Economics and Banking – Page 413 – Digital Finance Analytics (DFA) Blog

APRA Proposes to Report ADIs Liquidity Data

The Australian Prudential Regulation Authority (APRA) today released a consultation package on the proposed publication of liquidity statistics for authorised deposit-taking institutions (ADIs).

APRA proposes to expand the current statistics published in the Quarterly Authorised Deposit-taking Institutions (ADI) Performance publication to include relevant information on the liquidity of ADIs. APRA proposes to introduce liquidity statistics for banks, and expand the existing liquidity statistics published for credit unions and building societies.

APRA invites submissions on the proposal by 30 March 2016. The consultation package can be found on the APRA website at: www.apra.gov.au/adi/PrudentialFramework/Pages/Consultation-on-the-publication-of-ADI-liquidity-statistics.aspx

Of most interest, and welcome, is the Liquidity Coverage Ratio (LCR).

APRA does not currently publish any statistics on LCR ADIs in QADIP. Under the LCR requirements that came into effect on 1 January 2015, LCR ADIs are required to maintain a sufficient level of unencumbered high quality liquid assets (HQLA) to meet their liquidity needs for a 30 calendar day period under a severe stress scenario. Absent a situation of financial stress for locally-incorporated LCR ADIs, the value of the LCR must not be less than 100 per cent5.

The LCR is calculated as the percentage ratio: Stock of high-quality liquid assets / Total net cash outflows over the next 30 calendar days

APRA proposes to publish aggregate LCR statistics each quarter in QADIP. The statistics would include the components of the LCR: HQLA and other qualifying LCR liquid assets. Expected cash outflows and cash inflows under the LCR stress scenario would also be published.

APRA also proposes to publish statistics at the ADI segment-level for: banks (as well as major banks, other domestic banks and foreign subsidiary banks sub-segments). There are currently no credit unions or building societies subject to the LCR regime, but should this change APRA would include LCR statistics for these segments subject to meeting confidentiality obligations.

APRA proposes to publish statistics on a Level 2 consolidation basis from December 2014 reference period onwards, commencing in the March 2016 edition of QADIP. APRA does not propose to publish statistics for the 30 June 2014 and 30 September 2014 quarters, as the underlying data were submitted on a ‘best endeavours’ basis.

Major banks reduce maximum loan amounts

In the September 2015 edition of the Property Imperative, DFA highlighted the impact of reductions in loan values being offered, as lenders tightened their lending criteria and affordability guidelines. This trend has been confirmed in more recent media reports, and will potentially make it difficult for some refinancing borrowers to get the loans they need, and further dampen property demand and prices. It will also make the on-ramp for first time buyers even steeper.

According to Australian Broker,

“Major banks have significantly reduced the amount they are prepared to lend home buyers, a new analysis by leading brokerage Home Loan Experts has revealed.

A couple with a combined income of $120,000 purchasing an investment property can now borrow up to $80,000 less from a major bank than they could a year ago, according to the calculations published in a report by the Sydney Morning Herald.

Investment property buyers aren’t the only ones affected either. The maximum loan size for the same hypothetical couple buying an owner-occupied home has fallen by up to $65,000, according to the Sydney-based brokerage’s calculations.

According to the Sydney Morning Herald report, the calculations were based on the borrowing power or maximum loan amount for a couple earning $60,000 each, with two children. The comparison compared December 2014 with December 2015 and included Commonwealth Bank, National Australia Bank and Westpac. The broker was not able to access comparative figures for ANZ from 2014.

Commonwealth Bank, for example, would have lent $640,000 as a housing investment loan a year ago, compared with $560,000 now — an $80,000 reduction.

Westpac would have lent the couple buying an owner-occupied home $645,000 a year ago, but this amount has fallen to $580,000 — a $65,000 reduction.

Home Loan Experts mortgage broker Christina Parnham told the Sydney Morning Herald that the maximum loan amount has been reduced because banks are requiring borrowers be tested against how they would cope with higher interest rates.

“You’re going to have to be able to service the loan at about 7.5 to 8%,” she said.

At the same time, Farnham says banks have adopted more conservative assumptions about living expenses”

APRA Data Shows Investment Loans Slowing

The APRA monthly banking statistics to end November show that housing loans by ADI’s (a.k.a banks) rose by 0.8% to $1.41 trillion. This was driven by a 1.19% rise in owner occupied loans ($889 billion) and 0.14% rise in investment loans ($517 billion). As we reported, the RBA said that total loans were worth $1.51 trillion, the difference being the non-bank sector. There is still noise in the data (the RBA said that there was a switch of $1.9bn loans between investment and owner occupied loans in the month). Overall, investment lending is below the 10% speed limit.

Looking at individual banks data, Westpac still holds the highest value of investment loans, whilst CBA is the largest lender of owner occupied loans.

Looking at the relative splits between owner occupied and investment loans, HSBC, Bank of Queensland and Westpac have the highest proportion of investment loans.

The monthly movements highlight that within the numbers there are still some funnies going on, including reclassification of loans.

Owner Occupied Lending Drives Housing Loans To New High of $1.51 Trillion

The RBA released their November Credit Aggregates. Total housing loans (SA) reached $1.51 trillion up 0.7%, thanks to growth of 1.05% in owner occupied loans, whilst loans for investment property grew by just 0.09%. Total owner occupied loans totalled $968 billion, and investment loans $548 billion, so investment loans now comprise 36.1% of all loans on book (from a high of 38.6% in July). We need to be a little cautious, as further adjustments were made in the classifications. The RBA tell us that “following the introduction of an interest rate differential between housing loans to investors and owner-occupiers in mid-2015, a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $32.5 billion over the period of July 2015 to November 2015 of which $1.9 billion occurred in November. These changes are reflected in the level of owner-occupier and investor credit outstanding”.

Of note is the relative movement in business lending, which was 33.2% of all loans, to $826 billion, up 0.11% in the month. Business lending is still restrained, compared with lending for property, the latter unproductive, and simply stoking household debt. Productive lending for growth is under pressure. Personal credit fell again to $147.9 billion, down 0.2%.

Looking at the 12 month growth figures, investment lending is now below the 10% speed limit, at 9.1%, whilst owner occupied loans are at 6.5%, the highest rate for 6 years (Feb 2011).

Monetary Policy, Financial Stability, and the Zero Lower Bound

Fed Vice Chairman Stanley Fischer spoke about three related issues associated with the zero lower bound (ZLB) on nominal interest rates and the nexus between monetary policy and financial stability: first, whether we are moving toward a permanently lower long-run equilibrium real interest rate; second, what steps can be taken to mitigate the constraints imposed by the ZLB on the short-term interest rate; and, third, whether and how central banks should incorporate financial stability considerations in the conduct of monetary policy. The experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.

Are We Moving Toward a World With a Permanently Lower Long-Run Equilibrium Real Interest Rate?
We start with a key question of the day: Are we moving toward a world with a permanently lower long-run equilibrium real interest rate? The equilibrium real interest rate–more conveniently known as r*–is the level of the short-term real rate that is consistent with full utilization of resources. It is often measured as the hypothetical real rate that would prevail in the long-run once all of the shocks affecting the economy die down. In terms of the Federal Reserve’s approach to monetary policy, it is the real interest rate at which the economy would settle at full employment and with inflation at 2 percent–provided the economy is not at the ZLB.

Recent interest in estimates of r* has been strengthened by the secular stagnation hypothesis, forcefully put forward by Larry Summers in a number of papers, in which the value of r* plays a central role. Research that was motivated in part by attempts that began some time ago to specify the constant term in standard versions of the Taylor rule has shown a declining trend in estimates of r*. That finding has become more firmly established since the start of the Great Recession and the global financial crisis.

A variety of models and statistical approaches suggest that the current level of short-run r* may be close to zero. Moreover, the level of short-run r* seems likely to rise only gradually to a longer-run level that is still quite low by historical standards. For example, the median long-run real federal funds rate reported in the Federal Reserve’s Summary of Economic Projections prepared in connection with the December 2015 meeting of the Federal Open Market Committee has been revised down about 1/2 percentage point over the past three years to a level of 1-1/2 percent. As shown in the figure below, a decline in the value of r* seems consistent with the decline in the level of longer-term real rates observed in the United States and other countries.

What determines r*? Fundamentally, the balance of saving and investment demands does so. A very clear systematic exposition of the theory of r* is presented in a 2015 paper from the Council of Economic Advisers. Several trends have been cited as possible factors contributing to a decline in the long-run equilibrium real rate. One a priori likely factor is persistent weakness in aggregate demand. Among the many reasons for that, as Larry Summers has noted, is that the amount of physical capital that the revolutionary IT firms with high stock market valuations have needed is remarkably small. The slowdown of productivity growth, which has been a prominent and deeply concerning feature of the past four years, is another factor reducing r*. Others have pointed to demographic trends resulting in there being a larger share of the population in age cohorts with high saving rates.⁷ Some have also pointed to high saving rates in many emerging market countries, coupled with a lack of suitable domestic investment opportunities in those countries, as putting downward pressure on rates in advanced economies–the global savings glut hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago.

Whatever the cause, other things being equal, a lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived. The past several years certainly require us to reconsider that basic assumption.

Moreover, the experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.

I would note in passing that one possible concern about our unconventional policies has eased recently, as the Federal Reserve’s normalization tools proved effective in raising the federal funds rate following our December meeting. Of course, issues may yet arise during normalization that could call for adjustments to our tools, and we stand ready to do that.

The answer to the question “Will r* remain at today’s low levels permanently?” is that we do not know. Many of the factors that determine r*, particularly productivity growth, are extremely difficult to forecast. At present, it looks likely that r* will remain low for the policy-relevant future, but there have in the past been both long swings and short-term changes in what can be thought of as equilibrium real rates Eventually, history will give the answer.

But it is critical to emphasize that history’s answer will depend also on future policies, monetary and other, notably including fiscal policy.

Banks and The Value of Their Customer Data

Interesting article in the SMH, discussing the leverage banks hope to get from the data they hold on customers. The explosion in digital banking has meant the banks’ information about their customers has ballooned. And advances in technology mean they can analyse it in ways that were previously impossible, to ensure they remain relevant.

Here is a snip-it:

… as banks eye the huge potential to enmesh themselves more deeply in consumers’ lives, and fight off lower-cost competitors.

Thanks to advances in computing power and customers’ embrace of digital finance, banks know more than ever about what their customers are up to: whether it’s browsing the web, shopping online, visiting the mall, or interacting on social media.

Already, they are busily harnessing this vast amount of data to sell products to customers before they ask for them: pushing travel insurance to someone who’s just bought airline tickets, or suggesting a home loan to the newlywed couple. But over the coming years, it is set to get much more tailored to the individual, and far more widespread.

As the traditional business of banking faces growing competition from new digital rivals, experts predict banks will increasingly be pushed into targeting customer “experiences” as they seek to remain relevant, and highly profitable.

Inevitably, however, this will involve a tension between what customers regard as the bank being helpful, and when it veers into the territory of ‘Big Brother’.

Follow the link to read the full article.

The Impact of Unconventional Monetary Policy Measures

An IMF Working Paper has been released “The Impact of Unconventional Monetary Policy Measures by the Systemic Four on Global Liquidity and Monetary Conditions“. The paper examines the impact of unconventional monetary policy measures (UMPMs) implemented since 2008 in the United States, the United Kingdom, Euro area and Japan—the Systemic Four—on global monetary and liquidity conditions. Overall, the results show positive significant relationships. However, there are differences in the impact of the UMPMs of individual S4 countries on these conditions in other countries. UMPMs of the Bank of Japan have positive association with global liquidity but negative association with securities issuance. The quantitative easing (QE) of the Bank of England has the opposite association. Results for the quantitative easing measures of the United States Federal Reserve System (U.S. Fed) and the ECB UMPMs are more mixed. Of significant concern are the spill-over effects, which will continue to impact many economies, including those in developing countries as attempts are made to bring policy settings back to “more normal” settings.

In recent years, central banks in several systemically important countries have adopted unconventional monetary policy measures (UMPMs)—ranging from large scale purchases of public and private debt securities to direct lending to banks—designed to inter alia, repair the monetary transmission mechanism by ensuring depth and liquidity in financial markets and provide monetary accommodation at the zero lower bound of policy interest rates. One distinguishing feature of UMPMs, which has also been referred to as quantitative easing (QE), is that the central bank actively uses its balance sheet to influence market prices and conditions beyond the use of a short-term or “policy” interest rate. As a result of these policies, the balance sheets of the central banks implementing the UMPM programs expanded significantly over the period 2008–14. This has led to large injections of money into the economy through increased reserves (which, by a “money multiplier,” increased broad money), as well as introduction of negative interest rates for some policy instruments in some advanced countries. With money and securities being imperfect substitutes, these programs resulted in portfolio rebalancing of assets of the United States, the United Kingdom, Euro area, and Japan—the Systemic Four (S4)— banks and corporations, which in turn increased asset prices. Investors responded by acquiring more risky assets outside the S4 that became relatively more attractive compared with S4 government bonds and securities: capital outflows from the S4 rebounded leading to increased inflows and issuance of new securities in emerging market economies (EMEs).

The overall effect of the S4 UMPMs on the rest of the world (RoW) liquidity and monetary conditions is not yet clear, as positive trade and capital spillovers may likely be accompanied by increased macro-financial vulnerabilities. While empirical studies find evidence of significant spillovers of monetary easing in the S4 on the RoW through trade and finance channels, research on the impact of the S4 UMPMs on the RoW banks’ balance sheets, liquidity, and money supply is still in an embryonic stage. Indeed, the substitution of cross-border banking flows with portfolio flows of non-banks does raise new concerns about financial vulnerabilities. The growing role of non-financial corporations (NFCs) as de facto “financial intermediaries” may reduce the effectiveness of macroprudential policies and limit the ability of policy makers to respond to future shocks.

Seen from a broader perspective, such UMPM programs might also lead to a loosening of fiscal discipline and shifts in the allocation of resources. In this context, the overall effect of the S4 UMPMs on the RoW is likely to be dependent on both the specific policy frameworks of affected countries and each UMPM program. Likewise, the affect of S4 UMPMs reversals on the RoW, i.e., monetary policy normalization, could also be varied. Against this background, this paper attempts to break new ground in empirically investigating UMPM spillovers on global liquidity and monetary conditions and financial sector balance sheets in other countries. In particular, we focus our analysis on spillovers from S4 monetary policy easing (conventional and QE/UMPMs) on the RoW’s monetary aggregates, banks’ balance sheets (NFC deposits), and NFC securities issuances. We also assess potential threats stemming from UMPMs unwinding to the RoW. To the best of our knowledge, this topic remains largely unexplored, which is a major gap in understanding of UMPM spillovers/leakages.

The paper focuses on specific QE programs and UMPMs implemented by the S4: (i) the large-scale assets purchase (LSAP) by the U.S. Fed, split by type of securities into purchases of U.S. treasuries, mortgage backed securities (MBS), and securities of government sponsored enterprises (GSE); (ii) the QE strategy implemented by the Bank of England (BoE); (iii) the assets purchase program of the Bank of Japan (BoJ); and (iv) the ECB’s government bond purchases (phases one and two), the ECB’s three-year long-term refinancing operation (LTRO), and the ECB’s securities market program (SMP).

We find positive and statistically significant relationships between UMPM implementation and global liquidity and monetary conditions in terms of global NFC deposit growth (including China), banks’ cross-border flows, and issuance of securities (particularly in foreign currency). We also find significant differences in the impact of the UMPMs implemented by individual S4 on broad money, NFC deposits, and securities issuance in EMEs. The BoJ’s asset purchases programs appear to have a positive impact on global liquidity and other countries’ monetary conditions, while they appear to have a negative association with issuance of securities. In contrast, the effects of the QE program implemented by the BoE have strong negative association with global liquidity, measured by broad money and NFC deposits and positive impact on issuance of NFC securities. Results for QE implemented by the U.S. Fed and ECB UMPMs are mixed.

The paper develops a new quarterly dataset covering the period Q1:2002–Q2:2014, leveraging monetary data reported by IMF member countries through the IMF’s standardized report forms (SRFs), which have the advantage of providing a consistent set of definitions based on the IMF’s Monetary and Financial Statistics Manual, and can be replicated over time and across countries using officially reported data. Core and non-core liabilities of banks are computed using detailed SRF data reported to the IMF on a confidential basis. Leveraging the IMF’s SRFs is our major advantage, relying on broad money as monetary aggregate, which is comparable across SRF reporting countries. In contrast, other studies have typically relied on countries’ self-reported monetary aggregates under more traditional classifications (e.g., M0, M2, etc.) subject to different national definitions, which make cross-country comparisons less meaningful.

The UMPMs implemented by the S4 and analyzed in this paper are negatively correlated with the nominal long term (LT) interest rates (Figure 1), confirming existing results of the empirical studies that show that UMPMs had significant impact on respective long-term government bond yields (LT interest rates).

This suggests that S4 UMPMs contributed to the compression of long-term interest rates in S4, which prompted a materialization of rebounded private capital outflows from these countries (Figure 2).Through a detailed descriptive and econometric analysis the results of this paper suggest that the impact on global liquidity, monetary conditions, and bank balance sheets from individual S4 UMPMs differ depending on the nature of each program, initial macro-economic conditions, and countries’ policy response. The U.S. QE programs might dominate in impact due to its size and the relevance of the U.S. dollar as a global transaction currency.

In addition, while we find a positive impact of S4 UMPMs on global liquidity and money growth, the differential nature of these programs can potentially have countervailing effects on each other and on global liquidity. For example, the U.S. Fed was concentrating on the asset side of the balance sheet to support the financial intermediary function, while the BoJ was targeting the liability side to provide a buffer against funding liquidity by increasing private banks’ excess reserves. The difference in policies explained in part by the differences in financial systems (market-based system in the United States versus bank-based system in Japan). Targeted assets purchases programs may have a potential positive impact on asset markets as they may prevent excessive swings in asset prices.

The S4 UMPM policies had a statistically significant impact on the EMEs’ banks money supply and funding liquidity though their impact on bank balance sheets, NFCs deposits, and NFC securities issuance. The portfolio rebalancing channel of QE/UMPM policies has led to the redistribution and increased issuance of EMEs’ debt and has increased the non-core liabilities in EME banking sectors.

The results also suggest that non-core liabilities of EME banks exhibit higher volatility than those of developed countries, making EMEs banking systems more vulnerable to the S4 monetary policy reversals and unwinding of the programs. At the same time, macroprudential regulation in EMEs may become less effective due to the increased significance of the non-banking sector as de facto “financial intermediary.”

Furthermore, UMPM programs have been accompanied by economic costs, since they seem to have led to the reallocation of resources on banks’ balance sheets and possibly contributed to loosening fiscal discipline in EMEs. Therefore, close monitoring of macro-financial vulnerabilities in EMEs and undertaking debt sustainability analysis on a frequent basis may be prudent to head-off policy mistakes and to maintain financial stability. Finally, as monetary policy begins to normalize in the S4, RoW liquidity and monetary conditions might get tighter. As the “taper tantrum” episode of 2013 showed, simply signaling a change in future monetary policy can create a wave of extreme volatility in the markets, influencing RoW exchange rates, flows and asset prices. This suggests the need for better communication among central banks and with the financial markets in addition to strengthening of the global financial safety net.

A full assessment of the effects of the UMPMs can be made only after a complete return to a normalized monetary policy. Nonetheless, at this point, our analysis can help shed light on the potential impact of the UMPMs on global monetary and liquidity conditions.

Note that 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.

Central Counterparties and the Too Big to Fail Agenda

In a speech by Andrew Gracie, Executive Director of Resolution of the Bank of England, at the 21st Annual Risk USA Conference, he outlines some of the elements in the Too Big To Fail (TBTF) resolution agenda. The aim is to ensure that in the event that a global systemically important financial institution (G-SIFI) fails there is minimal interruption of the activities of a firm that are critical to the functioning of the broader financial system. And achieving that outcome without recourse to taxpayer bailouts, as public authorities were forced to during the crisis.

He says that progress in developing a new paradigm for global systemically important banks (G-SIBs) has been impressive. Key Attributes of Effective Resolution Regimes for Financial Institutions1 were agreed by G20 leaders around this time four years ago. Statutory regimes consistent with this standard are now in place in the US, EU and Japan – in fact in all but a handful of jurisdictions where G-SIBs are headquartered. Crisis Management Groups (CMGs) have been working on resolution plans for each of the G-SIBs. The authorities participating in the CMGs have committed at a senior level in a resolvability assessment process (RAP) to the resolution strategies emerging for each of the G-SIBs. These CMGs work towards identifying barriers to making resolution work and how these should be removed. Often these barriers are consistent across firms. Perhaps most notable is the requirement for loss absorbency – establishing a liability structure for G-SIBs that is consistent with bail-in, not bail-out. Again, there has been significant progress here. The Financial Stability Board (FSB) issued a consultation document2 on a minimum standard for Total Loss Absorbing Capacity (TLAC) last November and is committed to producing a final standard ahead of the G20 summit next month in Antalya. This will be a major step on the road to ending “Too Big to Fail.”

He goes on to discuss the same TBTF agenda for other types of G-SIFIs, in particular central counterparties (CCPs). CCPs form a key part of the global financial landscape. They have become ever more important since the crisis. This will continue as mandatory central clearing is introduced around the world. These entities are an essential part of the international financial system, and need appropriate regulation and viable resolution paths in an event of failure, without causing a cascading crash. This aspect of the international financial markets and their control bears close watching.

Addressing the systemic risks associated with over-the-counter (OTC) derivatives markets is one of the reasons why G20 leaders introduced mandatory central clearing. People tell us that we have thus created in CCPs concentration risk and critical nodes. This is true in part, but we did this on the basis that in CCPs risks could be better recognised and identified, better managed and reduced via better netting. Nonetheless, as many before me have commented the largest CCPs are becoming increasingly systemic and interconnected such that their critical services could not stop suddenly without risk of wider contagion. Thus, not only do we have to ensure that the level of supervisory intensity matches the risks, something my supervisory colleagues are very focused on, we must also address the issue of what should happen if a CCP were to fail.

This is already widely recognised. So too is the need for an international solution to the questions that CCP recovery and resolution presents. The largest CCPs are systemically relevant at a global level, important for financial stability in multiple jurisdictions due to the nature of their business and the composition of their members and users. They serve multiple markets, having dozens of clearing members from different countries and clearing products in multiple currencies. A patch-work of approaches to recovery and resolution would risk regulatory arbitrage and competitive distortion and so, whilst the fiscal backstop against the unsuccessful resolution of a CCP is ultimately a national one, it is best that the answer on how to avoid this backstop ever being used is developed at a global level.

Fortunately, that work is already underway and CCP recovery and resolution forms an important part of the Financial Stability Board’s (FSB) continuing agenda to end Too Big To Fail (TBTF). In October 2014 an Annex was added to the Key Attributes of Effective Resolution Regimes to cover their application to Financial Market Infrastructures (FMIs). More recently, the FSB published its 2015 CCP workplan. As part of this, a group on financial market infrastructure (fmi CBCM), equivalent to the Cross-Border Crisis Management Group (CBCM) that I chair for banks, has been established within the FSB to take forward international work on CCP resolution. Authorities in a number of jurisdictions are responding to the need for effective resolution arrangements for CCPs, with legislative proposals expected in the EU, Canada, Australia, Hong Kong and elsewhere to add to existing regimes, including in the US under Title II of Dodd Frank. In the UK, the Bank of England has formal responsibility for the resolution of UK-incorporated CCPs. To aid us in drawing up resolution plans for UK CCPs, we have established the first Crisis Management Group for a CCP. We hope and expect it to be the first of many.

But work on CCP resolution needs to be seen in the broader context of financial reform:

The Committee on Payment and Market Infrastructures, along with the International Organisation of Securities Commissions (CPMI-IOSCO) is continuing its work on CCP resilience and recovery. Work is in train on stress testing, on loss allocation and on disclosure requirements, as well as on ensuring consistent application of the Principles for Financial Market Infrastructures (PFMIs) which set regulatory expectations for CCPs at a global level. All of this is important not only in its own right, but also to provide the market – the users of CCPs – with the tools and incentives to monitor resilience and drive effective risk management in CCPs themselves. To encourage competition between CCPs on resilience, not cost.

At the same time, the first line of defence for a CCP lies in the resilience of its members. Ongoing work to raise the prudential standards for banks on capital and liquidity, among other areas, should greatly reduce the risk of CCPs having to deal with a failing clearing member. And the progress I mentioned before on G-SIB resolution should help to ensure that, where a firm does fail, its payment and delivery obligations to the CCP continue to be met. I should add as an aside that there is more still to be done internationally in terms of removing technical and other obstacles to maintaining continuity of access to CCPs and other FMIs in the context of bank resolution. That continuity is not just essential to the bank in resolution but may also be critical for clients. If there is doubt about continued access to clearing services from a bank in resolution, clients may look to migrate rapidly to another provider. These issues around continuity and portability will be the subject of work within the FSB over the course of the coming year.

Together, these initiatives to improve the resilience and recovery arrangements for CCPs and their members will help to reduce the probability of CCP default. But while improvements to resilience are necessary they may not by themselves be sufficient. No institution is “fail safe”. Ultimately, we need to have a credible resolution approach for CCPs.

If we do, resolution should offer a continuing benefit in helping to incentivise recovery by removing expectations that the taxpayer will be compelled to step in. By contrast, if we do not have a credible regime in resolution, we run the risk of weakening the incentives both to manage a CCP prudently, as well as incentives for clearing members to contribute to a CCP’s recovery should it get into trouble. The benefits of resolution to market discipline and recovery are common to all financial institutions. But that is not the only insight from banks that is relevant to CCPs.

Before going too far in talking up the similarities, I should note – although it should go without saying – that CCPs are very different from their bank clearing members in many important respects, including their business models, legal structures and balance sheets. CCP recovery and resolution therefore poses some specific issues, some of which I will touch on today. However, at base there are principles that are common to the resolution of any systemically important institution.

Perhaps the most obvious similarity between the resolution of banks and CCPs is in the common objective: resolution should deliver continuity of critical economic functions without reliance on solvency support from taxpayers to achieve it. For that continuity to be achieved it is not enough that the financial losses of the institution are fully absorbed; the going-concern resources of the institution, or of any successor institution, must be restored to a sufficient level to command market confidence prior to any post-resolution restructuring or wind-down.

In the case of banks, this means that when a bank suffers losses eroding its going concern capital to the point where triggers for resolution are met, (i) it enters into resolution; (ii) its creditors are bailed in to recapitalise the firm; and (iii) this bail-in replicates what would have happened in a court-based commercial restructuring or insolvency. In other words, losses are allocated according to the creditor hierarchy but without the value destruction created by the hard stop of insolvency. This ensures that the resolution provides continuity and meets the safeguard that creditors are not worse off than in insolvency. While these are the essential elements of a resolution, they are likely to play out differently in the context of a CCP.

Intervention by a resolution authority, especially at a point where default management procedures have yet to be exhausted is action that cannot be taken lightly. Nor can the discretion of a resolution authority to deviate from the existing rules of the CCP be unbounded. Appropriate creditor safeguards are central to ensuring that an effective resolution regime does not unduly interfere with property rights or undermine its own value by introducing unnecessary uncertainty into a financial institution’s contractual relationships both in resolution and outside of it.

Perhaps the most fundamental safeguard to creditors in resolution is that the actions of the resolution authority will not leave them worse off than if the authority had not intervened and the firm had instead entered a liquidation proceeding. For the purposes of determining this No Creditor Worse Off protection, bank resolution takes an insolvency counterfactual; recognition that a failing bank that meets the conditions for resolution would in most likelihood lose its licence at that point if not resolved, thereby tipping it into insolvency (whether cash-flow, balance-sheet or both) if it was not there already. That insolvency counterfactual requires an ex post assessment of the value of assets and liabilities of the firm. That is no easy task but one that can, and has been, credibly undertaken.

For CCPs the task of assessing an insolvency counterfactual is likely to be harder still – particularly if it must rely upon a forecast of how the rest of the waterfall would have unfolded, the behaviour of the CCP’s participants and the movements of the markets in the days that would have followed if resolution had not taken place. A liquidation counterfactual must also confront the argument that the CCP would have protected itself from insolvency through full tear-up.

Given these valuation challenges, I suspect there will need to be careful further consideration given to the formulation and practical application of the NCWO safeguard; we must end up with a safeguard that is sufficiently certain and capable of estimation in advance that both creditors and resolution authorities are able to make sensible decisions before, during and after resolution.

With that, let me conclude by summing up some key points:

CCP resolution is both a necessary and inevitable part of the overall post-crisis reform agenda to end Too Big to Fail. As private, profit-making enterprises CCPs must be allowed to fail, but, given their systemic importance, many will need to be allowed to do so in a manner that maintains the continuity of their critical functions.

Having a credible resolution regime for Clearing Members is a big step forward in helping to reduce the risk of clearing member default and from that the risk of CCP failure.

But reliance on successful resolution of members does not negate the need for CCP resolution arrangements to be capable of responding to both default and non-default losses emerging from both systemic and idiosyncratic shocks.

In thinking about the underlying objectives and needs of a CCP resolution regime, there are many similarities to bank resolution and these should not be forgotten, but clearly there are many differences too and we need to recognise that.

Effective resolution requires the ability to act promptly and before the point at which the chance of stabilising the CCP is lost. The resolution authority must have a variety of tools at its disposal to enable it to respond to the reason the CCP failed. It should be able to intervene in a timely and forward-looking way before the end of the waterfall – but incentives must be aligned and we want this to be set up in a way that promotes CCP resilience and makes recovery work.

In order to continue a CCP’s critical services in resolution, there must be an ability both to cover the losses credibly in a failure scenario and to recapitalise the CCP’s going concern resources – i.e. its capital, margin and default fund. How we achieve this is something for FSB to address so that the shared interest in maintaining stability in the global financial system can be realised.

Debt Overhang and Deleveraging

What is the relationship between high consume debt levels, and consumption? This is an important question for Australia, given the current record levels of personal debt, and sluggish consumer activity. Also, what will happen should house prices slip back, and households shift to a deleveraging mentality? The short answer is it will have a significant depressive economic impact – if insights from a newly published paper are true.

In a Bank of Canada Staff Working Paper, “Debt Overhang and Deleveraging in the US Household Sector: Gauging the Impact on Consumption” they use a dataset for the US states to examine whether household debt and the protracted debt deleveraging helps to explain the dismal performance of US consumption since 2007, in the aftermath of the housing bubble. By separating the concepts of
deleveraging and debt overhang—a flow and stock effect—they conclude that excessive indebtedness exerted a meaningful drag on consumption over and beyond income and wealth effects.

The leveraging and subsequent deleveraging cycle in the US household sector had a significant impact on the performance of economic activity in the years around the Great Recession of 2007-09. A growing body of theoretical and empirical studies has therefore focused on explaining to what extent and through which channels the excessive buildup of debt and the deleveraging phase might have contributed to depressing economic activity and consumption growth.

They use panel regression techniques applied to a novel data set with prototype estimates of personal consumption expenditures at the state-level for the 51 US states (including the District of Columbia) over the period from 1999Q1 to 2012Q4. They include the main determinants as used in traditional consumption functions, but add in debt and its misalignment from equilibrium. They conclude that excessive indebtedness of US households and the balance-sheet adjustment that followed have had a meaningful negative impact on consumption growth over and beyond the traditional effects from wealth and income around the time of the Great Recession and the early years of the recovery. The effect is mostly driven by the states with particularly large imbalances in their household
sector. This might be indicative of non-linearities, whereby indebtedness begins to bite only when there is a sizable misalignment from the debt level dictated by economic fundamentals. They show that some states experienced significant deleveraging and a fall in household wealth.

They argue that the nature of the indebtedness determines the ultimate impact of debt on consumption. The drag on US consumption growth from the adjustments in household debt appears to be driven by a group of states where debt imbalances in the household sector were the greatest. This suggests that the adverse effects of debt on consumption might be felt in a non-linear fashion and only
when misalignments of household debt leverage away from sustainable levels – as justfied by economic fundamentals – become excessive. Against the background of the ongoing recovery in the United States, where the deleveraging process appears to be already over at the national level, one might expect house-hold debt to support consumption growth going forward as long as the increase in debt does not lead to a widening of the debt gap.

Note that Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank of Canada, the European Central Bank or the Eurosystem.

Non-Majors Strike Back – AFG

The AFG Competition Index for the last quarter of 2015 shows that non-major lenders have made up ground after a punishing few months for the challenger sector.

AFG General Manager of Sales and Operations said the recent turnaround had been dramatic. “We have been through a period of uncertainty and this has seen the majors use the size of their balance sheets to dominate their smaller competitors.

“This quarter the tide has turned and non-majors have had their best run since June, just prior to the regulator enforced changes to investment and interest only lending policy being introduced. Over the last 3 months we have seen the non-majors adjust to these changes and it appears that the flow of business is settling back into a more competitive pattern.

“Looking at the product categories, the non-majors have made up ground across all lending products apart from fixed. Their share of refinancing has increased from 29.8% in August to 39.5% in November. During the same period, investor lending has gone from 27.4% of the total to 29.1% while first homeowners has leapt from 27% to 32%. The non-major’s share of fixed rates fell from 45.2% in August and a high of 56.8% in May to 42.5% for the last quarter.

“After a three year trend of declining use of fixed rate loans, the tide has turned. The corresponding increase in the major’s share of fixed rate lending has reflected that change. The next edition of the AFG Mortgage Index, due for release in mid January, will show that fixed rate lending as a percentage of AFG’s overall business, has increased from 11% to 13%.

“Borrower expectations that the likelihood of an interest rate rise in the new year has many borrowers opting to fix their home loans,” said Mr Hewitt. “Once again, the changing nature of the market means Australian borrowers are recognizing more than ever the
value of using a broker to help them navigate their way through.”