Economics and Banking – Page 449 – Digital Finance Analytics (DFA) Blog

When Is Macroprudential Policy Effective?

Given the buoyant housing market, and the potential risks which are exposed, there has been significant interest in the potential use of macroprudential tools to try and help alleviate the worst excesses. But some question whether they are, in fact, effective. A recent Bank For International Settlements Working paper casts some interesting light on this question. BIS Working Papers No 496 When is macroprudential policy effective? by Chris McDonald of the Monetary and Economic Department was released in late March.

Loan-to-value (LTV) and debt-to-income (DTI) limits have become increasingly popular tools for responding to house price volatility since the global financial crisis. Nonetheless, our understanding of the effects of these policies is uncertain. One aspect not well understood is how their effectiveness varies over the cycle. It is also not clear if the effects of tightening and loosening are symmetric. This paper seeks to address these issues by considering the effects of policy changes at different parts of the housing cycle. Then, controlling for this, I evaluate if the effects of tightening and loosening are symmetric or not.

There are at least two inter-related reasons for using macroprudential policies: (i) to create a buffer (or safety net) so that banks do not suffer overly heavy losses during downturns; and (ii) to restrict the build-up of financial imbalances and thereby reduce the risk of a large correction in house prices. Here I examine the relationship between changes in LTV and DTI limits and the build-up of financial imbalances. There is a growing group of economies that use macroprudential policies to target imbalances in their housing markets in this way. This analysis relies on the experience of these economies: many of which are from Asia, though the results are likely to be relevant to other economies as well.

The literature on the effectiveness of macroprudential policies at taming real estate cycles has grown quickly since the 2008 financial crisis. For a wider discussion on the effectiveness of macroprudential policies, the background papers by the Committee on the Global Financial System (2012) and the International Monetary Fund (2013) provide a good overview. The consensus is that these measures can contain housing credit growth and house price acceleration during the upswing. Kuttner and Shim (2013) estimate the effects of a range of policy changes on housing credit growth and house price inflation across 57 economies. They find that tightening DTI limits reduces housing credit by 4 to 7 percent, while tightening LTV limits reduces housing credit by around 1 percent. Crowe et al (2011) also find evidence that LTV limits prevent the build-up of financial imbalances. They find that the maximum allowable LTV ratio between 2000 and 2007 was positively correlated with the rise in house prices across 21 economies.

By looking at 100 policy adjustments across 17 economies, I find that changes to LTV and DTI limits tend to have bigger effects when credit is expanding quickly andwhen house prices are relatively expensive. Tightening measures (such as lowering the maximum LTV ratio) during upturns lower the level of housing credit over the following year by 4-8 percent and the level of house prices by 6-12 percent.

Conversely, during downturns they reduce housing credit by 2-3 percent and house prices by 2-4 percent. This is consistent with the finding of Classeans et al (2013): that the persistent (or long-run) effects of LTV and DTI limits increase with the intensity of the cycle. Several measures of the housing cycle correlate with the effects of changes to LTV and DTI limits. Stronger credit growth before tightening is associated with bigger effects. While there might be several reasons for this, one explanation is that lending is available to more marginal borrowers during booms. High house-priceto-income ratios are also correlated with bigger tightening effects. Limits on LTV and DTI ratios appear to become more constraining when houses are expensive. This may be an important element for explaining cross-country differences in the effectiveness of macroprudential policies, given that house-price-to-income ratios can differ substantially.

Tightening LTV and DTI limits appears to be more effective than loosening them, as found in past research. In downturns, ie when credit growth is weak and house prices are relatively cheap, tightening reduces the level of housing credit by around 2-3 percent and loosening raises it by 0-3 percent. Given the bounds of uncertainty, these are not that different – consistent with loosening having small effects because it usually occurs during downturns.

Digital Disruption and P2P Lending

DFA research was featured in a Sydney Morning Heald feature today “Banks look vulnerable as lucrative loans market gets personal online” by banking reporter Clancy Yates. The article nicely highlights some of the interesting and potentially disruptive plays in the evolving Australian market, including the peer-to-peer lending sector.

Greek Bad Bank Potentially Positive, Likely Insufficient – Fitch

According to Fitch Ratings, the Greek government’s intention to create a “bad bank” is a positive step towards achieving reform because it recognises that high volumes of non-performing loans (NPL) are impeding new lending. Nevertheless, banking sector reform proposals included in a broader package presented to eurozone partners on 1 April 2015 appear insufficient relative to the scale of the problems faced by Greek banks, despite potential benefits for banks’ asset quality and liquidity.

The package describes banking sector deficiencies as ‘critical’. We agree with this and believe failure of the banks is a real possibility, as indicated by the ‘CCC’ ratings assigned to the country’s largest banks.

NPLs have reached staggeringly high levels. Fitch estimates that domestic NPLs at National Bank of Greece, Piraeus Bank, Eurobank Ergasias and Alpha Bank (which together account for around 95% of sector assets) reached EUR72bn at end-2014, equivalent to 35% of combined domestic loans. Net of reserves, Greek NPLs reached a high EUR30bn and still exceeded the banks’ combined equity.

The proposal to create an asset management company, or bad bank, using remaining funds from the Hellenic Financial Stability Fund (HFSF), to deal with NPLs is potentially positive for the banks’ asset quality. The asset manager may also help banks’ weakened liquidity position if they, for example, receive HFSF-related funds in exchange for transferred NPLs.

However, the asset manager is unlikely to provide a material near-term solution to Greek banks’ asset quality problems unless it is highly geared. This is mainly because the volume of NPLs held by Greek banks vastly exceeds the EUR10.9bn HFSF buffer that would serve as capital for the bad bank.

The funding profile of the asset manager is still unclear. Fitch notes that Spain’s bad bank model, which hinged on government guaranteed bond issuance, with bonds qualifying for discount at the ECB, is unlikely to be replicated in Greece as Greek bonds cannot currently be pledged as collateral to the ECB. Fitch anticipates that Greek banks would still need to retain (and finance) sizeable stocks of unreserved NPLs, constraining future credit growth.

Furthermore, establishing correct values for the troubled loans will be difficult given the exceptionally challenging operating conditions. Therefore any transfers to an asset manager are likely to require asset write-downs, potentially further eroding banks’ solvency.

Fitch notes that Ireland and Spain’s bad banks have helped restructure balance sheets – but in these cases, troubled loans transferred to bad banks were linked to real estate. This is not the case in Greece where impairments are spread across all segments, making it more difficult to identify loans eligible to be transferred to an asset manager and to establish appropriate haircuts.

Proposals to introduce supervisory reform are potentially positive but will also be challenging to implement within a short timeframe, particularly in view of the period of extreme stress that the country is undergoing.

The proposals include a suggestion that NPLs should be resolved in a “socially fair” manner, which along with further wording, appears to hint at potential creditor unfriendliness. Fitch is uncertain whether some debt forgiveness is on the cards and whether the proposals point to state-directed lending ambitions. Similarly, proposals include expansion of the role of the Bank of Greece to encompass consumer protection, a function which, in other countries, often includes debtor-friendly measures.

Is The Housing Finance Worm Turning?

The ABS Housing Finance data for February 2015 was released today. The trend estimate for the total value of dwelling finance commitments excluding alterations and additions rose 0.8%. Owner occupied housing commitments rose 1.0% and investment housing commitments rose 0.4%. This is the first time growth in owner occupied loans has exceeded investment loans for many months. As a result the proportion of investment loans dropped below 50% for the first time this year. The cut in RBA rates also stimulated demand for the refinance of existing loans. We also see the bulk of investors purchased established dwellings, not newly constructed property.

The trend data (which irons out monthly changes) held investment loans over 50%, but also registered a slight drop.

In trend terms, the number of commitments for owner occupied housing finance rose 0.2% in February 2015. In trend terms, the number of commitments for the purchase of established dwellings rose 0.5%, while the number of commitments for the purchase of new dwellings fell 1.4% and the number of commitments for the construction of dwellings fell 1.1%. The number of loans to owner occupiers buying established homes, excluding refinancing, fell by 0.9 per cent.The overall value of loans made in the month was a record $18 billion, excluding refinancing of existing loans. New construction was up about 2%.

In percentage terms, refinance of loans increased slightly, relative to new loans.

In original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments rose to 13.7% in February 2015 from 13.6% in January 2015.

If we overlay the DFA modelling of first time investor loans, overall first time buyer activity was up. Remember, also the data refers to loans, not property transfers, and we know form our surveys that additional purchases were made without the need for a mortgage by overseas investors, and local purchases cashed up thanks to the Bank of Mum and Dad.

Finally, the bulk of lending is being done by the banks, relative to credit unions and building societies. The total loans on book was $1.375 trillion.

It is also worth noting that building societies are lending a smaller proportion of investment loans, and the falling trend here, compared with the rising trend in the credit union sector, though both are well below the 34% of banks loan portfolio.

Bank of England Maintains Bank Rate at 0.5%

The Bank of England’s Monetary Policy Committee at its meeting today voted to maintain Bank Rate at 0.5%. The Committee also voted to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion. The minutes of the meeting will be published at 9.30 a.m. on Wednesday 22 April.

The previous change in Bank Rate was a reduction of 0.5 percentage points to 0.5% on 5 March 2009. A programme of asset purchases financed by the issuance of central bank reserves was initiated on 5 March 2009. The previous change in the size of that programme was an increase of £50 billion to a total of £375 billion on 5 July 2012.

Information on the Asset Purchase Facility can be found on the Bank of England website at http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx.

The Bank will continue to offer to purchase high-quality private sector assets on behalf of the Treasury, financed by the issue of Treasury bills, in line with the arrangements announced on 29 January 2009 and 29 November 2011.

No Rate Change Today – RBA

At its meeting today, the Board decided to leave the cash rate unchanged at 2.25 per cent.

Moderate growth in the global economy is expected in 2015, with the US economy continuing to strengthen, even as China’s growth slows a little from last year’s outcome.

Commodity prices have declined over the past year, in some cases sharply. The price of oil in particular is much lower than it was a year ago. These trends appear to reflect a combination of lower growth in demand and, more importantly, significant increases in supply. The much lower levels of energy prices will act to strengthen global output and temporarily to lower CPI inflation rates. Prices for key Australian exports have also been falling and therefore Australia’s terms of trade are continuing to decline.

Financial conditions are very accommodative globally, with long-term borrowing rates for several major sovereigns at all-time lows. Financing costs for creditworthy borrowers remain remarkably low.

In Australia the available information suggests that growth is continuing at a below-trend pace, with overall domestic demand growth quite weak as business capital expenditure falls. As a result, the unemployment rate has gradually moved higher over the past year. The economy is likely to be operating with a degree of spare capacity for some time yet. With growth in labour costs subdued, it appears likely that inflation will remain consistent with the target over the next one to two years, even with a lower exchange rate.

Credit is recording moderate growth overall. Growth in lending to investors in housing assets is stronger than to owner-occupiers, though neither appears to be picking up further at present. Lending to businesses, on the other hand, has been strengthening recently. 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 risen, in part as a result of declining 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 likely, particularly given the significant declines in key commodity prices. A lower exchange rate is likely to be needed to achieve balanced growth in the economy.

At today’s meeting the Board judged that it was appropriate to hold interest rates steady for the time being. Further easing of policy may be appropriate over the period ahead, in order to foster sustainable growth in demand and inflation consistent with the target. The Board will continue to assess the case for such action at forthcoming meetings.

A Deep Dive Into Mortgage Discounts

We have been highlighting the battle for market share, and the varying discounts which are available to some. Today we deep dive into the world of discounts, drawing data from our market model. We conclude that households, on average, get better discounts which using a broker, discounts for investment loans are more generous, and reconfirm that more affluent households get the best deals. We also see that competition and deep discounts are making many loans unprofitable to the banks who make them (taking fully absorbed costs into account). As such, the current deep discounts are unsustainable.

We start by looking at the average discounts in basis points individual loan providers are offering. Some are significantly more aggressive than others. We have hidden the real names of the lenders concerned. We see that there are more banks offering owner occupied loans than investment loans. The best average discount for an investment loan is from provider 9.

Some of the owner occupied providers are quite generous in their discounts, but generally investment loans get bigger discounts at the moment.

Looking at channel of origination, and year of inception of the loans, we see that consistently third party (broker) loans get bigger discounts, and that the discounts have been growing in recent years. In the owner occupied sector, discounts for loans via the branch (first party) are slightly lower in 2015.

In the investment loan sector, we see a trend of growing discounts in recent years, with third party originated loans getting a better deal.

Turning to the DFA property segments, in the investment loan category, we see that portfolio investors are getting the very best discounts, whilst first time buyers are not doing so well, but they are slightly ahead of holders, refinance and trading down households.

Looking at our master household segments, we see that the wealthy – professionals and young affluent get the best deals. Those with less bargaining power do not do so well.

This is true of both investment mortgages (above) and owner occupied mortgages below, though we see that in the latter case, the discounts are slightly less generous.

We also see that interest only loans command a larger discount in some states, especially in ACT. Others are more line ball.

In comparison interest only owner occupied loans can consistently command a larger discount, than normal repayment loans, but as highlighted already these discounts are on average a little lower than in the investment sector.

So what is the profit impact of these discounts? DFA has calculated the relative profit of each loan and using an index we can display the relative profit contribution in cash terms. For owner occupied loans, up until 2013, most years were net profitable to the lenders. We note that this changed in 2014 and 2015 as discounts expanded, and competition increased. Overall in cash terms they are making a slight net loss on some loans written now. This is partly explained by the one off costs of setting up a new loan, and initial broker commissions. As loans age, they on average become more profitable.

The investment loan profit footprint is very interesting, as here we see a consistent fall in the profit index since 2010, with the largest drops in 2014 and 2015. This is explained partly by the significant growth in volumes, and the deeper discounting. Again, older loans become more valuable. Most banks would calculate an amortised cost of origination, spread over a number of years, but we prefer a true cash view.

We conclude from this that recent loans for many providers (especially those less efficient) will be loosing money initially, and the portfolio will be supported by the older more profitable loans. We also think that discounts are unsustainable at current levels, and will see them come off over the next few months.

Is P2P Lending Becoming Banks Outsourcing Their Loan Process…and Risk?

From The Conversation (UK)

By bringing together savers and borrowers directly, peer-to-peer lending, or P2P for short, bypasses the banks. The cumulative total of loans is forecast to reach £2.5 billion in the UK this year, according to the trade body, Peer2Peer Finance Association. Although these totals are as yet still a tiny proportion of the UK’s £170 billion consumer credit market, this could change fast.

Its credentials as a game-changing industry prompted the Bank of England’s Andrew Haldane to suggest: “The banking middle men may in time become the surplus links in the chain.” However, following news that the giant investment bank Goldman Sachs may be poised to back peer-to-peer lender, Aztec Money, it is clear that the very nature of P2P lending is changing. Banks and other big institutions are quietly recasting themselves as new links in the chain.

Banks are themselves becoming major lenders on some P2P platforms. For example, Forbes estimates that in the US, 80-90% of the capital lent through the two largest P2P lenders, Prosper and LendingClub, is now institutional money.

This means that when you take out a P2P loan, you are now less likely to be borrowing from individuals who often combine a social approach to lending with their desire for investment returns. As an investor, you might find it harder to compete for the best value loans.

Some banks and big institutions are buying up bundles of loans originated on P2P platforms, in some cases repackaging them and selling them on as asset-backed securities. Those with all but the sketchiest memories will immediately recall the way US mortgages were repackaged and traded prior to the 2007 global financial crisis.

What Happens After QE?

Interesting comments from FitchRatings in their Global Perspective series.

There has long been a sense of finality about quantitative easing (QE): when policy interest rates are at or near zero, it seems the last option available to central banks in countering deflation. But this ignores other monetary and exchange rate policies implemented in the past, those recently considered implausible but being deployed at present, and additional creative ideas that may – by necessity and where possible – receive more widespread use in the future.

Ultimately, central banks control the quantity of money (narrowly defined) and exert influence over its price (the interest rate). With this in mind, it is logical to conclude that once the price of money is at its minimum, and further accommodation is desirable, central banks are left with only the quantity of money to consider. However, there are a few other policy options, although they would be likely to prove contentious and subject to questions about their effectiveness.

In the Past: Exchange Rate Interventions

Another way to express the price of money that central banks, including those in advanced economies, have at times tried to influence is the price of foreign currency, the exchange rate.

In September 1985 finance ministers and central bank governors of France, Germany, Japan, the UK and US announced in the Plaza Accord that “exchange rates should play a role in adjusting external imbalances” and that “an orderly appreciation of the main non-dollar currencies against the dollar is desirable”. This was directed primarily at the Japanese yen/US dollar exchange rate, to reduce the US-Japan trade imbalance and the broader US current account deficit. A year later the US dollar had depreciated by 35% against the yen (see chart), and two years later US inflation was more than 4%, where it remained until mid-1991.

There are two common objections to exchange rate intervention. First, it is a zero-sum game: one country’s beneficial depreciation is at the expense of others’ appreciations. Second, intervention is ineffective in the longer term when market forces take hold.

One counter to these objections is that they are inconsistent with each other, at least over time. More importantly, policymakers may eventually conclude that it is not a zero-sum game if countries in deflation represent a broader global risk to growth. And, as with QE, doubts about the effectiveness of currency intervention may be shelved when other policy options appear to have been exhausted and policymakers need to be seen to be taking all necessary steps.

In the Present: Doing the “Unthinkable”

It seems sensible that nominal interest rates have a zero lower bound, as investors would be unlikely to buy assets that, if held to maturity, deliver a nominal loss. It also seems sensible that central banks would want to avoid pushing policy rates below zero. They have long argued that the proper functioning of financial markets would be impaired by negative nominal rates.

Nevertheless, the zero lower bound has been breached by both policymakers and the market. At end-March, the Swedish central bank repo rate, the Swiss central bank three-month LIBOR (Swiss franc) target range, and the Danish central bank certificate of deposit rate were below zero. A number of European government bond yields were also negative.

At least some objections to breaching the zero lower bound on policy interest rates have clearly been set aside, and – assuming deflationary conditions warrant it – the rationale for doing so may become more appealing. From a central bank perspective, two risks associated with negative yields are that they encourage a greater reliance on cash, taking funds outside the financial system, and there could be a run-up in credit, portending asset bubbles and financial instability.

A shift towards large-scale cash holdings in advanced economies appears improbable, if for no reason other than it being impractical. Asset price bubbles and future financial instability may present a bigger problem, but the calculus of central banks could change. If faced with the choice of immediate, intractable deflation and potential financial instability, policymakers may opt to first address the more pressing challenge.

The Future: Policy Creativity

Negative interest rates and a return of more active exchange rate policies might not be the only options to consider. The government and Nationalbank of Denmark have developed another strategy to provide additional monetary accommodation. The government is issuing no bonds until further notice, and will draw on its deposits at the central bank as needed, effectively adding to base money. This may not be an option for many countries (Danish government deposits at the Natioanlbank were large), but it underscores the potential for policy creativity.