Economics and Banking – Page 448 – Digital Finance Analytics (DFA) Blog

RBA Glass Is Half Full

The RBA minutes were released today, confirming that the board is waiting for more data, especially on inflation. They acknowledge slow wage growth and declining savings and a slow pickup in the non-mining sector. They also acknowledged risks in the housing market, especially in Sydney. I have to say, they appear to be in the “glass half full” side of the room. Also. movements in exchange rates just before the last two rate announcements were referred to ASIC but no issues have been identified. Here is the release:

International Economic Conditions

Members noted that growth of Australia’s major trading partners had continued at around its average pace in early 2015. Growth in China looked to have eased a little further and this was likely to have contributed to further declines in iron ore and coal prices. Globally, the fall in oil prices in the second half of 2014 had led to lower inflation and was expected to provide additional support to demand in Australia’s trading partners. Monetary policies remained very accommodative.

In China, the authorities had announced a target for GDP growth in 2015 of 7 per cent, ½ percentage point below the target for 2014. Recent indicators suggested that economic conditions had softened. Growth of fixed asset investment had been slowing, particularly in real estate and manufacturing, and prices of residential property and sales volumes had declined further. Members noted that the deterioration in conditions in the property market had increased the vulnerability of leveraged property developers and local authorities that relied on revenue from land sales to support their infrastructure investment. They also noted that the central authorities had indicated a willingness to adjust policies to support employment growth, while remaining committed to putting financing on a more sustainable footing. The weakness in the property market in China had flowed through to slower growth in the demand for steel, which had, in turn, contributed to the recent falls in iron ore prices, even though Chinese imports of Australian iron ore had continued to increase.

The modest recovery of the Japanese economy was continuing. Labour market conditions remained tight and the recent annual spring wage negotiations had resulted in several large companies increasing base wages by more than they did a year earlier. In the rest of the Asia-Pacific region, growth had continued at around its average pace of the past decade, although there had been variation in the composition of growth across the region.

Members observed that the US economy had continued to grow, but that the pace of growth may have moderated in the early months of this year partly in response to the temporary effects of adverse weather conditions and industrial action at some ports. Labour market conditions had strengthened further over the past six months or so; employment had increased at around its fastest pace in several years and the unemployment rate had declined further. Members noted that overall wage growth in the United States remained subdued. The Federal Open Market Committee (FOMC) had indicated that it was likely to begin the process of normalising interest rates in the second half of this year if economic conditions continued to evolve as expected.

In the euro area, economic activity had continued to recover gradually. The unemployment rate had declined a little further and there had been a noticeable lift in activity in some euro area periphery economies. Lower oil prices had reduced consumer price inflation significantly, but core measures of consumer price inflation had not changed much in recent months and remained well below the target of the European Central Bank (ECB). There had been some signs that conditions in the construction sector had stabilised and credit to both households and businesses was increasing, albeit gradually.

Members observed that bulk commodity prices had declined further over the past month. Although much of the decline over 2014 was driven by expansion in global supply, the slowing in growth of Chinese demand had contributed more recently. A small (but increasing) share of Australian iron ore production was estimated to be unprofitable at prevailing prices, while the decline in oil prices since the middle of 2014 was expected to lower the prices of Australian liquefied natural gas exports over the next few months.

Domestic Economic Conditions

The December quarter national accounts, which were released the day after the March meeting, confirmed that the Australian economy had grown at a below-average pace over 2014. Members noted that growth in dwelling investment, consumption and resource exports had picked up, but that business investment had continued to fall and public demand had made little contribution to growth over the year. Recent indicators suggested that the below-trend pace of GDP growth had continued into the March quarter.

Overall conditions in the housing market had remained strong, supported by very low interest rates and relatively strong population growth. Housing prices had continued to rise strongly in Sydney and, to a lesser extent, Melbourne, but growth in prices had eased recently in some other parts of the country. Other indicators of activity had also suggested strong conditions in the established housing market in Sydney and Melbourne. Housing credit overall had been growing at about 7 per cent in six-month-ended annualised terms, while credit to investors had grown at a pace a little above 10 per cent on the same basis. Recent data on loan approvals suggested that growth in housing credit was likely to continue at this pace, but not accelerate, in the months immediately ahead. Meanwhile, new dwelling approvals and loan approvals for new construction were at high levels, pointing to strong growth in dwelling investment over coming quarters.

Household consumption had increased in the December quarter, supported by low interest rates and rising household wealth. Even so, growth in household consumption over the second half of 2014 had been slightly below average, reflecting subdued growth in household income, while the saving ratio had continued its gradual decline of the past two years. More timely data had indicated that growth in the value of retail trade in January and February was about average and that consumer confidence had been close to average levels.

Mining investment was estimated to have declined by 13 per cent over 2014 and an even larger decline was expected over 2015. Moreover, members observed that the recent declines in oil prices could lead to some scaling back of investment plans in the oil and gas sector. Non-mining investment had been subdued for some time. Forward-looking indicators (such as the ABS capital expenditure survey and non-residential building approvals) as well as liaison suggested that it was likely to remain subdued, and could even decline, over the next year or so. Members noted, however, that there had been a pick-up in growth of credit to businesses of late. They also observed that the strongest improvement in investment intentions (apparent in the recent capital expenditure survey) had been recorded for industries experiencing the strongest output growth, such as rental, hiring & real estate and retail trade. More recently, survey measures of business confidence and capacity utilisation remained a little below average, while measures of business conditions were around average levels.

Members observed that there had been significant variation in the composition of domestic demand growth across the states over the course of 2014. Dwelling investment and consumption had contributed to growth in all states, whereas business investment had subtracted from growth in Queensland and Western Australia, mainly reflecting the decline in mining investment in these states. Members noted that public demand had contributed to domestic demand growth only in New South Wales and Victoria over the year and had made no contribution to output growth for the country as a whole.

Resource exports had grown strongly in the December quarter and there were early indications of strength in resource exports in the first few months of 2015. However, lower commodity prices were expected to lead to some reduction in the growth of production, and therefore exports, in 2015, particularly for coal. The data for recent quarters were consistent with the lower exchange rate having provided support to net exports, particularly for services.

Recent employment growth had been stronger than a year earlier, but it was still below the growth of the working-age population. Consequently, the unemployment rate had continued its gradual upward trend of recent years, notwithstanding a modest decline in February to 6.3 per cent. Other indicators, such as hours worked and the participation rate, had provided further evidence of spare capacity in the labour market. The various forward-looking indicators were stronger than a year earlier, but remained at levels consistent with only modest employment growth in the months ahead.

Members noted that the national accounts measures of wage growth had remained subdued. Combined with some pick‑up in labour productivity growth over recent years, this had meant that unit labour costs had not changed much for about three years. Various measures of inflation expectations had remained slightly below their longer-run averages.

Financial Markets

The Board’s discussion of financial markets commenced with the unusual trading in the Australian dollar that occurred in the period immediately prior to the announcement of the Board’s decisions in both February and March. Members noted that the illiquid conditions that existed in the foreign exchange market at that time meant that small trades could move the price by relatively large amounts, and that once such movements occurred it would be highly likely that algorithmic trading strategies would exacerbate such movements, particularly given the illiquid environment. Moreover, the occurrence of these movements meant that liquidity was likely to decline further as more liquidity providers pulled back from the market during this window.

Members were aware of the investigations currently being undertaken by the Australian Securities and Investments Commission and were informed that internal work since the March meeting had not identified any evidence of procedural lapses or conduct that could have led to the early release of relevant information.

Global financial markets over the past month had continued to focus on the expected path of US monetary policy as well as the strained relationship between the Greek Government and its creditors.

Members noted that projections by members of the FOMC for the path of the federal funds rate had been revised down at the FOMC’s March meeting. Those projections remained above market expectations, which had flattened further following the FOMC’s reassessment and again after the release of weaker-than-expected employment data for March. Markets expected the first rise in the US federal funds rate to occur towards the end of the year.

Members also noted that negotiations between the new Greek Government and the European Commission, the ECB and the International Monetary Fund were fraught. As a result, there was some risk that Greece would not receive assistance funds in a timely fashion and the government would continue to rely on emergency measures to cover its liquidity needs. Greek banks in particular continued to face deposit outflows and had lost access to private funding markets, and as a result had increased their reliance on ECB funding. On a more positive note, members observed that there continued to be little contagion to other euro area periphery countries.

Members were briefed about the ECB’s balance sheet expansion in March, mainly reflecting lending to banks under its latest targeted longer-term refinancing operation and the commencement of government bond purchases. The ECB had also announced in March that it would not purchase bonds that carried yields below the rate that it paid on deposits (at present –0.2 per cent), indicating that the ECB would need to buy relatively long-dated German Bunds.

Government bond yields in most of the major economies remained at very low levels. They had shown little net change in the United States and Japan, while yields on long-term German Bunds had declined further following the launch of the ECB’s sovereign bond purchasing program. Domestically, longer-term government bond yields had also declined and the 10-year Australian bond yield was around its record low, with the spread to US yields close to its lowest level since 2001.

There were sizeable rises in equity prices in European and Japanese markets in March, while equity prices in China had increased by 15 per cent over the past month and by 90 per cent since the middle of 2014. In contrast, equity prices in Australia had been little changed in March. Prices of resource stocks remained under pressure.

The US dollar had appreciated a little further on a trade-weighted basis over March, taking the rise since July 2014 to 14 per cent. Over the same period, members observed that both the euro and the Australian dollar had depreciated by around 20 per cent against the US dollar. While the renminbi had both appreciated and depreciated at different times since July 2014, these moves had roughly netted out against the US dollar overall and the renminbi had therefore appreciated noticeably against most other currencies. Members also noted that the Australian dollar had recorded an all-time low against the New Zealand dollar.

Members concluded their discussion of financial markets with the observations that lending rates for business and housing in Australia had continued to edge down over the previous month, and that financial markets assigned a high probability to a reduction in the cash rate at the current meeting, and an even higher probability to a reduction occurring by the May meeting.

Considerations for Monetary Policy

Members’ overall assessment was that the outlook for global economic growth had not changed significantly over the past month and that it would be supported by stimulatory monetary policies and the fall in the price of oil since mid 2014. They observed that the apparent slowing of growth in China, in particular the further deterioration in conditions in the Chinese property market, had placed some additional downward pressure on the demand for steel and on the prices of Australia’s key commodity exports. Conditions in global financial markets had remained very accommodative. Changes to the stance of monetary policy by any of the major central banks and further significant developments in Europe had the potential to affect financial market conditions in Australia, including the exchange rate, over the coming year.

Data available at the time of the meeting suggested that the Australian economy had continued to grow somewhat below trend in the December quarter and into the first quarter of 2015. There had been evidence to suggest that the growth in consumption and dwelling investment had picked up, supported by the very low levels of interest rates. Exports were also growing. However, a significant pick-up in non-mining business investment was yet to occur and several indicators suggested it would remain subdued for longer than had earlier been anticipated. At the same time, the recent declines in bulk commodity prices could, at the margin, lead to a larger-than-expected fall in mining investment and some decline in the production of iron ore and coal. Data for the labour market suggested that the economy was likely to be operating with a degree of spare capacity for some time and that labour market conditions were likely to remain subdued. As a result, wage pressures were expected to remain contained and inflation was forecast to remain consistent with the target over the next year or so.

Members remained alert to the possibility that the low levels of interest rates could foster imbalances in the housing market. The most recent data suggested that activity in the housing market had remained strong, but there had been little change to housing market conditions overall or in the growth of housing credit in early 2015. Although prices continued to rise rapidly in Sydney and, to a lesser extent, Melbourne, trends elsewhere were more varied. Members noted that the Bank was working with other regulators to assess and contain risks arising from the housing market.

Overall, members considered that the current setting of monetary policy was accommodative and providing support to the economy. They also acknowledged that a lower exchange rate would help achieve more balanced growth in the economy. Further depreciation of the Australian dollar was likely given the recent declines in key commodity prices.

In considering whether or not to reduce the cash rate further at this meeting, members discussed the various channels through which monetary policy was affecting the economy at present, including the asset price and exchange rate channels. In assessing the operation of the cash flow channel in particular, they noted that the responsiveness of borrowers and savers to changes in interest rates and asset prices was unusually uncertain in a world of very low interest rates and high household leverage. Members also saw advantages in receiving more data, including on inflation, to assess whether or not the economy was on the previously forecast path and allowing more time for the economy to respond to the reduction in the cash rate earlier in the year.

Taking all these factors into account, the Board judged that it was appropriate to hold interest rates steady for the time being, while accepting that further easing of policy may be appropriate over the period ahead to foster sustainable growth in demand and inflation consistent with the target. The Board would continue to assess the case for such action at forthcoming meetings.

The Decision

The Board decided to leave the cash rate unchanged at 2.25 per cent.

What Does The Fed’s Bank Stress Tests Tell Us?

Last month the results from the latest Dodd-Frank Act Stress Tests were released. Unlike the APRA tests the outcomes of which (other than high-level general comments), are totally secret; the results for individual banks are disclosed, allowing comparisons to be made. In addition, there is real focus on capital ratios, which in Australia according to the Murray report should be lifted here, because currently our banks are supported by an implicit government guarantee. Looking at the US regime provides insights into how banking supervision works.

By way of background, in the wake of the recent financial crisis, under the DoddFrank Act, the US Federal Reserve is required to conduct an annual stress test of banks with total consolidated assets of $50 billion or more as well as designated nonbank financial companies. The tests are designed to see if these banks have appropriate capital adequacy processes and capital to absorb losses during stressful conditions, whilst meeting obligations to creditors and counterparties and continuing to serve as credit intermediaries.

There are two elements to the tests, first examining a banks capital adequacy, capital adequacy process, and planned capital distributions, such as dividend payments and common stock repurchases – Comprehensive Capital Analysis and Review (CCAR), and second a forward-looking quantitative evaluation of the impact of stressful economic and financial market conditions – Dodd-Frank Act Stress Test (DFAST). The scenarios are not disclosed prior to testing, so to an extent, the banks are not able to dress up their results.

This is the fifth round of stress tests led by the Federal Reserve since 2009 and the third round required by the Dodd-Frank Act. The 31 firms tested represent more than 80 percent of domestic banking assets. The Federal Reserve uses its own independent projections of losses and incomes for each firm.

Moreover, the banks have to pass the tests in order to pay out rewards to its investors, so it is much more than a mathematical academic exercise. The Fed is more and more focussing on the culture of the organisations and some banks failed the qualitative assessment. As the testing has evolved, this activity has become more are more part of normal supervisory activities, rather than a once a year proof.

Overall, the Fed’s judgment is that American banks carry enough cash and have strong enough internal risk management systems to weather a severe economic downturn. 28 of 31 financial institutions tested had adequately balanced capital and risk in hypothetical downturn, allowing them to return cash to shareholders as planned.

We look at the work in more detail.

The Scenario Modelling, (DFAST).

The Federal Reserve’s projections of revenue, expenses, and various types of losses and provisions that flow into pre-tax net income are based on data provided by the 31 banks participating in the test and on models developed or selected by Federal Reserve staff and reviewed by an independent group of Federal Reserve economists and analysts. The models are intended to capture how the balance sheet, RWAs, and net income of each BHC are affected by the macroeconomic and financial conditions described in the supervisory scenarios, given the characteristics of the banks loans and securities portfolios; trading, private equity, and counterparty exposures from derivatives; business activities; and other relevant factors.

The adverse and severely adverse supervisory scenarios used this year feature U.S. and global recessions. In particular, the severely adverse scenario is characterized by a substantial global weakening in economic activity, including a severe recession in the United States, large reductions in asset prices, significant widening of corporate bond spreads, and a sharp increase in equity market volatility. The adverse scenario is characterized by a global weakening in economic activity and an increase in U.S. inflationary pressures that, overall, result in a rapid increase in both short- and long-term U.S. Treasury rates.

The Severely Adverse Scenario

The severely adverse scenario for the United States is characterized by a deep and prolonged recession in which the unemployment rate increases by 4 percentage points from its level in the third quarter of 2014, peaking at 10 percent in the middle of 2016. By the end of 2015, the level of real GDP is approximately 4.5 percent lower than its level in the third quarter of 2014; it begins to recover thereafter. Despite this decline in real activity, higher oil prices cause the annualized rate of change in the Consumer Price Index (CPI) to reach 4.3 percent in the near term, before subsequently falling back. In response to this economic contraction—and despite the higher near-term path of CPI inflation, short-term interest rates remain near zero through 2017; long-term Treasury yields drop to 1 percent in the fourth quarter of 2014 and then edge up slowly over the remainder of the scenario period. Consistent with these developments, asset prices contract sharply in the scenario. Driven by an assumed decline in U.S. corporate credit quality, spreads on investment-grade corporate bonds jump from about 170 basis points to 500 basis points at their peak.

Equity prices fall approximately 60 percent from the third quarter of 2014 through the fourth quarter of 2015, and equity market volatility increases sharply. House prices decline approximately 25 percent during the scenario period relative to their level in the third quarter of 2014.

The international component of the severely adverse scenario features severe recessions in the euro area, the United Kingdom, and Japan, and below-trend growth in developing Asia. For economies that are heavily dependent on imported oil—including developing Asia, Japan, and the euro area—this economic weakness is exacerbated by the rise in oil prices featured in this scenario. Reflecting flight-to-safety capital flows associated with the scenario’s global recession, the U.S. dollar is assumed to appreciate strongly against the euro and the currencies of developing Asia and to appreciate more modestly against the pound sterling. The dollar is assumed to depreciate modestly against the yen, also reflecting flight-tosafety capital flows.

In this severely adverse scenario, Over the nine quarters of the planning horizon, losses at the 31 BHCs under the severely adverse scenario are projected to be $490 billion.

This includes losses across loan portfolios, losses from credit impairment on securities held in the BHCs’ investment portfolios, trading and counterparty credit losses from a global market shock, and other losses. Projected net revenue before provisions for loan and lease losses (pre-provision net revenue, or PPNR) is $310 billion, and net income before taxes is projected to be –$222 billion. There are significant differences across banks in the projected loan loss rates for similar types of loans. For example, while the median projected loss rate on domestic first-lien residential mortgages is 3.5 percent, the rates among banks with first-lien mortgage portfolios vary from a low of 0.9 percent to a high of 12.5 percent. Similarly, for commercial and industrial loans, the range of projected loss rates is from 3.0 percent to 14.0 percent, with a median of 4.8 percent. Differences in projected loss rates across BHCs primarily reflect differences in loan and borrower characteristics.

The aggregate tier 1 common capital ratio would fall from an actual 11.9 percent in the third quarter of 2014 to a post-stress level of 8.4 percent in the fourth quarter of 2016.

The Adverse Scenario

In the adverse scenario, the United States experiences a mild recession that begins in the fourth quarter of 2014 and lasts through the second quarter of 2015. During this period, the level of real GDP falls approximately 0.5 percent relative to its level in the third quarter of 2014, and the unemployment rate increases to just over 7 percent. At the same time, the U.S. economy experiences a considerable rise in core inflation that results in a headline CPI inflation rate of 4 percent by the third quarter of 2015; headline inflation remains elevated thereafter. Short-term interest rates rise quickly as a result, reaching a little over 2.5 percent by the end of 2015 and 5.3 percent by the end of 2017. Longer-term Treasury yields increase by less. The recovery that begins in the second half of 2015 is quite sluggish, and the unemployment rate continues to increase, reaching 8 percent in the fourth quarter of 2016, and flattens thereafter. Equity prices fall both during and after the recession and by the end of the scenario are about 25 percent lower than in the third quarter of 2014. House prices and commercial real estate prices decline by approximately 13 and 16 percent, respectively, relative to their level in the third quarter of 2014.

In the adverse scenario, projected losses, PPNR, and net income before taxes are $314 billion, $501 billion, and $178 billion, respectively. The accrual loan portfolio is the largest source of losses in the adverse scenario, accounting for $235 billion of projected losses for the 31 BHCs. The lower peak unemployment rate and more moderate residential and commercial real estate price declines in the adverse scenario result in lower projected accrual loan losses on consumer and real estate-related loans. The ninequarter loan loss rate of 4.1 percent is below the peak industry-level rate reached during the recent financial crisis but still higher than the rate during any other period since the Great Depression of the 1930s. As in the severely adverse scenario results, there is considerable diversity across firms in projected loan loss rates, both in the aggregate and by loan type. The aggregate tier 1 common capital ratio under the adverse scenario would fall 110 basis points to its minimum over the planning horizon of 10.8 percent before rising to 11.7 percent in the fourth quarter of 2016.

Standing back, a few observations are worth thinking about, courtesy of the The Harvard Law School Forum on Corporate Governance and Financial Regulation.

1. More post-stress capital exists today than did pre-stress capital during the financial crisis: The 31 banks’ post-stress Tier 1 Common ratio (T1C) average 8.2% under the severely adverse scenario, which is higher than the same banks’ pre-stress T1C average of 5.5% at the beginning of 2009. Average pre-stress T1C is also up again this year from last year (11.9% versus 11.5%) as is post-stress T1C (8.2% versus 7.6%).

2. Industry capital ratios improve faster overall than at the largest banks: The six largest banks accounted for about half of the total increase in industry Tier 1 common equity. However, these institutions make up 70% of industry-wide RWA, demonstrating that the other 25 banks are disproportionately accounting for the increase in industry-wide capital.

3. Leverage ratio appears binding for many of the largest banks: The leverage ratio is the binding constraint for many large banks as they remain close to the 4% minimum. The leverage ratio is particularly punitive for banks with significant capital markets activities. However, as the proposed G-SIB capital surcharge comes into play, these banks will further increase their common equity, lessening the impact of the leverage ratio in the future.

4. Fed models seem to be maturing and becoming more predictable: For the first time, the Fed disclosed the degree to which its stress models have changed, indicating that there were only incremental changes to most models. This model stability (and the fact that the Fed’s economic scenarios have been held fairly constant over time) should allow banks to better anticipate the Fed’s projected capital losses in the future. Banks can integrate this information into their future capital distribution plans in order to maximize their distributions to shareholder without having to raise regulatory flags by taking the mulligan.

5. Loan loss rates improve due to fewer legacy problem portfolios and improved underwriting standards: Total loan loss rates continued their march downward, reaching 6.1% under the severely adverse scenario (down from 6.9% in 2014 and 7.5% in 2013). This decline is driven by improvements in first lien loans, junior liens, and credit cards, as legacy problem portfolios are being removed from balance sheets and improved underwriting standards are taking hold (as alluded to above, Fed models and scenarios in these areas have remained stable). First lien and junior lien loss rate declines are particularly impactful, with decreases of 2.1 and 1.6 percentage points respectively. Commercial and industrial loan loss rates remained stable from last year, but were generally higher for banks with significant leveraged lending businesses (which the Fed has been expressing concern about in recent years).

6. Banks overall are positioned well under the adverse scenario’s rising interest rate environment: Firms have generally prepared for the prospect of rising rates, as reflected in the adverse scenario results that show 27 of the 31 firms posting a pre-tax profit over the nine quarters. The average T1C falls only 110 bps from start to minimum, and 80 bps of that erosion is recouped by the end of the nine quarters through an increase in PPNR for these banks, largely due to asset-sensitive balance sheets more than offsetting unrealized AFS losses over time.

7. Minimum capital ratios look worse than reality: A few banks that heavily trade in the capital markets have post-stress minimum capital ratios close to the 8% requirement. However, we do not believe these banks will be as constrained in their capital distributions as it may appear. The trough in their ratios comes very early in the nine-quarter stress horizon, due to the market shock component which disproportionately impacts these firms, but rises in subsequent quarters.

8. DFAST (and CCAR) will likely be tougher in the future: The Fed indicated late last year that it may add all or a portion of the proposed G-SIB capital surcharge to post-stress capital ratios. Although we would not expect a proposed rule in this regard until at earliest the second half of this year, it is possible that such a rule could be finalized in time for DFAST 2016 given that stress testing deadlines will occur three months later. Timing aside, in our view the G-SIB capital surcharge will ultimately factor into stress testing. At a minimum for 2016, Fed expectations will be higher as a result of the extra three months for banks to prepare.

The Comprehensive Capital Analysis and Review (CCAR)

In November 2011, the Federal Reserve issued the capital plan rule and began requiring Bank Holding Companies (BHCs) with consolidated assets of $50 billion or more to submit annual capital plans to the Federal Reserve for review. For the CCAR 2015 exercise, the Federal Reserve issued instructions on October 17, 2014, and received capital plans from 31 BHCs on January 5, 2015. The capital plan rule specifies four mandatory elements of a capital plan:

an assessment of the expected uses and sources of capital over the planning horizon that reflects the BHC’s size, complexity, risk profile, and scope of operations, assuming both expected and stressful conditions, including estimates of projected revenues, losses,reserves, and pro forma capital levels and capital ratios (including the minimum regulatory capital ratios and the tier 1 common ratio) over the planning horizon under baseline conditions, supervisory stress scenarios,and at least one stress scenario developed by the BHC appropriate to its business model and portfolios;. a discussion of how the company will maintain all minimum regulatory capital ratios and a pro forma tier 1 common ratio above 5 percent under expected conditions and the stressed scenarios; a discussion of the results of the stress tests required by law or regulation, and an explanation of how the capital plan takes these results into account; and a description of all planned capital actions over the planning horizon;
a detailed description of the BHC’s process for assessing capital adequacy;
the BHC’s capital policy; and
a discussion of any baseline changes to the BHC’s business plan that are likely to have a material impact on the BHC’s capital adequacyor liquidity.

When the Federal Reserve objects to a BHC’s capital plan, the BHC may not make any capital distribution unless the Federal Reserve indicates in writing that it does not object to the distribution.

CCAR differs from DFAST by incorporating the 31 participating bank holding companies’ (“BHC” or “bank”) proposed capital actions and the Fed’s qualitative assessment of BHCs’ capital planning processes. When the CCAR was subsequently released, some banks came close to failing the tests. The Fed objected to two foreign BHCs’ capital plans and one US BHC received a “conditional non-objection,” all due to qualitative issues. Bank of America received the only sanction among U.S. firms and the bank is to resubmit its capital plan due to weaknesses in its modeling practices and internal controls. Bank of America’s conditional failure means it will have to shelve plans to increase dividends and issue stock buybacks until the Fed reviews its updated submission in six months. Santander and Deutsche Bank will also have to put investor payouts on hold. It was widely expected that the two banks would trip up on the stress tests, which have proven difficult for foreign-based banks. Santander failed its first test last year, while this was Deutsche Bank’s first attempt.

Looking at the CCAR, here are some further key points:

1. Capital planning process enhancements pay off: The fact that only two plans were rejected indicates that BHCs’ investments in quality processes have been worthwhile, most recently at Citi. Banks now have more room to make the CCAR exercise more sustainable by reducing costs and integrating with financial planning for better strategic decision making.

2. No amount of capital can make up for deficient processes: In objecting to the capital plans, the Fed cited foundational risk management issues such as risk identification and modeling quality. The press leak of this year’s rejections could have been an intentional effort to avoid an overreaction to last week’s positive quantitative-only DFAST results (avoiding confusion from prior years).

3. Return of the “conditional non-objection”: The Fed reintroduced the conditional non-objection in CCAR 2015 for one US BHC, Bank of America, after a one-year hiatus. Under this qualified pass, the Fed is requiring the bank to fix issues related to its loss and revenue modeling and internal controls, and to resubmit its capital plan by the end of the third quarter of 2015. Although matters requiring immediate attention (“MRIAs”) generally must be remediated within one CCAR cycle, conditional passes seem to operate as super-MRIAs by giving the Fed teeth to require remediation within six months (which may be particularly important this year, given the three month extended CCAR cycle for 2016). However, BHCs receiving this pass have ultimately been able to follow through on their proposed capital distributions, so the return of the conditional pass may be more of a broad message from the Fed: even though all US BHCs passed this year, their CCAR processes must continue to improve.

4. Large banks see little downside to taking the mulligan, so are being more aggressive with planned capital actions: Three of the largest US BHCs exercised the option to adjust their planned capital distributions downward, after receiving last week’s DFAST results indicating their initial plans distributed too much capital. The use of this “mulligan” continues to be limited to the largest institutions with the most sophisticated capital planning processes, and is increasingly being taken as they attempt to pay out more to shareholders. However, the Fed may look unfavorably on this development if viewed as a sign of weak capital planning capabilities (and may rethink stress testing guidelines in the future).

5. Fed and BHC loan loss modeling differences are converging, but the gap remains wide: Continuing the previous two years’ trend, the gap between Fed and BHC loan loss rate projections has again shrank this year—by about 30% across loan-types driven mostly by residential loan loss projections. This convergence will likely help management better align its proposed capital actions with the Fed’s views and more precisely assess the risk of taking the mulligan. However, the gap remains wide, at over 140 basis points across loan categories, including about 440 basis points for CRE loans. While the Fed’s projected loan loss rates have been declining rapidly under the severely adverse scenario (reaching a 6.1% average this year, down from 6.9% in 2014 and 7.5% in 2013), BHCs’ projections have been declining more slowly.

6. Fed asset growth projections continue to exert downward pressure on stressed Tier 1 common ratios: CCAR 2014 marked the first time that the Fed projected banks’ growth in risk-weighted assets, which significantly reduced stressed Tier 1 common ratios. This year Fed projections again exceed BHC projections, this time by about 10% under Basel I (versus about 12% last year) under the severely adverse scenario. As a result, banks’ stressed Tier 1 common ratios are about 90 basis points lower on average than they would have been under the Fed’s 2013 approach.

7. Caution signs line the road ahead for new CCAR entrants: As part of last year’s CCAR, the Fed noted that the 12 then-new CCAR entrants would not be held to the same high standards applicable to the largest BHCs. This year, in contrast, the Fed made clear that this grading curve does not apply to new entrants that are supervised by the Fed’s Large Institution Supervision Coordinating Committee (“LISCC”). Therefore, large intermediate holding companies and certain nonbanks deemed systemically important should take notice that the Fed’s heightened standard for LISCC firms will likely apply to them when they enter CCAR down the road.

8. Proving comprehensive risk identification will be one of the biggest challenges for CCAR 2016: A new expectation for 2015 required banks to prove (rather than simply describe) the comprehensiveness of their risk identification process and its linkage to capital planning and scenario generation. Given the experienced challenges in doing so this year, expect this area to be an important Fed focus for CCAR 2016.

9. Binding constraints on capital will evolve: The Tier 1 leverage ratio continues to be a binding constraint, especially among the BHCs with the largest capital markets businesses. However, as the proposed G-SIB capital surcharge is implemented, these banks will further increase their common equity which will lessen the impact of the leverage ratio. The binding constraint will remain a moving target as banks seek to optimize their capital holdings given the phase-in of the G-SIB capital surcharge (along with expected short-term funding capital penalties and long-term debt requirements) and the upcoming implementation of the supplementary leverage ratio (“SLR”).

10. CCAR is bigger than stress testing: The Fed explicitly stated this year that outstanding supervisory issues, beyond capital planning, may result in a qualitative objection to a BHC’s capital plan. This statement clarifies that matters outside of capital planning, such as regulatory reporting (beyond the FR Y-14 and FR Y-9C series), enterprise risk management, and governance may lead to the Fed halting additional capital distributions to shareholders.

A Quick Look At Individual Banks

The individual bank data is interesting. You can read the details in the reports via the links above. However, here is the list of players assessed, sorted by the minimum tier 1 common ratio under the severely adverse scenario, which the WSJ reproduced from the report. Note the 5% hurdle rate which is becoming a critical lens to assess the true position of the banks, rather than the complexity of internal models.

Going Forward

The Federal Reserve evaluates planned capital actions for the full nine-quarter planning horizon to better understand each BHC’s longer-term capital management strategy and to assess post-stress capital levels over the full planning horizon. While the nine-quarter planning horizon reflected in the 2015 capital plans extends through the end of 2016, the Federal Reserve’s decision to object or not object to BHCs’ planned capital actions is carried out annually and typically applies only to the four quarters following the disclosure of results. However, starting in 2016, the stress testing and capital planning schedules will begin in January of a given year, rather than October, resulting in a transition quarter before the next CCAR exercise. As a result, the Federal Reserve’s decisions with regard to planned capital distributions in CCAR 2015 will span five quarters and apply from the beginning of the second quarter of 2015 through the end of the second quarter of 2016.

It seems to me that Australia really needs to step up its focus on capital regulation, and simply waiting for the next Basel dictates will not cut the mustard. I think we need a massive lift in disclosure here, and the Dodd-Frank model points a potential path.

Chinese Banks’ Earnings Unlikely to Improve in 2015 – Fitch

Fitch Ratings says Chinese banks’ 2014 results indicate their earnings remain under pressure and the agency does not expect meaningful improvement in the current year. The banks’ earnings will be challenged by deteriorating asset quality and net interest margins (NIM) that in 2015 will further feel the effects of stiff competition for deposits and on-going deregulation of deposit rates – the latter being especially true for mid-tier banks.

For Fitch-rated Chinese banks that have reported results for 2014, their revenue grew by 13.1%, but net profit only rose by 7.2% due to higher loan provisioning. State banks reported stable, if not slightly higher, NIMs, reflecting efforts to shift towards loans with higher yield, such as micro and small-business loans, and lower-cost funding sources like core deposits. In contrast, the mid-tier banks’ NIMs were under pressure, which they tried to offset by expanding non-interest income.

Fitch estimates the rated banks’ new NPL formation rate accelerated to 0.85% in 2014 from 0.42% a year earlier, as they continued to expand loans and assets. In 2014, loans increased 11.4% and assets expanded 10.6% on average across Fitch’s rated portfolio, with mid-tier banks speeding ahead with asset growth of 16.6%, compared with the state banks’ 9.0%. Fitch views the system’s pace of credit growth as unsustainable, with the banks already being highly leveraged by emerging market standards.

With slower economic growth, all Chinese banks reported further increases in NPLs, special mention loans and overdue loans in 2014, even as more bad loans were written off and/or disposed. The reported system NPL ratio was 1.25% at end-2014 (up from 1.0% at end-2013) while the provision coverage ratio was 232%. However, most mid-tier banks reported NPL ratios of 1.02%-1.3% and provision coverage ratios around 180%-200%. The Viability Ratings on Chinese banks range between ‘bb’ and ‘b’, reflecting, among other things, Fitch’s expectation that slower economic growth could weaken borrowers’ repayment ability and drive further deterioration in asset quality, the pressure on banks from high leverage, and their potential exposure to liquidity events.

Fitch believes the health of credit quality remains overstated across the banking system. Banks with lower provision coverage will face greater pressure to dispose their NPLs in 2015 in order to meet the requirement to maintain a minimum 150% provision coverage ratio.

Although banks have been shoring up capital, their capital positions are unlikely to improve meaningfully as long as their loans and assets keep expanding at the current pace. Banks that adopted revised capital calculations raised their core tier 1 capital ratios by 92-154bps, except Agricultural Bank of China, whose core tier 1 capital ratio fell by 16bp. The mid-tier banks’ core tier 1 remained largely unchanged. The banks’ tier 1 and total capital ratios were also lifted by the issuance of Basel III-compliant securities during 2014, while the state banks reduced their dividend payout ratios and China CITIC Bank suspended the distribution of final dividends to replenish capital.

For the banks that disclosed information on wealth management products (WMPs), outstanding WMPs at the end-2014 increased by 41% on average, with the amount of WMPs issued during 2014 up 35%. The majority of the WMPs have tenors shorter than one year. While most WMPs are non-principal guaranteed by the banks, Fitch believes banks may assume some losses in the event a WMP defaults or provide funding to the entities that bail out the WMPs that are in danger of default.

RBNZ Says Action Needed To Reduce Housing Imbalances

The Reserve Bank of New Zealand today urged greater attention be given to reducing housing market imbalances that are presenting an increasing risk to financial and economic stability.

In a speech to the Rotorua Chamber of Commerce, Reserve Bank Deputy Governor Grant Spencer said that: “Irrespective of the mix of demand and supply-based factors, the longer the excess demand persists, the further prices will depart from their underlying fundamental determinants, and the greater the potential for a disruptive correction.

“Since late 2014, housing market imbalances have become more accentuated, particularly in Auckland where the supply shortage is greatest, and house prices are particularly stretched, having increased by three times since the start of 2002.

“New Zealand is one of the few advanced economies that has not had a major house price correction in the past 45 years.”

Mr Spencer said that a downward correction in house prices in New Zealand could be prompted by a range of potential shocks, such as rising global interest rates, or a downturn in the global economy and financial markets.

With 60 percent of its lending in residential mortgages, the New Zealand banking system could be put under severe pressure in such a downturn. The resulting contraction in credit would amplify the impact to the domestic economy and financial system, making it more difficult to avoid a severe downturn.

Mr Spencer said that policies to ease the supply constraints must be the main priority, but are unlikely to yield quick results.

Considerable scope exists to streamline the multiple approval processes required to complete a residential development. There is also a need to adopt a more integrated approach to the planning and funding of new infrastructure.

“The proposed RMA reforms have the potential to significantly improve the planning and resource consenting processes.

“The best prospect for substantially increasing the supply of dwellings over the next one to two years appears to be in apartment development. The Government and the Auckland Council might consider focussing their efforts on simplifying the approvals process and increasing the designated areas for high-density residential development.”

On the demand side, Mr Spencer said that there are practical difficulties in using migration policies to manage the housing cycle.

“Nor can monetary policy be used currently to dampen housing demand, as CPI inflation is below the Reserve Bank’s target range.”

However, measures should be considered to counter the growth in investor and credit based demand for housing.

The Reserve Bank would like to see fresh consideration of possible policy measures to address the tax-preferred status of housing, especially housing investment.

“Investors are often setting the marginal market prices that are then applied to the full housing stock within a regional market. Indicators point to an increasing presence of investors in the Auckland market and this trend is no doubt being reinforced by the expectation of high rates of return based on untaxed capital gains.”

Mr Spencer said that macro-prudential policy is a potential instrument to help restrain credit-based demand pressures and improve the resilience of bank balance sheets to a potential housing downturn.

“The introduction of loan-to-value ratio restrictions (LVRs) in October 2013 helped to moderate housing market pressures despite strong net inward migration and the ongoing shortage of housing. The LVR restrictions have also improved the resilience of bank balance sheets. They will be removed or modified as market conditions allow.

“Other macro-prudential options are being assessed, including in relation to investor lending. However, such tools are not a panacea – their impact is inevitably smaller than the main drivers of the current housing market imbalance.”

Australian Growth Down And Unemployment Up – IMF

The latest edition of the IMF’s World Economic Outlook, just released, portrays a complex global picture. There are several points relevant to Australia, in the pre-budget run-up.

Legacies of both the financial and the euro area crises are still visible in many countries. To varying degrees, weak banks and high levels of debt—public, corporate, or household—still weigh on spending and growth. Low growth, in turn, makes deleveraging a slow process. Potential output growth has declined. Potential growth in advanced economies was already declining before the crisis. Aging, together with a slowdown in total productivity, has been at work. The crisis made it worse, with the large decrease in investment leading to even lower capital growth. As we exit from the crisis, capital growth will recover, but aging and weak productivity growth will continue to weigh. The effects are even more pronounced in emerging markets, where aging, lower capital accumulation, and lower productivity growth are combining to significantly lower potential growth in the future. More subdued prospects lead, in turn, to lower spending and lower growth today.
On top of these two underlying forces, the current scene is dominated by two factors that both have major distributional implications, namely, the decline in the price of oil and large exchange rate movements.
Australia’s projected growth of 2.8 percent in 2015 is broadly unchanged from the October prediction of 2.7 percent, as lower commodity prices and resource-related investment are offset by supportive monetary policy and a somewhat weaker exchange rate. 3.2 percent growth is forecast for 2016, supported by low interest rates and inflation.
The downturn in the global commodity cycle is continuing to hit Australia’s economy, exacerbating the long-anticipated decline in resource-related investment. However, supportive monetary policy and a somewhat weaker exchange rate will underpin nonresource activity, with growth gradually rising in 2015–16 to about 3 percent.
Average annual metal prices are expected to decline 17 percent in 2015, largely on account of the decreases in the second half of 2014, and then fall slightly in 2016. Subsequently, prices are expected to broadly stabilize as markets rebalance, mainly from the supply side. The largest price decline in 2015 is expected for iron ore, which has seen the greatest increase in production capacity from Australia and Brazil.
Exporters of commodities (Australia, Indonesia, Malaysia, New Zealand) will see a drop in foreign earnings and a drag on growth, although currency depreciation will offer some cushion.
Australian unemployment, net is forecast at 6.4 percent in 2015.
In addition to strong regulation and supervision, protecting financial stability may also require proactive use of macroprudential policies to tame the effects of the financial cycle on asset prices, credit, and aggregate demand.

ABC Business Does Banks And Property

The second in a series of segments on Australian Property was aired tonight by the ABC. The discussion centered on the banks exposure to property. You can read the online post here. The video includes comments from DFA.

Perspectives On Capital

The question of how much capital should a bank hold is running hot these days. To illustrate the point, lets look at the commentary surrounding the the semi-annual update of the Global Capital Index, which show the capital ratios for Global Systemically Important Banks, and which was released in early April by FDIC Vice Chairman Hoenig. The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring depositors for at least $250,000 per insured bank; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails. So what they say in significant.

Among the data in the report:

For the largest U.S. banking firms, the average tangible equity capital ratio – known inversely as the leverage ratio – is 4.97 percent. In other words, each dollar of assets is funded with 95 cents of borrowed money.

The largest regional and community banks, have tangible capital ratios ranging from 7.57 to 8.85 percent. That is, they operate with between 1.5 and 1.7 times more funding from their ownership than G-SIBs do.

“The Global Capital Index illustrates how financial resiliency is still sorely lacking,” Vice Chairman Hoenig said. “The sector of the financial industry with the greatest concentration of assets is the least well capitalized. Plainly put, it operates with the largest amount of borrowed, or as we say, leveraged funding, and thus it is the least well prepared to absorb loss. Yet the primary measure of capital – the risk weighted measure — makes the largest firms appear relatively more stable than they really are. The reality is that with too little owner equity funding individual firms, the industry as a whole also is undercapitalized and should one firm fail, the industry continues to be vulnerable to contagion and systemic crisis. It follows that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution.”

The Global Capital Index uses estimates of International Financial Reporting Standards (IFRS) to measure a firm’s tangible equity (loss-absorbing capital) against on- and off-balance sheet assets, as shown in column 8 of the table. The tangible capital measurement includes derivatives and other assets that are off-balance-sheet in US Generally Accepted Accounting Principles (GAAP) and Basel calculations. It is calculated by comparing equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets.

The tangible leverage ratio measures funds available to absorb loss against total balance sheet and some off-balance sheet assets. It does not attempt to predict or assign relative risk weights among asset classes. “It is more difficult to game, and it provides the most clear and complete picture of a banking firm’s ability to absorb loss regardless of source,” Vice Chairman Hoenig said.

In contrast, the ratios of Tier I capital to risk-weighted assets for all banks, largest to smallest, are above 10 percent and some of the largest have ratios of more than 15 percent. “This higher capital ratio is achieved by reducing on-balance sheet assets by a pre-assigned risk weight and excluding off-balance sheet assets, such as derivatives. This measure is misleading and overstates the strength of these firms’ balance sheets. No other industry is allowed to make these kinds of adjustments,” Vice Chairman Hoenig said. “The tangible leverage ratio provides a more accurate measure of assets and risks than the balance sheet reported under either GAAP or Basel.”

Lending Finance Tops Out?

The ABS data today provides an insight into the various categories of Finance to February 2015. The total value of owner occupied housing commitments excluding alterations and additions rose 1.0% in trend terms, whilst the value of total personal finance commitments fell 0.1%. The value of total personal finance commitments fell 0.2%. The trend series for the value of total commercial finance commitments rose 2.9%. Revolving credit commitments rose 4.8% and fixed lending commitments rose 2.1%. So, we see a rise in commercial lending (which of course includes investment property lending.) The rate of momentum in housing lending on the other hand appears to be slowing somewhat.

Looking at the relative share of investment property lending, we see it has turned down from a peak of 30.3% of all commercial lending to just of 29%, but still high compared with 2011. Banks are still preferring to lend for housing, though we are seeing a rise in commercial lending which is not property aligned – this is to be welcomed, and we need to see more, as productive lending to business will translated into real economic growth, whilst lending for property purchase inflates house prices, bank balance sheets, and household net wealth in book value terms.

Turning to housing lending, values still rising and a total of $31 billion was lent for property across all categories in the month. This is a record.

Looking at the mix, 38% was for investment housing, 30% for owner occupation, and 20% for refinance.

We see that just of 50% of secured loans (excluding refinance) were for investment purposes. Refinance was high, in response to the RBA rate cut in February.

Looking at the percentage movements, month on month, we see the rate of growth slowing across the board, with investment lending slowing the most. This could well indicate a potential turning point in the months ahead, despite strong demand for investment property in the system.

A Sharp Downturn (Though Unlikely) In China Would Impact Australia – World Bank

The latest East Asia and Pacific Economic Update from the World Bank says

“a significant slowdown in China, though unlikely, would exert large spillovers, particularly on commodity exporters. In China, a disorderly unwinding of real and financial vulnerabilities could trigger a sharp slowdown in investment and output growth. A steep decline in property prices could force developers and banks to deleverage quickly, leading to a sharp contraction in real estate investment. A disorderly unwinding of local government financing could trigger a sharp slowdown in infrastructure investment. A wave of bankruptcies in primary and heavy industries suffering from overcapacity could seriously derail fixed investment in otherwise healthy industrial sectors. And excessive risk taking in the shadow-banking system could eventually force a rapid cutback in liquidity and credit, deeply curtailing investment.

A slowdown of this order remains unlikely, given the substantial policy buffers available. As discussed in the October 2014 East Asia and Pacific Economic Update, there are significant fiscal, institutional, and exchangerate buffers to prevent a disorderly unwinding of debt. Ample fiscal space is available to deploy targeted stimulus or bail out debtors. The savings rate is 50 percent of GDP, financial repression restricts savings outside the banking system, the financial system is still predominantly state owned, and capital controls on bank lending and portfolio investment prevent sharp outflows. Foreign reserves, at US$3.9 trillion, are by far the largest in the world, and net international assets exceed US$2 trillion.

However, should a sharp slowdown materialize, it would exert large spillovers across the region. A onetime 1-percentage-point decrease in China’s GDP growth relative to the baseline (stemming from a 2-percentagepoint decrease in investment growth) would reduce growth in the region by approximately 0.2 percentage points (World Bank 2014). The impact would be relatively larger for commodity exporters, and for economies more tightly integrated into regional supply chains (Ahuja and Nabar 2012). In addition, the significant negative impact on Australia and New Zealand, among the world’s largest commodity suppliers, would lead to indirect spillovers on the Pacific Island Countries, given their tight links through trade, investment, and aid”.