Economics and Banking – Page 393 – Digital Finance Analytics (DFA) Blog

Fed Still Thinks Policy Rate Will Rise – Over Time

Fed Chair Yellen’s latest speech confirms that rate rises are still on the cards, at some point despite the latest poor jobs data. But is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy?

Let me now turn to the implications of the economic outlook, as well as the uncertainties associated with that outlook, for monetary policy. My overall assessment is that the current stance of monetary policy is generally appropriate, in that it is providing support to the economy by encouraging further labor market improvement that will help return inflation to 2 percent. At the same time, I continue to think that the federal funds rate will probably need to rise gradually over time to ensure price stability and maximum sustainable employment in the longer run.

Several considerations lead me to this conclusion. First, the current stance of monetary policy is stimulative, although perhaps not as stimulative as might appear at first glance. One useful measure of the stance of policy is the deviation of the federal funds rate from a “neutral” value, defined as the level of the federal funds rate that would be neither expansionary nor contractionary if the economy was operating near potential. This neutral rate changes over time, and, at any given date, it depends on a constellation of underlying forces affecting the economy. At present, many estimates show the neutral rate to be quite low by historical standards–indeed, close to zero when measured in real, or inflation-adjusted, terms.¹³ The current actual value of the federal funds rate, also measured in real terms, is even lower, somewhere around minus 1 percent. With the actual real federal funds rate modestly below the relatively low neutral real rate, the stance of monetary policy at present should be viewed as modestly accommodative.

Although the economy is now fairly close to the FOMC’s goal of maximum employment, I view our modestly accommodative stance of policy as appropriate for several reasons. First, with inflation continuing to run below our objective, a mild undershooting of the unemployment rate considered to be normal in the longer run could help move inflation back up to 2 percent more quickly. Second, a stronger job market could also support labor market improvement along other dimensions, including greater labor force participation. A third reason relates to the risks associated with the constraint on conventional monetary policy when the federal funds rate is near zero. If inflation were to move persistently above 2 percent or the economy were to become notably overheated, the Committee could readily increase the target range for the federal funds rate. However, if inflation were to remain persistently low or the expansion were to falter, the FOMC would be able to provide only a limited amount of additional stimulus through conventional means.

These motivations notwithstanding, I continue to believe that it will be appropriate to gradually reduce the degree of monetary policy accommodation, provided that labor market conditions strengthen further and inflation continues to make progress toward our 2 percent objective. Because monetary policy affects the economy with a lag, steps to withdraw this monetary accommodation ought to be initiated before the FOMC’s goals are fully reached. And if the headwinds that have lingered since the crisis slowly abate as I anticipate, this would mean that the neutral rate of interest itself will move up, providing further impetus to gradually increase the federal funds rate. But I stress that the economic outlook, including the pace at which the neutral rate may shift over time, is uncertain, so monetary policy cannot proceed on any preset path.

This point is well illustrated by events so far this year. For a time in January and early February, financial markets here and abroad became turbulent and financial conditions tightened, reflecting and reinforcing concerns about downside risks to the global economy. In addition, data received during the winter suggested that U.S. growth had weakened even as progress in the labor market remained solid. Because the implications of these developments for the economic outlook were unclear, the FOMC decided at its January, March, and April meetings that it would be prudent to maintain the existing target range for the federal funds rate.

Over the past few months, financial conditions have recovered significantly and many of the risks from abroad have diminished, although some risks remain. In addition, consumer spending appears to have rebounded, providing some reassurance that overall growth has indeed picked up as expected. Unfortunately, as I noted earlier, new questions about the economic outlook have been raised by the recent labor market data. Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015? Does the latest reading on the unemployment rate indicate that we are essentially back to full employment, or does relatively subdued wage growth signal that more slack remains? My colleagues and I will be wrestling with these and other related questions going forward.

Limiting access to payday loans may do more harm than good

From The US Conversation.

One of the few lending options available to the poor may soon evaporate if a new rule proposed June 2 goes into effect.

The Consumer Financial Protection Bureau (CFPB) announced the rule with the aim of eliminating what it called “debt traps” caused by the US$38.5 billion payday loan market.

But will it?

What’s a payday loan?

The payday loan market, which emerged in the 1990s, involves storefront lenders providing small loans of a few hundred dollars for one to two weeks for a “fee” of 15 percent to 20 percent. For example, a loan of $100 for two weeks might cost $20. On an annualized basis, that amounts to an interest rate of 520 percent.

In exchange for the cash, the borrower provides the lender with a postdated check or debit authorization. If a borrower is unable to pay at the end of the term, the lender might roll over the loan to another paydate in exchange for another $20.

Thanks to their high interest, short duration and fact that one in five end up in default, payday loans have long been derided as “predatory” and “abusive,” making them a prime target of the CFPB since the bureau was created by the Dodd-Frank Act in 2011.

States have already been swift to regulate the industry, with 16 and Washington, D.C., banning them outright or imposing caps on fees that essentially eliminate the industry. Because the CFPB does not have authority to cap fees that payday lenders charge, their proposed regulations focus on other aspects of the lending model.

Under the proposed changes announced last week, lenders would have to assess a borrower’s ability to repay, and it would be harder to “roll over” loans into new ones when they come due – a process which leads to escalating interest costs.

There is no question that these new regulations will dramatically affect the industry. But is that a good thing? Will the people who currently rely on payday loans actually be better off as a result of the new rules?

In short, no: The Wild West of high-interest credit products that will result is not beneficial for low-income consumers, who desperately need access to credit.

I’ve been researching payday loans and other alternative financial services for 15 years. My work has focused on three questions: Why do people turn to high-interest loans? What are the consequences of borrowing in these markets? And what should appropriate regulation look like?

One thing is clear: Demand for quick cash by households considered high-risk to lenders is strong. Stable demand for alternative credit sources means that when regulators target and rein in one product, other, loosely regulated and often-abusive options pop up in its place. Demand does not simply evaporate when there are shocks to the supply side of credit markets.

This regulatory whack-a-mole approach which moves at a snail’s pace means lenders can experiment with credit products for years, at the expense of consumers.

Who gets a payday loan

About 12 million mostly lower-income people use payday loans each year. For people with low incomes and low FICO credit scores, payday loans are often the only (albeit very expensive) way of getting a loan.

My research lays bare the typical profile of a consumer who shows up to borrow on a payday loan: months or years of financial distress from maxing out credit cards, applying for and being denied secured and unsecured credit, and failing to make debt payments on time.

Perhaps more stark is what their credit scores look like: Payday applicants’ mean credit scores were below 520 at the time they applied for the loan, compared with a U.S. average of just under 700.

Given these characteristics, it is easy to see that the typical payday borrower simply does not have access to cheaper, better credit.

Borrowers may make their first trip to the payday lender out of a rational need for a few bucks. But because these borrowers typically owe up to half of their take-home pay plus interest on their next payday, it is easy to see how difficult it will be to pay in full. Putting off full repayment for a future pay date is all too tempting, especially when you consider that the median balance in a payday borrowers’ checking accounts was just $66.

The consequences of payday loans

The empirical literature measuring the welfare consequences of borrowing on a payday loan, including my own, is deeply divided.

On the one hand, I have found that payday loans increase personal bankruptcy rates. But I have also documented that using larger payday loans actually helped consumers avoid default, perhaps because they had more slack to manage their budget that month.

In a 2015 article, I along with two co-authors analyzed payday lender data and credit bureau files to determine how the loans affect borrowers, who had limited or no access to mainstream credit with severely weak credit histories. We found that the long-run effect on various measures of financial well-being such as their credit scores was close to zero, meaning on average they were no better or worse off because of the payday loan.

Other researchers have found that payday loans help borrowers avoid home foreclosures and help limit certain economic hardships.

It is therefore possible that even in cases where the interest rates reach as much as 600 percent, payday loans help consumers do what economists call “smoothing” over consumption by helping them manage their cash flow between pay periods.

In 2012, I reviewed the growing body of microeconomic evidence on borrowers’ use of payday loans and considered how they might respond to a variety of regulatory schemes, such as outright bans, rate caps and restrictions on size, duration or rollover renewals.

I concluded that among all of the regulatory strategies that states have implemented, the one with a potential benefit to consumers was limiting the ease with which the loans are rolled over. Consumers’ failure to predict or prepare for the escalating cycle of interest payments leads to welfare-damaging behavior in a way that other features of payday loans targeted by lawmakers do not.

In sum, there is no doubt that payday loans cause devastating consequences for some consumers. But when used appropriately and moderately – and when paid off promptly – payday loans allow low-income individuals who lack other resources to manage their finances in ways difficult to achieve using other forms of credit.

End of the industry?

The Consumer Financial Protection Bureau’s changes to underwriting standards – such as the requirement that lenders verify borrowers’ income and confirm borrowers’ ability to repay – coupled with new restrictions on rolling loans over will definitely shrink the supply of payday credit, perhaps to zero.

The business model relies on the stream of interest payments from borrowers unable to repay within the initial term of the loan, thus providing the lender with a new fee each pay cycle. If and when regulators prohibit lenders from using this business model, there will be nothing left of the industry.

The alternatives are worse

So if the payday loan market disappears, what will happen to the people who use it?

Because households today face stagnant wages while costs of living rise, demand for small-dollar loans is strong.

Consider an American consumer with a very common profile: a low-income, full-time worker with a few credit hiccups and little or no savings. For this individual, an unexpectedly high utility bill, a medical emergency or the consequences of a poor financial decision (that we all make from time to time) can prompt a perfectly rational trip to a local payday lender to solve a shortfall.

We all procrastinate, struggle to save for a rainy day, try to keep up with the Joneses, fail to predict unexpected bills and bury our head in the sand when things get rough.

These inveterate behavioral biases and systematic budget imbalances will not cease when the new regulations take effect. So where will consumers turn once payday loans dry up?

Alternatives that are accessible to the typical payday customer include installment loans and flex loans (which are a high-interest revolving source of credit similar to a credit card but without the associated regulation). These forms of credit can be worse for consumers than payday loans. A lack of regulation means their contracts are less transparent, with hidden or confusing fee structures that result in higher costs than payday loans.

Oversight of payday loans is necessary, but enacting rules that will decimate the payday loan industry will not solve any problems. Demand for small, quick cash is not going anywhere. And because the default rates are so high, lenders are unwilling to supply short-term credit to this population without big benefits (i.e., high interest rates).

Consumers will always find themselves short of cash occasionally. Low-income borrowers are resourceful, and as regulators play whack-a-mole and cut off one credit option, consumers will turn to the next best thing, which is likely to be a worse, more expensive alternative.

Author: Paige Marta Skiba, Professor of Law, Vanderbilt University

Monetary/fiscal policy mix has implications for debt and financial stability

The mix of monetary and fiscal policies in an economy has important implications for debt levels and financial stability over the medium term, Bank of Canada Governor Stephen S. Poloz said.

In the Doug Purvis Memorial Lecture given at the Canadian Economics Association’s annual conference, Governor Poloz used the Bank’s main policy model to construct three “counterfactual” scenarios of events from the past 30 years that show how different policy mixes can influence the amount of debt taken on by the private and public sectors.

Tight monetary policy with easy fiscal policy may lead to the same growth and inflation results as easy monetary policy paired with tight fiscal policy in a given situation, the Governor explained. However, the consequences for government and private sector debt levels would be quite different.

Recent experience in Canada and elsewhere shows that debt levels—whether public or private—can provoke financial stability concerns, said Governor Poloz. The insight about policy mix is important as authorities worldwide work to incorporate financial stability issues into the conduct of monetary policy, he added.

The Governor stressed that the counterfactuals are intended to illustrate the impact of the policy mix on debt levels; they aren’t meant to be taken as an opinion about what the best policy mix was in the past or is now.

“Hindsight is always 20:20 and such a discussion would have little meaning,” Governor Poloz said. “The best mix of monetary and fiscal policy will depend on the economic situation.”

There should be a degree of coordination between the monetary and fiscal authorities that allows both to be adequately informed of each other’s policies and consider their implications on debt levels over the medium term, the Governor said. In Canada’s case, the central bank operates under an explicit inflation-targeting agreement with the federal government that enshrines its operational independence, while allowing for both parties to share information and judgment, Poloz said. This framework represents “a simple yet elegant form” of policy coordination, he noted.

The lecture honours Doug Purvis, a Canadian macroeconomist and Queen’s University professor. In 1985, Purvis delivered the Harold Innis Lecture, in which he argued that rising government debt levels would eventually compromise the ability of authorities to implement stabilization policies. Governor Poloz said his lecture today is meant to build on Purvis’ initial insights by bringing more advanced macroeconomic models to bear on the topic, and linking them to the topical issue of financial stability.

Major Banks Under Pressure?

The latest data from APRA to March 2016 relating to the financial position of the banking sector, makes interesting reading. Net Profit after tax for the sector fell 12.5% to $30.8 billion, total assets rose 1.1% from March 2015 and the capital adequacy ratio rose 1.1% to 13.8%. Total provisions were down 13.9% compared with March 2015.

However, once again we have calculated some key ratios, and overlaid this over their loans and advances and there are a number of stresses revealed when we look at the four major banks. Their total provisions are lower despite a rise in consumer delinquency and specific commercial risks, capital adequacy is lower in the past quarter (despite all the raising), and the ratio of loans to share capital, while up slightly, is still lower than in 2010. The sector is under pressure and we think dividend payouts will have to fall and provisions will need to rise.

APRA says

on a consolidated group basis, there were 156 ADIs operating in Australia as at 31 March 2016, compared to 157 at 31 December 2015 and 165 at 31 March 2015.

The net profit after tax for all ADIs was $30.8 billion for the year ending 31 March 2016. This is a decrease of $4.4 billion (12.5 per cent) on the year ending 31 March 2015.

The cost-to-income ratio for all ADIs was 50.0 per cent for the year ending 31 March 2016, compared to 48.4 per cent for the year ending 31 March 2015.

The return on equity for all ADIs was 11.6 per cent for the year ending 31 March 2016, compared to 14.2 per cent for the year ending 31 March 2015.

The total assets for all ADIs was $4.53 trillion at 31 March 2016. This is an increase of $51.1 billion (1.1 per cent) on 31 March 2015.

The total gross loans and advances for all ADIs was $2.91 trillion as at 31 March 2016. This is an increase of $89.0 billion (3.2 per cent) on 31 March 2015.

The total capital ratio for all ADIs was 13.8 per cent at 31 March 2016, an increase from 12.7 per cent on 31 March 2015.

The common equity tier 1 ratio for all ADIs was 10.3 per cent at 31 March 2016, an increase from 9.2 per cent on
31 March 2015.

The risk-weighted assets (RWA) for all ADIs was $1.83 trillion at 31 March 2016, an increase of $25.9 billion (1.4 per cent) on 31 March 2015.

Impaired facilities were $14.4 billion as at 31 March 2016. This is a decrease of $0.8 billion (5.2 per cent) on 31 March 2015.

Past due items were $12.5 billion as at 31 March 2016. This is an increase of $18.1 million (0.1 per cent) on 31 March 2015; Impaired facilities and past due items as a proportion of gross loans and advances was 0.93 per cent at 31 March 2016, a decrease from 0.98 per cent at 31 March 2015.

Specific provisions were $6.9 billion at 31 March 2016. This is a decrease of $16.7 million (0.2 per cent) on 31 March 2015; and specific provisions as a proportion of gross loans and advances was 0.24 per cent at 31 March 2016, a decrease from 0.25 per cent at 31 March 2015.

Brokers Are The Winners In The Home Loan Wars

The latest Quarterly ADI Property Exposure stats from APRA paints an interesting picture of lending for residential property. Total stock of loans across the 150 entities tracked was $1.4 trillion. In the last quarter, $81.7 billion of loans were approved, down by 1.2% a year ago but the average loan balance rose by 5% to $252,000 and the number of loans rose 4% compared with a year ago. Brokers received around $247m in upfront commissions in the quarter from ADIs and generated about 46% of loans by value. The current ASIC review of broker remuneration is therefore highly relevant.

Looking at the banks, we see the mix of investment loans sitting at 36%, down from its high of 39% in 2015. The recent switches between owner occupied and investment loans – around $40 billion, shows in the results.

The proportion of interest only loans, which at a portfolio level, is sitting at 30% is still close to the record of 30.3%. Interest only loans are taken by investors wanting to maximise their tax benefits, and owner occupied borrowers trying to reduce monthly repayments. Regulators have recently been concerned about the status of these loans, and now new loans have to have a repayment plan, even if interest only. What though of interest only loans written before the tighter standards?

It is important to highlight that though the proportion of new loans being written on an interest only basis is around 35%, (from a peak of 43% in 2015), the major banks are still writing a larger share than portfolio, so expect to see continued growth in the interest only sector.

We see the regulator’s hand when we look at the new loans, and those over 90% loan to value (LVR). Around 10% of loans are written above this threshold, whereas in 2008 banks lent more than 20% above this level. Also worth noting that credit unions and building societies had a spurt of higher LVR lending in 2013/15, as they completed for business.

We see a rise in the proportion of loans originated by brokers. Around 50% of new loans come though this channel. We also see a rise in the proportion of building societies using brokers, and credit unions are also on the train along with foreign banks. Brokers have become a significant influence in the market and lenders have to work with them (at the expense of loans via branch channels). This changes the competitive landscape, and the economics of loan origination.

Finally, we see a fall in non-standard loans, though around 4% of new loans are still being written outside standard terms.

Fast finance with new online NAB QuickBiz Loan

National Australia Bank (NAB) today announced it will introduce a new $50,000 unsecured business loan for Australian small businesses.

The NAB QuickBiz Loan, which has been developed by in-house innovation hub NAB Labs and will launch in early June, allows eligible customers to apply for up to $50,000 in funding via a new online application process.
The new online platform uses NAB’s Application Programming Interface (API) technology to assist with the credit check on the customer’s application and provide an automated credit decision within minutes. Customers will have finance for their business account within three days of NAB receiving their signed loan document.

NAB Group Executive Business Banking Angela Mentis said: “The Australian economy relies on entrepreneurs who innovate, establish new industries and create jobs. As the biggest business bank in the country, we stand ready to back Australian businesses with great ideas, providing simple, quick funding solutions to support small businesses looking to grow”.

New NAB research shows around 1 in 3 Australians would like to run their own business with young Australians clearly the most aspirational (nearly 1 in 2) and this offer will help businesses in those early years with the important cash flow they may need.

The research also showed that banking support (49%) is still commonly cited as a critical element to building businesses.

“In the early days of business ownership, small businesses often only require small amounts of funding – and many owners don’t have a property or other significant assets to secure a loan against. We’re responding to these customer needs, placing more emphasis on the strength of the business rather than traditional physical bricks and mortar security,” Ms Mentis said.

The initiative means NAB is the only big four bank to offer such an online service without a third party referral involved.

Executive General Manager NAB Labs, Jonathan Davey, said the NAB QuickBiz Loan was another example of the bank’s agile approach to meet customer needs.

“We are listening to our customers and focusing on the development of capabilities to drive better customer experiences,” Mr Davey said.

“It’s another example of NAB Labs agile development and rapid prototyping approach, where we build to decide, rather than decide to build, delivering solutions that make a real difference for our customers.”

Mortgage brokers: ASIC goes fishing

From The Conversation.

The Australian Securities and Investments Commission (ASIC) inquiry into the way mortgage brokers are paid may uncover some isolated shady dealings but the system of remuneration for brokers is already regulated well enough by intense competition.

Assistant Treasurer Kelly O’Dwyer announced the inquiry last year in line with recommendations from the Financial System Inquiry and ASIC recently commenced the inquiry with a scoping paper. The focus is likely to be on whether the advice of brokers is in the best interests of the customers.

As always, there are questions about whether the remuneration incentives for brokers distort their advice. And, again as always, there are questions about whether the fact that big banks own some brokers leads these brokers to favour the products of their owners, and not necessarily to offer the products most appropriate to the customer.

In many ways, the inquiry is just part of the ongoing reviews of different parts of the finance sector. The same arguments are likely to be rehashed.

In announcing the review, ASIC Commissioner Peter Kell was clear that:

“We are focused on consumer protection issues in the context of personal credit products, ranging from small amount credit contracts through to home loans.”

There has been some discussion in the press that loans organised by brokers default at a higher rate than loans written by banks. The Australian Prudential Regulation Authority (APRA) might regard this as a concern for financial stability, but ASIC will be concerned with whether people are getting loans they really should not be. The focus will clearly be on consumer outcomes.

It’s worth looking at the mortgage broking sector mainly because it has been growing rapidly and is now quite big. About half of all mortgages are provided through brokers, up from 40% a decade ago. The upfront commissions for brokers are about 0.5%, which yields annual revenue of close to A$2 billion.

So it is a big and rapidly growing financial sector and ASIC has duly been charged to have a look around for problems. Australia already has laws addressing any concerns. The National Consumer Protection Act has, since 2011, put the onus on providers to act in the best interests of customers. ASIC is really just checking up that the law is being complied with.

While there may be some bad behaviour, it is hard to see what the concern is. People have a choice.

They can go to their own financial institution and buy a mortgage direct from the manufacturer. Alternatively, they can look around among financial institutions to find the mortgage that works for them.

Now they can also go to one of the dozens of mortgage brokers to see if one of them can find a better deal. From the customers’ point of view, there are hundreds of retail outlets (banks and mortgage brokers) offering mortgages.

The fact that mortgage brokers are taking market share away from the banks suggests that customers really appreciate the mortgage broker effectively cutting the buyer’s cost of searching.

There shouldn’t be a problem with the banks paying the broker for delivering the customer, as there is a clear cost saving to the bank. It does not need to have as many branches or as many staff.

Seen from the bank’s point of view, it can originate the mortgage through its own branch and incur some overhead and running costs, or initiate the loan through the broker channel and pay the broker for its overhead and running costs.

Ultimately, the client is buying a product, in this case a mortgage. The price the customer pays is transparent, as are the terms and conditions.

If brokers were not providing a good service, customers could easily swing back to searching for their own mortgage among the banks, or simply walk down the street to another broker. Smart customers will thus keep the providers honest and make sure competition works as it should.

There is a not a lot of academic research into the issues associated with remunerating mortgage brokers. What there is tends to be from the US, which has not had a good record in managing mortgages over recent years. The most relevant paper suggests that loan quality can be improved though requiring registration, higher education standards and continuing education and/or by requiring brokers to post bonds.

The ASIC inquiry will uncover more information about the sector. It may also find some people have behaved badly (as in any area of human endeavour), but it’s hard to see a significant structural problem in a very competitive market.

Author: Rodney Maddock, Vice Chancellor’s Fellow at Victoria University and Adjunct Professor of Economics, Monash University

Home Lending Rises Again To New Record $1.56 trillion

Latest credit aggregate data from the RBA today, shows lending momentum to business and the housing sector remained strong. As a result, total lending to residential property rose by $6.7 billion or 4.3% to $1.56 trillion, seasonally adjusted, with loans for owner occupation comprising $6.0 billion and $0.7 billion for investment housing. Business lending rose by $6.5 billion, or 0.76% to $854 billion. Housing lending is still growing at 7% annualised, well above inflation and income growth. This is sufficient to maintain home price growth.

Investment lending makes more than 35.4% of all lending for housing, and all lending for housing comprises more than 60% of all lending in Australia. So the banks remain strongly leveraged to the housing sector.

Looking at the 12 month growth rates, we see investment lending sliding from about 10% last year to around 6.5%, business lending growing at 7.4% and lending for owner occupation growing at 7.3%. These growth trends contain the adjustments between owner occupied and investment lending due to reclassification.

The RBA says:

Following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $40 billion over the period of July 2015 to April 2016 of which $1.2 billion occurred in April. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

Will Australia’s big banks reap $7.4 billion over ten years from company tax cuts?

From The Conversation.

Opposition Leader Bill Shorten’s line of attack during the leaders’ debate focused squarely on the Coalition’s long-term plan to cut the company tax rate from 30% to 25%.

Twice during the debate Shorten said the proposed tax cuts equated to giving A$7.4 billion over ten years to Australia’s big four banks (National Australia Bank, the Commonwealth Bank, ANZ and Westpac).

Is that right?

Checking the source

When asked for a source to support that assertion, a Labor spokeswoman referred The Conversation to modelling conducted by think-tank The Australia Institute.

The Labor spokeswoman said:

Bill was emphasising the clear point of contrast in this election campaign, which is that Malcolm Turnbull wants to spend $50 billion giving huge companies a tax cut while Labor wants to invest in schools, Medicare and growing good jobs.

The Australia Institute modelling

In a press release, The Australia Institute said that for their economic modelling:

The value of company tax provisions was derived from 2015 full year annual reports for the big four banks. That figure summed to $11,123 million. That figure was projected forward to 2026-27 to give the no-change scenario.

To arrive at the figure of $7.4 billion, The Australia Institute modelling assumed bank profit would increase in line with nominal Gross Domestic Product. Under this assumption, the amount of tax payable would also increase in line with nominal GDP. This would give nominal increases of:

2.5% in 2015-16;

4.25% in 2016-17; and

5% in 2017-18 and subsequent years.

As the think tank noted in its press release, the company tax cuts would not affect the big banks until 2024-25. That’s when the 30% company tax rate will fall to 27% for all companies with further reductions of 1% per year, hitting 25% in 2026-27.

The Australia Institute calculated the following results:

The Australia Institute

A reasonable guesstimate – but not a fact

On these calculations, the “$7.4 billion over the next ten years” claim is not a fact. But it’s also not an unreasonable guesstimate – although it is, of course, really over the three years from 2024-25 through 2026-27. There is no advantage to the big banks over the first seven of the next ten years.

According to the Australian Taxation Office, the four big banks paid a total of $9.5 billion in company tax in the 2013-14 financial year.

The government has proposed increasing the turnover threshold below which the rate of company tax payable is 27.5%, from $10 million in 2016-17 to $1 billion in 2022-23.

The government’s proposed policy says that the company tax rate for all companies (including the four big banks) with turnover exceeding $1 billion will fall from 30% to 27% in 2024-25, and then by a further one percentage point in 2025-26 and another percentage point (to 25%) in 2026-27.

So, on that basis, The Australia Institute’s maths checks out.

A grain of salt

As with all economic modelling, this modelling and any claims based on it should be taken with a large grain of salt.

Any assumption about the banks’ profit growth over the next ten years is entirely arbitrary, and I have no idea whether it is at all justified. Only time will tell.

If the banks’ profits grew by only 2% per annum over this period, then the benefit to them from the cut in the company tax rate proposed by the Coalition would be “only” $4.8 billion; if they grew by 10% per annum the benefit to them would be $12 billion (over the three years from 2024-25 to 2026-27).

Verdict

Shorten’s statement relies on modelling assumptions made by The Australia Institute think-tank about bank profit growth. It is not a statement of fact but rather a guesstimate. It is not an unreasonable guesstimate, but depends entirely on whether the think tank’s assumptions about bank profit growth come true or not. – Saul Eslake

Review

This article correctly reflects the analysis of The Australia Institute upon which the claim of a “windfall” for the large banks has been based. As the author notes, the baseline figure is a guesstimate based on not unreasonable assumptions about the growth of the economy and the impact of the proposed business tax cuts upon bank profits, albeit seven years out. – Pat McConnell

Author: Saul Eslake, Vice-Chancellor’s Fellow, University of Tasmania; Reviewer, Pat McConnell, Honorary Fellow, Macquarie University Applied Finance Centre, Macquarie University

Climate Risks For Property Owners And Their Bankers

Mortgage underwriting is all about correctly assessing risks. How much is the property worth? How big is the loan? How well placed are the borrowers to repay the loan? What is the credit risk? But, according to a new discussion paper There goes the neighbourhood: Climate change, Australian housing and the financial sector by the Climate Institute, banks and their customer need to be more alert to risks associated with Climate Change.

I spoke to the author, Kate Mackenzie, about the paper which highlights important issues for lenders and prospective purchasers. She says banks should be undertaking detailed portfolio modelling to analyse the current and future risks in their property loan portfolios (after all their insurers have the data), and prospective purchasers should be exploring the impacts from floods and other natural forces before purchase (there are tools available, or try getting online insurance quotes for a prospective property). She says that Local Authorities may sometime grant planning approvals on land which is or will become risk prone, and buyers should beware.

The report says that some of the homes built, bought and sold in Australia are vulnerable to flood, cyclone and bushfire, as well as growing risks such as storm surge, landslip and coastal erosion. Australia is highly exposed to climate change and this will exacerbate many of these risks. Whilst It is often possible to “defend” or “adapt” housing to some of these risks, not all are adaptable, and some only at a prohibitive expense.

Unsurprisingly, individual buyers and residents are often unaware of risk levels, particularly rising levels of risk or emerging risks. Even when public authorities, financial institutions and other stakeholders possess information about current and future risk levels, they are sometimes unwilling, and sometimes unable, to share it with all affected parties.Thus, foreseeable risks are allowed to perpetuate, and even to grow via new housing builds. The full scale of the risk may only be recognised either through disaster or damage, or when insurance premiums become unaffordable. Any of these events can in turn affect housing values. Damaged, destroyed or devalued housing has social costs – either to individuals, or to the broader public via government. Australia’s housing stock is expanding, and with continuing gaps in policy, regulations and industry, it is highly likely that some of this new stock is more vulnerable than buyers, residents and other stakeholders would assume.

Virtually all banks, in every year, clearly identified risks of climate impacts to their own operations, and describe measures taken to ameliorate this. Most banks, in most years, cited indirect risk via institutional financing, in particular to the agricultural sector. In some cases, banks described developing and deploying screening methods to ameliorate this risk.

However, references to climate impacts via residential property were far patchier. Several banks, for example, referred to material risks via their customers’ ability to repay mortgages, and even referred to studies of the aggregate exposure of Australian housing to climate impacts. Moreover, the banks’ own industry group, the Australian Banking Association, has been relatively silent on this matter.

Industry has tended to defend its position, but the paper offers some important commentary on their arguments.

1. Property value in land: The assertion that the property’s value is solely in the land rather than the building will be irrelevant in several scenarios, particularly when we consider climate change. For example, there are limitations to measures that can mitigate the effects of coastal erosion. Land that is at increasingly frequent risk of flooding may be still suitable for dwellings, but the increasing cost will reduce the value of the properties. This has been seen in bushfire prone areas.

2. Full-recourse loans protect banks: Australian mortgages are almost universally issued on a “non-recourse” basis. This means that, in contrast to some US states, borrowers cannot simply “hand back the keys” to their lender, thereby offloading their obligations. In Australia, the risk of property devaluation remains with the individual, while the banks are relatively protected from a scenario in which borrowers default on properties that become worth less than the amount of the outstanding loan.

3. Already incorporated into credit risk practices: A review of big four bank submissions to CDP (formerly Carbon Disclosure Project) reveals a broad range of approaches to physical climate risk in the residential mortgage portfolio. While all banks discuss climate impact resilience measures for their own property portfolio (bank branches etc.), and two banks mention incorporating physical climate risk into their commercial lending practices, there is little mention of incorporating physical climate risk into residential property lending risk assessments.

4. Size and distribution of property portfolios mean this couldn’t be material for big banks: Several banks have already disclosed exact amounts of provisioning following natural disasters. In fact, at least three of the big four banks have individually acknowledged there is some risk. Westpac has acknowledged in several CDP submissions that increased flood risk from climate change represents a risk to its mortgage and other loan assets, ANZ in 2007 said it would begin to devise a method to analyse this risk and NAB states that it is exposed to the physical effects of climate change to its customers, not only in residential property, but also as an agri-business lender.

It is true that all amounts of costs incurred to date are small relative to the banks’ overall balance sheets – for example, NAB reported a $76 million provision for bad and doubtful debts associated with the 2011 floods in Queensland and Victoria. However the nature of climate change means these risks will increase – particularly if urban, coastal development continues to grow without adequate resilience standards.

5. Use of mortgage insurance removes risk to banks: Mortgage insurance is taken out by banks to protect against loss from mortgage defaults, particularly where the loan-to-valuation ratio is high, or when the borrower is deemed high risk. Lenders mortgage insurers (LMIs) are the providers of this cover. In terms of financial risk, LMIs will specifically not cover loss due to natural hazards. There is also debate around the role of LMIs in Australia, in terms of their own financial stability and their role in the broader financial system. An RBA report in 2013 noted that while industry practices have mitigated some risks related to LMIs, they are highly correlated to the broader mortgage market. Therefore, in a credit market downturn, LMIs could be procyclical, or at least fail to be counter-cyclical. Another limitation of LMIs is that they only cover about a quarter of all mortgages. The limitations of LMIs as a hedge against mortgage losses are illustrated by mortgage-related losses suffered by several banks due to natural disasters. Finally, Australia’s prudential supervisor, APRA, has explicitly limited the amount of protection that banks can assign to LMI, by placing a floor of 20 per cent for “loss given default” on internal risk-based (IRB) models. This is the same whether or not the mortgage is covered by LMI.

6. Average mortgage duration: Average mortgage age in Australia is thought to be around 4.5 to 5 years. However this is an average from a market that has, in aggregate, grown every year for decades. Although definitive data is not collected on non-securitised mortgage age, it is likely a proportion is due to owners “cashing out” as prices rise. This is unlikely to be a mitigating factor for banks with up to 25-year mortgage exposures on risky properties.

The paper recommends Australian banks should:

examine climate risk to their own mortgage books and ensure it is integrated into their risk assessment processes
use their role as the predominant providers of property development finance to support good policy – both through individual commercial lending decisions and through submissions to and engagement with policymakers
work with other stakeholders – in the public, private and civil society sectors – to research and develop ways to minimise climate impact risk to housing, and to address losses that will occur in an equitable way
actively support the development of: an open and accessible platform for natural peril data, including both historical incidence and projected or emerging risks due to climate change and policy to achieve this outcome
make information publicly available so that market expectations can adjust gradually, avoiding sudden, detrimental impacts.

The Climate Institute is Australia’s leading climate policy and advocacy specialist. Backed primarily through philanthropic funding, the Institute has been marking solutions to climate change happen, through evidence based advocacy and research, since 2007.