Category: Economics and Banking

Remuneration Review to Extend Beyond Brokers (But In Secret)

ASIC has evidently released the final scope of its review of remuneration in the mortgage broking industry – but only to industry insiders. According to media, the corporate regulator has confirmed it will review the remuneration arrangements of “all industry participants forming part of the value distribution chain”. This includes lending institutions, aggregation and broking entities, and associated mortgage businesses – such as comparison websites and market based lending websites – and referral and introducer businesses.

But why, we ask, was the scope not publicly disclosed? Why are ASIC seeking input only from industry participants? We agree the remuneration review is required – but the lack of transparency is a disgrace.

We asked ASIC about this and they replied:

At this point in time, ASIC has not published a media release commenting on the review or making the review available for download at this stage.

ASIC will usually put out a public statement, such as a media release or media advisory, on significant regulatory activities and outcomes, in order to:

  1. be transparent and accountable for what we do
  2. help inform our regulated population and the public of expected standards and of our priorities and areas of focus.

So they are happy with a private review evidently!

Worth also bearing in mind, the UK banned commission payments in the mortgage industry, which has moved to a fee for service model.

From Australian Broker.

ASIC has released the final scope of its review into the mortgage broking industry, in which it confirms the review will extend far beyond mortgage brokers.

The final scope, released to the industry yesterday, sets out the parameters of the review. These were informed by input received from industry and consumer representatives through industry roundtables and subsequent written feedback. In it, the corporate regulator has confirmed it will review the remuneration arrangements of “all industry participants forming part of the value distribution chain”.

This includes lending institutions, aggregation and broking entities, and associated mortgage businesses – such as comparison websites and market based lending websites – and referral and introducer businesses.

ASIC also confirmed the review will extend to non-monetary benefits that relate to the distribution of residential loan products.

However, the review will not extend to loan products outside of residential mortgages, such as reverse mortgages or construction loans, which do not comprise a predominate proportion of the home lending mortgage market.

NAB has already come out in support of ASIC’s final scope.

“We believe ASIC’s scope is appropriate and we look forward to continuing to work with the regulator throughout the review,” Anthony Waldron, NAB EGM broker partnerships, said.

“We’re dedicated to working with brokers to deliver a great customer experience and we believe this review will help continue to build trust and confidence in the mortgage broking industry.”

 

Microfinance could wind up being the new subprime

From The Conversation.

Microfinance has been celebrated as a way to get money into the hands of poor people, and most famously women, so they can jump start small businesses. These tiny loans with minimal requirements to borrow have become a global phenomenon.

The 2005 United Nations “year of microcredit” was followed in 2006 by a Nobel Peace Price to the Grameen Bank in Bangladesh. In the decade since, microcredit has grown from a visionary call for women’s empowerment to a mainstay of economic development initiatives. Increasingly it has even moved into mainstream commercial banking. There seems to be a general consensus that for entrepreneurship, you simply add credit and stir.

It’s estimated that there are about 90 million active borrowers in microfinance institutions (MFIs) worldwide, and the sector granted US$81.5 billion in loans in 2012.

Meanwhile, MFIs have grown into emerging areas such as mobile banking, insurance and savings, education loans, and digital financial services. As the suite of financial services and products has expanded, so has the wider development mission. The notion of providing credit to poor women has evolved into the bigger idea of building a robust financial system that can serve poor and low income communities.

Like the microcredit movement that it grew out of, the push for “financial inclusion” challenges the current state of affairs. Currently, using money is by far the most expensive for people with the least money to spare. There’s a need to fundamentally rethink financial services along more inclusive lines.

What could be wrong with expanding financial services to include the billions of people currently left out of the traditional banking sector?

More inclusive and democratic forms of banking surely bring financial services to people and communities that had been excluded from key markets. But academic research and policy analysts both sound some notes of caution. Economists such as Charlotte Wagner have studied the growth of microfinance and found it to be part of the same credit glut experienced in the traditional banking sector in the mid-2000s. It could be susceptible to the same boom and bust cycles.

Has the rapid expansion of credit left the sector vulnerable to an unstable global credit market? Disturbing stories of borrower suicides in India linked to over-indebtedness would point in that direction. A volatile market and increasing pressures on debt collection might be some unintended outcomes of a global push for financial inclusion.

My research on the hidden costs of microfinance began with two years of on-the-ground anthropological fieldwork on the culture of credit in Latin America. Behind the numbers, what was the experience of living on credit for the families, neighbourhoods, and communities enrolled in these development projects?

What I ultimately found was that women navigated an economic world that was awash in credit. In fact, many people in the financial services industry in Paraguay, from microcredit borrowers all the way up to a credit scoring executive, told me that when it came to credit they were “bicycling.” The common saying implied that they spun the pedals by paying off one loan with the next.

Turning the wheels of the “credit bicycle” meant constantly seeking out new opportunities to borrow. In practice, these debts were from development organisations, consumer credit, local businesses, savings and loan cooperatives, finance companies, and informal loans from friends and family. And they were directed toward a mix of small business ventures, consumption, and income smoothing. Microcredit, with its mission of financial inclusion and very lenient requirements for things like credit history, income, or collateral requirements, ultimately supported exactly this sort of “bicycling” credit.

Unintended consequences

The research suggests the “democratisation of finance” for micro-entrepreneurship could go the same way as that of the mortgage market, particularly in the United States: subprime lending.

The social justice impulse to promote access to banking services, especially to women, is a good one. But it is not that dissimilar to the social justice impulse to promote home ownership for people who had previously been excluded from the mortgage market. In the bigger picture, this also means the financial sector is increasingly targeting very vulnerable communities, whether poor women or low-income homeowners, as a source of profit.

The repayment rate on microcredit loans has been very high, up to 98%. In Paraguay, this was often because women feared losing this crucial lifeline and falling off the “credit bicycle.” Most of the borrowers I encountered would no more be able to do without debt than many in the developed world would be able to cut up their credit cards.

Like the mortgage market, though, perhaps one crucial element of financial inclusion will be to ask some hard questions of the protections needed as loans grow. We ask women borrowers to rely on one another and on their families to make their loan payments. They must look inward to their social networks for a safety net. As subprime lending reshapes their economic lives and livelihoods, we might also question how long those communities might be expected to shoulder the risks alone.

Author: Caroline Schuster, Lecturer, School of Archaeology and Anthropology, Australian National University

Five Critical Risks in an Era of Negative Interest Rates

A speech by Professor John Iannis Mourmouras, Deputy Governor of the Bank of Greece, examines the impact of low and negative interest rates on economies. He starts by stating that this unconventional monetary policy is not temporary. Rates will be ultra low for a long time. As a result, bank profits will be eroded; financial market will be negatively impacted; investors will be forced to take higher risks so creating stability risks; governments will not be under pressure to reduce debt; and operational risks increase.  He concludes that the time has come for other policy tools, including fiscal and structural ones.

After nine years of low interest rates and large-scale market interventions, the consensus is that this unconventional monetary policy is not temporary, while in most advanced economies the prospect for normalisation seems rather remote. Indeed, most of continental Europe (the euro area, Denmark, Sweden and Switzerland) and, as of last January, also Japan have moved towards a much more accommodative monetary policy by introducing negative policy interest rates, and/or negative central bank deposit rates. Together with forward guidance and quantitative easing, such measures have created an unprecedented situation, in which nominal interest rates are negative in a number of European countries across a range of maturities in the benchmark yield curve, from overnight to even five- or ten year maturities! Indeed, 88 of the 346 securities in the Bloomberg Eurozone Sovereign Bond Index have negative yields, thus nearly $2 trillion of debt issued by European governments is currently trading at negative yields. Illustrative examples are those of Switzerland and Germany, in which 18 out of 19 bond issues and 14 out of 18 bond issues respectively are priced with negative yields. As a result, almost one quarter of the world’s GDP is produced in countries with negative interest rates.

There are, however, a number of concerns associated with the use of negative interest rates, each of which is considered in turn.

I. Erosion of bank profitability: As negative deposit rates impose a cost on banks with excess reserves, there is a higher probability that the banks’ net interest margins (the gap between commercial banks’ lending and deposit rates) will shrink, since banks may be unwilling to pass negative deposit rates onto their customers to avoid an erosion of their customer base and subsequent reduced profitability. The extent of the decline in profitability will depend on the degree to which banks’ funding costs also fall. The central bank could reduce concerns about bank profitability by raising the threshold at which the negative central bank deposit rate applies, as the Bank of Japan recently introduced a three-tier system, a different way from the ECB’s negative interest rate policy. Doing so, however, it could reduce the transmission of negative deposit rates to market rates, namely the power of negative interest rate policy transmission through the credit and portfolio rebalancing channel. Moreover, compressed long-term interest rates also reduce profit margins on the standard banking maturity transformation of short-term borrowing and lending at a somewhat longer term. So far, lenders have been reluctant to pass on the costs of negative rates to customers and have taken almost all of the burden. But, as recent research by the BIS
shows, the impact on profitability becomes more drastic over time, as short-term benefits such as lower rates of loan defaults diminish.

II. Negative effects on financial markets: Money market funds make conservative investments in cash-equivalent assets, such as highly-rated short-term corporate or government debt, to provide liquidity to investors and help them preserve capital by paying a modest positive return. While these funds aim to avoid reductions in net asset values, this objective may not be attainable if rates in the market are negative for a considerable period of time, prompting large outflows and closures and reducing liquidity in a key segment of the financial system. For insurance and pension funds, a low-for-long interest rate environment poses challenges, which may even be exacerbated if rates enter into negative territory. They may find themselves unable to meet fixed long-term obligations. Life insurance companies will also be less able to meet guaranteed returns.

III. Excessive risk-taking: Increased financial stability risks, stemming from search for yield and higher leverage. Keeping interest rates at negative levels for a long time increases borrowing attractiveness in key sectors of the economy and the risk of bubbles. This can not only lead to an inefficient allocation of capital, but leave certain investors with more risk than they appreciate, as investors in search of higher yields necessarily turn to excessive risky assets.

IV. Disincentive for government debt reduction: With interest rates at negative levels, governments are under no pressure to reduce their debt. Negative rates actually encourage them to borrow more. And if government borrowing becomes a sort of free lunch, there is a clear disincentive for fiscal discipline. Ultra-low interest rates flatter the debt service ratio, painting a misleading picture of debt sustainability. For instance, persistent negative rates may potentially act as an “anaesthetic” to governments of eurozone countries, especially in the europeriphery, meaning that they will proceed only slowly with fiscal and structural reforms, given the fiscal space that they gain from lower debt servicing costs.

V. Operational risks: The issuance of interest-bearing securities at negative yields may face design challenges. Areas that are commonly mentioned as sources of concern are interest bearing securities, particularly floating-rate notes (renegotiating, collecting interest, use as collateral) in the context of negative interest rates. More generally, if negative rates were to prevail for long, they may entail the need to redesign debt securities, certain operations of financial institutions, the recalculation of payment of interest among financial agents, and other operational innovations, the costs of which may offset negative rate benefits. For instance, most option-pricing models either do not work or do not work well with negative interest rates, particularly entailing risks for the compatibility of trading systems and other market infrastructure.

In brief, persistent negative rates may change expectations and create distortions (for instance, in terms of saving habits and, in that sense, they may be a topic for behavioural economists to look at). It is still unknown what their long-term effects will be (e.g. on the erosion of bank profitability). In contrast, QE has been tested successfully in the US and the UK and I would also like to remind you that monetary policy– conventional or unconventional – entails considerable time lags. It takes time to see the results at full length. However, there is definitely something positive about negative interest rates: it is a strong reminder that the time has come for other policy tools, including fiscal and structural ones.

Westpac Turns The Property Investment Lending Tap On

Westpac has lifted the maximum LVR for investment loans to 90%, up from 80% (which was below many other lenders). With the largest share of investment loans they trimmed back their lending to the sector last year in order to get under the regulators 10% speed limit. Now the brakes are off, and with refinance growth slowing, and loans to overseas investors on the nose, lenders are targetting the investment sector.  Other underwriting parameters are still tighter than they were.

The Digital Finance Analytics household survey highlighted that demand from investors was on the rise, and last month there was more growth in investment loans, as investors gained renewed confidence in home price growth, and saw the prospect of negative gearing changes dissipate. The RBA’s rate cut was the gilt on the gingerbread.

Given that household lending appears to be the only game in town to force economic growth, it will be interesting to see how the RBA and APRA react to a resurgence in the more risky investment lending sector. They seem happy with a 7% annual growth in credit, a rate way higher than real incomes or inflation, meaning high household debt will go higher still.

Re-Proposed and Strengthened Pay Rules for US Banks

From Moody’s

Last Monday, six US federal regulators1 proposed rules to prohibit financial institutions from offering incentive-based compensation that could encourage excessive risk-taking by senior executive officers and other so-called significant risk takers. The rules, mandated by the Dodd Frank Act, will apply to a broader range of employees than the regulators’ 2011 joint proposal, which was never implemented. The new proposal introduces more stringent requirements for incentive compensation deferral and compensation recoupment (i.e., clawback).

The rule would apply to banks, asset managers, broker-dealers and other financial institutions with total consolidated assets of more than $1 billion. Larger institutions would have more stringent requirements in the new tiered approach, which classifies institutions into Level 1, those with $250 billion or more in assets, which would have the most stringent standards; Level 2 institutions with $50-$250 billion would have less stringent standards; and Level 3 institutions with $1-$50 billion (Level 3) would have easier requirements.

The revised rules apply to a larger swath of employees than the 2011 proposal. For example, the definition of “senior executive officers” has been expanded to cover roles including chief compliance officer, chief credit officer and the heads of control functions. The definition of “significant risk takers” such as loan officers and underwriters would also include employees who receive at least one-third of their pay from incentive compensation (excluding senior executive officers) and meet certain compensation tests, such as being among the top 5% of highest-compensated employees.

At Level 1 banks, the largest banks, senior executives would be required to defer at least 60% and other key risk takers at least 50% of their annual incentive compensation for at least four years. At Level 2 institutions, senior executives would defer 50% and other key risk takers 40%, for at least three years. Most large banks that require deferrals defer at least half of senior executives’ incentive compensation for three years, but few use a four-year period. During the deferral period, the awards would be subject to reduction and forfeiture in various adverse outcomes, including poor financial performance. Reducing compensation before it has vested is easier than clawing it backing it after it has been paid out.

To cover compensation that has already been paid out, tough clawback policies apply to 100% of incentive-based compensation for up to seven years after the awards have vested in cases of misconduct, including fraud, intentional misrepresentation of information used to determine the individual’s bonus compensation, and misconduct that resulted in significant financial or reputational harm to the bank. Most banks already have clawback polices in place, but clawback periods rarely extend beyond three years, and then only at the largest banks.

Most aspects of the proposal are credit positive, but the mandatory deferral and vesting periods may be too short to cover risks that only become apparent over say seven to ten years, as with fines and litigation.

Other jurisdictions, including the UK and Switzerland, require longer minimum deferral, vesting, and clawback periods, which we view favorably.

Because the proposal is largely consistent with current practice and interagency guidance, we expect larger banks will have little difficulty implementing the rules, with the possible exception of strengthening clawback polices and expanding the scope of covered employees. Smaller banks may face more difficulty adapting to the changes since their compensation practices vary more widely.

Was The Last RBA Rate Cut Needed?

From Business Insider.

The intervention of former RBA governors continues.

Recently Bernie Fraser said he is not “in the slightest” bit worried about letting inflation in Australia slip below the bottom of RBA’s 2-3% band.

His comments have now been reiterated by Ian Macfarlane, the man who followed him as governor of the Reserve Bank.

The AFR reports this morning that Macfarlane, who is now a director of the ANZ bank, took dead aim at market traders and forecasters whom he implies don’t understand the RBA’s approach to inflation targeting.

He said the problem at the Reserve Bank “is that financial markets, particularly offshore, assume a mechanical application of what they regard as the standard model”.

That’s a comment that reflects the reality of how the RBA has conducted monetary policy since the inflation targeting approach was first adopted under Fraser’s reign at the bank.

“The RBA has always prided itself on having a more flexible – as opposed to mechanical – inflation targeting model than other countries,” Macfarlane said.

He’s right on the money. The flexibility the RBA has given itself in the management of monetary policy, and its approach to the wild gyrations of the Australian dollar, are in no small part responsible for Australia’s magic run of 25 years without a recession.

But Macfarlane also appears to have a message to those who believe the RBA will have to cut deeply in the future (my emphasis).

The inflation targeting approach says that if inflation forecasts are below target, we should run an easy monetary policy – we already have that. It doesn’t say that each time we receive an inflation statistic showing it is below target, we have to cut interest rates.

You can read the original story at the AFR here.

Global Low Rates For Longer

What is driving long-term interest rates lower around the world lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years. The ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

BoE-RatesIn a speech to the London Business School, external Bank of England MPC member Gertjan Vlieghe, explores the reasons for low long-term interest rates. “Long-term interest rates play an important role in monetary policy.

They are a key part of the transmission mechanism, via which monetary policy affects the wider economy.

And they contain useful information about expected future policy rates and expected future inflation.”

Jan also reflects on the current UK outlook. He says that the EU referendum has caused increased uncertainty and poses challenges for the MPC in assessing how much of the continued slowdown in GDP growth “is due to the referendum, an effect which should be short-lived, and how much of it reflects a more fundamental loss of underlying momentum, which might be more persistent”. Given this, following the referendum he “would like to see convincing evidence of an improvement in the economic outlook, in line with the forecasts in the May Inflation Report. If such improvement is not apparent soon, this will reduce my confidence that inflation is likely to return to the target within an acceptable time horizon without additional monetary stimulus.”

In the UK, long-term interest rates have been coming down gradually since the early 1980s and the current 10 year bond yield is now about 1.5%.

Jan decomposes long-term interest rates into real and nominal components as well as expectations and risk premia components. He finds that “the most important factor behind the fall in long-term interest rates since the financial crisis has been a downward revision in the expected path of policy rates, with inflation expectations relatively stable, thus reflecting lower expected future real rates”.

This analysis suggests that “the reason expected future real rates are low is that monetary policy has responded, and is expected to continue to respond, appropriately to persistent forces weighing on demand and inflation”.

The analysis also suggests asset purchases have not “distorted” government bond yields. Instead, the main effect of asset purchases on long-term interest rates appears to have been due to the signal sent by purchases about the Bank’s reaction function and thereby led to a downward revision of the expected future path of interest rates. This finding also “sheds light on the likely impact of unwinding asset purchases”.

Finally, Jan applies the same decomposition to a range of countries with varying monetary policies all of which show “a substantial fall in the expected path of future interest rates” with the path of future policy rates “revised down by several percentage points on average.” This suggests that “what is driving long-term interest rates lower is not asset purchases or otherwise distortive monetary policies, but rather global economic circumstances that are expected to require very low policy rates for many years”.

This supports Jan’s argument in his speech in January that ongoing effects from debt deleveraging and shifts in demographics the distribution of income may lead, for many years to come, to substantially lower interest rates than we have seen in the past.

RBNZ Does Digital Banking Disruption

An article published today in the NZ Reserve Bank Bulletin explores the potential effects of digital disruption to banks and broader financial system stability. Consumers now expect the same seamless digital services from banks as they receive from other industries. Hence, the banking industry is being ‘digitally disrupted’ as banks and technology firms race to meet this expectation.

DIgiThis article explores whether the digital disruption of banking is a ‘disruption’ or more of a ‘distraction’ and aims to understand the concept of digital disruption of banking, what is driving it, what are the impacts on banks, and what are the impacts on financial system stability. It finds that the disruption is occurring in all areas of banking but particularly in retail customer interactions.

Banks using new technologies to improve their services is not a new phenomenon. Over the late 1980s to 1990s automated teller machines (ATMs), electronic debit and credit cards, and telephone banking started replacing paper-based payments. Then, through 2000 to 2010, basic banking products became digitally available through the introduction of remote access to bank accounts via mobile banking and internet banking.  However, these earlier digital trends were predominantly driven by the supply side (i.e. by banks themselves) to improve the cost efficiency of supplying banking services, and therefore improve profitability.

This current wave of digitisation is different to earlier periods of innovation in the banking industry in that it is primarily driven by consumers rather than banks. Consumers now expect more accessible, convenient and smarter transactions (using internet and mobile devices) when accessing and managing their finances, as they have experienced this convenience in other activities such as shopping and transportation. Advances in new technologies and the changing customer expectations have enabled non-bank firms, such as large technology companies (for example Amazon, Facebook and Google) and start-ups (for example PushPay, Moven and Harmoney), to provide innovative bank-like services and take a share of the banking industry profits. These firms can be referred to as ‘disruptors’.

The emergence of disruptors poses a threat to the traditional banking model and is referred to as the disruption of the banking industry. A survey by Efma and Infosys Finacle (2015) revealed that 45 percent of banks viewed global technology companies as high threat and 41 percent of banks also viewed start-up companies as high threat. Under the current model of retail banking most services are provided by banks. However, after the digital disruption of banking, ‘front-end’ (or ‘customerfacing’) banking services such as the sales and distribution of banking products, account management and payment instructions may also be provided by disruptors. However, disruptors do not appear to be engaging in ‘back-end’ services such as holding deposits and settling payments because these activities tend to be captured by prudential regulation which makes them more expensive to provide due to additional compliance costs.

‘Millennials’ (the generation born 1981–2000) appear to be driving this ‘disruption’ of banking services. A three-year survey of views of 10,000 Millennials in the United States reported that the banking industry was the industry with the highest risk of disruption due to the Millennials’ low loyalty towards banks and expectations that technology companies could service their banking needs better. The survey found that:

  • 71 percent of respondents would rather go to the dentist than hear from their bank,

  • one in three respondents was open to switching banks,

  • nearly half of the survey participants were counting on the change to traditional banking models to come from technology start-ups; and

  • 73 percent of respondents indicated they would be more excited about a new financial product offering from Google, Amazon, Apple, PayPal or Square than from their bank.

Banks’ core roles are to act as an intermediary between depositors and borrowers, help manage risks for depositors and lenders, and provide payment services. In fulfilling these roles the banks provide security and convenience to the depositors and access to credit for borrowers. Banks are also key agents in the creation of money (via fractional reserve banking), distribution of notes and coins, and are part of the transmission of monetary policy (via the rates charged for loans and paid on deposits). A central question is if and how this ‘digital disruption’ described in the previous section will affect the bank’s core roles or whether this disruption is limited to the banks’ retail distribution models and interactions with consumers. It appears that digital disruption will impact both the retail distribution and customer interaction models of banks, as well as potentially disrupting the core role of banks.

A survey by McKinsey&Company of the customer segments and products of 350 globally leading financial technology firms (or leading ‘disruptors’) revealed that all banking segments are at risk of disruption.   However, the main area of concentration of these disruptors is the retail sector, and the various products and services tied to payments, lending and financing.

A key potential effect of digital disruption on banks in the short to medium term is the loss of profitable activities and services.

In the long term, banks’ role in the financial system may be challenged. Disruptors may become systemically important if they supply a large portion of front-end banking services. For example, if peer-to-peer or equity lending platforms grow rapidly then it is possible that a significant number of credit decisions could be made by lending platforms. Likewise it is possible a significant number of payments may be initiated using mobile wallets.

If banks lose profits generated at the front-end of banking services they may become less resilient in an economic downturn. Stress test results reveal that the profitability of New Zealand banks provides a buffer against losses in downturn scenarios where a large number of creditors default on their loans. Lower profitability results in a smaller buffer against potential losses caused by an economic downturn, and also reduces access to international capital markets as the cost of funds increases in proportion to the riskiness of the bank.

In a more hypothetical long term scenario, banks may be challenged to change the fundamental model of banking in order to meet the demands of Millennials as they progress through life. As described above, digital disruptors are more likely to have a stronger relationship with younger customers (or Millennials) which could pose a considerable threat to the business models of incumbent banks.

In the short to medium term, digital disruption may result in new risks and increased instability in the financial system. For example, peer-to-peer lenders do not take on credit risk in the same manner as a bank, they do undertake decisions on behalf of lenders and so may introduce different operational risks to the borrowing and lending process. Likewise, payments innovations may introduce new operational risks to the payments system.

Further, as banks undertake core banking system redevelopment projects this may increase project risks to the banking system. Large technology projects commonly run over time and over budget and if these projects are not managed appropriately they could result in significant disruptions to customer services and bank profitability.

In the medium to long term, digital disruption of the banking sector may improve the efficiency of the financial system. For example, new payments providers increase the speed and ease of initiating payments for consumers, and the application of new technologies (such as ‘blockchain’) could increase the speed and reduce the cost of making cross-border payments. In addition, P2P platforms reduce the cost of matching borrowers with lenders as there are no physical branches to maintain.

The long term impact of digital disruption on financial system soundness is less clear. Soundness may be reduced if existing banks’ profitability buffers are reduced due to increased competition from digital disruptors. However, digital disruption may also improve financial system soundness if it results in more competitors entering the banking sector and fewer systemically important banking entities. This may reduce the impact of a single entity failure. Further, this may alleviate the ‘too-big-to-fail’ risk where authorities may feel pressured to prevent large banks from failing due to systemic concerns. This would in turn, reduce the probability of banking entities taking on risks that they are not willing to bear (moral hazard).

The introduction of new ‘digital’ competitors is driving banks to respond with digital strategies including the modernisation of their core banking systems. Digital disruption may impact financial stability both positively and negatively, and the Reserve Bank continues to monitor it closely.

RBA Minutes Show Lower Reported Inflation Tipped The Cut … Just

The RBA Board minutes, released today suggests that, inflation outlook apart, things are set fair … so, given the low rate already, why cut at all? Have they been captured by central bank group think? After all, ultra low/negative rates are working so well in er… well, not Japan, Europe, UK or USA… Chances are going lower will just make the journey back to more normal times more painful and longer.

In considering the stance of monetary policy, members noted that the recent data on inflation and labour costs had been lower than expected at the time of the February Statement on Monetary Policy. Although the March quarter outcome for the CPI reflected some temporary factors, the broad-based softness in prices and labour costs signalled less momentum in domestic inflationary pressures than had previously been expected. As a result, there had been a downward revision to the inflation outlook and the profile for wage growth. Underlying inflation was expected to remain around 1–2 per cent over 2016 and to pick up to 1½–2½ per cent by mid 2018.

The recent data suggested that growth in Australia’s major trading partners was likely to be a little softer than previously expected and below its decade average in 2016 and 2017. While growth in the Chinese economy had continued to slow, the growth outlook had remained much as previously forecast based on the expectation of further support being provided by more stimulatory policy settings. The renewed focus of the Chinese authorities on the short-term growth targets had been accompanied by a strong rally in bulk commodity prices over recent months. Higher commodity prices would typically support incomes and activity in Australia. However, the rally in commodity prices was not expected to boost mining investment over the next couple of years.

Sentiment in financial markets had improved following a period of heightened volatility earlier in the year. Despite uncertainty about the global economic outlook and policy settings among the major jurisdictions, funding costs for high-quality borrowers remained very low and, globally, monetary policy was remarkably accommodative.

Domestically, the outlook for economic activity and unemployment had been little changed from that presented three months earlier. The available data suggested that the economy had continued to rebalance following the mining investment boom, supported by very accommodative monetary policy and the depreciation of the exchange rate since early 2013, which had helped the traded sector. GDP growth overall had been a bit stronger than expected over 2015, but appeared to have been sustained at a more moderate pace since then. Growth was forecast to pick up gradually to be above estimates of potential growth later in the forecast period. Accordingly, the unemployment rate was expected to remain around current levels for a time before declining gradually as GDP growth picked up. The exchange rate depreciation since early 2013 was assisting with growth and the economic adjustment process, although an appreciating exchange rate could complicate this.

In coming to their policy decision, members noted that developments over recent months had not led to a material change in the outlook for economic activity or the unemployment rate, but the outlook for inflation had been revised lower. At the same time, they took careful note of developments in the housing market, which indicated that supervisory measures were strengthening lending standards and that the potential risks of lowering interest rates therefore were less than they had been a year earlier.

Members discussed the merits of adjusting policy at this meeting or awaiting further information before acting. On balance, members were persuaded that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting.

The Decision

The Board decided to lower the cash rate by 25 basis points to 1.75 per cent, effective 4 May.

Why the Reserve Bank should resist calls to alter its inflation range

From The Conversation.

For economists and others who ‘grew up’ being challenged to achieve low and stable inflation against the background of high and volatile inflation rates that emerged in Western countries in the 1970s (and persisted in Australia through the 1980s), the possibility inflation could be ‘too low’ can seem like something from another universe.

The Reserve Bank of Australia’s 2-3% inflation target was more-or-less unilaterally promulgated by Bernie Fraser (who was RBA Governor from 1989 until 2006).

In a speech just after the 1993 election (at which the Liberal Opposition had advocated the introduction of a 0-2% inflation target, similar to that which had been adopted in New Zealand in 1989), Fraser suggested that:

“If the rate of inflation in underlying terms could be held to an average of 2-3% over a period of years, that would be a good outcome. Such a rate would be unlikely to materially affect business and consumer decisions, and it would avoid the unnecessary costs entailed in pursuing a lower rate.”

Although Bernie Fraser was initially “rather wary of inflation targets”, he explicitly couched the series of interest rate hikes he implemented during the second half of 1994 as being undertaken in order to maintain inflation within the 2-3% range.

The target was formally embodied in a Statement on the Conduct of Monetary Policy agreed between newly-installed Treasurer Peter Costello and newly-appointed RBA Governor Ian Macfarlane shortly after the 1996 election, and has been re-iterated after each change of government and upon each appointment of a new RBA Governor ever since.

Australia’s approach to inflation targeting differs from that of most other countries which have inflation targets in two important respects. First, it does not stem from a government directive, nor is it enshrined in legislation. As former Governor Ian Macfarlane has said, “the government didn’t introduce it, we introduced it”.

The Reserve Bank does not have to “explain itself” to politicians if it “misses” its target for some reason. Second, the target is intentionally and explicitly flexible. It is expressed as a range, to be achieved “on average” and “over the course of the business cycle” (a term which is not anywhere defined), rather than at all times and in all places, as it were.

This means that the Reserve Bank can “tolerate” inflation being either above or below the target for a temporary period if it has good reason to believe that the deviation is only temporary, or is the result of some one-off factor whose influence will soon pass, without needing to take monetary policy actions to push it back into the target range more quickly but which would, in the RBA’s judgement, not otherwise be necessary.

This “flexible inflation targeting regime” has served Australia well over the past two-and-a-bit decades. The target is widely perceived to be “credible” – that is, it is widely recognised and understood that the Reserve Bank will do what it needs to do in order to ensure that it is achieved (as it demonstrated, for example, in 1994 and in 2007).

As a result, it has served to “anchor” inflationary expectations – that is, to give participants in the economy (businesses, consumers, union officials, governments and others) a sound basis for expecting that inflation will average somewhere between 2 and 3% over the medium-to-longer term – as it was intended to do.

And it has allowed the RBA to keep interest rates more stable than would have been the case if it had been required to chase after inflation on each and every occasion on which it temporarily departed from the target range.

With the annual “headline” rate of inflation having been below the bottom end of the 2-3% target range since the December quarter of 2014, and more recently the annual “underlying” inflation rate also having dropped below 2%, some have suggested that the inflation target should itself be lowered.

This would allow the central bank more room to accommodate unusually low inflation without having to cut rates to levels which might risk triggering unsustainable rates of credit growth and/or an asset price bubble.

Ironically, the opposite proposition was put during the resources boom of 2010-12, when some suggested that the RBA should increase its inflation target so as not to have to raise interest rates as much in the face of the inflationary pressures which it was feared that boom might engender.

The RBA resisted such calls on that occasion, and should do so on this. As it is formulated, the RBA’s flexible inflation target gives it latitude to determine how dogmatic it needs to be in pursuit of “low and stable” inflation.

If it were to change its target every time it appeared as though inflation might be either above or below the target range for an extended period, the target would eventually lose whatever role it has as an “anchor” for inflation expectations, increasing the chance that inflation would – as a result of the well-documented propensity of inflation expectations to become self-fulfilling – remain above or below the target for even longer, and perhaps by even wider margins.

Australia’s inflation targeting regime has served the country well, and the challenges it faces at this time are not so great as to warrant altering it.

Author: Saul Eslake, Vice-Chancellor’s Fellow, University of Tasmania