Macroprudential Policy in the U.S. Economy

Fed Vice Chairman Stanley Fischer spoke at the “Macroprudential Monetary Policy” conference. He remains concerned that the U.S. macroprudential toolkit is not large and is not yet battle tested. The contention that macroprudential measures would be a better approach to managing asset price bubbles than monetary policy, he says, is persuasive, except when there are no relevant macroprudential measures available. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment.

This afternoon I would like to discuss the challenges to formulating macroprudential policy for the U.S. financial system.

The U.S. financial system is extremely complex. We have one of the largest nonbank sectors as a percentage of the overall financial system among advanced market economies. Since the crisis, changes in the regulation and supervision of the financial sector, most significantly those related to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the Basel III process, have addressed many of the weaknesses revealed by the crisis. Nonetheless, challenges to our efforts to preserve financial stability remain.

The Structure, Vulnerabilities, and Regulation of the U.S. Financial System
To set the stage, it is useful to start with a brief overview of the structure of the U.S. financial system. A diverse set of institutions provides credit to households and businesses, and others provide deposit-like services and facilitate transactions across the financial system. As can be seen from panel A of figure 1, banks currently supply about one-third of the credit in the U.S. system. In addition to banks, institutions thought of as long-term investors, such as insurance companies, pension funds, and mutual funds, provide anotherone-third of credit within the system, while the government-sponsored enterprises (GSEs), primarily Fannie Mae and Freddie Mac, supply 20 percent of credit. A final group, which I will refer to as other nonbanks and is often associated with substantial reliance on short-term wholesale funding, consists of broker-dealers, money market mutual funds (MMFs), finance companies, issuers of asset-backed securities, and mortgage real estate investment trusts, which together provide 14 percent of credit.

Fed-Fig-1In the first quarter of this year, U.S. financial firms held credit market debt equal to $38 trillion, or 2.2 times the gross domestic product (GDP) of the United States. As the figure shows, the size of the financial sector relative to GDP grew for nearly 50 years but declined after the financial crisis and has only started increasing again this year.

From the perspective of financial stability, there are two important dimensions along which the categories of institutions in figure 1 differ. First, banks, the GSEs, and most of what I have called other nonbanks tend to be more leveraged than other institutions. Second, some institutions are more reliant on short-term funding and hence vulnerable to runs. For example, MMFs were pressured during the recent crisis, as their deposit-like liabilities–held as assets by highly risk-averse investors and not backstopped by a deposit insurance system–led to a run dynamic after a large fund broke the buck. In addition, nearly half of the liabilities of broker-dealers consists–and consisted then–of short-term wholesale funding, which proved to be unstable in the crisis.

The pros and cons of a multifaceted financial system
The significant role of nonbanks in the U.S. financial system and the associated complex web of interconnections bring both advantages and challenges relative to the more bank-dependent systems of other advanced economies. A potential advantage of lower bank dependence is the possibility that a contraction in credit supply from banks can be offset by credit supply from other institutions or capital markets, thereby acting as a spare tire for credit supply. Historical evidence suggests that the credit provided by what I termed long-term investors–that is, insurance companies, pension funds, and mutual funds–has tended to offset movements in bank credit relative to GDP, as indicated by the strong negative correlation of credit held by these institutions with bank credit during recessions. In other words, these institutions have acted as a spare tire for the banking sector.

However, complexity also poses challenges. While the financial crisis arguably started in the nonbank sector, it quickly spread to the banking sector because of interconnections that were hard for regulators to detect and greatly underappreciated by investors and risk managers in the private sector.6 For example, when banks provide loans directly to households and businesses, the chain of intermediation is short and simple; in the nonbank sector, intermediation chains are long and often involve a multitude of both banks and other nonbank financial institutions.

Regulatory, supervisory, and financial industry reforms since the crisis
U.S. regulators have undertaken a number of reforms to address weaknesses revealed by the crisis. The most significant set of reforms has focused on the banking sector and, in particular, on regulation and supervision of the largest, most interconnected firms. Changes include significantly higher capital requirements, additional capital charges for global systemically important banks, macro-based stress testing, and requirements that improve the resilience of banks’ liquidity risk profile.

Changes for the nonbank sector have been more limited, but steps have been taken, including the final rule on risk retention in securitization, issued jointly by the Federal Reserve and five other agencies in October of last year, and the new MMF rules issued by the Securities and Exchange Commission (SEC) in July of last year, following a Section 120 recommendation by the Financial Stability Oversight Council (FSOC). More recently, the SEC has also proposed rules to modernize data reporting by investment companies and advisers, as well as to enhance liquidity risk management and disclosure by open-end mutual funds, including exchange-traded funds. Other provisions include the central clearing requirement for standardized over-the-counter derivatives and the designation by the FSOC of four nonbanks as systemically important financial institutions. The industry has also undertaken important changes to bolster the resilience of its practices, including notable improvements to internal risk-management processes.

Some challenges to macroprudential policy
The steps taken since the crisis have almost certainly improved the resilience of the U.S. financial system, but I would like to highlight two significant challenges that remain.

First, new regulations may lead to shifts in the institutional location of particular financial activities, which can potentially offset the expected effects of the regulatory reforms. The most significant changes in regulation have focused on large banks. This focus has been appropriate, as large banks are the most interconnected and complex institutions. Nonetheless, potential shifts of activity away from more regulated to less regulated institutions could lead to new risks.

It is still too early to gauge the degree to which such adaptations to regulatory changes may occur, although there are tentative signs. For example, we have seen notable growth in mortgage originations at independent mortgage companies as reflected in the striking increase in the share of home-purchase originations by independent mortgage companies from 35 percent in 2010 to 47 percent in 2014. This growth coincides with the timing of Basel III, stress testing, and banks’ renewed appreciation of the legal risks in mortgage originations. As another example, there have also been many reports of diminished liquidity in fixed-income markets. Some observers have linked this shift to new regulations that have raised the costs of market making, although the evidence for changes in market liquidity is far from conclusive and a range of factors related to market structure may have contributed to the reporting of such shifts.

Despite limited evidence to date, the possibility of activity relocating in response to regulation is a potential impediment to the effectiveness of macroprudential policy. This is clearly the case when activity moves from a regulated to an unregulated institution. But it may also be relevant even when activity moves from one regulated institution to an institution regulated by a different authority. This scenario can occur in the United States because different regulators are responsible for different institutions, and financial stability traditionally has not been, and in a number of cases is still not, a central component of these regulators’ mandates. To be sure, the situation has improved since the crisis, as the FSOC facilitates interagency dialogue and has a shared responsibility for identifying risks and reporting on these findings and actions taken in its annual report submitted to the Congress. In addition, FSOC members jointly identify systemically important nonbank financial institutions. Despite these improvements, it remains possible that the FSOC members’ different mandates, some of which do not include macroprudential regulation, may hinder coordination. By contrast, in the United Kingdom, fewer member agencies are represented on the Financial Policy Committee at the Bank of England, and each agency has an explicit macroprudential mandate. The committee has a number of tools to carry out this mandate, which currently are sectoral capital requirements, the countercyclical capital buffer, and limits on loan-to-value and debt-to-income ratios for mortgage lending.

A second significant challenge to macroprudential policy remains the relative lack of measures in the U.S. macroeconomic toolkit to address a cyclical buildup of financial stability risks. Since the crisis, frameworks have been or are currently being developed to deploy some countercyclical tools during periods when risks escalate, including the analysis of salient risks in annual stress tests for banks, the Basel III countercyclical capital buffer, and the Financial Stability Board (FSB) proposal for minimum margins on securities financing transactions. But the FSB proposal is far from being implemented, and a number of tools used in other countries are either not available to U.S. regulators or very far from being implemented. For example, several other countries have used tools such as time-varying risk weights and time-varying loan-to-value and debt-to-income caps on mortgages. Indeed, international experience points to the usefulness of these tools, whereas the efficacy of new tools in the United States, such as the countercyclical capital buffer, remains untested.

In considering the difficulties caused by the relative unavailability of macroprudential tools in the United States, we need to recognize that there may well be an interaction between the extent to which the entire financial system can be strengthened and made more robust through structural measures–such as those imposed on the banking system since the Dodd-Frank Act–and the extent to which a country needs to rely more on macroprudential measures. Inter alia, this recognition could provide an ex post rationalization for the United States having imposed stronger capital and other charges than most foreign countries.

Implications for monetary policy
Though I remain concerned that the U.S. macroprudential toolkit is not large and not yet battle tested, that does not imply that I see acute risks to financial stability in the near term. Indeed, banks are well capitalized and have sizable liquidity buffers, the housing market is not overheated, and borrowing by households and businesses has only begun to pick up after years of decline or very slow growth. Further, I believe that the careful monitoring of the financial system now carried out by Fed staff members, particularly those in the Office of Financial Stability Policy and Research, and by the FSOC contributes to the stability of the U.S. financial system–though we have always to remind ourselves that, historically, not even the best intelligence services have succeeded in identifying every significant potential threat accurately and in a timely manner. This is another reminder of the importance of building resilience in the financial system.

Nonetheless, the limited macroprudential toolkit in the United States leads me to conclude that there may be times when adjustments in monetary policy should be discussed as a means to curb risks to financial stability. The deployment of monetary policy comes with significant costs. A more restrictive monetary policy would, all else being equal, lead to deviations from price stability and full employment. Moreover, financial stability considerations can sometimes point to the need for accommodative monetary policy. For example, the accommodative U.S. monetary policy since 2008 has helped repair the balance sheets of households, nonfinancial firms, and the financial sector.

Given these considerations, how should monetary policy be deployed to foster financial stability? This topic is a matter for further research, some of which will look similar to the analysis in an earlier time of whether and how monetary policy should react to rapidly rising asset prices. That discussion reached the conclusion that monetary policy should be deployed to deal with errant asset prices (assuming, of course, that they could be identified) only to the extent that not doing so would result in a worse outcome for current and future output and inflation.

There are some calculations–for example, by Lars Svensson–that suggest it would hardly ever make sense to deploy monetary policy to deal with potential financial instability. The contention that macroprudential measures would be a better approach is persuasive, except when there are no relevant macroprudential measures available. I believe we need more research into the question. I also struggle in trying to find consistency between the certainty that many have that higher interest rates would have prevented the Global Financial Crisis and the view that the interest rate should not be used to deal with potential financial instabilities. Perhaps that problem can be solved by seeking to distinguish between a situation in which the interest rate is not at its short-run natural rate and one in which asset-pricing problems are sector specific.

Of course, we should not exaggerate. It is one thing to say we have no macroprudential tools and another to say that having more macroprudential measures–particularly in the area of housing finance–could provide major financial stability benefits. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment. In this regard, a number of recent research papers have begun to frame the issue in terms of such tradeoffs, although this is a new area that deserves further research.

It may also be fruitful for researchers to continue investigating the deployment of new or little-used monetary policy tools. For example, it is arguable that reserve requirements–a traditional monetary policy instrument–can be viewed as a macroprudential tool. In addition, some research has begun to ask important questions about the size and structure of monetary authority liabilities in fostering financial stability.

Conclusion
To sum up: The need for coordination across different regulators with distinct mandates creates challenges to the timely deployment of macroprudential measures in the United States. Further, the toolkit to act countercyclically in the face of building financial stability risks is limited, requires more research on its efficacy, and may need to be enhanced. Given these challenges, we need to consider the potential role of monetary policy in fostering financial stability while recognizing that there is more research to be done in clarifying the potential costs and benefits of doing so when conditions appear so to warrant.

After all of the successful work that has been done to reform the financial system since the Global Financial Crisis, this summary may appear daunting and disappointing. But it is important to highlight these challenges now. Currently, the U.S. financial system appears resilient, reflecting the impressive progress made since the crisis. We need to address these questions now, before new risks emerge.

Federal Court finds Fast Access Finance breaches National Credit Act

ASIC says that the Federal Court has found that payday lenders, Fast Access Finance Pty Ltd, Fast Access Finance (Beenleigh) Pty Ltd and Fast Access Finance (Burleigh Heads) Pty Ltd (the FAF companies) breached consumer credit laws by engaging in credit activities without holding an Australian credit licence.

ASIC claimed that the FAF companies constructed a business model which was deliberately designed to avoid the protections offered to consumers by the National Consumer Credit Protection Act 2009 (National Credit Act), including the cap on interest charges. Consumers who were seeking small value loans (of amounts generally ranging from $500 to $2,000) entered into contracts that purported to be for the purchase and sale of diamonds in order to obtain a loan. Consumers in ASIC’s case were completely unaware of the actual nature of the contracts into which they were entering and assumed that they were obtaining a traditional loan.

The Federal Court found that the true purpose of the contracts was to satisfy the consumer’s need for cash and the FAF companies’ desire to make a profit from meeting such a need. The provisions in the contracts for the sale and resale of diamonds added nothing to the transaction. The effect of these contracts was to charge interest well in excess of the 48% interest rate cap that should have applied to these types of loans. In some cases interest of over 1000% was charged.

The Court also found that the FAF companies intended to conceal the true nature of the transaction from those responsible for enforcing the interest rate cap.

Deputy Chairman Peter Kell said, ‘Consumers seeking small amounts of credit are often desperate for money, making them vulnerable to manipulation by those who seek to operate outside the law.’

‘Safeguards exist under the law to ensure people are not exploited. ASIC will act against companies which deliberately disregard their obligations under the National Credit Act.’

The matter will be listed for a further hearing, on a date to be set, in relation to the declarations sought by ASIC, civil penalties and compensation payable by the FAF companies. The maximum penalty payable by the FAF companies for engaging in credit activities without a credit licence is $1.1 million for each contravention. 

Bank Portfolio Loan Movement Analysis

Following on from the APRA data released yesterday, today we look at the bank loan portfolio movements. Looking at home loans first, the APRA credit aggregates which focus on the ADI’s shows that the stock of home loans was $1.378 trillion, up from $1.367 trillion in July, or 0.8%. Within that, investment loans fell from $539.5 bn to $535.5 bn, down 0.7%, whilst owner occupied loans rose from $827 bn to $843 bn, up 1.9%, thanks to the ongoing reclassification. We see some significant portfolio re-balancing at Westpac between owner occupied and investment loans, continuing a trend we observed last month. We also see a relatively strong movement in owner occupied loans, as we predicted, as the focus shifts from investment lending to owner occupied loans.

APRA-August-2015-Loan-Portfolio-MovementsThe relative portfolio shares have not changed that much, but the consequences of the Westpac moves means their relative share of investment lending is down somewhat from 28.9% to 28.2% of the market, whilst CBA moved from 24.2% to 24.4% and NAB from 17.3% to 17.4%.

APRA-Home-Lending-Shares-August-2015Looking at trend portfolio movements (which we calculate by summing the monthly movements from September 2014 to August 2015 using the APRA data, adjusted for the ANZ and NAB revisions which were announced earlier), the annual market growth for investment loans is 10%, in line with the APRA speed limit, and we see some banks above. We expect to see further revisions as we progress.

APRA-Investment-Loans-By-Lender-August-2015Looking at the owner occupied side of the ledger, average portfolio growth was 6.88%, and again we see a fair spread with some well above the 10% mark – though of course there is as yet no speed limit on owner occupied lending.

APRA-YOY-OO-Movements-August-2015Turning to credit cards, the $40.8 bn portfolio of loans hardly changed in the month of August, so the mix between providers showed no noticeable movement.

APRA-Cards-August-2015Finally, looking at deposits, there were small portfolio movements, with overall balances rising 0.6% to $1.87 trillion.

APRA-Deposits-Aug-2015  Looking at the banks, in dollar terms, NAB lost a little share, whilst CBA outperformed with an increase of $5bn in deposits. The noise in the data needs to be recognised, however, because in July, the position was somewhat reversed.

APRA-Deposit-Movements-August-2015

We also note APRA published a paper on revisions to the ADI data, APRA’s analysis shows that, in the 24 editions of MBS from January 2013 to December 2014:

  1. There were 82 reporting banks, an average 2,148 new data items published in each edition of MBS, for a two year total of 51,553 data items.
  2. there were 1,951 revisions to data items (an average of 81 data items revised per edition). There is approximately a 4.6 per cent likelihood of any data item being revised within a year from its first publication;
  3. on average, six banks (around nine per cent of all banks) resubmitted data per month that resulted in revisions to MBS;
  4. there were 557 revisions (about 29 per cent of all revisions, or 1.0 per cent of all data items) over 10 per cent and more than $100m of the original value (‘significant revisions’); and
  5. revisions to data items relating to the loans-to and deposits-from non-financial corporations were the two most significantly revised data items, together accounting for 20 per cent of all ‘significant revisions’, between January 2013 and December 2014.

Following analysis of MBS revisions, APRA intends to improve the usefulness of MBS by individually listing revisions of more than five per cent and $5m of the original value in future editions of MBS.

APRA publishes revisions to its statistics to improve the usefulness of its publications.  APRA publishes revised statistics when better source data becomes available or  occasionally, after a compilation error has been identified. Better source data typically becomes available from resubmissions of data by reporting institutions.  APRA lists ‘significant revisions’ to statistics and aims to explain the circumstances under which they were revised. Significant revisions currently include those revisions more than $100 million and over 10 per cent of the original value. These significant revisions are listed in the ‘revisions’ section of the Back Series of Monthly Banking Statistics publication.

To minimise the frequency of revisions, APRA analyses past revisions to identify potential improvements to source data and compilation techniques. Such analysis is considered international best practice. The International Monetary Fund’s (IMF’s) Data Quality Assessment Framework (DQAF) for example states that statistical agencies should ensure that “studies and analyses of revisions and/or updates are carried out and used internally to inform statistical processes.” The DQAF also recommends that “studies and analyses of revisions are made public.”

Given the substantial revisions we are currently seeing in the 2015 series, especially relating to investment and owner occupied lending, we would expect to see more details of significant changes in the future.

IMF Report On Australia Shows Work Is Needed

The IMF released their latest review of Australia. They expect growth to remain under trend to 2.8% in 2020, house prices to remain high along with household debt, household savings to fall, and the cash rate to fall before rising later. Mining investment will continue to fall, and non mining investment to rise, with a slow fall in unemployment to 5.5% by 2020. They supported the FSI recommendations for banks to hold more capital. They cautioned that if investor lending and house price inflation do not slow appreciably, these policies may need to be intensified.

On September 14, the Executive Board of the International Monetary Fund (IMF) concluded the 2015 Article IV consultation1 with Australia.

Australia has enjoyed exceptionally strong income growth for the past two decades, supported by the boom in global demand for Australia’s natural resources and strong policy frameworks. However, the economy is now facing a large transition as the mining investment boom winds down and the terms of trade has fallen back. Growth has been below trend for two years. Annualized GDP growth was around 2.2 percent in the first half of 2015, with particularly weak final domestic demand, and declining public and private investment. Capacity utilization and a soft labor market point to a sizeable output gap. Nominal wage growth is weak, contributing to low inflation.

The terms of trade has fallen sharply over the past year. Iron ore prices have fallen by more than a third and Australia’s commodities prices are down by around a quarter since mid-2014. The exchange rate has depreciated further in recent months following news about economic and financial market developments in China. This has significantly reduced the likely degree of exchange rate overvaluation and should help support activity. Although the current account deficit narrowed to 2.8 percent of GDP in 2014 as mining-related imports declined, it is expected to widen somewhat in 2015.

With subdued inflation pressure, and a weaker outlook, the Reserve Bank of Australia (RBA) cut its policy rate by a further 50bps in the first half of 2015 to 2 percent. While housing investment has picked up strongly, consumer confidence indicators and investment expectations remain muted. Consumption growth has also been moderate reflecting weak income growth. But low interest rates have pushed up asset prices. Overall house price inflation is close to 10 percent, but is around 18 percent in Sydney. Buoyant housing investor lending has recently prompted regulatory action to reinforce sound residential mortgage lending practices.

Fiscal consolidation has become more difficult and public debt is rising, albeit from a low level. Lower export prices and weak wage growth are denting nominal tax revenues; unemployment is adding to expenditures. The national fiscal deficit remained at 3 percent in fiscal year

(FY, July–June) 2014/15, broadly unchanged from the previous year. The FY 2015/16 Budget projects a return to surplus in 2019–20. The combination of tightening by the States and the commonwealth implies an improvement in the national cyclically-adjusted balance by some 0.7 of a percent of GDP on average over the next three years.

Executive Board Assessment

Executive Directors commended Australia’s strong economic performance over the past two decades, which has been underpinned by sound policies, the flexible exchange rate regime, earlier structural reforms, and a boom in the global demand for resources. They noted, however, that declining investment in mining and a sharp fall in the terms of trade are posing macroeconomic challenges, while potential growth is likely to slow in the period ahead. Accordingly, Directors agreed that continued efforts to support aggregate demand and raise productivity will be critical in transitioning to a broader-based and high growth path.

Directors noted that a supportive policy mix is needed to facilitate the structural changes underway. With a still sizeable output gap and subdued inflation, most Directors agreed that monetary policy is appropriately accommodative and could be eased further if the cyclical rebound disappoints, provided financial risks remain contained. Directors also noted that the floating exchange rate provides an important buffer for the economy.

Directors broadly agreed that a small surplus should remain a longer-term anchor of fiscal policy. In this regard, many Directors supported the authorities’ planned pace of adjustment, which they viewed as striking the right balance between supporting near-term activity and addressing longer-term spending commitments. Some Directors, however, considered that consolidation could be somewhat less frontloaded, given ample fiscal space. Directors broadly concurred that boosting public investment would support demand, take pressure off monetary policy, and insure against downside risks. In this context, they welcomed the authorities’ continuing to establish a pipeline of high-quality projects.

Directors highlighted that maintaining income growth at past rates and boosting potential growth would require higher productivity growth. They expressed confidence that this could be achieved, given Australia’s strong institutions, flexible economy, track record of undertaking comprehensive structural reforms, and the opportunities created by Asia’s rapid growth. Nonetheless, further reforms in a variety of areas will be required. In this regard, Directors noted the findings of the Competition Policy Review and looked forward to their implementation. Furthermore, addressing infrastructure needs will relieve bottlenecks and housing supply constraints. Directors also encouraged a shift toward more efficient taxes, while ensuring fairness.

Directors supported the recommendations of the Financial System Inquiry. They noted that while banks are sound and profitable, significantly higher capital would be needed in a severe adverse scenario to ensure a fully-functioning system. Accordingly, they welcomed the authorities’ commitment to make banks’ capital “unquestionably strong” over time. To address risks in the housing market, Directors supported targeted action by the regulator. They cautioned that if investor lending and house price inflation do not slow appreciably, these policies may need to be intensified.

Almost 1 in 10 loans would fail underwriting standards: report

From MortgageBusiness.

A new report examining the impact of regulatory changes on the Australian mortgage market has concluded that nine per cent of home loans written so far this year would now fail current underwriting standards.

Released this week, The Property Imperative Report V report from Digital Finance Analytics (DFA), applied the typical underwriting criteria being used today to the 26,000 households surveyed in the DFA Household Finance Confidence index.

The modelling assumed that, as a result of regulatory changes, all mortgages written today will be assessed on a serviceability hurdle rate of 7.5 per cent, interest-only loans require a repayments path, and real spending must be used rather than a standard ratio.

“Given the tighter criteria in play now, we were not surprised to discover that some loans would now not be approved without an override – meaning they were outside current norms,” DFA principal Martin North said.

“Overall about four per cent of loans in the national portfolio would now fail underwriting standards and two-thirds were for investment purposes,” Mr North said.

The report found that the majority of loans fell in the $500,000 to 750,000 range, predominately in NSW (six per cent) and Victoria. The loans were most likely to have been written in 2014 or 2015.

“Nine per cent of loans written so far this year would now fail current underwriting standards,” Mr North said.

“We expect underwriting criteria to continue to tighten, so more loans will fall outside current underwriting standards, representing some potential downstream portfolio risks.”

The report also found that there is almost no difference now between an interest-only loan and a principal- and-interest repayment loan.

“This is a significant change, highlighting the fact that the previous affordability benefit for an interest-only proposition has dissipated,” Mr North said.

The DFA report examined banks, non-banks and the mutual sector.

 

What Does The Latest Credit Data Really Tell Us?

Today we got the RBA Credit Aggregates and APRA Monthly Banking Statistics to August 2015.  Whilst the overall trends may superficially appear clear, actually, they are are clouded in uncertainty, thanks to significant reclassification between owner occupied and investment loans. As a result, any statement about “investment loans slowing” may be misleading. Total housing lending rose 0.63% seasonally adjusted to a new record of $1.49 trillion, of which $1.38 trillion sits with the banks, the rest is from the non-bank sector.

Starting with the RBA data (table D1),  overall housing growth for the month was 0.6%, and 7.5% for the 12 months (both seasonally adjusted). Owner occupied lending grew by 0.6% in the month, and 5.6% for the 12 months, whilst investment lending grew 0.7% for the month, and 10.7% for the year – still above the APRA speed limit. The chart below show the 12 month movements. It also shows business lending at 0.5% in the month, and 5.3% in the 12 months, and personal credit 0.1% in the month and 0.7% in the 12 months. It is fair to say from these aggregates that investment lending fell a little, and we think it is likely to continue to fall as lending criteria are tightened, but there is still momentum, and as we showed in our surveys demand, though tempered by tighter lending criteria.

RBA-Aggregates-Credit-Growth-PC-August-2015However, and this is where it starts to get confusing, the RBA says “Growth rates for owner-occupier and investor housing credit reported in RBA Statistical Table D1 have been adjusted to take into account the fact that the purpose of a large number of loans was reported to have changed in August, mainly from investment to owner-occupation. Similar adjustments are likely to be required in coming months. However, the stocks of owner-occupier and investor housing credit reported in RBA Statistical Table D2 have not been adjusted. The total stock of housing credit and its rate of growth are unaffected by this change.”

So, the data in D2 shows a significant fall in the stock of investment loans, and because of the adjustments not being made to these numbers (RBA please explain why you are using two different basis for the data) we need to be careful. On these numbers, owner occupied loans rise 1.5% in the month and investment lending fell 0.7%. The 12 month movements would be for owner occupied loans 6% and investment loans 8.3%.

RBA-Housing-Credit-Aggregates-Aug-2015What we can see is that the proportion of lending to business is still at a very low 33%, and this highlights that the banks are still focusing on home lending, with an intense competitive focus on the owner occupied refinance sector, and much work behind the scenes to push as much lending into the owner occupied bucket as possible. Remember that some banks had previously identified loans which should have been in the investment category, so more than 3% of loans were switched, lifting the proportion of investment loans above 38%.

RBA-Credit-Aggregates-Aug-2015The APRA credit aggregates which focus on the ADI’s shows that the stock of home loans was $1.378 trillion, up from $1.367 trillion in July, or 0.8%. Within that, investment loans fell from $539.5 bn to $535.5 bn, down 0.7%, whilst owner occupied loans rose from $827 bn to $843 bn, up 1.9%, thanks to the ongoing reclassification.  Looking at the movements by banks, the average market movement for investment loans over 12 months (and using the APRA monthly movements as a baseline) was 9.92%, just below the speed limit, and we see some of the major banks below the speed limit now, whilst other lenders remain above. These numbers have become so volatile however, that the regulators really do not know what the true score is, and the banks have proved their ability to recast their data in a more favorable light.

APRA-Investment-Loans-By-Lender-August-2015It is unlikely the “fog of war” will abate any time soon, so we caution that the numbers being generated by the regulators need to be handled carefully.

We will be looking at the individual portfolio movements as reported by APRA in a later post. We like a challenge!

Lending to tighten as banks look to avoid mortgage risk

From Mortgage Professional Australia.

Lending to tighten as banks look to avoid mortgage risk​
Specific postcodes or suburbs won’t be denied home loans, but one financial analyst believes Australia’s big banks are moving to a path of more restrictive lending.

Martin North, the principal of Digital Finance Analytics, believes major lenders will soon be introducing different lending criteria and stricter servicing requirements as they look to reduce the amount of risk they carry on their mortgage books.

“I think what we’re seeing is a general drift towards the end of the more sporty loans we were seeing, the dial has been turned up in terms of the capital requirements banks are facing and the risk dial has been turned up as APRA says these are the things we want to see happen,” North said.

“We’re not going to see ghettos were you can’t get a loan, but LVRs are going to be dialled back, it’s going to be harder to get interest only loans and there could be changes to terms and conditions so we see things such as risk premiums on loans for certain areas,” he said.

North’s comments come after Fairfax media revealed earlier this week that NAB has two groups totalling more than 80 Australian postcodes identified as either being “areas where significant deterioration in credit risk has been observed” (Group A postcodes) or “areas which are exhibiting characteristics which may indicate future deterioration in credit risk” (Group B postcodes).

There are 40 Group A postcodes, which are predominantly located in areas affected by the downturn in the resource and manufacturing industries, with 22 Western Australian and 11 Queensland postcodes in the group.

The remaining seven postcodes are found in South Australia, Northern Territory and Tasmania. The Group A postcodes are now subject to a 70% LVR.

The bank has classified 43 postcodes in Group B, with 34 of them located in Sydney, while five are found in Melbourne and suburbs in this group are now subject to an LVR of 80%.

According to North, the identified postcodes present risks due to a number of different reasons.

“The first reason is the probability of default, which is tied to economic and employment conditions, and would apply to places in Western Australia or Queensland where the mining boom has deteriorated or areas like South Australia where the manufacturing industry has been hit,” he said.

“There are also concentration risks where you have a location that has been popular and a bank has a lot of people in that area with loans and they’ll then look to throttle back on lending to there.

“The final one is overvaluation, where a bank thinks the value of properties in the area are extended and they’re concerned that in a corrective market they’ll be worth less than what the loan. These are usually areas that have seen rapid growth and an area like inner Sydney would be a good example of that.”

While banks such as NAB may be introducing measures to reduce the level of risk they take on in the future, North said the current risk position of their mortgage portfolios may not yet truly be known.

“If you look back at the loans that were written over the last 12 – 18 months when lenders were being more aggressive, then I would estimate that about 8 – 9% wouldn’t meet today’s lending criteria.

“There’s some implicit risk there and most mortgage trouble start in the first two or three years, so in the near future we’ll see whether that leads to an increase in defaults.”

ING DIRECT Increases Rates for Property Investors

ING Direct has announced they are increasing variable rates on existing investment property loans by 0.37%pa effective 5 November 2015. They had previously tightened investment loan criteria.

Existing customers who hold both owner-occupied and residential investment loans with ING Direct will not be subject to this interest rate change.

The current rates for new investment property borrowers remain unchanged.  ING Direct Orange Advantage is priced at 4.84%pa (5.03%pa comparison rate) for investors.

The bank has $38 billion in mortgages on book, of which about one third are investment loans, according to recent APRA data.

Fed Still Expecting To Lift Rates

In a wide-ranging speech, at the Philip Gamble Memorial Lecture, Fed Chair Yellen discussed inflation in the US and monetary policy. The net summary is that the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.

Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 percent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. These projections embody two key judgments regarding the projected relationship between real activity and interest rates. First, the real federal funds rate is currently somewhat below the level that would be consistent with real GDP expanding in line with potential, which implies that the unemployment rate is likely to continue to fall in the absence of some tightening. Second, participants implicitly expect that the various headwinds to economic growth that I mentioned earlier will continue to fade, thereby boosting the economy’s underlying strength. Combined, these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.

By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years. It’s important to emphasize, however, that both the timing of the first rate increase and any subsequent adjustments to our federal funds rate target will depend on how developments in the economy influence the Committee’s outlook for progress toward maximum employment and 2 percent inflation.

The economic outlook, of course, is highly uncertain and it is conceivable, for example, that inflation could remain appreciably below our 2 percent target despite the apparent anchoring of inflation expectations. Here, Japan’s recent history may be instructive, survey measures of longer-term expected inflation in that country remained positive and stable even as that country experienced many years of persistent, mild deflation. The explanation for the persistent divergence between actual and expected inflation in Japan is not clear, but I believe that it illustrates a problem faced by all central banks: Economists’ understanding of the dynamics of inflation is far from perfect. Reflecting that limited understanding, the predictions of our models often err, sometimes significantly so. Accordingly, inflation may rise more slowly or rapidly than the Committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response.

Considerable uncertainties also surround the outlook for economic activity. For example, we cannot be certain about the pace at which the headwinds still restraining the domestic economy will continue to fade. Moreover, net exports have served as a significant drag on growth over the past year and recent global economic and financial developments highlight the risk that a slowdown in foreign growth might restrain U.S. economic activity somewhat further. The Committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy. That said, in response to surprises affecting the outlook for economic activity, as with those affecting inflation, the FOMC would need to adjust the stance of policy so that our actions remain consistent with inflation returning to our 2 percent objective over the medium term in the context of maximum employment.

Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.

Fixing the global financial safety net: lessons from central banking

In a speech to the David Hume Institute in Edinburgh, Minouche Shafik, Bank of England Deputy Governor for Markets and Banking, describes the global safety net for dealing with sovereign debt crises as “more of a patchwork than a safety net.” The need to fix the safety net has been brought into sharper focus by the challenges facing emerging markets: lower growth, falling commodity prices and potential spillovers from the possible exit of exceptional monetary policy in advanced economies. Drawing on lessons from central banks’ response to banks’ liquidity needs during the financial crisis, she identifies policy reforms that could reduce the systemic implications of sovereign debt crises and allow nations to cope with shocks.

“The benefits of free trade are now well established. Similarly, economic theory provides compelling arguments for the potential advantages of integrated global capital markets based on the efficient allocation of resources. But, in practice, cross-border capital flows can be fickle and flighty, with destructive effects on the real economy.” They leave nations exposed to a ‘capital stop’, in much the same way that banks can experience a run on their deposits.

Minouche concludes that the current safety net – a mix of national foreign exchange reserves, regional financing arrangements, central bank swap lines and the International Monetary Fund (IMF) – is suboptimal: fragile, fragmented, and inefficient. If we are to continue to benefit from global financial integration then we need a system that can effectively and efficiently provide liquidity insurance to fundamentally sound sovereigns in order to contain spillovers to other parts of the globe.

Drawing on the experience of central banks, she notes that more reliable provision of liquidity support has been made possible by the fact that supervision is tougher on capital and liquidity requirements, banks undergo regular stress testing, and credible resolution tools are being put in place. What would the equivalent enablers be for sovereigns? Minouche suggests:

• Better surveillance, and particularly of the vulnerabilities to sudden stops;
• Stress testing countries’ balance sheets through better debt sustainability assessments; and
• Better mechanisms for dealing with debt restructuring and reducing the risk of disorderly spillovers.

Given the “complex and messy process whereby markets and the official sector deal with sovereign debt restructurings”, how might the risk of disorderly spillovers be reduced? Three preliminary ideas are suggested:

• Using state-contingent bonds to increase risk-sharing with private sector creditors, for example GDP-linked bonds.
• Facilitating agreements on a debt restructuring in bond contracts by expanding the use of new style collective action clauses so that decisions can be taken by a majority of creditors across all bond issuances, without the need for an issuance-by-issuance vote.
• Reducing international spillovers by reviewing the preferential treatment that cross-border sovereign exposures receive in prudential regulation.

At the heart of the global safety net, Minouche suggests, needs to be a more reliably resourced IMF that has well defined arrangements for collaborating with regional financing arrangements. Unless improvements are made, it will be difficult to achieve and sustain the benefits of integrated global capital markets.