fee income, while some smaller regional banks reported declines in fee income as a result of lower volumes of loans.

Fee income from deposit accounts declined further over 2015. The decline in fee income was broad based across most types of deposit fees, but there were notable declines in fee income relating to non-transaction accounts such as term deposits and online savings accounts.

Total fee income from businesses increased by 3.9 per cent, primarily reflecting higher fee income from small businesses. By product, growth in fee income from businesses continued to be driven by merchant fees and business loans. Fee income from bank bills declined sharply in 2015, similar to previous years. Fee income from other business products was little changed. The increase in loan fee income was mainly due to increases in unit fees for small business loans, although lending volumes also increased. Loan fee income from large businesses declined over 2015 as several banks lowered their unit fees due to increased competitive pressures.

Growth in merchant fee income over 2015 was evenly spread across small and large businesses. The increase in income from merchant fees was largely a result of growth in the number and value of transactions, resulting from a higher number of merchant terminals on issue and increased use of contactless payments. This partially offset a decline in fees earned on cash payment services, via ATM and deposit account withdrawals. A few banks also increased unit fees on merchant services, although the ratio of merchant fee income to the value of credit and debit card transactions continued to decline during 2015. Fee income from business deposit products also declined slightly. This was mainly due to a reduction in deposits held by these customers; however, the decline in fee income was also the result of customer switching between deposit accounts in order to make use of lower fee products.