Economics and Banking – Page 446 – Digital Finance Analytics (DFA) Blog

Finance Through a Fintech is Fast, but Ask These Questions First

Interesting article in the BRW by Neil Slonim, of thebankdoctor.com that aligns with my earlier post on Online Lending for SMEs.

There has been considerable recent discussion about fintechs injecting much needed competition into the SME lending market. For those unfamiliar with this new word, fintech (financial technology) is a line of business using software for the purpose of disrupting incumbent players such as banks. ASIC Chairman Greg Medcraft recently said “the time is ripe for digital disruption and ASIC wants to make it easier for fintechs to navigate the regulatory system”. Notwithstanding these encouraging developments it is still early days and small business owners would be wise to resist the lure of quick and easy money from fintechs until they really understand how they work.

The attraction of fintechs is the expectation of a “quick yes” via a streamlined online approval process. Fintechs usually offer business loans between $5k and $300k and terms generally range from 7 days to 12 months. They make funds available in a matter of days and sometimes even hours. Rates vary from around 9 per cent to 30 per cent and often well beyond. Most loans are made without property security. Fintechs are generally not suited for businesses that have requirements for long-term debt and if you have property security you will get a better rate elsewhere.

Some business owners will try a fintech if the bank either rejects them or can’t make a decision in the time frame required. Others will by-pass the bank based on a preconceived belief that the banks wont help them.

For better or worse most SMEs know what to expect when dealing with banks. They know the big banks have been around forever and have large and strong balance sheets but this new breed of lender is an entirely different species.

Unlike the banking sector where four well known players and their offshoots control around 90 per cent of the market there are already many fintechs in the SME space with new entrants constantly popping up as entrepreneurs see the opportunity to disrupt the big four oligopoly. As more players enter this field, it will be interesting to see how they go about developing and conveying a distinctive customer value proposition.

Australian owned fintechs currently operating in the SME space include Moula, Prospa, getcapital, and ucapital. The US online lender Ondeck is establishing a local operation in conjunction with MYOB and some well-known local investors. The barriers to entry are relatively low and the level of regulation is not as stringent as for banks. Issues such as funding, liquidity and fraud will no doubt come to the fore when the first fintech fails. Liquidity events could lead to unscrupulous fintechs embarking on a Ponzi scheme but we can safely assume that no fintech will be the beneficiary of a ‘too big to fail’ government bailout. If you borrow from a fintech that gets into difficulty how would you refinance a loan that a bank wouldn’t touch?

Borrowing from fintechs is expensive due to relatively high funding costs plus high default rates. Ondeck US’s operation has a default rate of 6 to 7 per cent and when an unsecured loan falls into default, the lender’s recovery prospects plummet.

Potential borrowers need to be mindful of all these issues. So how does a business decide if fintech borrowing is right for them and if so which is the most suitable lender? Here are three tips for SMEs to consider:

1. DO YOUR DUE DILIGENCE

Do your DD as you would if you were looking for any new major supplier or stakeholder. Some of your queries will be able to be satisfied via the lender’s website but if you’re not sure about anything, call them. Ask questions like:

•Who are your shareholders and management?

•What qualifications and experience do you have?

•How much capital have you committed?

•Can I speak to some existing clients?

•How reliable is your funding source?

2. BE SURE YOU UNDERSTAND AND CAN AFFORD TO PAY THE FEES

Ensure you understand all the fees and charges. For instance, fintechs often quote an interest rate based on the term of the transaction so a 3 per cent rate which might look fair to you could in fact be 3 per cent on a loan of 30 days which represents an annualised rate of interest of 36 per cent.

Once you understand all the costs, re-visit your forecasts to ensure you can still make an acceptable profit. No point in working just for your financier!

3. CONSIDER WHAT WILL HAPPEN IF THINGS GO WRONG.

You probably have a good idea of what happens if you cant meet your obligations to a bank. How would this work with a fintech? How open would they be to extending the term of your financing arrangements if for instance a debtor is slow to pay? What dispute resolution procedures do they have?

HOW ARE THE BANKS RESPONDING?

The banks recognise they are burdened with legacy cost structures that place them at a disadvantage relative to disruptors who have lower cost and more scalable systems. They are acutely aware of the threat and are monitoring developments closely. Fintechs are not yet taking market share from the banks but clearly the potential exists for serious inroads once this business model becomes established.

In time banks will respond by acquiring the better structured and performing fintechs. Another bank strategy will be to take equity in start up fintechs backed by big name players with deep pockets as Westpac has done with the online personal lender Society One.

It’s still early days but over time fintechs will become a significant alternative funding source for SMEs. In the meantime SMEs contemplating borrowing from a fintech would be well advised to first ensure they understand exactly what they are getting themselves into.

Neil Slonim is a banking advisor and commentator and founder of theBankDoctor.com.au , a not for profit online source of independent banking advice for SMEs.

Mirrored with permission of the author.

Why Online Lending Will Take Off With Small Business Owners

Interesting recent article from Fortune Insider with a relevant perspective on the potential for online lending for small business though from a US perspective.

At a minimum, banks are perfect partners in the new game.

Earlier this month, the momentum behind the online lending industry was in full view at LendIt—an industry gathering that didn’t exist four years ago, but grew from about 700 attendees last year to more than 2,500 this year. What was clear is that it’s no longer a question of whether these disruptors will change the game in small business lending, but how quickly.

In fact, in his remarks at LendIt attendees in New York City, former Treasury Secretary Larry Summers predicted that online lenders could eventually capture upwards of 70% of the small business lending market. That may be an overly optimistic prediction, but one thing is clear online lending is a welcome innovation in the small business sector.

Dozens of new companies have jumped in from FundBox to Square, joining longer term players like OnDeck, Lending Club and Funding Circle. At the same time, the entrance of big money from hedge funds and institutional investors has created an energy that has gotten the attention of long-time observers of the financial industry.

Small business owners were the hardest hit in the Great Recession due in part to their reliance on available credit. In the years following, the sluggishness of the overall economic recovery in many ways was a result of these important job creators still not being able to readily access the capital they needed from their traditional sources – banks.

Many banks make loans today pretty much the way they did 50 years ago, relying on expensive personal underwriting and a mountain of paperwork. That makes small dollar loans not economical. Yet, loans under $250,000 are what most small businesses want. Add to that, the number of community banks – a critical source of small business loans – has been shrinking, from 14,000 in 1984 to less than 7,000 today.

As is often the case throughout our nation’s history, in step the entrepreneurs with dozens of new companies entering the lending space with a new approach. Much of the innovation behind these new startups is based on using technology to deliver a more streamlined application and approval process. They use new algorithms to access and analyze more data from different sources about a borrower than the traditional bank.

Today borrowers fill out an online application that typically takes 30-60 minutes. They get a response within hours and can be funded in days. This customer service is winning the attention of frustrated small business owners who on average were spending 26 hours on the loan process and waiting weeks or even months for an answer from a bank. The word is beginning to spread. In a recent Federal Reserve survey 18% of small business owners reported seeking capital online with a 38% approval rate, compared to a 31% approval rate at large national banks.

Ease of use doesn’t grow an industry all on its own, though, but available capital does. Yes, interestingly, what’s really fueling the growth of accessible capital for small business owners is accessible capital itself. Peer-to-peer capital has given way to hedge funds and institutions looking for yield, and a hungry finance industry ready to package and syndicate the funding.

Despite the bright outlook, some worrisome questions remain. What happens to all this new capital in a downturn or when yield is available elsewhere? Can the new algorithms really predict which small businesses will succeed and which will fail? What about the high cost of some of these new loans? Regulation is largely absent in this new industry. How can small businesses really know how to pick the right product and do they know much they are paying?

How will traditional banks respond? Don’t count them out yet. There are several factors that actually could give the established players a competitive advantage. For instance, while new online lenders are spending considerable sums to find small business customers, traditional banks have thousands of those customers and have mountains of data about them.

At a minimum, banks are perfect partners in the new game. They can connect customers to the online platforms, share information for the credit approval processes and they can even put their capital to work as investors.

Needless to say, transformation is coming, and it’s coming in an industry that is not known for it. As Summers noted last week, former Federal Reserve Chair Paul Volker once pointed out that the only useful innovation in finance in the past generation has been the ATM.

All indicators are that this transformation will only continue to pick up its pace. As it does, one thing is clear – while investors may see gains, in all likelihood, small businesses will be the biggest winners.

Hot Investment Lending – AFG

AFG announced their April 2015 Mortgage Index statistics today. It further confirms the momentum in the investment property sector, in both Sydney and Melbourne.

The housing market’s strong 2015 performance continued during April with AFG processing total mortgages of $4,380 million for the month. This compares with $3,674 million in April 2014 and is a record for the month of April. In keeping with seasonal trends, the figure is somewhat lower than the $5,236 million recorded for March, because of the Easter holidays, when property markets are typically more subdued.

The result reflected increasing Victoria investor activity, combined with already strong NSW investor activity. AFG processed a higher proportion of home loans for investors in Victoria last month than ever before at 40.9%, up from 36.7% in March 2015, and 36.9% in April 2014. In NSW, the proportion of investor mortgages remained around its all-time high of 52.8% of applications.

Mark Hewitt, General Manager of Sales and Operations says: “Investor activity in both Sydney and Melbourne is now at the highest levels we have recorded in 21 years. Elsewhere it’s a different story – for example in Western Australia, where first home buyers comprise a much larger proportion of buyers than elsewhere, property investment cooled somewhat last month.”

Queensland property investment rose to 36.7% in April from 33.3% in March, in South Australia there was an increase from 37.7% to 38.2%, and in WA figures softened from 33.6% to 32.8%. First home buyer figures remained at low levels across all of Australia, except for WA, comprising just 2% of new mortgages in NSW, 6.4% in SA, 7.7% in QLD, 8.9% in VIC and 18% in WA.

The proportion of new borrowers choosing fixed home loans was 13.6%, continuing an overall decline since October 2014 when 18.2% of borrowers chose to fix their rates.

Basel Compliance Not Linked To Bank Performance

An IMF Working Paper was released today, entitled “Does Basel Compliance Matter for Bank Performance?”. They conclude that overall Basel compliance has no association with bank efficiency. This is important because the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

However, there is no evidence that any common set of best practices is universally appropriate for promoting well-functioning banks. Regulatory structures that will succeed in some countries may not constitute best practice in other countries that have different institutional settings. There is no broad cross-country evidence as to which of the many different regulations and supervisory practices employed around the world work best. As a consequence, the question of how regulation affects bank performance remains unanswered. Regulators around the world are still grappling with the question of what constitutes good regulation and which regulatory reforms they should undertake.

The global financial crisis underscored the importance of regulation and supervision to a well-functioning banking system that efficiently channels financial resources into investment. In this paper, we contribute to the ongoing policy debate by assessing whether compliance with international regulatory standards and protocols enhances bank operating efficiency. We focus specifically on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). The relationship between bank efficiency and regulatory compliance is investigated using the (Simar and Wilson 2007) double bootstrapping approach on an international sample of publicly listed banks. Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency.

From a theoretical perspective, scholars’ predictions as to the effects of regulation and supervision on bank performance are conflicting. The greater part of policy literature on financial regulation has been inspired by the broader debate on the role of government in the economy. The two best-known opposing camps in this field are the public interest and the private interest defenders, who both, nonetheless, agree on the assumption of market failure. For the public interest camp, governments regulate banks to ensure better functioning and thus more efficient banks, ultimately for the benefit of the economy and the society. For the private interest camp, regulation is a product of an interaction between supply; it is thus the outcome of private interests who use the coercive power of the state to extract rents at the expense of other groups.

According to the public interest view, which largely dominated thinking during the 20th century, regulators have sufficient information and enforcement powers to promote the public interest. In this setting, well-conceived regulation can exert a positive effect on firm behavior by fostering competition and encouraging effective governance in the sector. In contrast, according to the private interest view, efficiency may be distorted because firms are constrained to channel resources to special-interest groups. This implies that regulation may not play a role in improving bank efficiency. Kane (1977) suggested that these conflicting views help frame the complex motivations underlying regulatory policies. He argues that officials are subject to pressures to respond to both public and private interests, and that the outcome of such an oscillation depends on incentives. Swings in the approach to regulation reflect the interplay of industry and political forces and the occurrence of exogenous shocks (crises for example). These complex interactions may have conflicting effects on the efficiency of the banking system.

We focus on the adoption of international capital standards and the Basel Core Principles for Effective Bank Supervision (BCP). These principles, issued in 1997 by the Basel Committee on Bank Supervision, have since become the global standards for bank regulation, widely adopted by regulators in developed and developing countries. The severity of the 2007–09 financial crisis has cast doubt on the effectiveness of these global standards; regulatory reforms are under way in several countries. The initial crisis-induced assessment of regulatory failure is now giving way to a more complex regulatory dialogue and detailed evaluation of the principles underlying international regulatory standards as well as the implications of their adoption, in terms of banks’ safety and soundness. In addition, the burden of compliance with international regulatory standards is becoming increasingly onerous, and financial institutions worldwide are developing compliance frameworks to enable management to meet more stringent regulatory standards. As regulators refine and improve their approach and methodologies, banks must respond to more stringent compliance requirements. This has implications for risk management and resource allocation, and, ultimately, on bank performance.

On the regulators’ side, excessive reliance on systematic adherence to a checklist of regulations and supervisory practices might hamper regulators’ monitoring efforts and prevent a deeper understanding of banks’ risk-taking. More specifically, to shed some light on the aforementioned issues, we aim to answer the following questions: (i) Does compliance with international regulatory standards affect bank operating efficiency? (ii) By what mechanisms does regulatory compliance affect bank performance? (iii) To what extent do bank-specific and country-specific characteristics soften or amplify the impact of regulatory compliance on bank performance? (iv) Does the impact of regulatory compliance increase with level of development?

Building on the IMF and the World Bank Basel Core Principles for Effective Bank Supervision (BCP) assessments conducted from 1999 to 2010, we evaluate how compliance with BCP affects bank performance for a sample of 863 publicly listed banks drawn from a broad cross-section of countries. We focus on publicly listed banks, on the assumption that these institutions are subject to more stringent regulatory controls and compliance requirements. This focus should also enhance cross-country comparability because these banks share internationally adopted accounting standards. Further, we categorize the sample countries by both economic development and geographic region.

Our results indicate that overall BCP compliance, or indeed compliance with any of its individual chapters, has no association with bank efficiency. This result holds after controlling for bank-specific characteristics, the macroeconomic environment, institutional quality, and the existing regulatory framework, and adds further support to the argument that although compliance has little effect on bank efficiency, increasing regulatory constraints may prevent banks from efficiently allocating resources. When only banks in emerging market and developing countries are considered, we find some evidence of a negative relation with specific chapters that relate to the effectiveness of the existing supervisory framework and the ability of supervisors to carry out their duties. However, these results need to be treated with caution, because they may also reflect the inability of assessors to provide a consistent cross-country evaluation of effective banking regulation.

RBA Cuts To Record Low – 2%

The RBA cut the cash rate by 25 basis points today, in the hope that i) households who are already carrying record debt will be persuaded to spend and borrow more, and ii) the “quiet word” from the regulator will keep a cap on exploding house prices in Sydney by controlling exuberant investment lending. The journey back from this record low will be low and painful, and if a real crisis hits, there is so little left in the locker. Worth re-reading the recent Fitch commentary on the US who are facing a high debt, higher interest rate future.

At its meeting today, the Board decided to lower the cash rate by 25 basis points to 2.0 per cent, effective 6 May 2015.

The global economy is expanding at a moderate pace, but commodity prices have declined over the past year, in some cases sharply. These trends appear largely to reflect increased supply, including from Australia. Australia’s terms of trade are falling nonetheless.

The Federal Reserve is expected to start increasing its policy rate later this year, but some other major central banks are stepping up the pace of unconventional policy measures. Hence, financial conditions remain very accommodative globally, with long-term borrowing rates for sovereigns and creditworthy private borrowers remarkably low.

In Australia, the available information suggests improved trends in household demand over the past six months and stronger growth in employment. Looking ahead, the key drag on private demand is likely to be weakness in business capital expenditure in both the mining and non-mining sectors over the coming year. Public spending is also scheduled to be subdued. The economy is therefore likely to be operating with a degree of spare capacity for some time yet. Inflation is forecast to remain consistent with the target over the next one to two years, even with a lower exchange rate.

Low interest rates are acting to support borrowing and spending, and credit is recording moderate growth overall, with stronger lending to businesses of late. Growth in lending to the housing market has been steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have been supported by lower long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.

At today’s meeting, the Board judged that the inflation outlook provided the opportunity for monetary policy to be eased further, so as to reinforce recent encouraging trends in household demand.

The Macroeconomic Effects of Public Investment

An IMF working paper was released today entitled “The Macroeconomic Effects of Public Investment:Evidence from Advanced Economies”. Six years after the global financial crisis, the recovery in many advanced economies remains tepid. This is highly relevant to the current Australian economic and budget debate.

There are now worries that demand will remain persistently weak — a possibility that has been described as “secular stagnation”. One response that is being considered (see for example the European Commission 2014) is an increase in public infrastructure investment, which could provide a much-needed fillip to demand and is one of the few remaining policy levers available to support growth. But there are open questions about the size of the public investment multipliers and the long-term returns on public capital, both of which play a role in determining how public-debt-to-GDP ratios will evolve in response to higher public investment. To assess appropriately the benefits and costs of increasing public investment in infrastructure, it is critical to determine what macroeconomic impact public investment will have. The paper attempts to shed more light on this subject.

What are the macroeconomic effects of public investment? To what extent does it raise output, both in the short and the long term? Does it increase the public-debt-to-GDP ratio? How do these effects vary with key characteristics of the economy, such as the degree of economic slack, the efficiency of public investment, and the way the investment is financed? To address these questions, the paper examined the historical evidence on the macroeconomic effects of public investment in 17 OECD economies over the 1985–2013 period.

They found that such investment raises output in both the short and long term, crowds in private investment, and reduces unemployment, with limited effect on the public debt ratio. They also found that these effects vary with a number of mediating factors. The effects of public investment are particularly strong when there is slack in the economy and monetary accommodation. In such cases, the boost to output from higher government investment may exceed the debt issued to finance the investment. Government projects are more effective in boosting output in countries with higher efficiency of public investment. Finally, the mode of financing investment matters. They find suggestive evidence that debt-financed projects have larger expansionary effects than budget-neutral investments financed by raising taxes or cutting other government spending.

The findings suggest that for economies with clearly identified infrastructure needs and efficient public investment processes and where there is economic slack and monetary accommodation, there is a strong case for increasing public infrastructure investment. Moreover, evidence suggests that increasing public infrastructure investment will be particularly effective in providing a fillip to aggregate demand and expanding productive capacity in the long run, without raising the debt-to-GDP ratio, if it is debt financed. Finally, the results show how critical increasing investment efficiency is to mitigating the possible trade-off between higher output and higher public-debt-to-GDP ratios. Thus a key priority in many economies, particularly in those with relatively low efficiency of public investment, should be to raise the quality of infrastructure investment by improving the public investment process.

ANZ 1H 2015 Results 3% Higher

ANZ released their results for 1H 2015 today. They reported a statutory profit of $3,506m up 3% from 1H14, and a cash profit of $3,676m, up 5% from 1H14. This was slightly better than expected. The result was driven by significant growth in customer deposits (up 12%) and advances (up 10%) and a provision charge of $510 million down 3%. The Group total loss rate saw a modest decline over the year, from 21bps to 19bps and ANZ’s expectation is that the loss rate will stabilise in 2H15. It expects to be operating in a lower growth operating environment going forwards.

A 4% increase in the Interim Dividend to 86 cents per share will see ANZ shareholders receive $2.4 billion, of which around 73% will be delivered to Australian based Retail and Institutional investors. ANZ expects to maintain a payout ratio for the Financial Year 2015 towards the upper end of the 65 to 70% of Cash Profit range.

ANZ’s Capital Ratio at the end of the first half was 8.7%, up 40 basis points (bps) on the same half in 20144. This half the Dividend Reinvestment Plan will operate with a 1.5% discount which is expected to result in a participation ratio of around 20% on a full year basis.

Looking across the divisions, in Australia, profit grew 8%, driven by a 6% uplift in both income and profit before provisions. Customer numbers, business volumes and market share all grew driven by investment in products, sales and service capacity and capability. Additional staff and training, new and improved digital tools including online applications, expanded customer coverage and improved service levels delivered increased Retail loan volumes, up 8% and C&CB loan volumes, up 4%. Deposits increased 3% and 6% respectively. Home lending has now grown above system for five consecutive years. Retail net interest margin fell 5 basis points from 2.01% in 2H2014 to 1.97%. The C&CB Business delivered ongoing growth despite subdued business sector confidence. ANZ’s historic strength in the Small Business Banking (SBB) segment continued with lending up 15% having grown at double digit rates for the past 3 years. Deposits in SBB have also grown strongly and at $31 billion, are more than double the level of loans.

International and Institutional Banking increased profit by 7% with strong contributions from Global Markets customer sales and the Cash Management business along with ongoing benign credit outcomes. PBP increased by 1%. Geographically, Asia Pacific Europe and America (APEA) was the standout, with profit up 18%. In Asia, customer revenues increased 13%, largely through increased focus on lower capital intensity, higher return products like Foreign Exchange, Cash Management and Debt Capital Markets. ANZ is also growing strongly in the region’s key trade and investment flow corridors including those between Australia and Hong Kong, China and Hong Kong and Australia and Singapore.

In the Trade business while volumes were broadly maintained, deteriorating commodity prices reduced the value of shipments, lowering income slightly. Lending growth across the network partially offset ongoing loan margin compression which is being felt most acutely in Australia. The quality of the loan book remains high, at 79% investment grade. Deposits increased 17%, including a 27% increase in deposits in APEA. The percentage uplift in both deposits and lending in part reflects the depreciation of the Australian Dollar during the period. A record Global Markets revenue result was in large part delivered via a record customer sales outcome, most notably in Asia. Increased activity particularly in rates, commodities and FX, assisted sales in the second quarter of the year.

In New Zealand (all figures in NZD), the business has increased momentum, with income growth of 6% and profit before provisions up 8%. Economic momentum has lifted lending volumes. Profit growth after provisions was up 1% reflected a lower level of provision write-backs than in the prior comparable period. Home lending lifted 6% with market share increasing in key regions like Auckland and Christchurch. Streamlined products and processes along with digital tools helped lift Commercial and Agri business with lending up 6%.

Focussing on the Australian mortgage performance, which made up 69% of the Australian division credit exposure, there was more growth in NSW (1x3x system) than other states. Investment lending share increased, growing at system, and more loans were originated via the broker channels at 1.3x system. ANZ has been growing is mobile lender base, with a 50% increase in NSW.

Total home lending was $218 bn, up 8% net, with 934k loan accounts. The average balance at origination was $376k, (much higher than Westpac at $235k), the average LVR was 71% at origination (same as Westpac).

43% of the portfolio was ahead on repayments (Westpac was 73%) and 35% of the portfolio is interest only. 90+ day delinquencies were 5.7 basis points with highest rates in Queensland. Note this excludes non-performing loans.

Westpac 1H 2015 Result Flat

Westpac announced their 1H results today, with cash earnings of $3,778 million, flat compared with the prior corresponding period and 2% lower than 2H14. Statutory net profit was $3,609 million, flat on 1H14, and 8% lower than 2H14. The expense to income ratio was 42.5% from 41.2% and there was a further improvements in asset quality with impaired assets as a percentage of gross loans falling 16 basis points to 0.35%. Whilst provisions were down, and net margins maintained at 2.01% (excluding treasury), weaker treasury income eroded the overall performance. Overall result was a little below consensus forecasts. The interim fully franked dividend was 93 cents per share, up 3% from 1H14, but 1% from 2H14.

Retail banking did quite well, but the Investment bank earnings were 17% lower due to the $85 million post tax charge as a result of derivative adjustments and a lower impairment benefit, despite customer revenues rising 6% and strong lending growth.

We see indications of building headwinds ahead relating to capital requirements, significant deposit repricing to offset mortgage discounts, and a continued reliance on the mortgage book to underpin growth. We also note a tightening of lending criteria in terms of interest rate buffers, and an intent to reduce investment property lending to below the 10% growth “alert” level. We, in other words, see responses to the dead hand of the regulator.

The Group’s common equity Tier 1 (CET1) capital ratio of 8.8% is well above regulatory minimums. However, due to other items, including changes in mortgage risk factors implemented during the half, the ratio is currently at the lower end of the Group’s preferred capital range of 8.75% to 9.25%. Given the current uncertainty over future capital settings, including the introduction of the next set of reforms from the Basel Committee on Banking Supervision, and the Federal Government’s assessment of the final recommendations from the Financial System Inquiry, the Group will operate at the upper end of the preferred capital range. So the Group will issue shares to satisfy the DRP for the interim dividend (at a 1.5% discount), and partially underwrite the DRP to increase CET1 capital by approximately $2 billion.

Overall net operating income was up 1%, and within that, net interest income rose 2%, supported by growth of 3% mostly from rise in Australian mortgages, and customer deposit growth of 3%, with focus on growing efficient deposits. However, net interest margin were down 1bp due to lower Treasury revenue. Margins excluding Treasury and Markets were overall flat. Turning to non-interest income, it was down 2%, whilst fees and commissions were up 1% to $1,478m, wealth and insurance fell 1% to $1,134m, trading income was down 10% to $425m (up 16% excluding derivative adjustments) and other income was down 17% to $49m.

Net Interest Margin was down 1 bp to 2.05%. NIM up across WRBB (1bp), New Zealand (2bps), and slightly down in St.George (2bps). Most margin pressure was in WIB (down 11bps). NIM excluding Treasury and Markets flat at 2.01%. Within that, we see a 6bps decrease in asset spreads primarily from impact of competitive pricing in mortgages. Business and institutional spreads also lower, 5bps increase from improved customer deposit spreads on term deposits, online accounts and savings deposits, partially offset by 1bps impact of lower hedging benefit on low-rate deposits, 3bps benefit from term wholesale funding as pricing for new term senior issuances was lower than maturing deals, 1bp decrease from increased holdings of high quality liquid assets and cost of CLF and 1bp decline in capital and other due to lower hedging rates. Treasury and Markets down 1bp, reflecting lower Treasury earnings.

Looking at the Australian mortgage business, they have an Australian mortgage market share of 23.1% and the book grew by 0.9x system. The 3% lift in balances was partly offset by run-off of $25.2bn, up 6%. Around 20% of loans were above 80% LVR, little changed from last period, with the average LVR on new loans at 71%. 53.2% of new loans were through WBC’s proprietary channels, the share via brokers therefore continuing to rise (1H14 was 57.5% through own channels).

Portfolio losses of $38m in 1H15 represent an annualised loss rate of 2bps (net of insurance claims) and loss rates remain very low by international standards. Mortgage insurance claims for 1H15 were $1m (2H14 $6m, 1H14 $3m). Properties in possession remain <2bps of the portfolio, however have increased, mainly in Qld, where natural disasters and a decline in mining investment have seen weaker conditions and a review of treatment of hardship will likely see a rise in reported delinquencies in future periods.

Australian mortgage customers continue to display a cautious approach to debt levels, taking advantage of historically low mortgage rates to pay down debt and build buffers. Including mortgage offset account balances, 73% of customers are ahead of scheduled payments, with 23% of these being more than 2 years ahead. Mortgage offset account balances up $3.3bn or 14% (up 29% 1H15/1H14) to $27bn. Credit decisions across all brands are made by the Westpac Group, regardless of the origination channel.

Westpac has made significant changes to their serviceability assessment. Loan serviceability assessments include an interest rate buffer, adequate surplus test and discounts to certain forms of income (e.g. dividends, rental income). Westpac now has a minimum assessment rate, often referred to as a floor rate, set at 7.10% p.a. The minimum assessment rate is at least 210bps higher than the lending rate and is applied to all mortgage debt, not just the loan being applied for. We note that the minimum assessment rate and buffer has increased from 6.80% p.a. and 180bps respectively – the regulators quiet word perhaps?

Investment property loans (IPLs) are 46.3% of Westpac’s Australian mortgage portfolio and compared to owner-occupied applicants, IPL applicants are on average older (75% over 35 years), have higher incomes and higher credit scores. 87% of IPLs originated at or below 80% LVR. Majority of IPLs are interest-only, however the repayment profile closely tracks the profile of the principal and interest portfolio, and 62% of interest-only IPL customers are ahead on repayments. IPL 90+ days delinquencies is 36bps and continue to outperform the total portfolio average. IPL portfolio losses represent an annualised loss rate of 2bps (net of insurance claims) – in line with total portfolio losses of 2bps. Self-managed Superannuation Fund balances are a very small part of the portfolio, at 1% of Australian mortgage balances.

We are told that All IPLs are full recourse and loan serviceability assessments include an interest rate buffer, minimum assessment rate, adequate surplus test and discounts to certain forms of income (e.g. dividends, rental income). In adiditon, all IPLs, including interest-only loans, are assessed on a principal & interest basis and specific credit policies apply to IPLs to assist risk mitigation, including holiday apartments subject to tighter acceptance requirements, additional LVR restrictions apply to single industry towns, minimum property size and location restrictions apply, restrictions on non-resident lending include lower maximum LVR and discounts to foreign income recognition.

Westpac says it had more than 10% growth in investment loans (which may trigger interest from APRA and potentially additional capital), so it is actively managing the number down to 10%. We suspect this translates into tighter underwriting criteria. That said, bank portfolio stress testing indicates that even under extreme scenarios, losses, including those via their captive Lenders Mortgage Insurer would be manageable.

They predict that investment property lending will remain buoyant and that whilst the property market supply is not meeting demand, the market is fundamentally sound.

Turning to capital, Westpac’s preferred common equity Tier 1 (CET1) capital range is 8.75% – 9.25%. The management buffer above regulatory minimums takes into consideration the capital conservation buffer (CCB) requirement from January 2016, stress testing to maintain an appropriate buffer in a downturn, quarterly volatility of capital ratios associated with dividend payments. Given current regulatory uncertainties the Group has decided it is appropriate to move capital ratios to the upper end of the preferred range and will be issuing shares to satisfy the DRP at a 1.5% discount. They flag a number of potential capital headwinds. These include, RBNZ changes to risk weighting of investor property loans, BCBS2 initial consultation on standardised approach for determining Credit RWA and consults on RWA capital floors for advanced banks, proposals announced December 2014 with first consultation due mid-2015. BCBS work plan target date for completion end 2015. Implementation date and transition arrangements to be advised. In addition, they are awaiting Government and APRA response to provide more information on implementation of FSI recommendations, leverage ratio disclosure expected during 2015 and applicable (Pillar 1) from 2018, FSB3 undertaking a QIS4 on TLAC5 during 2015 with rules for G-SIBs expected to be finalised at G20 summit in 2015. D-SIB impacts unknown and risk model enhancements and recalibrations – IRRBB. Net net, as we have discussed we expect capital demands to be raised in the future, and this will require the bank to lift its capital buffers.

Basel IV – Is More Complexity Better?

In December 2014, The Bank For International Settlements issued proposed Revisions to the Standardised Approach for credit risk for comment. It proposes an additional level of complexity to the capital calculations which are at the heart of international banking supervision. Comments on the proposals were due by 27 March 2015. These latest proposals, which have unofficially been dubbed “Basel IV”, is a continuation of the refining of the capital adequacy ratios which guide banking supervisors and relate to the standardised approach for credit risk. It forms part of broader work on reducing variability in risk-weighted asset. We want to look in detail at the proposals relating to residential real estate, because if adopted they would change the capital landscape considerably. Note this is separate from the proposal relating to the adjustment of IRB (internal model) banks. Whilst it aspires to simplify, the proposals are, to put it mildly, complex

For the main exposure classes under consideration, the key aspects of the proposals are:

Bank exposures would no longer be risk-weighted by reference to the external credit rating of the bank or of its sovereign of incorporation, but they would instead be based on a look-up table where risk weights range from 30% to 300% on the basis of two risk drivers: a capital adequacy ratio and an asset quality ratio.
Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate, but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage. Further, risk sensitivity would be increased by introducing a specific treatment for specialised lending.
The retail category would be enhanced by tightening the criteria to qualify for the 75% preferential risk weight, and by introducing a fallback subcategory for exposures that do not meet the criteria.
Exposures secured by residential real estate would no longer receive a 35% risk weight. Instead, risk weights would be determined according to a look-up table where risk weights range from 25% to 100% on the basis of two risk drivers: loan-to-value and debt-service coverage ratios.
Exposures secured by commercial real estate are subject to further consideration where two options currently envisaged are: (a) treating them as unsecured exposures to the counterparty, with a national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight according to a look-up table where risk weights range from 75% to 120% on the basis of the loan-to-value ratio.
The credit risk mitigation framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts, and updating corporate guarantor eligibility criteria.

Real Estate Capital Calculation Proposals

The recent financial crisis has demonstrated that the current treatment is not sufficiently risk-sensitive and that its calibration is not always prudent. In order to increase the risk sensitivity of real estate exposures, the Committee proposes to introduce two specialised lending categories linked to real estate (under the corporate exposure category) and specific operational requirements for real estate collateral to qualify the exposures for the real estate categories.

Currently the standardised approach contains two exposure categories in which the risk-weight treatment is based on the collateral provided to secure the relevant exposure, rather than on the counterparty of that exposure. These are exposures secured by residential real estate and exposures secured by commercial real estate. Currently, these categories receive risk weights of 35% and 100%, respectively, with a national discretion to allow a preferential risk weight under certain strict conditions in the case of commercial real estate.

Residential Owner Occupied Real Estate

In order to qualify for the risk-weight treatment of a residential real estate exposure, the property securing the mortgage must meet the following operational requirements:

Finished property: the property securing a mortgage must be fully completed. Subject to national discretion, supervisors may apply the risk-weight treatment for loans to individuals that are secured by an unfinished property, provided the loan is for a one to four family residential housing unit.
Legal enforceability: any claim (including the mortgage, charge or other security interest) on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning the collateral must be such that they provide for the bank to realise the value of the collateral within a reasonable time frame.
Prudent value of property: the property must be valued for determining the value in the LTV ratio. Moreover, the value of the property must not be materially dependent on the performance of the borrower. The valuation must be appraised independently using prudently conservative valuation criteria and supported by adequate appraisal documentation.

The current standardised approach applies a 35% risk weight to all exposures secured by mortgage on residential property, regardless of whether the property is owner-occupied, provided that there is a substantial margin of additional security over the amount of the loan based on strict valuation rules. Such an approach lacks risk sensitivity: a 35% risk weight may be too high for some exposures and too low for others. Additionally, there is a lack of comparability across jurisdictions as to how great a margin of additional security is required to achieve the 35% risk weight.

In order to increase risk sensitivity and harmonise global standards in this exposure category, the Committee proposes to introduce a table of risk weights ranging from 25% to 100% based on the loan-to-value (LTV) ratio. The Committee proposes that the risk weights derived from the table be applied to the full exposure amount (ie without tranching the exposure across different LTV buckets).

The Committee believes that the LTV ratio is the most appropriate risk driver in this exposure category as experience has shown that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the lower the loss incurred in the event of a default. Furthermore, data suggest that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the less likely the borrower is to default. For the purposes of calculating capital requirements, the value of the property (ie the denominator of the LTV ratio) should be measured in a prudent way. Further, to dampen the effect of cyclicality in housing values, the Committee is considering requiring the value of the property to be kept constant at the value calculated at origination. Thus, the LTV ratio would be updated only as the loan balance (ie the numerator) changes.

The LTV ratio is defined as the total amount of the loan divided by the value of the property. For regulatory capital purposes, when calculating the LTV ratio, the value of the property will be kept constant at the value measured at origination, unless an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value. Modifications made to the property that unequivocally increase its value could also be considered in the LTV. The total amount of the loan must include the outstanding loan amount and any undrawn committed amount of the mortgage loan. The loan amount must be calculated gross of any provisions and other risk mitigants, and it must include all other loans secured with liens of equal or higher ranking than the bank’s lien securing the loan. If there is insufficient information for ascertaining the ranking of the other liens, the bank should assume that these liens rank pari passu with the lien securing the loan.

In addition, as mortgage loans on residential properties granted to individuals account for a material proportion of banks’ residential real estate portfolios, to further increase the risk sensitivity of the approach, the Committee is considering taking into account the borrower’s ability to service the mortgage, a proxy for which could be the debt service coverage (DSC) ratio. Exposures to individuals could receive preferential risk weights as long as they conform to certain requirement(s), such as a ‘low’ DSC ratio. This ratio could be defined on the basis of available income ‘net’ of taxes. The DSC ratio would be used as a binary indicator of the likelihood of loan repayment, ie loans to individuals with a DSC ratio below a certain threshold would qualify for preferential risk weights. The threshold could be set at 35%, in line with observed common practice in several jurisdictions. Given the difficulty in obtaining updated borrower income information once a loan has been funded, and also given concerns about introducing cyclicality in capital requirements, the Committee is considering whether the DSC ratio should be measured only at loan origination (and not updated) for regulatory capital purposes.

The DSC ratio is defined as the ratio of debt service payments (including principal and interest) relative to the borrower’s total income over a given period (eg on a monthly or yearly basis). The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. The DSC ratio must be prudently calculated in accordance with the following requirements:

Debt service amount: the calculation must take into account all of the borrower’s financial obligations that are known to the bank. At loan origination, all known financial obligations must be ascertained, documented and taken into account in calculating the borrower’s debt service amount. In addition to requiring borrowers to declare all such obligations, banks should perform adequate checks and enquiries, including information available from credit bureaus and credit reference agencies.
Total income: income should be ascertained and well documented at loan origination. Total income must be net of taxes and prudently calculated, including a conservative assessment of the borrower’s stable income and without providing any recognition to rental income derived from the property collateral. To ensure the debt service is prudently calculated, the bank should take into account any probable upward adjustment in the debt service payment. For instance, the loan’s interest rate should (for this purpose) be increased by a prudent margin to anticipate future interest rate rises where its current level is significantly below the loan’s long-term level. In addition, any temporary relief on repayment must not be taken into account for purposes of the debt service amount calculation.

Notwithstanding the definitions of the DSC and LTV ratios, banks must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of their residential real estate portfolio.

The risk weight applicable to the full exposure amount will be assigned, as determined by the table below, according to the exposure’s loan-to-value (LTV) ratio, and in the case of exposures to individuals, also taking into account the debt service coverage (DSC) ratio. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given residential real estate exposures must apply a 100% risk weight to such an exposure.

Some points to note.

Differences in real estate markets, as well as different underwriting practices and regulations across jurisdictions make it difficult to define thresholds for the proposed risk drivers that are meaningful in all countries.
Another concern is that the proposal uses risk drivers prudently measured at origination. This is mainly to dampen the effect of cyclicality in housing values (in the case of LTV ratios) and to reduce regulatory burden (in the case of DSC ratios). The downside is that both risk drivers can become less meaningful over time, especially in the case of DSC ratios, which can change dramatically after the loan has been granted.
The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. That said, the Committee recognises that differences in tax regimes and social benefits in different jurisdictions make the concept of ‘available income’ difficult to define and there are concerns that the proposed definition might not be reflective of the borrower’s ability to repay a loan. Further, the level at which the DSC threshold ratio has been set might not be appropriate for all borrowers (eg high income) or types of loans (eg those with short amortisation periods). Therefore the Committee will explore whether using either a different definition of the DSC ratio (eg using gross income, before taxes) or any other indicator, such as a debt-to-income ratio, could better reflect the borrower’s ability to service the mortgage.
There are no specific proposal to treat loans that are past-due for more than 90 days.

Investment Loans

Bearing in mind that 35% of all loans are for investment purposes in Australia, the proposals relating to loans for investment purposes are important. So how will they be treated under Basel 4?

There are a number of pointers in the proposals, though its not totally clear in our view. First, we think the proposals would apply to separate loans where repayment is predicated on income generated by the property securing the mortgage, i.e. investment loans rather than a normal loans where the mortgage is linked directly to the underlying capacity of the borrower to repay the debt from other sources. Such loans might fall into a special commercial real estate category, specialist lending category, or a fall back to the unsecured category, each with different sets of capital weights.

The Committee proposes that any exposure secured with real estate that exhibits all of the characteristics set out in the specialised lending category should be treated for regulatory capital purposes as income-producing real estate or as land acquisition, development and construction finance as the case may be, rather than as exposures secured by real estate. Any non-specialised lending exposure that is secured by real estate but does not satisfy the operational requirements should be treated for regulatory capital purposes as an unsecured exposure, either as a corporate exposure or other retail exposure, as appropriate.

Specialised lending exposure, would be defined so if all the following characteristics, either in legal form or economic substance were met:

The exposure is typically to an entity (often a special purpose entity (SPE)) that was created specifically to finance and/or operate physical assets;
The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and
As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

On the other hand, in order to qualify as a commercial real estate exposure, the property securing the mortgage must meet the same operational requirements as for residential real estate. If the loan is a commercial real estate category, the risk weight applicable to the full exposure amount will be assigned according to the exposure’s loan-to-value (LTV) ratio, as determined in the table below. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given commercial real estate exposure must apply a 120% risk weight.
LTVNote, if this LTV refers to market value, the threshold should be set at a lower level: eg 50%.

Where the requirements are not met, the exposure will be considered unsecured and treated according to the counterparty, ie as “corporate” exposure or as “other retail”. However, in exceptional circumstances for well developed and long established markets, exposures secured by mortgages on office and/or multipurpose commercial premises and/or multi-tenanted commercial premises may be risk-weighted at [50%] for the tranche of the loan that does not exceed 60% of the loan to value ratio. This exceptional treatment will be subject to very strict conditions, in particular:

the exposure does not meet the criteria to be considered specialised lending
the risk of loan repayment must not be materially dependent upon the performance of, or income generated by, the property securing the mortgage, but rather on the underlying capacity of the borrower to repay the debt from other sources
the property securing the mortgage must meet the same operational requirements as for residential real estate
two tests must be fulfilled, namely that (i) losses stemming from commercial real estate lending up to the lower of 50% of the market value or 60% of loan-to value (LTV) based on mortgage-lending-value (MLV) must not exceed 0.3% of the outstanding loans in any given year; and that (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. This is, if either of these tests is not satisfied in a given year, the eligibility to use this treatment will cease and the original eligibility criteria would need to be satisfied again before it could be applied in the future. Countries applying such a treatment must publicly disclose that these and other additional conditions (that are available from the Basel Committee Secretariat) are met. When claims benefiting from such exceptional treatment have fallen past-due, they will be risk-weighted at [100%].

Implications and Consequences

We should make the point, these are proposals, and subject to change. But it would mean that banks using the standard approach to capital could no longer just go with a 35% weighting, rather they will need to segment the book based on LTV and servicability at a loan by loan level. Investment loans may become more complex and demand higher capital weighting. The required data may be available, as part of the loan origination process, but additional processes and costs will be incurred, and it appears net-net capital buffers will be raised for most players. The capital would be determined using two risk drivers: loan-to-value and debt-service coverage ratios with risk weights ranging from 25 percent to 100 percent. Investment loans may require different treatment, (and the RBNZ discussion paper recently issued may be relevant here, where investment loans are handled on a different basis.)

Finally, a word about those banks on IRB. Currently, under their internal models, they are sitting on an average weighting of around 17% (compared with 35% for standard banks). There are proposals to lift the floor to 20% minimum, and the FSI Inquiry recommend higher. Indeed, Murray called for the big banks to lift the average mortgage risk weighting to a range of 25% to 30%. This would bring them closer to the average mortgage risk weighting used by Australia’s regional banks and credit unions, though as described above, these, in turn, may change. Incidentally, the Bank of England thinks 35% is a good target. Basel 4 will also reduce the variance between standardised banks and those using their own models by requiring the internal models not to deviate from the RWA number in the standardised model by a certain amount: the so-called “capital floor”.

Interestingly the US is focussing on an additional measure, The Tier 1 Common measure, which is unweighted assets to capital, and has set a floor of 5%, or more. The Major Banks in Australia carry real, or non-risk-weighted, equity capital of just 3.7% of assets. Some banks are leveraged over seventy times the equity capital to loans, which is scarily high, but then the RBA (aka the tax payer) would bail them out if they get into trouble, so that’s OK (or not). This means that just $1.70 in assets will now support a $100 loan.

We wonder if the ever more complex models being proposed by Basel are missing the point. Maybe we should be going for something simpler. Many banks of course have invested big in advanced models to squeeze the capital lemon as hard as they can. But stepping back we need approaches which allow greater ability to compare across banks, and more transparent disclosure so we can see where the true risks lay. Certainly capital buffers should be lifted, but we suspect Basel 4, despite the best of intentions, is going down the wrong alley.

Can Indebtedness and Interest Rates Both Increase?

In FitchRating’s latest Global Perspective, James McCormack, Fitch’s Global Head of Sovereign Ratings highlights the dilemma facing the US where rates are low and debt is high. What happens when interest rates rise? Given that both household and corporate debt levels are much higher now, the potential exists for a much more negative impact in terms of debt sustainability and economic performance.

Private sector deleveraging has been a critical feature of the post-crisis US economic recovery, and will remain an important consideration for growth and stability as interest rates move higher. Borrowers have benefited from a more-than 30-year trend of falling rates, but the eventual reversal will test the degree to which private sector balance sheets have been strengthened in the post crisis period. With debt levels still high by historical standards, higher interest rates may have a pronounced impact on growth in the period ahead.

A Cycle Ends: Meaningful Deleveraging

The increase in household debt by 30 percentage points of GDP between 2000 and 2008 was unprecedented, as has been the subsequent deleveraging (see chart 1).

The previous 30 percentage point increase took more than 40 years, and there had never been a meaningful deleveraging prior to 2009. At end-2014, household debt was back to its 2002 level as a share of GDP, and below its 2008 peak in nominal terms. A similar, though less marked, pattern is evident in the corporate sector, unlike in previous credit cycles when corporate debt levels were more volatile than those of households. Corporate debt is now lower than in 2009 as a share of GDP, but 12% higher than the pre-crisis peak in nominal terms.

The Long View: Lower Rates Allowed for Higher Debt

Taking a much longer view, even accounting for post-crisis reductions, household and corporate debt levels have trended higher since the early 1950s (when data became available). Moreover, it is widely accepted – if not explicitly acknowledged – that a continuation of this trend is a sign the US economy is getting back to “normal”. The resumption of private sector credit growth on the back of improved balance sheets is a big part of the narrative of the US recovery, and a meaningful difference with conditions in the Eurozone. Historical interest rate developments provide insight to the steady run-up in US debt, and are a basis of concern looking forward. Both nominal and real medium-term interest rates (approximated by 10-year US Treasury yields) have been falling since the early 1980s. Over the same period, there have been matching declines in effective interest rates faced by the household and corporate sectors (see chart 2).

Effective rates are calculated using BEA data on Interest Paid and Received by Sector, and Flow of Funds data on outstanding debt stocks. Critically, for the last 30 years, falling interest rates have offset the effects of higher debt levels to keep interest service ratios manageable (see chart 3).

There is a strong historical relationship between US economic growth and interest rates in both real and nominal terms. Over the last 50 years real GDP growth and 10-year US Treasury yields (using the GDP deflator) averaged 3.1% and 3.0%, respectively. In nominal terms they averaged 6.7% and 6.6%. On this basis, with 10-year Treasuries yielding less than 2%, they appear low by historical standards. Current conditions are certainly not unique. There have been periods when 10-year Treasury yields were consistently lower than economic growth. The last episode was the mid-2000s, when a global savings glut led to what Alan Greenspan described as a “conundrum”, whereby increases in the Fed Fund rate from 2004 were not matched by 10-year yields. With reasonably strong US growth at the time, households and corporates responded as might be expected – they borrowed more. Private credit growth subsequently outpaced nominal GDP growth and was one of the contributing factors of the global financial crisis.

The critical question is what will happen to 10-year Treasury yields and the effective interest rates faced by the corporate and household sectors as monetary policy is tightened in the current cycle? With smaller current account surpluses in Asia and among Middle East oil exporters, it seems less probable that a global savings glut will continue to hold US rates down. Despite the deleveraging that began in 2009, neither the household nor corporate sector is particularly well placed for a higher interest rate environment. Household interest payments as a share of GDP are now at the same level as the mid-1970s, when debt was lower by 35 percentage points of GDP. Corporate sector debt has increased by less, but interest payments are also at mid-1970s levels. It appears that for the first time since the early 1980s, the outlook for the US economy may be characterised by simultaneous increases in debt levels and effective interest rates. The difference now, however, is household and corporate debt levels are much higher, suggesting the potential for a much more negative impact in terms of debt sustainability and economic performance.