The “deadly embrance” between housing, house prices, and bank mortgages

An interesting IMF working paper “Mitigating the Deadly Embrace in Financial Cycles: Countercyclical Buffers and Loan-to-Value Limits” examines the limitations of Basel III in the home loan market, and makes the point that the risk-weighted focus, even with enhancement, does not cut the mustard especially in a rising or falling property market. Indeed, there is a “deadly embrance” between housing, house prices, and bank mortgages which naturally leads to housing boom and bust cycles, which can be very costly for the economy and difficult for central banks to manage. They find that macroprudential measures may assist, but even then the deadly embrace remains.

The financial history of the last eight centuries is replete with devastating financial crises, mostly emanating from large increases in financial leverage.  The latest example, the Global Financial Crisis of 2008-09, saw the unwinding of a calamitous run-up in leverage by banks and households associated with the housing market. As a result, the financial supervision community has acknowledged that microprudential regulations alone are insufficient to avoid a financial crisis. They need to be accompanied by appropriate macroprudential policies to avoid the build-up of systemic risk and to weaken the effects of asset price inflation on financial intermediation and the buildup of excessive leverage in the economy.

The Basel III regulations adopted in 2010 recognize for the first time the need to include a macroprudential overlay to the traditional microprudential regulations. Beyond the requirements for capital buffers, and leverage and liquidity ratios, Basel III regulations include CCBs between 0.0 and 2.5 percent of risk-weighted assets that raise capital requirements during an upswing of the business cycle and reduce them during a downturn. The rationale is to counteract procyclical-lending behavior, and hence to restrain a buildup of systemic risk that might end in a financial crisis. Basel III regulations are silent, however, about the implementation of CCBs and their cost to the economy, leaving it to the supervisory authorities to make a judgment about the appropriate timing for increasing or lowering such buffers, based on a credit-to-GDP gap measure. This measure, however, does not distinguish between good versus bad credit expansions and is irrelevant for countries with significant dollar lending, where exchange rate fluctuations can severely distort the credit-to-GDP gap measure.

One of the limitations of Basel III regulations is that they do not focus on specific, leverage-driven markets, like the housing market, that are most susceptible to an excessive build-up of systemic risk. Many of the recent financial crises have been associated with housing bubbles fueled by over-leveraged households. With hindsight, it is unlikely that CCBs alone would have been able to avoid the Global Financial Crisis, for example.

For this reason, financial supervision authorities and the IMF have looked at additional macroprudential policies. For the housing market, three additional types of macroprudential regulations have been implemented: 1) sectoral capital surcharges through higher risk weights or loss-given-default (LGD) ratios;3 2) LTV limits; and 3) caps on debt-service to income ratios (DSTI), or loan to income ratios (LTI). Use of such macroprudential regulations has mushroomed over the last few years in both advanced economies and emerging markets. At end-2014, 23 countries used sectoral capital surcharges for the housing market, and 25 countries used LTV limits. An additional 15 countries had explicit caps on DSTI or LTI caps. The experience so far has been mixed.in a sample of 119 countries over the 2000-13 period find that, while macroprudential policies can help manage financial cycles, they work less well in busts than in booms. This result is intuitive in that macroprudential regulations are generally procyclical and can therefore be counterproductive during a bust when bank credit should expand to offset the economic downturn.

Macroprudential regulations are often directed at restraining bank credit, especially to the housing market. They do not, however, take into account the tradeoffs between mitigating the risks of a financial crisis on the one side and the cost of lower financial intermediation on the other. In addition, given that these measures are generally procyclical, they can accentuate the credit crunch during busts. More generally, an analytical foundation for analyzing these tradeoffs has been lacking. MAPMOD has been designed to help fill this analytical gap and to provide insights for the design of less procyclical macroprudential regulations.

The MAPMOD Mark II model in this paper includes an explicit housing market, in which house prices are strongly correlated with banks’ credit supply. This corresponds to the experience prior and during the Global Financial Crisis. This deadly embrace between bank mortgages, household balance sheets, and house prices can be the source of financial cycles. A corollary is that the housing market is only partially constrained by LTV limits as the additional availability of credit itself boosts house prices, and thus raises LTV limits.

The starting point of the MAPMOD framework is the factual observation that, in contrast to the loanable funds model, banks do not wait for additional deposits before increasing their lending. Instead, they determine their lending to the economy based on their expectations of future profits, conditional on the economic outlook and their regulatory capital. They then fund their lending portfolio out of their existing deposit base, or by resorting to wholesale funding and debt instruments. Banks actively seek new opportunities for profitable lending independently of the size or growth of their deposit base—unless constrained by specific regulations.

In MAPMOD, Mark II, we extend the original model by introducing an explicit housing market. We use the modular features of the model to analyze partial equilibrium simulations for banks, households, and the housing market, before turning to general equilibrium results. This incremental approach sheds light on the intuition behind the model and simulation results.

The housing market is characterized by liquidity-constrained households that require financing to buy houses. A house is an asset that provides a stream of housing services to households. The value of a house to each household is the net present value of the future stream of housing services that it provides plus any capital gain/loss associated with future changes in house prices. We define the fundamental house price households are willing to pay to buy a house the price that is consistent with the expected income/productivity increases in the economy. If prices go above the fundamental house price reflecting excessive leverage, we refer to this as an inflated house price. The supply of houses for sale in the market is assumed to be fixed each period. House prices are determined by matching buyers and sellers in a recursive equilibrium with expected house prices taken as given. We abstract from many real-world complications such as neighborhood externalities, geographical location, square footage or other forms of heterogeneity.

Bank financing plays a critical role in the determination of house prices in the model. If banks provide a larger amount of mortgages on an expectation of higher household income in the future, demand for housing will go up, thus inflating house prices. Conversely, if banks reduce their loan exposure to the housing market, demand for houses in the economy will be reduced, leading to a slump in house prices. House prices therefore move with the credit cycle in MAPMOD, Mark II, just as in the real world.

Nonperforming loans and foreclosures in the housing market occur when households are faced with an idiosyncratic, or economy-wide, shock that affects their current LTV or LTI characteristics. Banks will seek to reduce the likelihood of losses by requiring a sufficiently high LTV ratio to cover the cost of foreclosure. But they will not be able to diversify away the systemic risk of a general fall in house prices in the economy. Securitization of mortgages in MAPMOD is not allowed. And even if banks were able to securitize mortgages, other agents in the economy would need to carry the systemic risk of a sharp fall in house prices. At the economy-wide level, the systemic risk associated with the housing market is therefore not diversifiable. The evidence from the Global Financial Crisis on securitization and credit default swaps confirms that this is the case, regardless of who holds mortgage-backed securities.

This paper presented a new version of MAPMOD (Mark II) to study the effectiveness of macroprudential regulations. We extend the original MAPMOD by explicitly modeling the housing market. We show how lending to the housing market, house prices, and household demand for housing are intertwined in the model in a what we call a deadly embrace. Without macroprudential policies, this naturally leads to housing boom and bust cycles. Moreover, leverage-driven cycles have historically been very costly for the economy, as shown most recently by the Global Financial Crisis of 2008–09.

Macroprudential policies have a key role to play to limit this deadly embrace. The use of LTV limits for mortgages in this regard is ineffective, as these limits are highly procyclical, and hold back the recovery in a bust. LTV limits that are based on a moving average of historical house prices can considerably reduce their procyclicality. We considered a 5 year moving average, but the length of the moving average used should probably vary based on the specific circumstances of each housing market.

CCBs may not be an effective regulatory tool against credit cycles that affect the housing market in particular, as banks may respond to higher/lower regulatory capital buffers by reducing/increasing lending to other sectors of the economy.

A combination of LTV limits based on a moving average and CCBs may effectively loosen the deadly embrace. This is because such LTV limits would attenuate the housing market credit cycle, while CCBs would moderate the overall credit cycle. Other macroprudential policies, like DSTI and LTI caps, may also be useful in this respect, depending on the specifics of the financial landscape in each country. It is, however, important to recognize that all these macroprudential policies come at a cost of dampening both good and bad credit cycles. The cost of reduced financial intermediation should be taken into account when designing macroprudential policies.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

 

Less Model Reliance Should Reduce Bank Ratio Variation – Fitch

The Basel Committee on Banking Supervision has proposed that banks should stop using models to calculate capital for some hard-to-model portfolios and face significant constraints on model usage for others. If adopted, this should reduce variation in capital adequacy ratios across banks, says Fitch Ratings. But this increases the need for the Committee to develop a more risk-sensitive standardised approach (SA).

The proposals, published earlier this month for consultation until 24 June, eliminate the use of Internal Ratings Based (IRB) models for low-default exposures to banks, financial institutions, and large corporates with assets in excess of EUR50bn. This means that all banks would use the revised SA for calculating risk weightings on these asset types.

Low-default portfolios are difficult to model because data is limited and historic default experience is low. Such data is needed for reliable IRB modelling. Although not included in these proposals, sovereign exposures are also regarded as low default, and we think it is likely that the Committee might adopt a similar approach for this portfolio once its sovereign risk-weight review is concluded.

The Committee’s proposals would still allow IRB modelling for exposures to smaller corporates and for retail customers, subject to restrictions to narrow the range of outcomes.

For example, proposals to increase minimum probability of default (PD) assumptions for retail mortgages to 5bp from 3bp could increase risk weights on these portfolios by 50% if all else remains equal. For corporates with revenues above EUR200m but assets below EUR50bn, models are still allowed, but loss-given default assumptions (LGD) on unsecured senior lending will be fixed at 45%. Currently, banks can use internal model estimates to calculate capital charges for these exposures that may be less conservative. The introduction of a minimum floor to the models will mean outputs are more comparable across banks.

For the first time, the Committee revealed its thoughts on the calibration of an aggregate permanent risk-weighted, asset-capital floor based on the revised SA, to be in the range of 60% to 90%. This will limit the benefit to banks from lower risk weights generated by their IRB models, compared with the revised SA weightings.

If the Committee’s proposals are adopted, the revised SA will become far more important than the IRB approach for calculating capital requirements. Reducing banks’ reliance on internal models could boost public confidence in regulatory capital ratios, and enable creditors to make better informed decisions.

Banks have developed IRB models at significant cost and we expect them to lobby hard to maintain incentives to continue to use the modelled approaches. The Committee does not intend to raise overall capital requirements for banks, but we think these proposals could lead to an increase in capital requirements for low-risk weight portfolios. Some banks might question their continued investment in internal models, although we think many might still use them for their own risk management. We think this would be useful because models can create more robust risk-management frameworks.

An earlier Basel Committee study signalled notable differences in how banks estimate key model parameters including PD and LGD for the same exposures. The review concluded that a significant source of risk-weighted asset variation was due to different modelling choices between banks, such as the definition of default, and adjustment for cyclical effects. In contrast, the SA reduces variability because it prescribes set risk weights for different risk categories.

Negative rates for 2-3 years become worry for banks – ECB’s Praet

Negative interest rates become a worry for banks’ business models if they persist for two or three years, the European Central Bank’s chief economist said on Thursday.

The ECB has charged banks for parking money overnight since June 2014, leading to complaints from lenders that their margins are being squeezed because they cannot pass on the charge to their depositors.

In his clearest acknowledgment to date of banks’ concerns, Peter Praet said: “The persistence of negative rates over time — two, three years — is something that becomes quite worrisome if you think about the implications for business models.”

In addition, Peter Praet, Member of the Executive Board of the ECB, in his speech, indicated that measures taken by the ECB, including negative interest rate policy is sizeable (again excluding the March 2016 decisions). According to their staff assessment, the policy is contributing to raise euro area GDP by around 1.5% in the period 2015-18.

 

BOQ lifts variable home loan interest rates

BOQ today announced it will increase interest rates on its variable home loan products by 0.12 per cent per annum for owner-occupiers and 0.25 per cent per annum for investors.

The increase will see the Bank’s Clear Path variable rate home loan lift to 4.72% per annum for owner-occupiers and 5.14% per annum for investors. The standard variable rate home loan will move to 5.86% per annum for owner-occupiers and 6.28% per annum for investors.   CEO Jon Sutton said the changes were driven by the need to balance growth, risk and margins over the longer term. “This is not a decision that was made lightly and we were very mindful of the impact on our customers even in an environment where interest rates remain at very low levels,” he said.  “However, given the fiercely competitive market and increased funding spreads and hedging costs, these increases are necessary to help us achieve the appropriate balance between growth, asset quality and profitability,” he said “We still retain very competitive products and pricing, particularly with our lead mortgage product Clear Path, which will enable us to continue to compete strongly in the segments we want to target. “Clear Path is a full-featured, low-fee product which, after these changes, still offers one of the best comparison rates in the market to our customers.”

The new rates will be effective from 15 April 2016.

Revisions to the Basel III leverage ratio framework

The Basel III framework introduced a simple, transparent, non-risk based leverage ratio to act as a credible supplementary measure to the risk-based capital requirements. The Basel Committee is of the view that a simple leverage ratio framework is critical and complementary to the risk-based capital framework and that a credible leverage ratio is one that ensures broad and adequate capture of both the on- and off-balance sheet sources of banks’ leverage.

The latest document sets out the Committee’s proposed revisions to the design and calibration of the Basel III leverage ratio framework. The proposed changes have been informed by the monitoring process in the parallel run period since 2013, by feedback from market participants and stakeholders and by the frequently asked questions process since the January 2014 release of the standard Basel III leverage ratio framework and disclosure requirements.

Among the areas subject to proposed revision in this consultative document are:

  • measurement of derivative exposures;
  • treatment of regular-way purchases and sales of financial assets;
  • treatment of provisions;
  • credit conversion factors for off-balance sheet items; and
  • additional requirements for global systemically important banks.

The final design and calibration of the proposals will be informed by a comprehensive quantitative impact study.

The Committee welcomes comments on all aspects of this consultative document and the proposed standards text. The deadline for submissions is Wednesday 6 July 2016.

APRA, Basel Committee: Another GFC is coming

From Australian Broker.

Both the global banking regulator and Australia’s banking regulator have warned another financial crisis is imminent.

Speaking at the Australian Financial Review (AFR) Banking and Wealth Summit in Sydney yesterday, Bill Coen, the secretary-general the Basel Committee on Banking Supervision, the global banking regulator, said another global financial crisis is “statistically certain”.

“As regulators, our focus is invariably on the downside risks rather than the upside. I’m an optimist by nature but maybe a pessimist by fact and experience. We know with statistical certainty there will be another financial crisis,” Coen said.

Echoing Coen’s warning, Wayne Byres, the chairman of Australian banking regulator APRA, said it is not a matter of “if” but “when”.

“When adversity arrives – and it will, it is not ‘if’, it will – to the extent possible we want the banking system to help alleviate rather than exacerbate problems. Ideally act as shock absorber not an amplifier.”

Byres said this is why it is important to build strength and resilience now.

“The main message I want to talk about today is that it is better we continue to invest in building resilience now when it can be done in an orderly manner from a position of relative strength than try to do so in more difficult times.”

Last year, the regulator announced an increase in the amount of capital required to be held by lenders against residential mortgages. This resulted in the big four banks raising more than $18 billion combined in new equity from shareholders.

APRA also enforced a limit on investment lending and warned it would be keeping a close watch on credit asessments.

Byres said capital requirements were likely to continue to move higher in 2016, amongst other regulatory work, to ensure our Australian banks are “unquestionably strong”, as recommended by the Murray Financial System Inquiry (FSI).

“Achieving this objective will involve work in four broad areas, and take the next several years to fully implement,” Byres told the summit.

“The four areas I have highlighted are: reinforcing capital strength; improving the stability of liquidity and funding profiles; enhancing both the public and private sectors’ readiness for adversity; and strengthening the risk culture within the financial system.”

According to Coen, increasing bank resilience in good times is the “most efficient and effective” way of dealing with periods of stress.

“The message here is caution against complacency,” Coen said.

ABC 7:30 Does Mortgage Debt Burden

On Monday 7:30 did a segment on the mortgage debt burden on Australian households. Using a leaked report prepared by APRA from before the GFC they indicated that the regulator was concerned about the level of mortgage debt in 2006, and included modelling to suggest that up to 7% of households could default by 2009, with ensuing pressure on the banks. At that stage mortgage debt was in the region of $700 bn.

Of course, the get-out-of-jail card was the GFC, with ensuing cuts in interest rates, the cash splash, and income growth meant the concerns were overtaken by events, and both households and banks survived (though some small ones were mopped up along the way). By the way, our own mortgage stress modelling should the same level of risks back then.

Jump forward to 2016, the total exposure of the banks to mortgages has doubled, interest rates are very low, and lending standards proved to be lax, such that the regulators have been tightening them recently. The big question is of course, whether the risks in the system, despite capital buffers being raised and lending criteria are being tightened, still exist.

We see mortgage stress at similar levels to those of 2006 (despite the ultra-low interest rates), 36% of loans are for investment properties, incomes are stagnant. Delinquency is set to rise.

If interest rates were to rise, some households would get into trouble. Our own modelling suggests about 9% of borrowers are now sitting with loans outside current underwriting limits.

And remember, the root cause is the RBA policy of using households to try and fill the hole left by the declining mining boom – housing finance growth was planned and wanted. Household debt has never been higher.

 

household-finances April 2016

The global policy reform agenda: completing the job

Global keynote spreech by William Coen, Secretary General of the Basel Committee, at the Australian Financial Review’s Banking and Wealth Summit, Sydney, 5 April 2016.

Introduction

Good morning, and thank you for the opportunity to participate in this summit. It is a pleasure to be in Sydney. I would like to thank the Financial Review for inviting me to be part of this event, which is indeed timely, since the Basel Committee aims to finalise a number of important regulatory reforms this year.

This morning I will say a few words about our recent proposals and outstanding reforms. I will describe the approach we are taking towards finalising the global regulatory framework. Our goal, as always, is to promote a safe and sound banking system, which is critical to ensuring sustainable economic growth. Australia’s economic growth record over the past two decades is the envy of many. As is the stability of its banking system. But, as regulators, our focus is invariably on the downside risks rather than the upside. And as we have learned from the all-too-frequent episodes of banking distress that have occurred throughout the world – increasing bank resilience in good times is the most efficient and effective way of dealing with periods of stress, which inevitably occur.

Building bank resilience is of course linked to the issue of capital. I will therefore offer a few thoughts on the subject of the level of bank capital. While critically important, regulatory capital is not, however, the sole focus of regulators. Strong supervision is essential and, above all, bank’s internal risk measurement and management are paramount. I will conclude with a look at some other areas where we need to bridge gaps to ensure resilience and profitability over the long term.

The Basel framework as a bridge

A bridge is an apt metaphor for the Basel framework, especially here in Sydney, with the celebrated Harbour Bridge only a few hundred metres away. Bridges must be safe and sound. A safe and sound banking system is exactly what the Basel framework aims to support. Bridges facilitate movement, commerce and trade. The financial system plays a crucial role in directing investment and funds between individuals and businesses. Bridges are complex to design and build. They must be sympathetic to their surroundings and their design and construction rely on the expertise of many parties. Global cooperation between regulators, duly recognising individual circumstances, is the Basel Committee’s tried and tested way of working. And, once complete, international prudential frameworks for banksdeliver benefits for all, as do strong bridges.

As strong bridges bring prosperity, weak bridges can undermine it. A weak bridge jeopardises the safety of those crossing it, and may create wider problems for society at large. A loss of confidence in a structure or its builders shakes confidence in every similar structure. These knock-on effects can be severe and persistent. So it is essential that a bridge, like the Basel framework, is built to last.

We must also not forget the importance of regular maintenance. The Harbour Bridge opened with four traffic lanes but now has eight, together with a complementary tunnel. Some parts are repainted every five years, while others last as long as 30 years. We face the same imperatives with the Basel framework. Maintenance does not imply re-opening every previous decision; we understand the importance of stability and certainty. But it does mean staying vigilant to market developments and keeping in mind the increasingly widespread use of the Basel framework.

Finalising global regulatory reform

The major outstanding topics that we will finalise this year relate to credit risk and operational risk. The Basel Committee recently published proposals on revising these two areas of the regulatory framework. Earlier this year, we finalised the regulatory capital framework for market risk.

One of our main goals this year is to address excessive variability in risk-weighted assets modelled by banks. Some – not us – have already dubbed these reforms “Basel IV”. I do not think the title in itself is important but I note that each moniker bestowed on the global regulatory framework was characterised by a substantial change from the earlier version. Basel II was a significant departure from the Basel I framework; while Basel III was a vastly different set of rules again. The current set of proposed reforms are meant to revise elements of the existing framework rather than introduce new ones. As such, I would not refer to these revisions as constituting “Basel IV”.

At the end of last year, the Committee consulted on proposals to revise the standardised approach for credit risk. This is the approach used by the vast majority of banks around the world. The Committee’s objective was to promote, as much as possible, the standardised approach as a suitable alternative to the modelled approaches. The standardised approach is of course also relevant for banks using internal models, as it may form the basis for an “output floor”, should the Committee decide to adopt such a floor. An output floor would cap the amount of capital benefit a bank using an internally-modelled approach would receive vis-à-vis the standardised approach. The Committee is still considering the specific design and calibration of an output floor.

The Committee recently consulted on revisions to operational risk and the internal ratings-based approaches for credit risk. For operational risk, our proposal did not include a modelled approach. While internal models are an essential part of risk management for many banks, the question is what role they should play in prudential rules. This is particularly relevant for operational risk. The Committee’s recent proposals to calculate capital for credit risk do not eliminate the use of models but place additional constraints around their use for regulatory purposes. I would emphasise the word “additional” – the kinds of constraint that have been proposed already exist in some form in the capital framework. Before we finalise the standards by the end of this year, we will analyse comments and conduct comprehensive quantitative impact studies (QIS).

The resources required to conduct these QIS exercises at banks and supervisory authorities are extensive. The appropriate level of minimum regulatory capital is a central question and we have a dedicated task force that is looking specifically at the calibration of the capital framework. We are tackling this question from the perspective of each individual policy on the table this year but are also taking an aggregate, overall view.

What is the right amount of capital?

Many people think that the Basel framework is all about capital. In many ways, they are right. For the past 25 years, the foundation of the international approach to the prudential regulation of banks has been a risk-based capital ratio. With respect to regulatory capital adequacy, there are two factors to consider: first, what counts as capital; and, second, how much of it do you need.

With Basel III’s definition of capital reforms, the Basel Committee took a great stride towards answering the first question. There is now, I think, a consensus that Common Equity Tier 1 is the most important component of capital, though with an acknowledgement that some other financial instruments may have a role to play in certain circumstances. Charts 1 and 2 show that banks have made very good progress in adjusting and increasing their core capital base. Banks’ leverage ratios and risk-weighted ratios have increased since the global financial crisis, with most of this increase stemming from banks augmenting their capital resources.

The level of capital is a more difficult question. There are many views on what the “right amount” should be. Banks, investors, rating agencies, depositors and regulators all have a different perspective on what is optimal. Even within groups there are different perspectives. Inside banks, loan officers, traders, risk managers and senior management may respond to capital requirements in different ways. And different regulators have different views on the question of how much capital is the right amount.

At the Committee, we work hard to bridge these different perspectives and to come to a consensus on a prudential framework of minimum standards that support a level-playing field for internationally active banks while also ensuring their resilience across financial cycles.

The Basel Committee’s view of capital

From the Basel Committee’s viewpoint, we define minimum requirements and do not try to answer the question of what is the optimal level of capital. Instead, we try to answer a slightly different question: “Is bank capital enough to ensure safe, resilient banks that perform better in the longer term?”

The banking sector has raised capital levels significantly. But there are still some gaps in the framework, which we will bridge by year-end. Some stakeholders seek short-term fixes, with some investors (and perhaps others) taking an unhealthy, if understandably myopic, view of bank performance and resilience. Our focus is on a far longer term. The process of devising international regulations is not well suited to delivering the quick fixes that are sometimes sought. Basel standards are minimum standards that support a sound banking system at all stages of the financial cycle. There will be circumstances, related to an individual bank, jurisdiction or financial cycle, that warrant having more capital than the minimum. For example, Australia has signalled its desire for its banks to be “unquestionably strong”, with Common Equity Tier 1 ratios in the top quartile of the benchmark set by peers. Other jurisdictions have also adopted regulations that are more stringent than the Basel standards. While we do not intend to significantly increase overall capital requirements, this does not mean avoiding any increase for any bank. And, as I said, it does not preclude individual jurisdictions from imposing higher standards.

I noted earlier that a risk-based capital ratio has underpinned our framework for a quarter of a century. This is, at heart, a simple concept: the amount of capital needed for a given activity should reflect the risk of that activity. The higher the risk, the higher the capital. This principle of risk-sensitivity is still very important to the Committee but it is not the only consideration.

The 1988 Basel I framework had limited risk-sensitivity. This sensitivity increased over time. Basel II allowed considerable use of internal models to determine capital requirements. In principle, internal models permit more accurate risk measurement. But, if they are used to set minimum requirements, banks have incentives to underestimate risk. Several studies have found substantial variation in risk-weighted assets across banks. For example, Charts 3 and 4 show the range of risk weights estimated by banks in hypothetical portfolio exercises we conducted on the banking and trading books. Complexity in internal models, banks’ choices in modelling risk parameters and national discretions in the framework have all contributed to this variation. However, I think it’s fair to say that the wide discretion provided to banks in the current framework is likely a major driver of this high degree of variability.

Such variation makes it difficult to compare capital ratios. Basel’s Pillar 3 framework – in its original form – failed to provide sufficiently granular, and sufficiently comparable, information to enable market participants to assess a bank’s overall capital adequacy and to compare it with its peers. The Committee has since addressed some of these disclosure deficiencies. Furthermore, some asset classes are inherently difficult to model. Together, this suggests that the use of internal models to cover all risks does not strike the right balance between simplicity, comparability and risk-sensitivity in the regulatory framework. I think it is not only regulators who feel that the balance between these objectives has been skewed too far towards risk-sensitivity and complexity. I know that, in many cases, academics, analysts, investors and perhaps even bank managers and board members would agree that the benefits of simplicity and comparability have been undervalued.

The Committee is therefore proposing greater restrictions on the use of internal models. This includes removing the option of using internal models to determine risk parameters for certain exposure categories. These categories are typically characterised by a scarcity of default data and/or model complexity. Specifically, we have recently proposed to:

  • remove the advanced measurement approaches for operational risk, where the inherent complexity and the lack of comparability arising from a wide range of internal modelling practices have exacerbated variability in capital calculations and contributed to an erosion of confidence in capital ratios;
  • remove the internal modelling approaches for exposures to banks, other financial institutions and large corporates, where it is judged that the model inputs cannot be estimated sufficiently reliably for regulatory capital purposes;
  • adopt floors for exposures to ensure a minimum level of conservatism where internal models remain available. These floors would be applied at the exposure – rather than portfolio – level; and
  • limit the range of practices regarding the estimation of model parameters under the IRB approaches.

Strong capital, narrowly defined, is not enough

The design of the overall regulatory framework has evolved significantly following the financial crisis. The foundation of the risk-based capital ratio is still in place, albeit strengthened with tougher materials, in the shape of higher-quality capital. But we have made many changes around it. The framework has been improved to catch up with modern traffic flows, particularly complex or illiquid trading activities and off-balance sheet exposures. Layers of capital buffers provide extra resilience.

The biggest change has been the introduction of multiple regulatory metrics. The revised framework complements the risk-based capital ratio with (i) a leverage ratio, (ii) standards for short-term and long-term liquidity management, (iii) large exposure limits, (iv) margin requirements and (v) additional going- and gone-concern requirements for the world’s most systemically important banks. Overall, this approach is more robust to arbitrage and erosion over time, as each measure mitigates the weaknesses of the others (Table 1). A number of empirical studies have suggested that simpler metrics are at times more robust than complex ones. We have kept this in mind when developing the leverage ratio, among other measures.

An appropriate level of resilience, in our view, is that implied by the combination of metrics that now comprise the Basel III framework.

But have we done enough? From a supervisor’s perspective, completing the regulatory standards is a critical step, but not the whole story. The financial crisis revealed, among other things, that implementation of the agreed standards was remiss. There were also weaknesses in banks’ internal controls. Also, incentive structures were not always aligned with the banks’ long-term soundness.

We have spent several years developing a framework to make sure that banks’ capital and liquidity buffers are strong enough to keep the system safe and sound. But these buffers can only be as reliable as the underlying risk measurement and management. No matter what standards the Basel Committee and national supervisors set to safeguard the system, it is ultimately banks themselves that determine their risk-taking, risk controls, business incentives and, ultimately, success or failure. These factors determine the way people ultimately behave. And we all know that in our current global financial system, much like a failed beam or girder, the failure of an individual bank is likely to have wider repercussions.

What else is needed?

So what else is needed? There are three areas that I would like to note: improved corporate governance and culture, better IT systems and effective stress-testing.

Let’s start with corporate governance. As noted by the Dutch central bank, “today’s undesirable behaviour in financial institutions is at the root of tomorrow’s solvency and liquidity problems”.1 The Basel Committee published Principles for enhancing corporate governance in 2006. They were revised in 2010, then again last year. The Committee has emphasised the need for more effective board oversight, with a focus on the skills and qualifications of individual board members as well as the collective board. The Principles also reinforce the imperative of rigorous risk management, appropriate resources and unfettered board access for the chief risk officer, as well as call for better discussions between a board’s audit and risk committees. Corporate culture has been an oft-publicised topic, with many senior management teams reinforcing appropriate norms for responsible and ethical behaviour. These norms are especially critical in terms of a bank’s risk awareness, risk-taking behaviour and risk management.

Next, IT systems. Many in the banking industry recognise the benefits of improving IT infrastructure. Banks’ risk data aggregation capabilities have been a source of concern for the Committee for some time now. The global financial crisis showed IT systems failed to support the broad management of financial risks. Many banks could not properly measure risk exposures and identify concentrations quickly and accurately, especially across business lines and legal entities. Risk reporting practices were also weak.

In 2013, the Basel Committee set out its Principles for effective risk data aggregation and risk reporting. We are monitoring their implementation. Though progress is being made, there is still a considerable way to go.

Finally, stress testing. Although not part of the Pillar 1 framework, stress testing plays an increasingly important role in a number of jurisdictions. In some countries, stress testing is an integral part of the assessment process. In others, it is used for contingency planning and communication. For some banks, supervisory stress testing has proven to be the binding regulatory constraint. Stress testing is also used by banks as a risk management tool and by macroprudential authorities for policy analysis. Over all these areas, stress testing has demanded more resources in both banks and supervisors. The Committee is monitoring these developments closely. I should also recognise here that APRA has used stress testing as part of their supervisory framework for many years now – long before it became fashionable.

Conclusion

In conclusion, I hope I have given you a flavour of the Committee’s perspectives and priorities as we embark on the final parts of our post-crisis policy reforms. High-quality capital and robust capital ratios have always been, and will remain, the keystone in the Basel framework. But high-quality capital must be complemented with effective governance and appropriate culture; strong risk management processes and internal controls; and a broad view of risk that encompasses all of a bank’s activities.

Here in Sydney, you have one of the world’s most iconic bridges, which has served the city well for more than 80 years. During the eight years of its construction, between 2,500 and 4,000 workers were employed in various aspects of its building. Since it opened, it has been continuously maintained to keep it safe for the public and to protect it from corrosion. This is the eighth, and we hope the final, year of the construction of Basel III. While it might not appear on as many picture postcards, I hope that Basel III will also serve as a model of safety and soundness for many years to come. Thank you.

RBA Holds Cash Rate Once Again

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

Recent information suggests that the global economy is continuing to grow, though at a slightly lower pace than earlier expected. While several advanced economies have recorded improved growth over the past year, conditions have become more difficult for a number of emerging market economies. China’s growth rate has continued to moderate.

Commodity prices have generally increased a little recently, but this follows very substantial declines over the past couple of years. Australia’s terms of trade remain much lower than they had been in recent years.

Sentiment in financial markets has improved recently after a period of heightened volatility. However, uncertainty about the global economic outlook and policy settings among the major jurisdictions continues. Funding costs for high-quality borrowers remain very low and, globally, monetary policy remains remarkably accommodative.

In Australia, the available information suggests that the economy is continuing to rebalance following the mining investment boom. Consistent with developments in the labour market, overall GDP growth picked up over 2015, despite the contraction in mining investment. The pace of lending to businesses has also picked up.

Inflation is quite low. Recent information has confirmed that growth in labour costs remains quite subdued. Given this, and with inflation also restrained elsewhere in the world, inflation in Australia is likely to remain low over the next year or two.

Given these conditions, it is appropriate for monetary policy to be accommodative. Low interest rates are supporting demand, while supervisory measures are working to emphasise prudent lending standards and so to contain risks in the housing market. Credit growth to households continues at a moderate pace, albeit with a changed composition between investors and owner-occupiers. The pace of growth in dwelling prices has moderated in Melbourne and Sydney and has remained mostly subdued in other cities.

The Australian dollar has appreciated somewhat recently. In part, this reflects some increase in commodity prices, but monetary developments elsewhere in the world have also played a role. Under present circumstances, an appreciating exchange rate could complicate the adjustment under way in the economy.

At today’s meeting, the Board judged that there were reasonable prospects for continued growth in the economy, with inflation close to target. The Board therefore decided that the current setting of monetary policy remained appropriate.

Over the period ahead, new information should allow the Board to assess the outlook for inflation and whether the improvement in labour market conditions evident last year is continuing. Continued low inflation would provide scope for easier policy, should that be appropriate to lend support to demand.

Unqualified advice a growing problem, warns FBAA

From Australian Broker.

The Finance Brokers Association of Australia (FBAA) is warning brokers about offering unqualified advice which isn’t covered by their Professional Indemnity (PI) insurance.

The FBAA has cited a recent case in which a broker was found to have breached his duty of care by the Credit Ombudsman Service and forced to pay more than $115,000. The Ombudsman claimed the broker had given incorrect and unqualified advice.

In addition, the client – who was forced to sell an investment property at a substantial loss – took the legal action against the broker.

The chief executive of the FBAA, Peter White, says in this instance the broker went outside the bounds of his role by providing property advice and acting as a real estate agent when he did not have a licence to do so.

“This should serve as a warning to brokers. If you give unqualified advice, your Professional Indemnity insurance won’t cover you,” he said.

White is now urging brokers to educate themselves and update their knowledge of PI insurance.

“I would plead for any broker who may have let their education slide to update their knowledge on the rights and wrongs when it comes to advice and insurance.”

According to White, unqualified advice is potentially a growing problem as the line between financial planners and real estate property sales and other arms of the broking industry become blurred in an endeavour to diversify revenue streams.

“If you are only a qualified finance broker, act as a broker and do your best to meet your client’s needs. If you also want to assist a client in other areas like property purchasing, get the necessary qualifications and training otherwise you may be at risk of a life changing personal pay out,” White said.