Economics and Banking – Page 458 – Digital Finance Analytics (DFA) Blog

Shadow Banking And Monetary Policy

The Bank of England just published a research paper “Do contractionary monetary policy shocks expand shadow banking?”

We previously discussed the role and importance of shadow banking, making the point that up to the 1980s, traditional banks were the dominant institutions in intermediating funds between savers and borrowers. However, since then, the role of market-based intermediaries has steadily increased. Whilst shadow banking cannot be defined as a homogenous, well-defined category, it embrances at least three types of intermediaries: asset-backed (ABS) issuers, finance companies, and funding corporations. In addition, shadow banking sector involves a web of financial institutions and a range of securitisation and funding techniques, and these activities are often closely intertwined with the traditional banking and insurance institutions. These interlinkages can involve back-up lines of credit, implicit guarantees to special purpose vehicles and asset management subsidiaries. So, given the focus on greater banking system regulation, and the role of monetary policy in this, the question is, does tighter monetary policy flow on to impact shadow banking. Is so, how?

Using detailed modelling, they find that monetary policy shocks do seem to affect the balance sheets of both commercial banks and their unregulated counterparts in the shadow banking sector. However, a monetary contraction aimed at reducing the asset growth of commercial banks would tend to cause a migration of activity beyond the regulatory perimeter to the shadow banking sector. In fact the monetary response needed to lean against shadow bank asset growth is of opposite to that needed to lean against commercial bank asset growth.

This means that monetary policy designed to control commercial banking may, as an unintended consequence, increase shadow banking activity (and so work against the policy intent). Therefore, they suggest that authorities should continue to develop a set of regulatory tools, complementary to monetary policy, that (a) seek to moderate excessive swings in risk-taking by commercial banks, as embodied in recent macroprudential frameworks, and (b) seek to strengthen oversight and regulation of the shadow banking sector. Monetary policy alone is not enough.

Lending For Housing Investment Higher Still

The ABS published their finance statistics today to November 2014. It appears to me we have an unbalanced economy, where more and more lending is flowing into property, stoked by investment demand (and encouraged by negative nearing). As a results, house prices rise, inflating the bank’s balance sheets, and personal assets. But there is less lending for productive commercial purposes.

The total value of owner occupied housing commitments excluding alterations and additions rose 0.5% in trend terms, and the seasonally adjusted series fell 0.2%.
The trend series for the value of total personal finance commitments rose 0.2%. Fixed lending commitments rose 0.5%, while revolving credit commitments fell 0.2%. The seasonally adjusted series for the value of total personal finance commitments fell 2.2%. Revolving credit commitments fell 3.1% and fixed lending commitments fell 1.4%.
The trend series for the value of total commercial finance commitments fell 2.8%. Revolving credit commitments fell 7.7% and fixed lending commitments fell 1.2%. The seasonally adjusted series for the value of total commercial finance commitments fell 2.6%. Fixed lending commitments fell 4.6%, while revolving credit commitments rose 3.8%.
The trend series for the value of total lease finance commitments fell 2.3% in November 2014 and the seasonally adjusted series fell 4.4%, following a fall of 4.6% in October 2014.

		Oct 2014	Nov 2014	Oct 2014 to Nov 2014
		$m	$m	% change

TREND ESTIMATES
	Housing finance for owner occupation(a)	17 169	17 248	0.5
	Personal finance	8 729	8 746	0.2
	Commercial finance	39 471	38 357	-2.8
	Lease finance	428	418	-2.3
SEASONALLY ADJUSTED ESTIMATES
	Housing finance for owner occupation(a)	17 309	17 282	-0.2
	Personal finance	8 922	8 730	-2.2
	Commercial finance	39 011	37 992	-2.6
	Lease finance	421	402	-4.4

Looking at the data in more detail, we see that commercial lending represent 59% of lending.

However, within commercial lending, we have lending for investment property. Cross matching the data. we see that of all commercial lending, more than 30% directly relates to residential investment property. Lending for other purposes has dropped.

Looking specifically at the housing sector, the growth in investment lending stands out.

In fact in trend terms half of all lending was for investment purposes, a record.

2015 should be the year when Government recognizes that it is time to act. The current settings will continue to risk financial stability and economic growth.

Bank Profits Under Pressure In 2015?

Fitch Ratings 2015 Outlook: Australian Banks report has a stable sector outlook for Australian banks in 2015, reflecting what should be a relatively steady operating environment despite a likely modest decline in real GDP growth and an elevated unemployment rate. These factors should in turn result in modestly weaker asset quality and an increase in impairment charges, which are likely to be offset by strengthened balance sheets and strong profitability.

A significant slowdown in China is the biggest risk to the outlook, given it is Australia’s largest trading partner, but such a slowdown is not Fitch’s base case. A relaxation of underwriting standards to improve growth also looms as a risk, although this appears less likely following the announcement in December 2014 of regulatory reviews of potentially higher-risk lending.

Housing credit growth is likely to slow in 2015, in part because of the regulatory review but also due to high household indebtedness and slower house price growth. Fitch expects household indebtedness to stabilise in 2015, with an easing in wage rises and as unemployment remains high.

Nevertheless, competition for loans will likely remain intense, placing some pressure on net interest margins. This and an expected rise in impairment charges will likely mean lower profit growth in 2015. Offsetting this, capital positions are likely to be strengthened, in part to address potential new requirements stemming from the 2014 Financial Services Inquiry (FSI) recommendations, while the shift towards more stable funding sources will probably continue.

Although banks may act on some FSI recommendations during 2015, many of the measures requiring government action, including legislation, are unlikely to be implemented before the end of the year. Fitch expects implementation timeframes to be set such that meeting the new requirements should not be overly onerous for banks

Latest Banking Statistics

Last week saw the release of the November data from both the RBA and APRA. Looking at the overall summary data first, total credit grew by 5.9% in the year to November 2014. Housing lending grew at 7.1%, business lending at 4.6%, and personal credit by 1.1%.

Looking at home lending, in seasonally adjusted terms, total loans on book rose to $1.42 trillion, with owner occupied loans at $932 billion, and investment loans at $483 billion, which equals 34.2%, a record.

From the APRA data, loans by ADI’s were $1.31 trillion, with 34.82% investment loans, which grew at 0.84% in the month. Looking at relative shares, CBA continues to hold the largest owner occupied portfolio, whilst WBC holds the largest investment portfolio.

Looking at relative movement, WBC increased their investment portfolio the most in dollar terms. CBA lifted their owner occupied portfolio the most.

Turning to deposits, they rose 0.39% in the month, to 1.78 trillion.

There was little change in relative market share, though we noted a small drop at nab, which relates to their cutting deposit rates from their previous market leading position.

Finally, looking at the cards portfolios, the value of the market portfolio rose by $627 billion, to $41,052 billion. There were only minor portfolio movements between the main players.

UK’s Financial System Not “Entirely Safe”

The UK’s financial system is not “entirely safe” according to former Bank of England governor Lord Mervyn King, speaking on BBC Radio 4’s Today programme. He questioned the banking system’s ability to withstand another crisis and argued the core problems that led to the meltdown have not yet been dealt with.

“I don’t think we’re yet at the point where we can be confident that the banking system would be entirely safe. I don’t think we’ve really yet got to the heart of what went wrong.”

The warning comes despite banks and other financial institutions being forced to hold more capital to prevent the risk of failure in the event of another downturn.

King, went on to say that imbalances between global economies have not yet been resolved. He added keeping base rate at the low of 0.5 per cent cannot go on .

“The idea that we can go on indefinitely with very low interest rates doesn’t make much sense.” However raising interest rates now “would probably lead to another downturn”.

He was at the helm of the Bank of England during the GFC.

His comments mirror some of the concerns highlighted in the recent Murray report.

The Capital Conundrum II

A series of separate but connected events will see capital requirements of banks continue to steadily increase from 2015 onwards. You can read about the capital issues in the earlier post. This is consistent with the outcomes from the G20. The international environment is driving capital requirements higher (on the back of the northern hemisphere government bailouts post the GFC). Locally the regulators are also making moves, and the recommendations from the Murray Financial Systems Inquiry (FSI) are also in play. Overall, some of the most significant elements are:

Globally Significantly Banks (GSIBs) likely to need to hold more capital, and this will likely flow down to other banks also.
Latest BIS recommendations on floors and ratios
APRA changing the liquidity coverage ratio
FIS on capital ratios
FIS on advanced IRB banks

There are other steps in the works also. The net effect is that capital requirements will be lifting in 2015, irrespective of the FSI (and the capital changes recommended do not need parliamentary approvals).

Here is DFA’s view of how these outcomes will translate in the Australian context

Banks need to raise $20-40 bn over next couple of years, – that is doable – and they will access the now functioning global markets. It will be ratings positive.
Smaller banks will be helped by the FSI changes to advanced IRB, if they translate, but will still be at a funding disadvantage
Deposit rates will be cut, they have been falling already despite RBA rate being static, this has not received enough commentary, there are millions of households reliant on income from deposits
Mortgage rates will lift a little, and discounting will be even more selective – Murray’s estimates on the costs are about right.
Lending rates for small business will rise further
Competition won’t be that impacted, and the four big banks will remain super profitable
We will still have four banks too big to fail, and the tax payer would have to bail them out in the event of a failure (highly unlikely but not impossible given the slowing economic environment here, and uncertainly overseas). The implicit government guarantee is the real issue.

Capital floors: The Design of a Framework Based on Standardised Approaches

The BIS also released a consultative paper which outlines the Basel Committee’s proposals to design a capital floor based on standardised, non-internal modelled approaches. The proposed floor would replace the existing transitional capital floor based on the Basel I framework. The floor will be based on revised standardised approaches for credit, market and operational risk, which are currently under consultation.

The floor is meant to mitigate model risk and measurement error stemming from internally-modelled approaches. It would enhance the comparability of capital outcomes across banks, and also ensure that the level of capital across the banking system does not fall below a certain level.

As noted in the Committee’s November 2014 report to the G20 Leaders, the Committee is taking steps to reduce variation in capital ratios between banks. The proposed capital floor is part of a range of policy and supervisory measures that aim to enhance the reliability and comparability of risk-weighted capital ratios. The Committee will consider the calibration of the floor alongside its work on finalising the revised standardised approaches.

Revisions to the Standardised Approach for Credit Risk

BIS has just released a proposal to strengthen the existing regulatory capital standards for discussion. This is one of a number of initiatives which are all driving capital requirements higher.

The proposed Revisions to the Standardised Approach for credit risk seek to strengthen the existing regulatory capital standard in several ways. These include:

reduced reliance on external credit ratings;

enhanced granularity and risk sensitivity;

updated risk weight calibrations, which for purposes of this consultation are indicative risk weights and will be further informed by the results of a quantitative impact study;

more comparability with the internal ratings-based (IRB) approach with respect to the definition and treatment of similar exposures; and

better clarity on the application of the standards.

The Committee is considering replacing references to external ratings, as used in the current standardised approach, with a limited number of risk drivers. These alternative risk drivers vary based on the particular type of exposure and have been selected on the basis that they are simple, intuitive, readily available and capable of explaining risk across jurisdictions.

Given the challenges associated with identifying risk drivers that can be applied globally but which also reflect the local nature of some exposures – such as retail credit and mortgages – the Committee recognises that the proposals are still at an early stage of development. Thus, the Committee seeks respondents’ comments and analysis with a view to enhancing the proposals set out in this consultative document.

The key aspects of the proposals are:

Bank exposures: would no longer be risk-weighted by reference to the bank’s external credit rating or that of its sovereign of incorporation, but would instead be based on two risk drivers: the bank’s capital adequacy and its asset quality.

Corporate exposures: would no longer be risk-weighted by reference to the borrowing firm’s external credit rating, but would instead be based on the firm’s revenue and leverage.

Further, risk sensitivity and comparability with the IRB approach would be increased by introducing a specific treatment for specialised lending.

Retail category: would be enhanced by tightening the criteria to qualify for a preferential risk weight, and by introducing an alternative treatment for exposures that do not meet the criteria.

Residential real estate: would no longer receive a 35% risk weight. Instead, risk weights would be based on two commonly used loan underwriting ratios: the amount of the loan relative to the value of the real estate securing the loan (ie the loan-to-value ratio) and the borrower’s indebtedness (ie a debt-service coverage ratio).

Commercial real estate: two options are currently under consideration: (a) treating the exposures as unsecured with national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight based on the loan-to-value ratio.

Credit risk mitigation: the framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts and updating the corporate guarantor eligibility criteria.