Latest Lending Data Investment Boom

The ABS released their Lending Data to January 2015. The recent trends continue, with a growing investment housing lending sector, at the expense of  other commercial lending. In trend terms, The total value of owner occupied housing commitments excluding alterations and additions rose 0.8%. The trend series for the value of total personal finance commitments fell 0.1%. Revolving credit commitments rose 0.2%, while fixed lending commitments fell 0.3%. The trend series for the value of total commercial finance commitments rose 1.1%. Revolving credit commitments rose 6.6%, while fixed lending commitments fell 1.0%. The trend series for the value of total lease finance commitments fell 2.5% in January 2015.

LendingMixJan2015We see a slight fall in relative terms in commercial lending, (and in this data. lending for investment housing is included in the commercial category. )

LendingMixPCJan2015But, splitting out the investment housing we see that more than 31% of all commercial lending is for investment housing – and note the consistent trend up from 19% in 2011.

LendingCommercialMixPCJan2015Turning to housing lending, we see investment loan flows were more than 51% of all new loans written (excluding refinance).

LendingHousingMixPCJan2015In other words, more investment loans than owner occupied loans were written in January 2015.

LendingHousingMixJan2015Finally, looking across all housing categories, we see that investment loans made up 41%.

LendingFinancePieJan2015  This momentum in investment lending continues to distort the market. We need proactive intervention, like the recently announced initiatives in New Zealand. I have to say I think APRA is just not cutting the mustard.

Is Low Inflation Good Or Bad?

Mark Carney, Governor, Bank of England, gave a speech on Inflation. I have summarised his arguments in this post because the current low inflation rates around the world have profound implications, and current inflation targets and assumptions reflect earlier responses to hyper inflation, which may not be so relevant now. That said, low inflation appears to carry significant risks, and low interest rates do not help.

16 of 18 inflation targeting economies had inflation below target in January 2015. These include US, UK, Canada, euro area, Norway, Sweden, Switzerland, Australia, China, India, Indonesia, Malaysia, New Zealand, Philippines, South Korea, Taiwan, Thailand and Brazil. 11 of those countries have inflation rates below 1%.

InflationJan2015For example, the Reserve Bank of New Zealand, said yesterday:

“Annual CPI inflation is expected to fall to around zero in the March quarter and remain low over 2015, reflecting the high exchange rate, low global inflation, and the recent falls in petrol prices. Inflation expectations appear to have fallen recently, and we will be closely monitoring the impact of this trend on wage and price setting behaviour, especially in the non-traded sector.”

There are some significant implications of this low inflation environment, especially bearing in mind that these countries are using central bank monetary policy to try and wrangle inflation above 2%. This 2% inflation seems to reflects the lessons of the past, including the fight against high inflation in the 1970s and 1980s, as well as the deflationary disasters that have followed past financial crises. The target is set by government, but managed by the central bank. Indeed, the banks have to explain to the politicians if inflation falls outside the target band. Mark Carney has just written an open letter to the UK Chancellor addressing the current low inflation there.

Whilst high inflation damages growth, in part, because high inflation also tends to be volatile, generating uncertainty that makes important economic decisions more difficult. In contrast, a little inflation ‘greases the wheels’ of the economy, helping it to absorb shocks. A positive average inflation rate also gives monetary policy space to respond to negative shocks by cutting interest rates. Persistently low inflation can be difficult. Deflation proper is potentially dangerous. During the Great Depression, sharp falls in prices reinforced collapsing output and skyrocketing unemployment.

A commonly cited reason is that falling prices prompt households and firms to delay spending and investment. The subsequent reduction in demand causes further reductions in prices through higher unemployment. That further reduces incomes and spending, drawing the economy into the vortex. But there is a more clear and present danger arising from the balance sheets of households and firms should deflation persist. When a household takes out a mortgage or a firm secures a loan, the amount owed is denominated in cash terms – that is, not adjusted for inflation. Unexpected, generalised, and persistently falling prices then mean the real value of debt increases: the same amount of money is owed, but that money now buys more goods and services. As a result, more consumption or investment needs to be foregone to service the debt. This debt-deflation dynamic was at the core of the Great Depression and in the Japanese malaise following the collapse of the asset bubbles of the 1980s. It would be a particular concern if the pace of wage growth were to follow prices down.

Whilst falling oil prices have impacted inflation, even “core inflation” which strips out such volatile factors continues to fall.

Core-Inflation-Jan-2015In some major economies there are additional disinflationary forces. For example, in the euro area, a series of necessary internal devaluations are weighing on wages and prices. In China, a rebalancing of investment and consumption risks generating further disinflation. The producer price inflation rate has been negative for 35 months in a row, reflecting long-standing overcapacity in industries such as concrete and steel, while the more recent weakness in the property market could further increase excess capacity in related sectors. All this suggests a persistent period of low inflation globally is a possibility, and could itself create a self-fulfilling fear of a bad outcome. Concerns that household or government debt will weigh on demand could cause firms to delay further their already weak investment spending. Such rational corporate caution is consistent with the behaviour of many financial asset prices, which appear to be pricing the possibility of material downside tail risks, such as that economic weakness and persistently low global inflation become mutually reinforcing. Those expectations matter as they feed into the wage and price setting processes that ultimately determine inflation.

Protracted global weakness could heighten the challenge of returning inflation quickly to target. That’s because weak global conditions would tend to push down on the equilibrium interest rate that would maintain demand in line with supply and inflation at the target. This equilibrium rate has likely been falling for the last three decades and turned sharply negative in the downturn. This meant central banks had to turn to unconventional policy tools to stimulate their economies in order to return inflation to target. In the cases of the UK and the US, these measures have been effective in supporting domestically generated inflation. Inflation is likely still to be negative in many countries, reflecting an excess of saving over investment.

RBNZ Left Rate Unchanged

The NZ Reserve Bank left the Official Cash Rate unchanged at 3.5 percent.

Global financial conditions remain very accommodative, and are reflected in high equity prices and record low interest rates. However, volatility in financial markets has increased since late-2014 following the sharp drop in oil prices, continued uncertainty about the global outlook and US monetary policy, and policy easings by a number of central banks.

Trading partner growth in 2015 is expected to continue at a similar pace to 2014. Growth remains robust in the US, but has slowed recently in China.

World oil prices are about 50 percent below their June-2014 peak, more reflecting increased supply than demand factors. The fall in oil prices is net positive for global economic growth, but will further reduce inflation in the near term, at a time when global inflation is already very low.

The domestic economy remains strong. The fall in petrol prices has increased households’ purchasing power and lowered the cost of doing business. Employment and construction activity are strong. Net immigration remains high, and monetary policy continues to be supportive. The housing market is showing signs of picking up, particularly in Auckland. However, there are a number of factors weighing on domestic growth, including drought conditions in parts of the country, fiscal consolidation, reduced dairy incomes, and the high exchange rate.

On a trade-weighted basis, the New Zealand dollar remains unjustifiably high and unsustainable in terms of New Zealand’s long-term economic fundamentals. A substantial downward correction in the real exchange rate is needed to put New Zealand’s external accounts on a more sustainable footing.

Annual CPI inflation is expected to fall to around zero in the March quarter and remain low over 2015, reflecting the high exchange rate, low global inflation, and the recent falls in petrol prices. Inflation expectations appear to have fallen recently, and we will be closely monitoring the impact of this trend on wage and price setting behaviour, especially in the non-traded sector.

Monetary policy remains focused on ensuring inflation settles at 2 percent over the medium term. As the economy expands, inflation returns gradually towards the midpoint of the target range.

Our central projection is consistent with a period of stability in the OCR. However, future interest rate adjustments, either up or down, will depend on the emerging flow of economic data.

First Time Buyer Investors On The March

The ABS published their Housing Finance to January 2015. Total lending for housing (both investment and owner occupied lending) lifted the stock 0.6% to $1.37 trillion. Investment rose 0.8% and owner occupied loans rose 0.5% in the month. Investment loans are close to 34.5% of all loans, a record.

ADILendingStockJan2015Looking at the changes in volumes by type, we see that the purchase of existing dwellings is rising, but refinancing, construction of new dwellings and purchase of new dwellings are down.

TrendChangeByTypeJan2015Looking across the states, momentum is rising in just two states, NSW and TAS. All other states are slowing.

StateTrendMovementsJan2015Turning to first time buyers, using the revised ABS data (method changed last month) and DFA survey data, we see that whilst first time buyers for owner occupation fell slightly (14.3% to 14.2% of all owner occupied loans), an additional 4,000 loans were written by first time buyers going direct to the investment sector. Much of this is centered on Sydney. As a result the cumulative first time buyer count is rising, with more than 21% of all loans effectively to first time buyers. You can read more analysis on this important trend here.

DFAFTBLoansJan2015This is another reason why no further assistance should be offered to “help” first time buyers into the market. It would be a waste of money.

 

 

NZ Reserve Bank Consulting On Property Investor Loans

The Reserve Bank of New Zealand is consulting on a new asset class treatment for mortgage loans to residential property investors within its capital adequacy requirements. They propose to separate investment and owner occupied loans from a capital perspective, (once loan types are defined), and apply different capital treatments, requiring more capital for investment loans, reflecting potential higher risk. This would be applied to both standards and advanced IRB banks, and they would allow a period of transition to the new arrangements, commencing 1 July 2015. The net impact would be to increase the capital costs to lenders of making investment mortgages, and potentially slowing momentum in this sector. RBA please note!

The Reserve Bank’s analysis shows that residential property investor loans are a sufficiently distinct category of loans and that by grouping them with other residential mortgage loans one is not in a position adequately to measure their risk as a separate group of loans. This can have negative consequences for a bank’s awareness of the proper risk associated with those loans and lead to insufficient levels of capital being allocated to them. The Reserve Bank therefore proposes that all locally incorporated banks hold residential property investment loans in a separate asset or sub-asset class. In addition, a primary purpose of the consultation is to seek views on how to best define a property investment loan.

Consultation closes on 7 April and once the Reserve Bank has settled upon a definition, it proposes to amend existing rules by requiring all locally incorporated banks to include residential property investment mortgage loans in a specific asset sub-class, and hold appropriate regulatory capital for those loans.

Reserve Bank Head of Prudential Supervision Toby Fiennes said: “International evidence suggests that default rates and loss rates experienced during sharp housing market downturns tend to be higher for residential property investment loans than for loans to owner occupiers.

“The proposal would bring the Reserve Bank’s framework more into line with the international Basel standards for bank capital. The proposed rule amendment is designed to ensure that banks hold adequate capital for the risks that they face from investment property lending.”

The Reserve Bank has previously consulted on a possible definition that would have seen loans to borrowers with five or more residential properties classified as loans to residential property investors. Partly as a result of submissions received, the Bank has reconsidered the definition, and is now consulting on three possible alternative ways to define loans to residential property investors:

  • if the mortgaged property is not owner-occupied; or
  • if servicing of the mortgage loan is primarily reliant on rental income; or
  • if servicing of the mortgage loan is at all reliant on rental income.

The proposed new rule would apply to all locally incorporated banks.

While the current proposal is not a macro-prudential policy proposal, creating consistent asset class groupings to be used by all banks would help the Reserve Bank to implement targeted macro-prudential policies in the future, should that become necessary.

Looking at the proposals in more detail:

They propose that residential property lending should be grouped in a separate asset class because the risk profile of these loans is observably different from owner-occupier mortgage loans, particularly in a severe downturn. The capital requirements that apply to IRB banks require long run PDs to be estimated on the basis of data that includes a severe downturn or, where that is not possible, to include an appropriate degree of additional conservatism.

Fortunately in New Zealand, we have not had a severe housing downturn in recent decades. But this also means that we do not have information on the difference in terms to default rates between residential property investors and owner-occupiers in such a scenario.

Based on the information available from other countries that have had a severe housing downturn, there is evidence to suggest that property investor loans are more strongly correlated with systemic risk factors than owner-occupier loans. This would point to a higher correlation factor in the Basel capital equation than the one that is currently used for all residential property loans. Moreover, although minimum downturn LGDs are prescribed within BS2B, they are effectively calibrated to owner-occupiers. It is therefore likely that the estimated risk weights that banks currently use for residential investor loans are too low and do not adequately reflect the risk that these loans represent.

The higher risk associated with residential property investment loans does not only apply to IRB banks. A residential property investment loan made by a bank operating on the standardised approach is equally a higher risk loan compared to a loan to an owner-occupier. The Basel approach seems to deal with this by recommending higher average risk weights for all residential property loans under the standardised approach.

In New Zealand, this has been implemented by allocating risk weights to residential mortgage loans that range from 35 to 100 percent, depending on a loan’s LVR and the availability of lender’s mortgage insurance.5 However, housing loans are a crucial area for maintaining financial stability in New Zealand and these risk weights do not adequately capture the higher risk associated with residential property investment loans.

The Reserve Bank believes that in this area, there are good reasons why a consistent conceptual approach across standardised and IRB banks makes sense. In addition, the Reserve Bank has a suite of macro-prudential tools available to help address financial stability concerns in certain circumstances. Having the same asset class groupings across all banks would help the Reserve Bank to implement targeted macro-prudential policies if that becomes necessary. Contrary to previous consultation papers on this subject therefore, the Reserve Bank now proposes to include a new asset class for residential property investors within the standardised approach, i.e. BS2A. This new asset class would also have separate, prescribed, risk weights from those that apply to non-residential property investment loans.

It is necessary to define what constitutes an investment loan. The first and in some ways simplest option would be to restrict the current retail residential mortgage asset class to owner-occupiers only. Any mortgage on a residential property that is not owner-occupied would be classified as a residential property investment loan and grouped in a new asset class.

Banks would have to verify the use of a property under this option. This information is already being collected at loan origination to some degree. Possible ways of identifying whether a property is owner-occupied or not include checking the borrower’s residential address and
whether the property generates any rental income. Other possible indicators could include eligibility for tax deductibility of the mortgage servicing costs on the property. The Reserve Bank appreciates that there could be cases where a borrower has more than one owner-occupied residential property and splits his or her time between those addresses. An example could be if a borrower uses one address during the week for work purposes and another on the weekends when he or she is with the family. Another case might be a bach that is not permanently occupied but also does not generate any rental income. The information the Reserve Bank collects from banks on new commitments already distinguishes between owner-occupiers and residential property investors while allowing for owner-occupiers to occupy more than one residential address. The same or a very similar definition could be used to distinguish between second and more properties that are still owner-occupied and properties that are used as residential properties, subject to considering adequate safeguards to ensure that this is not used as an avoidance mechanism.

The Reserve Bank also appreciates that there could be challenges for banks to monitor how a property is being used. A second flat that is used as a second residence by the owner-occupier when the loan is taken out could at some point be let out. While the Reserve Bank does not expect banks to regularly seek confirmation form borrowers as to the use of a property, it is expected that reasonable steps are taken to maintain up to date information. This could mean updating important information when there is a credit event.

An alternative option would be to use mortgage servicing costs as an indicator. If mortgage servicing are predominantly reliant on the rental income the property generates, then that loan should be classified as a residential property investment loan. Predominantly was defined as more than fifty percent. In other words, if a borrower’s other sources of income minus the bank’s usual allowances for living expenses, other loan servicing obligations and so on are sufficient to cover more than fifty percent of the loan servicing obligation of the residential property, that is interest as well as repayment of principal, then the loan continues to be classified as a residential mortgage loan in the retail asset class. This test would only apply to investment properties. Owner-occupied properties would be exempt from this requirement and continue to be classified as residential mortgage loans. There is, however, a question as to the point at which the reliance on the property’s rental income separates that loan from loans to owner-occupiers. The Reserve Bank has previously consulted on a threshold of 50 percent. But this still leaves plenty of scope for borrowers to acquire a small portfolio of investment properties without those mortgages being classified as residential property investment loans. A stricter definition would be to make it dependent on any rental income.

Irrespective of which definition and asset class treatment is decided on, banks are likely to require some time to implement the new requirements. For example, banks will have to assess which of their existing exposures are caught by the residential property investment loan definition, make changes to their information capture and IT systems and retrain staff. This will take some time. The Reserve Bank is therefore currently minded to phase the new requirement in over a period of nine months.

IRB banks may also have to develop new models for their residential property investment loan portfolio, although that is not necessarily the case and existing PD models would form a good basis on which to build residential property investor specific models. IRB banks, however, would have to amend their capital engines for residential investor loans to use the proposed LGDs and correlation factors.

It is proposed that IRB banks operate under the same risk weight requirements as standardised banks until their new models have been approved by the Reserve Bank. Furthermore, it is proposed that the new asset classification for residential property investors takes effect from 01 July 2015.

They are also proposing changes to capital requirements for reverse mortgages. Managing a portfolio of reverse mortgages requires long term assumptions to be made concerning a number of factors. If those assumptions turn out to be wrong, the risk to a lender could be significantly affected. For example, advances in geriatric healthcare might mean that people stay longer in their houses than currently anticipated. That could increase the risk of incurring a loss on a portfolio of reverse mortgages due to compound interest, the possibility of the borrower being granted further top ups and the difficulty of predicted house prices years and decades ahead.

While arrangements whereby the reverse mortgage has to be repaid after a certain period of time or stay below a set LVR are theoretically possible, they are not the norm and would most likely be to the disadvantage of the borrower, and thus undermine the attractiveness of a reverse mortgage.

To emphasise, one way in which the risk profile of a reverse mortgages differs from a normal mortgage is in the time dimension. Whereas a normal mortgage loan decreases over time, the opposite is the case for a reverse mortgage.

Finally, the Reserve Bank considers it more appropriate group credit card and revolving retail loans in the “other retail category and to remove QRRE as an option from its capital requirements for IRB banks. This would improve clarity within BS2B while having no direct impact on banks since no bank has been given approval to use the QRRE option.

Basel II framework for IRB banks introduced the concept of a ‘Qualifying Revolving Retail Exposure’ as one of three categories of retail loans. The other two categories are residential mortgages and other retail, a catch all for retail loans other than residential mortgages. The QRRE category is intended to be used for short-term unsecured revolving lines of credit, e.g. credit cards and certain overdraft facilities. In New Zealand credit card loans account for approximately 1 to 3 percent of banks’ total lending portfolios. Compared to the other two categories, the capital requirement for QRRE loans is generally lower (except for some very high probability of default (PD) buckets).

In line with Basel II, the Reserve Bank’s capital adequacy requirements provide for the use of the QRRE category. However, use of the QRRE classification is subject to Reserve Bank approval and no bank has been granted approval as yet. The Reserve Bank is concerned that some of the underlying assumptions of the QRRE category do not apply in the New Zealand context. The evidence supplied by banks when seeking approval for QRRE use has not able to demonstrate the validity of those assumptions in New Zealand.

 

New Zealand’s Potential New Capital Rules on Investor Mortgages are Credit-Positive – Fitch

Fitch Ratings views positively the Reserve Bank of New Zealand’s (RBNZ) consultation on the capital treatment for mortgages to residential property investors. Higher capital requirements for investor loans combined with the existing loan to value ratio (LVR) limit could help protect banks against material losses in the event of a property price correction.

The RBNZ proposes to modify existing capital rules by requiring banks to include investor mortgages in a specific asset sub-class, and hold appropriate regulatory capital for those assets. Investor mortgages in New Zealand have performed similarly to owner-occupied mortgages but the experience in other markets has shown weaker asset quality performance in a downturn. The consultation paper seeks to define the terminology of investor mortgages in order to make policy decisions by end-April 2015. Currently investor mortgages are treated the same as owner-occupier mortgages for regulatory capital purposes in New Zealand.

The introduction of higher capital rules for investor mortgages may also slow the growth rates of property prices, particularly in Auckland. Increased investor demand and a rise in investor mortgages appear to be a contributor to this strong growth, and the RBNZ’s proposed limit could address some of the risks associated with these loans. The agency expects banks to charge higher interest rates on investor mortgages to offset the higher capital requirements which may deter some of the more marginal investment activity in the market. Price rises in Auckland have exceeded 10% per annum over the last 24 months which is unlikely to be sustainable in the long-term.

Investor mortgages typically have lower LVRs relative to owner-occupier loans and therefore are less susceptible to the RBNZ’s existing LVR restrictions, introduced in October 2013. Banks are only allowed to underwrite a maximum of 10% of new mortgages with an LVR in excess of 80% which has reduced some potential risk in the banks’ mortgage portfolios.

The new measures could also indirectly help to limit growth in household indebtedness by reducing house price appreciation closer to income growth. New Zealand’s household debt, measured as a percentage of disposable income stood at 156% at end-September-2014, which is high relative to many peer countries and has increased by 5pp since 2012. Although interest rates are still low compared to the historical long-term average, a rise in the official cash rate could place borrowers at risk of being unable to service their mortgages, and may eventually lead to asset quality problems for the banks. However, this risk is partly mitigated through bank affordability testing, which includes adding a buffer above the prevailing market interest rate when assessing serviceability.

 

The Post-Crisis Bank Capital Framework

David Rule, Executive Director, Prudential Policy at the Bank of England gave a good summary of the current issues surrounding capital, and commented specifically on issues surrounding internal (advanced) methods.

Six and half years after the depths of the Great Financial Crisis, we know the shape of the future global bank capital framework. But important questions do remain. Today I want to focus on how regulators should measure risk in order to set capital requirements, with some final remarks on the particular case of securitisation. To start, though, a reminder of the key elements of the post-crisis, internationally-agreed framework:

  • Banks have minimum requirements for at least 4.5% of risk-weighted assets (RWAs) in core equity and 6% of RWAs in going concern Tier 1 capital, including for the purpose of absorbing losses in insolvency or resolution. Basel III tightened the definition of capital significantly.
  • Systemically-important banks have further loss absorbing capacity so that they can be recapitalised in resolution without taxpayer support, ensuring the continuity of critical functions and minimising damage to financial stability.
  • In November 2014, the Financial Stability Board (FSB) proposed that total loss absorbing capacity (TLAC) for globally systemically-important banks (G-SIBs) should comprise at least 16-20% RWAs.
  • Core equity buffers sit on top of this TLAC so that the banking system can weather an economic downturn without unduly restricting lending to the real economy; the Basel III capital conservation buffer for all banks is sized at 2.5% of RWAs.
    o Systemically-important banks hold higher buffers; and
    o Buffers can also be increased counter-cyclically when national authorities identify higher systemic risks.

The new bank capital framework will cause banks to hold significantly more capital than the pre-crisis regime. Major UK bank capital requirements and buffers have increased at least seven-fold once you take account of the higher required quality of capital, regulatory adjustments to asset valuations and higher risk weights as well as the more obvious increases in headline ratio requirements and buffers. Small banks have seen a lesser increase than systemically-important banks, reflecting the important new emphasis since the crisis on setting capital buffers and TLAC in proportion to the impact of a bank’s distress or failure on the wider financial system and economy. In sum, the framework is now impact- as well as risk-adjusted. From a PRA perspective, this is consistent with our secondary objective to facilitate effective competition.

We are currently in transition to the final standards, with full implementation not due until 2019. Although the broad shape is clear, I want to highlight four areas where questions remain:

First, the overall calibration of TLAC. The FSB will finalize its ‘term sheet’ that specifies the TLAC standard for G-SIBs in light of a public consultation and findings from a quantitative impact study and market survey. It will submit a final version to the G-20 by the 2015 Summit. National authorities will also need to consider loss absorbing capacity requirements for banks other than G-SIBs. In the United Kingdom, the Financial Policy Committee (FPC) will this year consider the overall calibration of UK bank capital requirements and gone-concern loss absorbing capacity.

Second, the appropriate level of capital buffers, including how and by how much they increase as banks are more systemically important. The Basel Committee has published a method for bucketing G-SIBs by their global systemic importance, a mapping of buckets to buffer add-ons and a list of G-SIBs by bucket. This will be reviewed in 2017. Separately the US authorities have proposed somewhat higher add-ons. National authorities also have to decide buffer frameworks for domestically systemically-important banks or D-SIBs. In the UK, the FPC plans to consult on a proposal for UK D-SIBs in the second half of this year.

Third, the location of capital buffers, requirements and loss absorbing capacity within international banking groups. A number of such groups are moving towards ‘sibling’ structures in which operating banks are owned by a common holding company. This has advantages for resolution: first, loss absorbing capacity can be issued from a holding company so that statutory resolution tools only have to be applied to this ‘resolution entity’ – the operating subsidiaries that conduct the critical economic functions can be kept as going concerns; and second, the operating banks can be more easily separated in recovery or post-resolution restructuring. It also fits with legislation in countries such as the UK requiring ring fencing of core retail banking activities and the US requiring a foreign banking organization with a significant U.S. presence an to establish intermediate holding company over U.S. subsidiaries. A ‘single point of entry’ approach to resolution might involve all external equity to meet buffers and external equity and debt included in TLAC being issued from the top-level holding company. An important question then is to what extent and on what terms that equity and debt is downstreamed from the top-level holding company to any intermediate holding companies and the operating subsidiaries. This will also be influenced by the final TLAC standard that includes requirements on these intragroup arrangements.

Finally, I would like to spend more time on my fourth issue: how to measure a bank’s risk exposures in order to set TLAC and buffers – or, in other words, determining the denominator of the capital ratio. Here regulators have to balance multiple objectives:

  • An approach that is simple and produces consistent outcomes across banks. Basel I, based entirely on standardised regulatory estimates of credit risk, met this test.
  • An approach that is risk sensitive and minimises undesirable incentives that may distort market outcomes. Whether we like it or not, banks will evaluate their activities based on return on regulatory capital requirements. So if those requirements diverge from banks’ own assessments of risk, regulation will change market behaviour. Sometimes that may be intended and desirable. But often it will not be. Basel I, for example, led to distortions in markets like the growth of commercial paperback-up lines because under-one-year commitments had a zero capital requirement. Subsequent developments of the Basel capital framework sought to close the gap between regulatory estimates of risk and firms’ estimates of risk by allowing use of internal models for market, operational and credit risk.
  • An approach that is robust in the face of uncertainty about the future. Estimates of risk based on past outcomes may prove unreliable. We should be wary of very low capital requirements on the basis that assets are nearly risk free. And behavioural responses to the capital framework may change relative risks endogenously. For example, before the crisis, banks became dangerously over-exposed to AAA-rated senior tranches of asset backed securities partly because, wrongly, they saw the risks as very low and partly because the capital requirements were vanishingly small.

Ideally regulators would design a framework for measuring risk exposures that maximises each of these objectives. But trade-offs are likely to be necessary and, in my view, the rank ordering of objectives should be robustness followed by risk sensitivity and simplicity. Prioritising robustness points to combining different approaches in case any single one proves to be flawed. So the PRA uses three ways of measuring risk: risk weightings, leverage and stress testing. By weighting all assets equally regardless of risk, the leverage exposure measure provides a cross check on the possibility that risk weights or stress testing require too little capital against risks judged very low but which subsequently materialise.

In the United Kingdom, the FPC’s view is that leverage ratio should be set at 35% of a bank’s applicable risk-weighted requirements and buffers.1 This is simple to understand and can be seen as setting a minimum average risk weight of 35%. So, for non-systemic banks with risk-weighted requirements and buffers of 8.5%, the minimum leverage ratio would be 3%. But a G-SIB, with a risk-weighted buffer add-on of, say, two percentage points, would a have an additional leverage buffer of 0.7 percentage points. And all firms would be subject to a leverage buffer equal to 35% of any risk-weighted counter-cyclical buffer. Another key advantage of using the same scaling factor and mirroring the different elements of the risk-weighted framework is that it creates consistent incentives for different types of banks and over time. By contrast, for example, setting the same leverage ratio for all firms would amount to setting a lower minimum average risk weight for systemically-important banks than other banks.

Stress testing complements risk weighted and leverage approaches by considering the impact of extreme but plausible forward-looking macroeconomic scenarios of current concern to policymakers. Because buffers are intended to absorb losses in an economic downturn, the natural role of stress testing in the capital framework is to assess the adequacy of the buffers based on the Basel risk-weighted and leverage measures. If an individual bank is shown to be an outlier in a stress test, with a particularly large deterioration in its capital position, supervisors may use Pillar II to increase its capital buffers. The PRA is currently consulting on its approach to Pillar II, including a ‘PRA buffer’ that would be used in this way to address individual bank risks. An advantage of concurrent stress testing across major banks is that policymakers can consider the wider systemic impact of the scenario. They can also test whether buffers are sufficient even if regulators prevent banks from modelling management actions that would be harmful to the wider economy: for example, if banks propose to reduce new lending in order to conserve capital. Used in this way, stress testing may inform calibration of the system-wide, countercyclical buffer if macro-prudential policymakers identify elevated systemic risks.

Leverage and stress testing are best seen as complements rather than alternatives to risk-weighted measures of capital, producing a more robust overall framework. Risk weightings will likely remain the binding constraint for most banks most of the time. A central priority of the Basel Committee over the next year or so is to restore confidence in risk weightings by designing a system that balances most effectively the three objectives of robustness, risk sensitivity and simplicity.

Risk sensitivity points to a continuing role for firms’ internal estimates and models. But that depends on finding solutions for problems with them. First, various studies by the Basel Committee have shown material variations in risk weights between banks for reasons other than differences in the riskiness of portfolios. Models appear to be producing excessive variability in capital outputs, undermining confidence in risk-weighted capital ratios and raising questions about gaming. Second, some models may produce low risk weights because the data underpinning them do not include stress events in the tail of the distribution. This is a particular concern in portfolios where the typical level of defaults is low but defaults may correlate in a systemic crisis: for example, exposures to other banks or high quality mortgages. For major global firms, average risk weights fell almost continuously from around 70% in 1993 to below 40% in 2008, since when they have remained around that level. Third, modelled capital requirements can be procyclical. For example, last year’s concurrent stress test of major UK banks by the Bank of England showed that some banks’ mortgage risk weights increased significantly in the test, particularly where banks took a ‘point in time’ approach whereby probability of default was estimated as a function of prevailing economic and financial conditions.

One solution would be to abandon use of banks own estimates and models entirely and use standardised regulatory risk weights. But standardised approaches have their own weaknesses. For example, finding simple and consistent techniques for measuring risk by asset class that work well across countries with different market structures and risk environments is not straightforward. Regulators typically face a trade-off between simplicity and risk sensitivity. An alternative approach is to find solutions for the problems with models. Some possible ideas might include:

  • Requiring banks to provide more transparency about their risk estimates and models. The work of the Enhanced Disclosure Task Force and Basel’s revised Pillar III templates are steps in this direction. Regular hypothetical portfolio exercises by supervisors can identify banks with more aggressive approaches.
  • Being more selective about where it makes sense to allow internal models and where standardised approaches may be more effective. In the case of credit risk, for example, models may be more robust in asset classes with longer and richer histories of default data; and the value-added of models for risk sensitivity is likely to be greater in asset classes where banks have significant private information about differences in risk.
  • Changing the specification of models to take greater account of potential losses if tail risks crystallise. The Basel Committee has already agreed to move from a value-at-risk to an expected shortfall approach to estimating market risk. For credit risk, increasing the implied correlation of default in the model might be a simple way to produce higher risk weights in asset classes where banks are estimating low probabilities of default but regulators are concerned about tail risks.
  • Broadening the use of so-called ‘slotting’ approaches in which banks use their own estimates to rank order risks but regulators determine the risk weights for each ‘slot’. Slotting makes use of the better information banks have about relative risk within an asset class. But regulators decide the level of capital requirements. Slotting was one of the options considered when regulators first started thinking about use of internal models in the capital framework in the 1990s.
  • Putting floors on the level of modelled capital requirements. The Basel Committee has recently consulted on the design of a floor based on standardised risk weights to replace the existing transitional capital floor based on the Basel I framework. But it has not taken decisions on calibration: in other words, how often the floors would ‘bite’.

The Basel Committee has said that it will consider the calibration of standardised floors alongside its work on finalising revised standardised approaches to credit risk, market risk and operational risk, and as part of a range of policy and supervisory measures that aim to enhance the reliability and comparability of risk-weighted capital ratios. Restoring confidence in risk weights will form a major part of the Committee’s agenda over the next year or so. Meanwhile, at a national level, supervisors can use Pillar II to address risks not adequately captured under internationally-standardised risk weightings. The PRA uses Pillar II actively to ensure banks have adequate capital to support all the risks in their businesses and has recently set out in a transparent way for consultation the methodologies it proposes using to inform its setting of Pillar II capital requirements.

Finally, I want to speak briefly about securitisation as an example of an area where regulators find it hard to measure risk. One reason is that part of the securitisation market grew up in order to exploit weaknesses in risk weightings by allowing banks to maximise reduction in capital requirements while minimising decreases in revenue. A lesson from the past is that the risk of unintended market consequences is high. Risk weighting approaches for securitisation have relied either on external tranche ratings or on regulatory formulae. Both have problems. Formulae may not include all the key dimensions of risk. Ratings agencies can. But their track record in the financial crisis was poor and authorities globally are seeking – and in the US case are required by law – to reduce reliance on rating agencies.

As well as the micro-prudential goal to ensure that banks measure securitisation risks appropriately and hold adequate capital against them, we also have a macro-prudential goal that the securitisation market develops in a sustainable way. These goals are aligned because, as we saw in the crisis, a market that develops in an unhealthy way can mean unexpectedly greater risks for banks. What are the characteristics of a sustainable securitisation market? One in which:

  • banks and other issuers can use securitisation to transfer risk and raise funding but not to manage capital requirements artificially;
  • investors are diverse and predominantly ‘real money’ as opposed to the fragile base of leveraged funds and bank treasuries that collapsed in Europe during the crisis;
  • issuers’ incentives are adequately aligned with those of investors; and
  • investors have the information they need to understand the risks they are taking.

If structured soundly in this way, securitisation markets can be an important channel for diversifying funding sources and allocating risk more efficiently. Overall, the development of a carefully structured securitisation market could enable a broader distribution of financial sector risk, allow institutional investors to diversify their portfolios and banks to obtain funding and potentially remove part of the risk from banks’ balance sheets to free up balance sheet capacity for further lending to the economy.

The Basel Committee published a revised securitisation framework in December last year. Jointly with IOSCO, it also published for consultation a set of criteria to help identify simple, transparent and comparable (STC) securitisation. This year, the Committee will consider how to incorporate such criteria into the securitisation capital framework. In my view, incorporating the STC criteria will serve both micro-prudential and macro-prudential objectives. First, it will add a measure of ‘structure’ risk into the capital framework complementing existing inputs such as the underlying risk weights on the securitised portfolio, maturity and tranche seniority. That should improve risk sensitivity. And more transparency will help regulators as well as investors to measure risk. Second, such criteria will encourage securitisation market to develop in a more healthy and sustainable way. Finally, and returning to my main theme, I conclude that the post-crisis capital regulation for banks globally should be based on different ways of assessing risk, with leverage and stress testing complementing risk-weighted measures within an integrated framework. Such an approach is most likely to achieve the objectives of robustness followed by risk sensitivity and simplicity.

RBA – No Rate Change Today

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

Growth in the global economy continued at a moderate pace in 2014. A similar performance is expected by most observers 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 has fallen significantly. 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.

Financial conditions are very accommodative globally, with long-term borrowing rates for several major sovereigns at all-time lows over recent months. Some risk spreads have widened a little but overall financing costs for creditworthy borrowers remain remarkably low.

In Australia the available information suggests that growth is continuing at a below-trend pace, with domestic demand growth overall quite weak. 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, with stronger growth in lending to investors in housing assets. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities over recent months. 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, though less so against a basket of currencies. It remains above most estimates of its fundamental value, 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, having eased monetary policy at the previous meeting, 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 further assess the case for such action at forthcoming meetings.

Loan Portfolio Analysis To January 2015 – Where APRA May Look

The Monthly Banking Statistics from APRA, released late last week, shows some interesting trends across the loans portfolios of individual banks in the sector. It of course does not include the non-banks. A number of smaller players are likely to gain APRA’s attention.

Looking first at the year on year portfolio movements for investment home loans, (of interest given APRA’s recent statements “strong growth in lending to property investors — portfolio growth materially above a threshold of 10 per cent will be an important risk indicator for APRA supervisors in considering the need for further action”), we see a market average (Jan-Jan) of 12%. But there are significant differences between players, with several above 20% growth, CBA at 15%, NAB at 12%, Suncorp at 11% and Westpac at 10%.

MBSYOYINVMovementsJan2015Looking at owner occupied loans, the market grew at 5.6%, with significant portfolio variations, including Members Equity at 13%, Bendigo and Adelaide at 9%, and Suncorp at 7%. Remember, these are net portfolio movements, (allowing for new loans, and existing loan run-off. Macquarie stands out, but that is because of the $1.5 billion portfolio of non-branded mortgages they purchased from ING in September.

MBSYOYOOMovementsJan2015 In January, the portfolio grew by 0.42% for owner occupied loans to $859,645 bn, whilst investment loans grew 0.76% to $462,358 bn. Investment loans make up 35% of the bank’s portfolios. Total lending was up by $7,107 Bn. Looking at the current share of loans, there was little change in mix, with CBA the largest owner occupied loans provider, and Westpac the largest investment loan provider.

MBSHomeLoansShareJan2015We see Macquarie, AMP and Heritage Buildoing Society growing their loan portfolios the fastest last month.

MBSHomeLoansMonthlyMovementsJan2015Turning to deposits, they grew by 0.61% in the month, up $10,948 bn, to $1,807,882 bn. There was little change in the overall portfolio, with CBA still holding nearly a quarter of the market.

MBSDepositSharesJan2015However, looking at the portfolio movements, we see the smaller players, like Bendigo ING, Rabobank and HSBC growing faster compared with the main players. This represents differential deposit discounting which has been in play, thanks to beguine wholesale markets, and competition for deposits easing – bad news for depositors, and rates continue to fall.

MBSDepositMovementsJaqn2015Finally, credit card balances fell slightly in the month (after the Christmas splurge) down $824 bn to $41,002 bn. Little change in the footprint of the major players.

MBSCardsJanuary2015

 

Foreign Investors Fees Still In The Air

Speaking on ABC Insiders this morning Josh Frydenberg, Assistant Treasurer made the point that the foreign investor regulations, recently announced were open for consultation, and that a number of issues had yet to be resolved. For example, should a foreign investor pay the fee each time they apply to purchase a property (so bidding on multiple properties would mean multiple fees)? Or should they pay one fee to cover multiple potential transactions? If they are not successful in purchasing the target property, is the fee refundable? He appeared to be advocating paying the fee before putting a bid in, one fee for multiple bids, and refundable if unsuccessful.

However to decide, we need to know if the fee is simply to cover the cost of appropriate agency administration, or whether it is designed to be a barrier to transact. It is not clear for the available material which is envisaged. Administration would be a combination of assessing the credential of the individual (so once per person), and also the property (so once per property). Also, if unsuccessful, is it appropriate to refund the entire fee? After all, the work needs to be done before allowing a bid (else if you only pay after a successful transaction, what happens if you were declined subsequently, once you have contracted to purchase?)

He also confirmed there had been no action taken on a residential purchase by a foreigner since 2006, adequate data was not being collected, and cross agency communication was not effective.

Clearly more work needs to be done to design this right. DFA suggests that a foreign investor should be able to make application for approval to purchase property in Australia. This should be a licence, which needs to be maintained and renewed from time to time. Then there would be a fee payable on each property application. This latter fee would be refundable in the case of an unsuccessful sale.  It would also reduce the red tape so some extent.