Economics and Banking – Page 414 – Digital Finance Analytics (DFA) Blog

Japan Goes For Negative Interest Rates

In a surprise decision, the Bank of Japan (BoJ) has announced a policy of negative interest rates in an attempt to boost the country’s flagging economy.

“At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan decided to introduce “Quantitative and Qualitative Monetary Easing (QQE) with a Negative Interest Rate” in order to achieve the price stability target of 2 percent at the earliest possible time. Going forward, the Bank will pursue monetary easing by making full use of possible measures in terms of three dimensions; quantity, quality, and interest rate”.

In a 5-4 vote, the Bank of Japan’s board imposed a 0.1% fee on deposits left with the Bank of Japan, effectively a negative interest rate, from the reserve maintenance period, which commences from February16, 2016.

The authorities hope negative interest rates will encourage commercial banks to lend more to promote investment and growth, and drive inflation higher. Latest data showed that Japan’s inflation rate came in at 0.5% in 2015, well below the BoJ’s 2.0% target.

This experiment takes Japan into new and uncharted territory.

“Japan’s economy has continued to recover moderately, with a virtuous cycle from income to spending operating in both the household and corporate sectors, and the underlying trend in inflation has been rising steadily. Recently, however, global financial markets have been volatile against the backdrop of the further decline in crude oil prices and uncertainty such as over future developments in emerging and commodity-exporting economies, particularly the Chinese economy. For these reasons, there is an increasing risk that an improvement in the business confidence of Japanese firms and conversion of the deflationary mindset might be delayed and that the underlying trend in inflation might be negatively affected”.

The Bank will adopt a three-tier system in which the outstanding balance of each financial institution’s current account at the Bank will be divided into three tiers, to each of which a positive interest rate, a zero interest rate or a negative interest rate will be applied, respectively.

1. The Three-Tier System
(1) Basic Balance: a positive interest rate of 0.1 percent will be applied With regard to the outstanding balance of current account at the Bank that each financial institution accumulated under QQE, the Bank will continue to apply the same interest rate as before. The average outstanding balance of current account, which each financial institution held during benchmark reserve maintenance periods from January 2015 to December 2015, corresponds to the existing balance and will be regarded as the basic balance to which a positive interest rate of 0.1 percent will be applied.
(2) Macro Add-on Balance: a zero interest rate will be applied A zero interest rate will be applied to the sum of the following amounts outstanding.
a) The amount outstanding of the required reserves held by financial institutions subject to the Reserve Requirement System
b) The amount outstanding of the Bank’s provision of credit through the Loan Support Program and the Funds-Supplying Operation to Support Financial Institutions in Disaster Areas affected by the Great East Japan Earthquake for financial institutions that are using these programs c) The balance calculated as a certain ratio of the amount outstanding of its basic balance in (1) (macro add-on). The calculation will be made at an appropriate timing, taking account of the fact that the outstanding balances of current accounts at the Bank will increase on an aggregate basis as the asset purchases progress under “QQE with a Negative Interest Rate.”
(3) Policy-Rate Balance: a negative interest rate of minus 0.1 percent will be applied A negative interest rate of minus 0.1 percent will be applied to the outstanding balance of each financial institution’s current account at the Bank in excess of the amounts outstanding of (1) and (2) combined.

Also, the Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period. The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

“a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen.3 With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years.
b) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at annual paces of about 3 trillion yen4 and about 90 billion yen, respectively.
c) As for CP and corporate bonds, the Bank will maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively”.

Owner Occupied Home Lending Drives ADI’s

The latest data from APRA, the monthly banking stats to December, provide data on the stock of loans and deposits held by the banks. Total housing loans on book were $1.42 trillion, up 0.7% from last month. Within the mix, owner occupied loans grew 1% ($898 bn) and investment loans by 0.17% ($518 bn). There were no declared adjustments between owner occupied and investment loans this month (first clear result for several months). Investment loans were 36.6% of book, still a big number.

The balance between $1.42 trillion and $1.52 trillion as reported today by the RBA relates to the non-bank sector.

Looking at the individual lenders portfolios, CBA still has the largest owner occupied share, and Westpac the biggest share of investment loans.

The main movements were in the owner occupied stream, with all the main lenders growing their footprint, other than Members Equity Bank who grew their investment loans. Among the majors, NAB made (net) most investment loans.

If we look at the 12 month portfolio movements by bank, we see that the investment loans market since January has now settled at 2.1% (after all the various tweaks and adjustments). This is below the APRA 10% speed limit. Now most of the major lenders are at or below the 10% hurdle, through a number of other players are still well above. Some, like Macquarie are explained by acquisitions, others by relative lending growth alone.

Turning to deposits, we see CBA still is the largest savings bank in Australia, though Westpac has been growing share, at the expense of NAB. Total deposits were $1.9 trillion, up $11 bn in the month – or 0.62%. This is a larger rise than the previous two months.

Looking at the cards portfolio, total balances were up slightly (thanks to Christmas) by $832 m to $42.2 bn. CBA lifted their share of cards balances, and they remain the largest cards player, followed by Westpac and ANZ Bank. We expect balances to fall in January as households repay their festive bloat.

Home Lending Up in December 2015 to $1.52 trillion

The RBA Credit Aggregates for December, released today, shows a continued rise in lending for housing, up 0.7% in the past month seasonally adjusted by $10.6 bn to $1.52 trillion. This includes all lending, including non-banks, seasonally adjusted. There are no reported series breaks this past month, so no abnormal shifts between investment and owner occupied loans . This is a rise of 7.1% over the past year.

The splits between owner occupied and investment lending shows that loans for owner occupation rose $10 bn, up 1.1%, to $967.7 billion. Loans for investment purposes also rose – just 0.09% or $0.49 billion to $546 billion, so investors are still in the market. The proportion of loans on book relating to investment lending has fallen again, to 36.1% from a high of 38.6% last year. This is still a big number, and higher that the levels which were thought to be a concern (as expressed by the regulators) last year, before recent swapping between categories. Remember the Bank of England is worried by their 16% share of investment loans – in Australia it is much higher!

Personal credit has fallen again, down 0.2% to $148 billion. But lending for business was only up 0.11%, or $0.94 billion to $826 billion. This represents a low 33.2% of all lending, down from 33.3% last month, and down from 34.7% in 2012. This continues to highlight the lack of investment in the grown engine of the economy – business – as compared to the easy money going towards housing. Structurally, we continue to have a problem, as housing growth is not productive and cannot lead to the right economic outcomes. Remember this is with interest rates at rock bottom.

We will review the APRA ADI data later.

Women are increasingly using payday loans, at growth rates above system

New DFA research shows that women who are most vulnerable and under the most significant financial pressure are most likely to access payday services. Those that do are quite likely to take multiple loans.

DFA, in conjunction with Monash University published a report on households in financial stress last year using data from our household surveys. It was cited by ASIC in their review of debt advice services, published yesterday.

We have now completed an extension to the analysis, commissioned by Good Shepherd Microfinance, looking in particular at how women are using payday loans. This analysis is relevant to the SACC review currently underway. Payday lending is defined as loans of $2,000 or less for terms between 16 days and 12 months, in accordance with the National Consumer Credit Protection Act 2009 definition of a small amount credit contract.

Our analysis reveals that women are increasingly using payday loans, at growth rates above system. This is explained partly by a low initial penetration rate, greater financial need and autonomy, and greater availability and ease of online loans. We expect these growth rates to continue.

Not all women are equally likely to access payday loans. Those in challenging financial situations, with sole charge of children are most likely to use this form of credit, and often do so as a form of emergency cash for household expenses. Solo women without children are less likely to use payday loans, and when they do, it tends to be for a specific purpose such as car repairs. Finally, the behaviour of women in family units is closely aligned to the general population, and the decision to access payday is often either a joint decision or delegated to another family member.

1. Are women increasingly using payday lending in Australia?

The short answer is “yes”; women are using payday lending more. In 2005 about 84,000 women had used payday lending, but this had grown to 177,000 in 2015, a 110% rise compared to growth in the total industry in Australia of 80% over the same period. Transactions initiated by women as the decision maker, whether in a family or other context, comprised about 27% of all payday loans in 2015.

Our analysis segments Australian households into various groups in order to identify those that are financially stressed (with a subset defined as financially distressed).

Financially stressed households are generally coping with their current financial situation (even if using unconventional means), while financially distressed households are not. By coping, we mean for example, short term borrowing from family, friends, or payday loans, as well as juggling multiple credit cards, moving debts from one credit source to another and deliberately making late payments. The distinction between financially stressed and financially distressed households is important, because the spectrum of financially stressed households in Australia using payday lending facilities has broadened significantly since 2005. During the period of analysis (and as shown in our original report) the rise in loans to financially distressed households grew only slightly, but there was a significant rise in the volume of loans made to financially stressed households. These classifications of households are, of course, dynamic, with financially stressed households moving into a position of distress and vice versa.

Across the general population, the average size of an individual payday loan fell between 2005 and 2015 from $776 to $611. Yet if we look at payday loans to women, the average loan made rose significantly from $427 in 2005 to $592 in 2015.

There are a number of reasons that may explain this. First, the proportion of loans to women has increased between 2005 and 2015. Second, more independent women are getting loans. Third, lenders have changed their lending criteria. Fourth, women have greater need of financial assistance and are borrowing more. Further research would be required to determine which of these factors have been most influential.

We conclude that women are more likely to use a payday loan today. They are able to access funds on-line, with lenders using on-line channels to attract households in less severe financial difficulty.

Some women in financial need have limited alternate options. We explore this later.

2. What are the household characteristics of women who use payday lending in Australia?

To answer this question, we have identified three discrete groups within which women may reside. Each has different drivers and needs, and uses payday lending to different degrees. This segmentation is based on analysis from our household surveys and is tailored specifically for this paper.

Using this segmentation, we can now overlay the payday lending data statistics from our surveys.

Of those women using payday lending in 2015, 47% came from the one-parent family segment, a much higher level than the 15% distribution of households with a single female parent across the general population. Conversely, while 64% of the general population falls within the family segment, the percentage of women using payday loans from this segment was only 36%.

3. How are women using payday lending in Australia?

Segmental analysis shows that one-parent women are more likely to have multiple loans over the last twelve months, compared with other female segments and the general population. Conversely, single women without children are most likely to have just one loan (87%), compared with general population (62%).

We find that one-parent women are more likely to have multiple concurrent loans, compared with other female segments and the general population.

On-line origination has become a predominant industry feature, and one-parent women are now the most likely segment to use this channel, thanks to the emergence of easy to use on-line apps.

We found broadly similar patterns of awareness of payday lending across the various segments, although families with a single female parent were far more likely to use a local shop or lender than the average, and were significantly more influenced by friends.

4. What are the motivations and drivers of women using payday lending in Australia?

Our segmental analysis highlights that families with a single female parent are more likely to use payday loans to cover emergency cash for household expenses compared with the general population, or other female segments. Solo women are more likely to use payday loans for car expenses and other one-off items rather than emergency cash scenarios. The family segment mirrors the broader population.

We now turn to the underlying reason why a household is in financial difficulty. A range of drivers is found in the sample. Once again, women in one-parent roles stand out from the general population, as they are more likely to get into difficulty because of a relationship breakdown (25%) and are experiencing a reduction in available government benefits. These women are less impacted by loss of employment than other segments and the general population.

How Sensitive Are Owner Occupied Mortgage Holders To Rising Interest Rates

Continuing our analysis of the impact of rate rises on mortgage holders, today we turn from investors (where we showed that a considerable proportion would be in difficulty if rates rose even a little), to look at owner occupied borrowers. For this snapshot we are only looking at households loans for occupation, so exclude investment loans from the picture (later we will combine the two). Again we use data from our surveys to assess how much of an interest rate rise households felt they could cope with, without getting into financial difficulties. “No Rise” means any lift in rate would be a problem. The remaining values show where a households tipping point is. (For example, if rates rose 2%, then the proportion of households under stress would be the sum of No Rise, 0.5%, 1%, 1.5% and 2% = 32% of households.)

We start with a summary view. This shows that about 13% of households with an owner occupied loan would be in financial discomfort if rates were to rise at all. This is a smaller proportion than we showed for investment property recently which was 27%. However, more than one third of households said they would be in difficulty if rates rose by 3%.

Drilling into the segmented data using the DFA property segments, we see that 35% of first time buyers would have difficulty if rates were to rise at all, and 18% of those trading up would be in pain. In both cases, these groups had large recent mortgages at higher LVR’s.

The state by state analysis shows that households in NSW and VIC are the most exposed to potentially rising rates, thanks to larger mortgages and higher loan-to-income (LTI) metrics. QLD and TAS households are somewhat exposed thanks to static income. Those in WA, have enjoyed high incomes in recent times, so despite high prices, are more insulated – though this could change with the re-balancing of the economy from the mining sector.

If we drill into the regions within states – and using NSW as an example – we see that more than 20% of those under pressure are in the Central Coast, and 27% are in the Sydney metro area – significantly correlated with recent high house prices. Other areas are less exposed to rate rises (though other risks, such as employment may be higher – refer to our earlier probability of default analysis).

Finally, if we cut the data by the DFA master household segments, we see that there are two which stand out. Those segments which are more affluent – Exclusive Professionals, and Young Affluent are more exposed, thanks to their higher leverage into property – they have the capacity to borrow more, and buy more expensive real estate. We also see a number of young growing families and wealthy seniors potentially exposed.

So once again we find a proportion of households on the brink of difficulty, and with little headroom to accommodate potential interest rate rises. Rates are currently very very low, and will probably remain that way for some time, but there are no guarantees. We also found that households who borrowed in the earlier part of 2015 were more exposed because lender underwriting criteria were more generous than in recent times, especially considering income multiples and LVR’s. However once again we see evidence that some households do not have the 2-3% interest rate buffer which the current APRA guidelines suggest.

Next time we will combine our owner occupied and investment loan analysis. We suspect for many households it will not look pretty!

How Sensitive Are Property Investors To Interest Rate Rises?

Continuing our series on potential material risks within investment loans, today we reveal some of the analysis we have undertaken on the potential impact on investors of prospective rate rises using data from our household surveys. We framed the questions here around how large a rise could an individual household cope with before getting into financial discomfort. We considered scenarios between zero and 7%. The overall results are startling. We found that about a quarter of property investors said they would have difficulty meeting any additional interest rises – even 0.5% – implying that they are already under financial pressure. Others could cope with various rises, though more than 50% of investors would be in potential difficulties should rates rise by 3%. On the other hand, more than 30% of investors were able to cope with a significant rise, even above 7% from current levels.

So which households are most exposed? We start by looking across the DFA property segments. We found that 20% of first time buyer investors would be concerned by any rise, whereas more than 40% for portfolio investors (who are more highly geared) and a considerable proportion of people who traded down and geared into an investment property recently would be caught out. Others, such as those refinancing, or holding property appear to be more able to swallow potential rises.

The size of the loan portfolio has a bearing on households, with the average portfolio investor having a balance of over $750,000 in investment property (some much more) so would be more sensitive to rate rises.. We conclude that generally households with smaller investment loans are (perhaps obviously) a little more able to cope with potential rises.

Next we cut the data by states. Here we found that investors in TAS were most concerned about potential rate rises, followed by SA and ACT. These are states were income growth (and property appreciation) is slowest. On the other hand, investors in WA and NT appeared more able to cope with significant rises

Finally, we examine the data by our core household segments. Here we found that wealthy seniors were the most exposed (incomes relatively flat compared with their investment portfolios), followed by stressed seniors and young affluent.

Of course, if rates were to rise – perhaps this is not likely in the near term – investors have the option of selling up, but the analysis shows that some would need to act quite fast in a rising rate environment. It also raises the question as to whether the banks underwriting criteria are working – because they should be assuming borrowers could cope with a rise to above 7.5%, which is 2-3% higher than most are currently paying. Our research suggests that some households are geared up to the hilt, and have no spare cash for unexpected raises down the track.

Next time we will add in the impact of owner occupied borrowing also.

UK Regulator Launches New Bank Start-up Unit

The UK Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have launched the New Bank Start-up Unit. The Unit is a joint initiative from the UK’s financial regulators giving information and support to newly authorised banks and those thinking of becoming a new bank in the United Kingdom.

The joint New Bank Start-up Unit will assist new banks to enter the market and through the early days of authorisation. It will draw staff from the PRA and the FCA with a dedicated helpline and email address. It will provide new banks with the information and materials they need to navigate the process to become a new bank, as well as with focused supervisory resource during the early years of authorisation.

The New Bank Start-up Unit will provide named case officers for firms during the authorisation process at both the PRA and the FCA and a greater level of supervisory support during the new bank’s early years after they have been authorised.

New banks will benefit from:

access to the New Bank Start-up Unit helpline;
access to supervisors at both the PRA and the FCA via the helpline;
regular capital and liquidity reviews, if appropriate;
monthly regulatory update emails;
invitations to seminars targeted at new and prospective banks and separately banks’ senior management and NEDs; and
invitations to events, alongside other firms, on key regulatory conduct topics.

Andrew Bailey, Deputy Governor, Prudential Regulation, Bank of England and CEO of the Prudential Regulation Authority said: “The New Bank Start-Up Unit builds on the work we have already done to reduce the barriers to entry for prospective banks, which has led to twelve new banks now authorised since April 2013. These new banks are a key part of bringing innovation to the sector, particularly where there is a gap in the market – whether it is the service they provide, the customers they target, the products they sell or the technology they use. With the launch of the New Bank Start-up Unit, applicants will now benefit from having a single place where they can get the advice and guidance they need to start a new bank and support once they are authorised.”

Tracey McDermott, Acting CEO of the FCA said: “The New Bank Start-Up Unit will help those who want to start a new bank in the UK navigate the regulatory process. Increasing competition in the banking sector is important for consumers and the new Unit will offer firms an accessible way to find the information they need to get themselves authorised”.

Economic Secretary to the Treasury Harriett Baldwin said: “A key part of our long term plan is to boost competition in banking, driving the industry to offer the best possible products and services to customers”. “I’m therefore delighted that the Prudential Regulation Authority and Financial Conduct Authority have now established a dedicated New Bank Start-up Unit, helping new banks to enter the market and through the early days of authorisation”.“Building on the three new banks that have already established this Parliament, this unit will help to stimulate even more competition and diversity in Britain’s banking sector.”

How Material Is “Material” For Property Investors?

The latest iteration of the BIS paper on proposed capital adequacy changes includes a fundamental change to the way the risk charge would be calculated for investment property purchases funded by a mortgage. Fundamentally, if repayments are “materially dependent on cash flows generated by the property”, then depending on the loan to value ratio, the risk weighting could be as high as 120%, significantly higher than today. We discussed this in our recent post.

BIS does not give any clear guidance on what “materially dependent” might mean, and comments are open until mid March, so finalisation will be later than this. However, this got us thinking. What would happen if, for some reason, the rental income stream stopped? Clearly in the short term, pending finding a new tenant or selling the property, the repayments would have to be made from other income streams – salary, investments and dividends.

So we have run some scenarios on our household database, to examine the potential impact. To start we estimate the average proportion of gross income which would need to go to servicing the investment mortgage. We have taken into account income from all sources (excluding rental income), and also calculated repayments based on the current interest rate, adjusted for discounts, and whether the mortgage was a principle and interest loan, or an interest only loan. We also take account of the impacts of negative gearing.

Over the next few days we will share some of our modelling, which will ultimately flow into our next Property Imperative report. Our last edition dates from September 2015 and is still available on request.

Our first analysis is grouped by our household property segments. These include households who only have investment property (Investors, and Portfolio Investors), as well as households with both an owner occupied property and an investment property (including first time buyers, holder, refinanced, trading-up and trading-down. You can read more about our segmentation here.

The chart shows the impact to their income if the repayments were to be serviced by said income, rather than rental streams. The chart shows the proportion of income which would be consumed, and the distribution of households by segment. There is considerable variation, but we see that a considerable proportion of households would need to put more than 25% of their income aside to service the mortgage. A small, but worrying proportion would require more than 50% of their income, and a small number more than 100%. This is significant, given the current low (and falling) income growth rates.

We can also look at the data through the lens of our master household segments. These are derived from a range of demographic and behaviourial elements. We see that generally more affluent households are more exposed to investment property, and as a result, require a larger proportion of their income (despite having larger incomes) to support the repayment required to replace rental income. We also see that stressed seniors, with a rental are more exposed, which is not surprising given their lower income levels.

Standing back, this initial analysis shows that it is not easy to determine what is “material”. Different segments and property portfolios will require different settings. In addition, as the extra capital charges being discussed will translate into higher mortgage interest rates for some, it appears that these increases will hit different segments to varying extents.

Will BIS attempt to describe conditions which are material, or leave it to the individual regulatory authorities – such as APRA?

Next time we will look at the consolidated impact of households with both owner occupied and investment loans. This is important because some households have more than half their income servicing property.

Debt, Demographics and the Distribution of Income

In a speech to the London School of Economics Dr Gertjan Vlieghe – an external member of the UK Monetary Policy Committee – examines the effects of debt, demographics and the distribution of income on growth and interest rates. In his first public speech since joining the MPC, Jan argues that these 3 Ds “are interacting powerfully to create an environment where a given level of growth might be consistent with substantially lower interest rates than in the past”. Jan explores these forces in turn and concludes by looking at the implications for UK policy. The 3 Ds in combination with the current outlook mean he continues to be “patient” about the need for a rate rise.

“Debt matters.” The crisis has shown that households with high debt levels reduce spending more sharply in response to a downturn than less leveraged households. This in turn makes recessions that follow a substantial build up in debt “more severe and longer-lasting”. Monetary policy is likely to have to respond to a significant debt overhang by cutting and maintaining low interest rates. This has been seen in the UK where, following almost 7 years of Bank Rate at 0.5%, private (non-financial) sector debt to GDP ratio has fallen from 190% in prior to the recession to 160% today. However, many other advanced economies have not reduced their debt burden and many emerging economies are still increasing their indebtedness. “This has the potential to create persistent spending disappointments, if monetary policy is unable to stimulate other spending sufficiently.”

Simultaneously we have seen two important demographic changes. We are living longer and having fewer children. The interaction between these two forces is complex and further research is required to understand the likely consequences. However, initial studies and the experience of Japan suggest that overall demographic shifts will lower the equilibrium rate of interest and “there is at least the possibility that the effect is quite large”. Moreover, “demographic effects are even more slow-moving than debt effects, so the impact on real interest rates might be even longer-lasting.”

The monetary policy implications of the third D, the distribution of income, are the least well understood but the work so far “suggests it matters greatly” for our understanding of the monetary transmission mechanism and that rises in inequality could “affect both total savings and reinforce the rise in debt and associated deleveraging effects”.

In sum, “it is not hard to imagine – though very hard to model – a story where all three Ds interact. A high debt economy faces headwinds and needs lower interest rates. A high debt economy with adverse demographic trends needs even lower interest rates. And a high debt economy with adverse demographic trends and higher inequality … well you get the picture.”

Current economic models do not reflect these changes, but policy makers must not assume “that the future will look like the past” and they must “be prepared for the possibility that real interest rates will remain well below their historical average for a very long time”.
Both these considerations make Jan “relatively more patient before raising rates” and in combination with the recent slowing in UK growth, continued weak inflation and an absence of upward wage pressure mean current conditions do not “warrant an increase in Bank Rate”. Jan adds that the need for patience is reinforced by the current asymmetry in monetary policy in that policy makers’ ability to stimulate spending is smaller than their ability to restrain it. This “potentially makes the effects of bad news more persistent even when monetary policy does all it can”.

Jan concludes: “In order to be confident enough of the medium-term inflation outlook to raise Bank Rate, I would like to see evidence that growth is not slowing further, and that a broad range of indicators related to inflation are generally on an upward trajectory from their current low levels.”

Finalized Basel Market Risk Capital Rule Improves Bank Capital Comparability

From Moody’s.

Last Thursday, the Basel Committee for Banking Supervision (BCBS) finalized its market risk capital framework, known as the Fundamental Review of the Trading Book. The final rule, which updates the Basel II and 2.5 approaches and takes effect January 2019 will increase the transparency and consistency of reporting risk-weighted assets (RWA) and capital metrics, which is a key goal of the BCBS agenda for 2016.

Under the new standards, banks’ reported market risk capital measures will be more comparable because of consistent risk factor identification, a more rigorous model approval process, and an enhanced standardized capital calculation serving as a capital floor to the internal models-approach calculation. The revised market risk capital framework enhances both the standardized and models-based approaches of calculating market risk exposure, recognizing that model variability is one of the key drivers of differing riskweighting and capital treatment for similar exposures across banks. Under the revised framework, internal models-approach banks will need to calculate market RWA under both methods, at trading desk level. Also, as the model validation process is reinforced under the framework, coverage of risks by the internal models approach could be narrowed – for example, they would be moved to the standardized approach.

These final rules will especially affect our rated universe of global investment banks (GIBs), which generally have significant trading operations, use internal models to calculate capital requirements, and have the largest share of market RWA as a percent of total RWA. We estimate that our rated GIBs’ market RWA account for about 10% of total RWA on average. It is unclear how the new market risk capital rules will specifically affect the capital requirements of the GIBs after the GIBs take mitigating actions, however, the BCBS estimated that in aggregate, banks would have a 40% higher market risk capital requirement on a weighted average basis and 22% higher on median basis under the new market risk standard versus the existing one. We expect that the finalization of these rules, which GIBs anticipated, will motivate them to further reduce and/or exit more capital-intensive trading activities. Although market risk has generally been smaller relative to credit and operational risk in bank capital requirements, the potential capital increase comes on top of other capital requirements that will start being phased in and will be material for some banks.

Key aspects of the internal models-approach include shifting the measure of stress loss risk or tail risk to an expected-shortfall measure from a value-at-risk measure to better capture the potential magnitude of tail losses, and including a stressed capital add-on for risk factors that cannot be modeled. The capital floor (capital charge under the internal-models approach relative to capital under the standardized approach) is set at 100%, meaning that banks have no incentive to move to the internal models-approach and suggesting that the BCBS believes that model-risk remains high despite the improvements in the new framework. The revised standardized approach uses an expanded factor sensitivities-based method, so that risks are evaluated more extensively and consistently across jurisdictions. Capital charges for risk factor sensitivities (i.e., delta, vega, and curvature risk) are applied to a broad group of risk classes, including interest rate risk, foreign-exchange risk and credit-spread risk.