Category: Economics and Banking

A Deeper Look at Recent Auckland Housing Market Trends: RBNZ

The Reserve Bank of New Zealand has published an analytic note “A Deeper Look at At Recent Housing Market Trends; Insights from Unit Record Data. It highlights the influence of investors and their impact on the overall market and the impact of LVR controls.

In October 2013 the Reserve Bank placed a temporary ‘speed limit’ on high loan-to-value ratio (LVR) residential mortgage lending, restricting banks’ new lending at LVRs over 80 percent to no more than 10 percent of total residential mortgage lending. This policy was implemented to reduce financial stability risks associated with the housing market, against the backdrop of elevated household debt, high and rapidly rising house prices, and a large share of new lending going to borrowers with low deposits. The policy had an immediate dampening effect on housing market activity and house price inflation, and facilitated a strengthening in bank balance sheets. However, since late 2014, upward pressure on the housing market has re-emerged, predominantly in Auckland, posing renewed risks to financial stability.

With the housing market showing renewed signs of strength, this paper provides a detailed overview of market conditions and examines developments following the imposition of the speed limit on high-LVR lending. We find that increased housing market activity in recent months has been driven by strong investor demand, both within and outside of Auckland, as reflected in increased investor purchases and significant growth in investor-related mortgage credit. Much of the increase in investor purchase shares has coincided with a fall in the share of movers, with the first home buyer share increasing slightly following its decline after the introduction of LVR speed limits.

We also investigate whether the LVR policy has led to an increase in cash buying activity or borrowing from institutions outside of the regulatory. We do not find evidence of the former with cash buyer shares falling in Auckland and remaining broadly flat in the rest of the country. There is some evidence of a modest increase in the share of transactions involving non-banks since October 2013, although non-bank activity remains low.

We then undertake a more detailed analysis of investor activity given their heightened prevalence in the market. The primary driver of their increased market share has been a rising incidence of small investors (that are heavily reliant on credit) in the market, as opposed to greater activity among larger investors. This suggests that the incoming changes to the LVR restrictions could have a significant dampening effect on Auckland housing market activity and house price inflation. We also find that investors are disproportionately represented at both ends of the price spectrum, contrary to popular opinion that investors predominantly buy relatively cheap properties for use as rentals.

Finally, we offer some additional insights into cash buyers, with the evidence pointing towards increased investor leverage relative to other market participants, consistent with the strong growth in investor-related mortgage commitments in recent months.

Property Group Spruiking SMSF Property Punished

Following ASIC action, the Supreme Court of NSW found Park Trent Properties Group Pty Ltd (Park Trent) had been unlawfully carrying on a financial services business for over 5 years by providing advice to clients to purchase investment properties through a SMSF.

In his judgment, his Honour Acting Justice Sackville said it was in the public interest that Park Trent be restrained from carrying on a financial services business.

ASIC launched legal proceedings in November 2014 against Park Trent who, by the time of the trial in June 2015 had advised over 860 members of the public to establish and switch funds into an SMSF.

In handing down his judgment, his Honour observed that Park Trent’s business model depended on “persuading relatively unsophisticated investors of the virtues of using their superannuation accounts to purchase investment properties and to establish SMSFs… Investors were influenced to make important decisions concerning their superannuation strategy with little or no genuine consideration of whether the decision took proper account of their individual financial circumstances. Some suffered financial loss as a consequence.”

His Honour also referred to the role of Park Trent’s CEO, Ronald Cross and referred to his “willingness to ignore legal advice as to the nature of Park Trent’s statutory obligations.”

His Honour said that his decision “serves as a warning to others who conduct or propose to conduct businesses which seek to influence clients to establish SMSFs for investment purposes, without having the necessary licence to do so.”

ASIC Deputy Chairman Peter Kell said: ‘This outcome demonstrates the courts, ASIC and the public will not tolerate this type of unscrupulous behaviour.

‘Property spruikers who recommend people invest in property via SMSFs, or facilitate such an investment, and who do not have an Australian financial services licence are breaking the law.

ASIC’s message is that anyone recommending or facilitating SMSFs as a way of investing in property will need to have a licence and provide appropriate advice that prioritises the client’s interests.

‘It is important that advisers who deal with SMSFs are appropriately licenced because the important safeguards and standards that come with being licenced are in place for a sector which is of growing importance to more Australian investors.’

The parties have until 29 October 2015 to file submissions on the form of final orders.

FSI Recommendations Backed By The Government

All but one of the Murray Financial Systems Inquiry have been accepted by the Government. The report, released today says that this is to ensure the Australian Financial Services system remains safe and secure.

This is an important step forwards in the development of the finance sector, and to ensure the interests of consumers are safeguarded. Importantly, the journey towards higher capital requirements will continue, with potential consequences for banking competition and product pricing. The obligations of financial advisors will be strengthened. Superannuation system to be reviewed to ensure efficiency, transparency and consumer choice. Excessive credit card surcharges to be banned. Leveraged superannuation borrowing will not be banned.

From the introduction:

The financial sector is the largest in our economy, having contributed $139 billion over the past year and employing around 400,000 Australians.

The financial system has a vital role in commercial activity across the Australian economy, contributing to productivity and growth. The biggest decisions Australians make in life — buying a home, providing for their retirement, or starting a business — are all supported by our financial system.

As the attached response details, the Government has accepted the overwhelming majority of the Inquiry’s recommendations. Our response also includes six additional measures that are consistent with the Inquiry’s underlying philosophy.

The Government’s response sets out an agenda for improving our financial system that builds on existing Government policy. The Government’s financial system program will be implemented in stages over the coming years. The Government’s program will position Australia to respond to the challenges and opportunities of the future.

Our financial system program is made up of five distinct strategic priorities that deal with each of these challenges.

• The resilience measures aim to reduce the impact of potential future financial crises by ensuring we are better able to weather them and lessen their cost to taxpayers and the economy.

• The superannuation and retirement incomes measures aim to improve the efficiency and operation of the superannuation system and in doing so boost retirement incomes.

• The innovation measures will unlock new sources of finance for the wider economy and support competition.

• The consumer outcomes measures are designed to give consumers confidence to participate in the financial system and the confidence that they are being treated fairly.

• The regulatory system measures aim to make regulators more accountable for their performance, more capable and more effective.

Highlights include:

  1. a focus on driving competition within the finance sector
  2. continued lifting capital reserves (which APRA has already started)
  3. a ban on credit card surcharges greater than the cost of processing the payment by the merchant, enforced by ACCC
  4. confirmation of review of interchange fees
  5. a review on the superannuation system by the Productivity Commission to ensure efficiency, transparency and consumer choice. Superannuation is about income in retirement, not generic investment
  6. improved governance for superannuation boards
  7. raise the competency of financial advisors, including professional qualifications and code of ethics
  8. rename ‘general advice’ to improve consumer understanding of financial advice
  9. financial advisers and mortgage brokers to adequately disclose their relationships with associated entities
  10. a focus on innovation (e.g. crowd sourcing equity funding) in the financial sector

They did not accept the proposed ban on leverage superannuation investment.

You can read DFA’s earlier analysis of the FSI report from last December.

Some of the small print areas of disagreement with Murray include:

  1. Direct borrowing by superannuation funds – does not agree with the Inquiry’s recommendation to prohibit limited recourse borrowing arrangements by superannuation funds. While the Government notes that there are anecdotal concerns about limited recourse borrowing arrangements, at this time the Government does not consider the data sufficient to justify significant policy intervention. The Government will however commission the Council of Financial Regulators and the Australian Taxation Office (ATO) to monitor leverage and risk in the superannuation system and report back to Government after three years. This timing allows recent improvements in ATO data collection to wash through the system. The agencies’ analysis will be used to inform any consideration of whether changes to the borrowing regulations might be appropriate.
  2. does not support the creation of a new Financial Regulator Assessment Board.
  3. Conduct post-implementation reviews of major regulatory changes more frequently – does not agree to conduct more frequent post implementation reviews (PIRs), as it has already implemented changes to strengthen the review regime in 2014
  4. Align the interests of financial firms and consumers – agrees more can be done to better align the interests of financial firms and consumers. However, we intend to take a different approach to that recommended by the Inquiry for retail life insurance.

Three additional recommendations were also added in by the Government:

  1. Ensure participation in international derivatives markets –  The Government will develop legislative amendments to clarify domestic regulation to support globally coordinated policy efforts and facilitate the ongoing participation of Australian entities in international capital markets. We will develop legislative amendments in the second half of 2015.
  2. Enhance retail consumer protections for client monies –  The Government will develop legislative amendments to improve protections for client monies held in relation to derivatives. These improvements are needed to ensure that investors’ monies are adequately protected when held by intermediaries.
  3. Clarify the definition of basic deposit products – The Government will develop legislative amendments to amend the definition of a basic deposit product in the Corporations Act 2001. These amendments will provide certainty for businesses and consumers by clarifying how certain term deposit products are treated under the law.

Rising mortgage rates – is it time to refinance your home loan?

From The Conversation.

Last week, Westpac hoisted its lending rate by 20 basis points in a bid to recover the costs of recent capital raisings. There is speculation other banks will follow. Australia’s non-bank lenders could be winners from such a scenario – but the choice may not be as simple as the lowest interest rate.

The outcome of the Financial Systems Inquiry

The background to Westpac’s move lies in recommendations by the Financial System Inquiry that the capital base of Australian banks should be increased to an “unquestionably strong” level and that there should be a narrower gap in different mortgage lending requirements between institutions.

As a result Australian banks have considerably increased capital levels this year by approximately $16 billion.

However, higher capital levels and bank stability may come at additional costs, even if trade-off theory suggests greater bank and system resilience would normally equal lower funding costs. That’s because bank investors have high dividend expectations, so this means the costs of boosting capital may be passed onto borrowers.

Capital levels are likely to increase further as regulators seek to narrow the gap between the practices of the big banks and smaller lenders, and amid their increasing concern at Australia’s house prices. In particular, large banks are expected to increase capital required under their internal risk weighting models for mortgages.

Will non-bank lenders grow their mortgage books?

Non-bank lenders provide mortgage loans with comparable features but unlike banks are exclusively funded from wholesale markets and not from consumer deposits.

As a result, banks face minimum capital requirements enforced by the Australian Prudential and Regulation Authority to protect depositors, while non-bank lenders are unregulated and may more freely choose their funding mix and hence have lower funding costs.

This often implies lower capital ratios for non-banks than banks. Raising capital levels for banks only may have an impact on the balance between bank and non-bank competitors.

The following chart shows the counts and total assets of banks and non-bank lenders in Australia over time:

Total assets of non-bank and bank lenders provided by Australian Prudential Regulation Authority, http://www.apra.gov.au

The size of non-bank lenders ($120 billion) is much smaller than the size for bank lenders ($3.8 trillion) and has shrunk in relative terms over the past years. This may suggest that Australians fail to really consider this sector to finance their homes despite competitive mortgage rates from non-bank lenders.

There are many reasons for this – convenience may be one of them as banks are able to offer a larger product range and cover most financial needs of consumers, and consumers prefer to bank with a single institution.

The small size is a great disadvantage as relative fixed costs are higher for small firms than for the major banks.

Should you choose a bank or non-bank to finance your home?

Consumers seeking mortgage finance for a property – either a new borrowing or refinancing of an existing loan – can choose between a large number of banks and non-bank lenders, along with hundreds of loan products.

Comparison websites generally rank lenders and products according to the most obvious criterion – the interest rate. Non-bank lender often provide the cheapest terms. But the lowest rate loan is not necessarily the best loan.

The choice between bank and non-bank lender can be important if you want to use an offset facility. Offset facilities are not always included and they can expose borrowers to lender risk.

Having savings in an offset facility means that in effect the lender owes you money. Banks are much less risky in this regard because they benefit from government guarantees as well as greater scrutiny that are tied to the bank status.

Non-bank lenders are excluded from such guarantees and furthermore may have a greater exposure to market instability.

During the global financial crisis non-bank lenders (especially overseas firms) that were funded through capital markets, rather than customer deposits, were challenged as wholesale funding markets dried up. Some failed and total volumes shrank between 2009 and 2013 (see chart above).

Still, it is likely that more Australians change to non-bank lenders in the future. Changing a lender is easy as mortgage brokers often provide the legwork, plus exit fees have been considerably reduced since new laws came into effect on 1 July 2010 limiting mortgage exit fees to the lender’s losses directly connected to the borrower exiting the loan early.

Are non-bank lenders dangerous to our system?

Low volumes mean non-bank lenders are currently of no systemic concern to the economy and regulators. However this may change in the future as volumes shift and grow for non-bank lenders.

New market participants enter as new non-bank loan platforms are developed. One example is internet-based peer-to-peer lending.

Australians may adapt to this new regime and take on new technologies offered and seek the lenders providing the cheapest funding. Consumers generally do not care about the lenders’ own funding and may arbitrage the differences in mortgage rates by shifting the business from regulated banks to unregulated non-banks.

A concern may arise if non-bank lending is successful and to become a large player that is systemically important. In such a scenario the government would be well advised to consider regulating the industry.

Such regulations may include minimum lending and funding standards with the mission to protect de facto consumer deposits via offset accounts and to ensure the credit supply in economic downturns when wholesale funding markets are constrained.

We may be some time away from such a scenario in light of the increasing dominance of bank lenders.

Author: Harry Scheule, Associate Professor, Finance, UTS Business School, University of Technology Sydney

ASIC helps consumers to understand risks of interest-only mortgages

ASIC has released a suite of online tools to help consumers better understand the risks of interest-only mortgages, to complement its review of loan providers’ compliance with responsible lending laws.

The new tools, available on ASIC’s MoneySmart website at moneysmart.gov.au, include:

ASIC Deputy Chairman, Peter Kell, said while ASIC’s review had found that banks and other lenders needed to lift their game to ensure compliance with responsible lending obligations, consumers can help themselves by doing their homework before taking on such a large financial commitment.

‘For most Australians, a mortgage is one of the most significant financial decisions they will make in their lives,’ Mr Kell said.

‘While an interest-only mortgage may be attractive due to their initial lower repayments, they generally cost more in the long run.  Some lenders have also started charging higher interest rates on interest-only mortgages compared to principal and interest mortgages.

‘Anyone thinking of taking out an interest-only mortgage needs to have a clear plan of action when the interest-only period ends to ensure they can afford the repayments, which may increase significantly,” said Mr Kell.

Mr Kell suggests consumers who are considering an interest-only mortgage, or who already have one at present, should consider the following:

  • ensure you can afford the increased repayments once the interest-only period ends, and also factor in an interest rate rise
  • the principal of the loan will not reduce while you are making interest-only repayments
  • using an offset account to reduce the cost of an interest-only mortgage will only work if you can keep making these extra repayments without making any withdrawals.  If you are tempted to dip into your offset account, then you might be better off with a principal and interest mortgage instead.

ASIC’s recent probe into interest-only mortgages reinforced the fact that lenders and brokers need to meet responsible lending obligations and ensure the interest-only loans they arrange meet their customers’ requirements and objectives.

‘We expect that lenders and brokers arranging interest-only mortgages would do so in a way that is consistent with their customers’ plans,’ Mr Kell said.

Background

On 20 August 2015, ASIC released a report of its review into how lenders provided interest-only mortgages to both investors and owner occupiers (refer: 15-220MR).  The review found that lenders providing interest-only mortgages needed to lift their standards to meet important consumer protection laws.

ASIC’s MoneySmart website provides trusted and impartial guidance and online tools for Australians on issues relating to money and finances. Visit ASIC’s MoneySmart at moneysmart.gov.au.

Australia is currently experiencing low interest rates.  Consumers should build in a buffer over the minimum repayment for any interest rate rises and increases in repayments, especially if they have taken out an interest-only mortgage.

Example: $500,000 mortgage over 30 years with a constant interest rate of 6%

  1. For a principal and interest loan, a consumer would pay around $582,274 in interest over the life of the loan.
  2. For an interest-only loan with a 5-year interest-only period, a consumer would pay around $619,493 in interest (an extra $37,219 over the life of the loan) and have to find an extra $332 per fortnight in repayments after 5 years.
  3. If the interest-only period was extended to 10 years, a consumer would pay around $662,720 in interest (an extra $80,446 over the life of the loan) and have to find an extra $498 per fortnight in repayments after 10 years.

Example image from ASIC’s MoneySmart interest-only calculator

Moneysmart Interest Only

Financial Stability Review Says Housing Risks Higher Than Thought

The RBA released their latest Financial Stability Review today. It is worth reading through the 66 pages, because there are a number of important themes, relating to housing. Underlying this though is a beat which could be interpreted as the RBA admitting they have misread the housing sector.

In summary, they recognise that underwriting standards were not as good as initially thought, the investment loan and interest only loan sectors carry potentially higher risks, and the changes to capital and regulatory standards will have a mitigating impact, over the medium term. That said, households remain well placed (despite the highest ever debt at lowest ever interest rates).

6tl-hhfinThey are however concerned about the impact of the current residential construction boom.

They also highlight risks from lending by banks to the commercial property sector, and the ongoing use of SMSF’s to invest in property.

There is also a section of the capital ratios for the banks, both under then IRB and standard approaches to capital ratios. Of particular note is for banks using the standard approach, they show how the presence of Lender Mortgage Insurance (LMI) and different LVR’s impact the capital weights. Despite the upcoming move from 17 to 25 basis points for banks under the advanced IRB approach, banks with the standard approach remain at a competitive disadvantage.

Basel III Implementation In Australia: Slow But Sure?

A progress report (the ninth) on adoption of the Basel regulatory framework was issued today by BIS.  This report sets out the adoption status of Basel III regulations for each Basel Committee on Banking Supervision (BCBS) member jurisdiction as of end-September 2015. It updates the Committee’s previous progress reports, which have been published on a semiannual basis since October 2011.

Regarding the consistency of regulatory implementation, the Committee has published its assessment reports on 22 members – Australia, Brazil, Canada, China, nine members of the European Union, Hong Kong SAR, India, Japan, Saudi Arabia, Mexico, Singapore, South Africa, Switzerland and the United States – regarding their implementation of Basel III risk-based capital regulations, which are available on the Committee’s website. This includes all members that are home jurisdictions of global systemically important banks (G-SIBs). The Committee has also published five assessment reports (Hong Kong SAR, India, Saudi Arabia, Mexico and South Africa) on the domestic adoption of the Basel LCR standards. The assessments of Russia, Turkey, South Korea and Indonesia are under way, including consistency of implementation of both risk-based capital and LCR standards. Further, preparatory work for the assessment of G-SIB standards has already started in mid-2015 and its assessment work will start later this year. By September 2016, the Committee aims to have assessed the consistency of risk-based capital standards of all 27 member jurisdictions and the consistency of G-SIB standards of all five member jurisdictions that are home jurisdictions of G-SIBs.

The Basel III framework builds on and enhances the regulatory framework set out under Basel II and Basel 2.5. The structure of the attached table has been revamped (effective from October 2015) to monitor the adoption progress of all Basel III standards, which will come into effect by 2019. The monitoring table no longer includes the reporting columns for Basel II and 2.5, as almost all BCBS member jurisdictions have completed their regulatory adoption. The attached table therefore reviews members’ regulatory adoption of the following standards:

  • Basel III Capital: In December 2010, the Committee released Basel III, which set higher levels for capital requirements and introduced a new global liquidity framework. Committee members agreed to implement Basel III from 1 January 2013, subject to transitional and phase-in arrangements.
  1. Capital conservation buffer: The capital conservation buffer will be phased in between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
  2. Countercyclical buffer: The countercyclical buffer will be phased in parallel to the capital conservation buffer between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
  3. Capital requirements for equity investment in funds: In December 2013, the Committee issued the final standard for the treatment of banks’ investments in the equity of funds that are held in the banking book, which will take effect from 1 January 2017.
  4. Standardised approach for measuring counterparty credit risk exposures (SA-CCR): In March 2014, the Committee issued the final standard on SA-CCR, which will take effect from 1 January 2017. It will replace both the Current Exposure Method (CEM) and the Standardised Method (SM) in the capital adequacy framework, while the IMM (Internal Model Method) shortcut method will be eliminated from the framework.
  5. Securitisation framework: The Committee issued revisions to the securitisation framework in December 2014 to strengthen the capital standards for securitisation exposures held in the banking book, which will come into effect in January 2018.
  6. Capital requirements for bank exposures to central counterparties: In April 2014, the Committee issued the final standard for the capital treatment of bank exposures to central counterparties, which will come into effect on 1 January 2017.
  • Basel III leverage ratio: In January 2014, the Basel Committee issued the Basel III leverage ratio framework and disclosure requirements. Implementation of the leverage ratio requirements began with bank-level reporting to national supervisors until 1 January 2015, while public disclosure started on 1 January 2015. The Committee will carefully monitor the impact of these disclosure requirements. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 (minimum capital requirements) treatment on 1 January 2018 based on appropriate review and calibration.
  • Basel III liquidity coverage ratio (LCR): In January 2013, the Basel Committee issued the revised LCR. It came into effect on 1 January 2015 and is subject to a transitional arrangement before reaching full implementation on 1 January 2019.
  • Basel III net stable funding ratio (NSFR): In October 2014, the Basel Committee issued the final standard for the NSFR. In line with the timeline specified in the 2010 publication of the liquidity risk framework, the NSFR will become a minimum standard by 1 January 2018.
  • G-SIB framework: In July 2013, the Committee published an updated framework for the assessment methodology and higher loss absorbency requirements for G-SIBs. The requirements will be introduced on 1 January 2016 and become fully effective on 1 January 2019. To enable their timely implementation, national jurisdictions agreed to implement by 1 January 2014 the official regulations/legislation that establish the reporting and disclosure requirements.
  • D-SIB framework: In October 2012, the Committee issued a set of principles on the assessment methodology and the higher loss absorbency requirement for domestic systemically important banks (D-SIBs). Given that the D-SIB framework complements the G-SIB framework, the Committee believes it would be appropriate if banks identified as D-SIBs by their national authorities were required to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.
  • Pillar 3 disclosure requirements: In January 2015, the Basel Committee issued the final standard for revised Pillar 3 disclosure requirements, which will take effect from end-2016 (ie banks will be required to publish their first Pillar 3 report under the revised framework concurrently with their year-end 2016 financial report). The standard supersedes the existing Pillar 3 disclosure requirements first issued as part of the Basel II framework in 2004 and the Basel 2.5 revisions and enhancements introduced in 2009.
  • Large exposures framework: In April 2014, the Committee issued the final standard that sets out a supervisory framework for measuring and controlling large exposures, which will take effect from 1 January 2019.

They published an assessment of Australia’s progress:

Oz-Status-Key OZ-Status-9Still a long way to go; highly complex, and this is before Basel IV arrives. Is more complexity better?

G20 finance ministers endorse reforms to the international tax system for curbing avoidance by multinational enterprises

G20 finance ministers endorsed the final package of measures for a comprehensive, coherent and co-ordinated reform of the international tax rules during a meeting on 8 October, in Lima, Peru.

During a meeting chaired by Turkish Deputy Prime Minister Cevdet Yilmaz, the G20 finance ministers expressed strong support for the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project, which provides governments with solutions for closing the gaps in existing international rules that allow corporate profits to « disappear » or be artificially shifted to low/no tax environments, where little or no economic activity takes place.

They renewed a commitment for rapid, widespread and consistent implementation of the BEPS measures and reiterated the need for the OECD to prepare an inclusive monitoring framework by early-2016  in which all countries will participate on an equal footing. Ministers agreed to forward the BEPS measures for discussion and action by G20 heads of state during their summit on 15-16 November in Antalya, Turkey.

“Base erosion and profit shifting is sapping our economies of the resources needed to jump-start growth, tackle the effects of the global economic crisis and create better opportunities for all,” said OECD Secretary-General Angel Gurría. “The G20 has recognised that BEPS is also eroding the trust of citizens in the fairness of tax systems worldwide, which is why we were called on to prepare the most fundamental changes to international tax rules in almost a century. Our challenge going forward is to implement the measures in this plan, rendering BEPS-inspired tax planning structures ineffective and creating a better environment for businesses and citizens alike,” Mr Gurría said.

Undertaken at the request of the G20 Leaders, the work to address BEPS is based on the 2013 G20/OECD BEPS Action Plan, which identified 15 actions to put an end to international tax avoidance. The plan was structured around three fundamental pillars: introducing coherence in the domestic rules that affect cross-border activities; reinforcing substance requirements in the existing international standards, to ensure alignment of taxation with the location of economic activity and value creation; and improving transparency, as well as certainty for businesses and governments.

Revenue losses from BEPS are conservatively estimated at USD 100-240 billion annually, or anywhere from 4-10% of global corporate income tax (CIT) revenues. Given developing countries’ greater reliance on CIT revenues as a percentage of tax revenue, the impact of BEPS on these countries is particularly significant

The final package of BEPS measures includes new minimum standards on: country-by-country reporting, which for the first time will give tax administrations a global picture of the operations of multinational enterprises; treaty shopping, to put an end to the use of conduit companies to channel investments; curbing harmful tax practices, in particular in the area of intellectual property and through automatic exchange of tax rulings; and effective mutual agreement procedures, to ensure that the fight against double non-taxation does not result in double taxation.

The BEPS package also revises the guidance on the application of transfer pricing rules to prevent taxpayers from using so-called “cash box” entities to shelter profits in low or no-tax jurisdictions, and redefines the key concept of Permanent Establishment, to curb arrangements which avoid the creation of a taxable presence in a country by reliance on an outdated definition.

The BEPS package offers governments a series of new measures to be implemented through domestic law changes, including strengthened rules on Controlled Foreign Corporations, a common approach to limiting base erosion through interest deductibility and new rules to prevent hybrid mismatch arrangements from making profits disappear for tax purposes through the use of complex financial instruments.

Nearly 90 countries are working together on the development of a multilateral instrument capable of incorporating the tax treaty-related BEPS measures into the existing network of bilateral treaties. The instrument will be open for signature by all interested countries in 2016.

The BEPS measures were agreed after a transparent and intensive two-year consultation process between OECD, G20 and developing countries and stakeholders from business, labour, academia and civil society organisations.

“Everyone has a stake in reversing base erosion and profit shifting,” Mr Gurria said. “The BEPS Project has shown that all stakeholders can come together to bring about change. Swift implementation by governments will ensure a more certain and more sustainable international tax environment for the benefit of all, not just a few.”

Examples of BEPS schemes to be eliminated

For further information on the OECD/G20 Base Erosion and Profit Shifting Project, including the 2015 Explanatory Statement, the 2015 BEPS Reports, background information and FAQs, go to: www.oecd.org/tax/beps-2015-final-reports.htm

Bank of England To Strengthen the UK Financial System

The Bank of England has today published two consultation papers: one on ring-fencing and one on operational continuity. These proposals will ensure that ring-fenced banks are protected from shocks originating in other parts of their groups, as well as the broader financial system, and can be easily separated from their groups in the event of failure.

Well-capitalised, resilient firms mean that when problems occur, critical economic functions, including retail banking, can be maintained and economic growth can be supported through ongoing banking activity.

Today’s proposals seek to ensure that ring-fenced banks have sufficient capital resources on a standalone basis, sheltering them from risks originating in other parts of their groups. The proposed rules also mean that a ring-fenced bank can be more easily detached from the wider group by ensuring intragroup arrangements operate on an arm’s length basis – helping ensure important services remain available in the event of a failure of other parts of the group.

The publication of these two consultation papers means firms will be able to put in place detailed plans to ensure that they are prepared to ring-fence their core retail activities from 1 January 2019.  These consultation papers also provide greater clarity on the operational continuity rules affecting other firms providing functions that are critical to the economy.

Andrew Bailey, Deputy Governor of the Bank of England and Chief Executive of the Prudential Regulation Authority (PRA) said:

“Making our firms more resilient has been at the forefront of our post-crisis reform agenda. Today represents an important step forward in achieving this aim. We have provided clarity for affected banks on how we will implement ring-fencing and this will enable firms to take substantial steps forward in their preparations for structural reform.”

Proposals for ring-fenced banks

The PRA is required under the Financial Services and Markets Act 2000, as amended by the Financial Services (Banking Reform) Act 2013, to make policy to implement the ring-fencing of core UK financial services and activities.

From 1 January 2019, banks with core deposits greater than £25 billion (broadly those from individuals and small businesses) will be required to ring-fence their core retail activities. To prepare for this, the PRA published near final rules on 27 May 2015 on governance, legal structure, and operational continuity and consulted on the approach to ring-fencing transfer schemes on 18 September 2015.

The proposals in today’s consultation papers look to ensure:

  • a ring-fenced bank has sufficient financial resources and liquidity;
  • intragroup exposures and arrangements between the ring-fenced bank and the rest of the group are managed in a prudent manner, at arm’s length;
  • the ring-fenced bank is clear on the PRA’s expectations on the use of financial market infrastructures; and
  • the ring-fenced bank can demonstrate the ability to continue to provide critical economic functions during resolution.

This consultation closes on 15 January 2016.

Operational continuity proposals

The PRA is also consulting on rules to ensure a broader range of banks, building societies and PRA-authorised investment firms structure their operations in a way that allows critical shared services to continue even in times of stress or failure.

Ensuring operational continuity is a necessary condition to make certain that firms can be resolved in an orderly fashion to support financial stability.

The PRA invites feedback on the proposals set out in this consultation paper, but respondents may wish to wait for the publication of the addendum, which will set a closing date for the consultation period.

Risks To Financial Stability; A UK Perspective

In a speech, Richard Sharp, member of the UK Financial Policy Committee, outlined the range of risks within the financial system. One topic he discusses is the buy to let sector, because  investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices.  HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market.

The complexity of global financial systems and markets requires that we aren’t exclusively concerned about the capitalisation of financial institutions.  We are also concerned about risk of contagion and amplification and therefore we monitor systemic resilience and vulnerability wherever we see them.

The crash certainly demonstrated how specific vulnerabilities can have massive implications through amplification when the systemic is fragile or stretched.  For example, although this summer’s fall in the Shanghai stock market saw peak to trough losses of 2.9 trillion dollars, there was no contagion or amplification in any way comparable to the experience of the 2007-2008 financial crisis.  By comparison the US subprime losses which precipitated the financial crisis of 2007-2008 are estimated at around 400 billion dollars but, as we know now, have had a devastating impact. Unfortunately these losses were heavily concentrated on highly leveraged, systemically important financial institutions.  As a result of a loss of confidence in the banking system, the subsequent contagion created profoundly greater costs.  For example, economists at the IMF estimate that the aggregate cost to the US economy alone was 4.5 trillion dollars in the period of 2007-2009.Comparable UK costs over the same regime were £370 billion.

Consequently, in fulfilling its primary responsibility to contribute to UK financial stability policy, the FPC has to monitor the banking system, the financial system as a whole, and global and domestic potential sources of instability.

A particular challenge is that the UK is the home for an outsized financial sector.  Bank of England economists have calculated that in 2013 the UK banking system was 450% of GDP – compared to around 100% in 1975 – larger than in Japan, the US and the ten largest EU economies.

However, a vibrant and successful financial sector is indeed a precious asset for our nation.  It is a source of employment for millions of people; it is a critical source of tax revenue; it supports a number of other leading industries based in the UK, such as accounting and law; it provides for inward capital investment; it is one of the few industries in which the UK is a world leader.  The FPC is building the capital and resolution framework to contribute to financial stability and to ensure there are no more bailouts.

The importance of the financial services industry to the UK is recognised by the remit the Chancellor has provided for the FPC.  He charges the Committee, subject to fulfilling its primary objective on financial stability, to consider the government priority of maintaining the international competitiveness of the UK financial system. However, it is unequivocal government policy that it is unacceptable that UK citizens should underwrite banks’ balance sheets.  One of the FPC’s priorities is to provide a capital and resolution framework for banks which ensures that they are capable of absorbing their own losses and are not ‘too big to fail’.

The actual losses borne by the banking system in the UK were unquestionably significant and life threatening; the six largest UK banks faced losses of up to 15% of risk weighted assets (nearly £67 billion in aggregate), with the largest losses concentrated in two institutions, Lloyds and RBS.  Of course, the FPC doesn’t exist to stop any financial institution or group of institutions experiencing severe losses.  Indeed, and inevitably, there may be severer losses arising from poor credit or investment judgement in the future.  Our responsibility is to have the insight to ensure that we are aware of risks to the financial system and that, in particular, the systemically important institutions are well capitalised and that any severe losses don’t threaten the financial system.

However, recognising the risk of excessive regulation, the Chancellor told MPs when discussing the creation of the FPC and its objectives in 2011 – “we don’t want the stability of the graveyard.” What he meant was that although the FPC has been granted significant powers, in using these powers we have to ensure that we don’t unwarrantedly undermine economic growth through excessive regulation.

This highlights that there are real trade-offs for us, as we seek to fulfil our mandate.  Firstly, we want to have well-capitalised banks but we don’t want to diminish the provision of credit to the real economy.  Secondly, whilst we want the provision of credit, we don’t want to risk promoting asset bubbles.  Thirdly, given its scale and importance as a source of household indebtedness, we want a disciplined property lending market; on the other hand, we don’t want unreasonably to restrict any individual’s ability to enrich his or her life through a housing purchase. Fourth, we may want to move quickly to ensure resolution, but we have to move in a globally coordinated way, which unavoidably has lengthened the process to agreeing a new resolution regime.  Fifth, we want to have a safe and stable financial system, but we do not want to encourage financial services firms to feel incentivised to locate in other jurisdictions with lighter touch regulation, or to inhibit the development of new innovative sources of finance.

The FPC has been granted considerable powers to give Directions to the PRA and the FCA in relation to the use of certain macroprudential tools specified in secondary legislation.  So far, in the area of bank capital requirements, Parliament has given the FPC macroprudential tools over sectoral capital requirements, and leverage ratio requirements. The FPC is also responsible for setting the countercyclical capital buffer for the UK.  Further it has Direction powers also in relation to tools with respect to the housing market – currently loan to value and debt to income limits in respect of owner-occupied lending.  HM Treasury also plans to consult by the end of this year on whether the FPC should be provided Direction powers over buy-to-let mortgages.

In seeking to preserve financial stability, the FPC can also make Recommendations to anybody, including to the PRA and the FCA on a “comply or explain” basis, and to HM Treasury, including on the boundaries within and around the perimeter of the PRA and FCA regulatory regimes.

In addition to these formal powers, the FPC also works closely with other authorities and committees within the Bank of England on issues of joint interest.  For example, the FPC and PRA Board both agreed the design of the annual and concurrent UK bank stress test scenario, the results of which will help inform judgements by both committees.

Before using its powers, the FPC considers a wide range of information, including market and supervisory intelligence.

The Committee has developed a set of Core Indicators that it will consider when using its powers of Direction.  These are indicators of key areas where vulnerabilities may build and signal an increase in financial stability risks.  For example, the level of credit-to-GDP above its long-run trend (the ‘credit-to-GDP gap’) is one of the key metrics the FPC considers when setting the countercyclical capital buffer, as research suggests that periods of excess credit growth often precede financial crises.

In addition, the FPC is required by law to conduct and publish cost-benefit analysis before using its tools (unless, in the Committee’s opinion, it is not reasonably practicable to do so). In the remit that the Chancellor set out for the FPC in July, he emphasised that the Committee must communicate how decisions to use its powers are compatible with its objectives, including its judgement as to the balance of risks to its objectives, how those risks are judged to have evolved and how they are expected to evolve.

Since its formation in April 2013, the FPC has made 15 Recommendations or Directions on a wide range of topics, including on: bank capital and liquidity requirements; the UK housing market; and the resilience of the UK financial system to cybercrime.  We set out our Recommendations in the biannual Financial Stability Report.

So the FPC has been fairly active in addressing risks.  But what risks are we concerned about now?  In July, the Committee published its Financial Stability Report, which highlighted the six major risks which, in the Committee’s judgement, are facing the UK financial system.  These were risks from: (1) the global environment; (2) potential illiquidity in markets; (3) the UK current account deficit; (4) the UK housing market; (5) misconduct in the financial system; and (6) cybercrime.  The Committee provided an update on some of these risks in the Record of its meeting in September.

With respect to the global environment, the Committee reported that, for the moment, things are getting somewhat less fragile in the euro area, in particular as a result of the fact that the immediate risks in relation to Greece have been addressed by the new programme agreed between the Greek government and its European partners.  However, there are signs that risks to emerging market economies, particularly commodity exporters, have risen and are significant.  This is partly as a result of a slowdown in China and the prospects of a potential ‘spill over’ from tighter monetary policy in the US, which could cause a material retrenchment in capital flows, as well as wealth effects. It is worth observing that one effect of US quantitative easing has been a considerable jump in the emerging market credit to GDP growth ratio.  Moreover, many of the EMEs have raised significant external capital in US dollars and are therefore also exposed to the risk of currency mismatch.  We need to consider whether capital markets can effectively trade such debt given liquidity concerns.

In fact we are concerned that global markets may not be able to absorb large shifts in assets, hence we are examining the capital market provision of liquidity very carefully.  This year, there have been a number of short-lived, non-systemic periods of very high market volatility, which exposed the fragility of market liquidity and that disorderly conditions in one market  could spill over to others.

In considering the risk of fragile market liquidity, for example assessing dealers’ ability to act as intermediaries in markets, the Bank and the FCA are working at an international level. The Committee is also closely monitoring risks from the UK’s current account deficit.  However, despite the deficit being close to record highs (at 5.2% in 2015 Q1), the capital flows funding the deficit are mostly long-term in nature, reducing the risk of investor flight, and do not yet appear to be creating vulnerabilities in specific sectors.

One risk which received a lot of publicity following the publication of the September Record was the UK housing market. It is worth observing how secure the UK housing market has been to investors historically.  This can be partly attributed to the fact that mortgages are typically well backed by housing assets, and that in the UK, unlike the US, mortgages are recourse loans, so homeowners can’t just walk away from their debts.  However, the rapid growth in the buy-to-let market has caught our attention – the stock of buy-to-let mortgages has increased by over 40% since 2008.  Why could this be a cause for concern?  Buy-to-let mortgages are typically extended on interest-only terms, meaning their loan-to-value levels fall more slowly over time than owner-occupied mortgages. In addition, buy-to-let mortgages can add to procyclicality in the housing and credit markets, as investors may increase demand for property in an upturn, as they seek capital gains.  Buy to let investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices.  As I mentioned earlier, HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market.  I believe it is important that the Committee is provided with powers. Beyond the risks the Committee have identified and, looking longer term, what troubles me?

It’s worth observing that – worryingly – global debt has increased considerably since the crash.  It has increased by 57 trillion dollars since 2007 – 2014, outpacing global GDP growth over that period.  As I mentioned, I’m most concerned about the fragility arising from this with respect to emerging markets.

Inevitably I have to be concerned that there are even greater risks out there which aren’t anticipated by even the best modellers of risk.  As a member of the FPC, I’ve had the benefit of seeing how governmental institutions approach forecasting. It is well known that the Bank, the IMF, and other august institutions failed to anticipate the crash.  Here for example is the IMF’s 2007 global financial stability map.  IMF-Risk-1The 2007 version singularly failed to reflect the incipient instability which was present and emerged so devastatingly – notice the radically different 2008 version.IMF-Risk-2Modelling is hard – In fact, when I first encountered the optimism of some modellers, it brought to my mind a story told by the educator Ken Robinson:

A teacher noticed that a 6 year old girl was working very hard on a drawing and he asked her what she was drawing.  She said she was drawing a picture of God.  When the teacher said, “But no one knows what God looks like”, she replied – “they will in a minute”.

The Bank’s own approach to forecasting underlines that they recognise limitations which any forecasters must confront.  It is clear that a single point one year forecast can be materially different from the outcome in reality.  Hence, the Bank produces fan charts which highlight the amplitude of uncertainty.  For our Committee, which does have to be concerned about fat tail events, it is worth observing that even the fan chart approach failed to capture the extreme events that occurred in 2007/08.

However, as a practitioner, I think that general expectations of precision from central bank forecasters maybe too great.  In the financial sphere we are well aware that not one of all the outstanding brains in the world can, with predictable regularity, determine which way the markets will be even in the next 24 hours let alone the next year.  Consequently, whilst, I’m content that the FPC should take account of its indicators and its forecasts, it must always provide for resilience and capital strength that takes account of the reality of unpredictable events.