Economics and Banking – Page 466 – Digital Finance Analytics (DFA) Blog

RBA Highlights Housing Supply Issues And Lending Regulation

The RBA made a statement today to the Inquiry into Affordable Housing. Several points to note:

1. They recognise the high price to income ratio we currently have, but also state that low rates make larger mortgages affordable.

the ratio of housing prices to incomes is at the top of its historical range; but

over time, this has been more than offset by falls in financing costs, so that the typical repayment burden as a share of income is not particularly high. This of course does not rule out affordability problems in particular market segments or for particular types of households.

The recent data from the Economist shows the relative data of prices against average income in different countries.

2. Supply of mortgages is not a constraint

there is no shortage of housing finance in Australia. Housing loan interest rates are currently as low as they have been in a generation, and households are not artificially constrained from borrowing as much as they can reasonably be expected to repay. I have already made the point that perceptions of affordability will differ across different types of households; but, if there is a perceived affordability problem in Australia, it is not due to a lack of finance.

3. There are property supply problems

It is the supply response that determines the extent to which additional demand results in higher prices over time. Our submission highlights that Australia faces a number of longstanding challenges in this area, including regulatory and zoning constraints, inherent geographical barriers and the cost structure of the building industry. There are also obstacles to affordable housing created by Australia’s unusually low-density urban structure, though this is gradually changing.

4. Lending practice reinforcement and other measures are on the cards

the Bank said in its Financial Stability Review last week that the composition of housing and mortgage market activity is becoming unbalanced. The review also indicated that we are discussing with APRA steps that might be taken to reinforce sound lending practices, particularly for investor finance, though not necessarily limited to that.

I want to emphasise that the banks in Australia are resilient, and mortgage lending in this country has historically been relatively safe. APRA has, however, noted a trend to riskier lending practices, and over the past couple of years has been seeking to temper these through its supervisory activities. There are also broader concerns with the macroeconomic risks associated with excessive speculative activity, since this activity can amplify the property price cycle and increase risks to households.

Our discussions with APRA and other agencies on these matters are ongoing, and there will be more to say about them in due course

Total Housing Lending Hits Another High At $1.39 Trillion – RBA

The monthly Financial Aggregates from the RBA for August are out, and shows yet another growth in housing lending. Total housing credit grew at an annual 6.7%, business credit at 3.2% and personal credit 1.1%. Total housing was $1.39 trillion, and now represents 60.7% of all bank lending, the highest it has ever been. In 1990, housing lending was 23% of all bank lending. The red area chart shows the relative proportion of housing lending, compared with all lending. The difference between the APRA number of $1.28 trillion represents the non-bank sector.

Here is the lending mix data right back to 1990 showing the proportion of the banks books in housing finance, as a total of all lending.

Looking at the mix of housing loans, investment lending makes up 33.9% of all housing lending, it has never been higher. Owner occupied lending was worth $919 billion, and investment lending, $471 billion. These are all seasonally adjusted numbers. The red area chart shows the relative proportion of investment housing lending, compared with all housing lending.

Looking at the relative growth, we see that investment lending grew 0.8% last month, whilst owner occupied loans grew 0.4%, seasonally adjusted.

The 12 month averages, which smooth some of the noise in the data shows strong investment growth, at 9.2%, the strongest for several years, (the all time high was in the credit fueled heights of 2003. when it reach more than 25%). Owner occupied growth was slower at 5.4%, but still the strongest since 2012.

Looking at business lending, we see it falling as a proportion of all lending, to 33%, and worth $760 billion. The red area chart shows the relative proportion of business lending, compared with all lending.

Personal credit (other than housing) fell to 6% of all lending, and worth $142 billion. The red area chart shows the relative proportion of other personal lending, compared with all lending.

Our banks are more and more reliant on housing lending, raising questions about concentration risks, should housing take a negative turn. We encourage the FSI to consider seriously the steps needed to re-balance the equation.

Deja Vu Housing Data For August From APRA

APRA published their monthly banking statistics for August 2014 today. The trend remains set, with investment lending running ahead of owner occupied lending. Further evidence that the RBA should react to the hot market. Total lending was up by $7.4 billion to a total of $1.28 trillion. Owner Occupied loans grew at 0.48% from last month, whilst investment loans grew at 0.78%. 65.4% of loans were for owner occupation, the rest investment. This data excludes the non-bank sector, which will be reported separately.

Looking at the bank specific data, Westpac leads the way on Investment Loans, with CBA continuing to grow its relative share of investment lending. Should the rules of the game change, thanks to RBA intervention, then WBC and CBA (the Sydney based banks) are likely to feel the heat more than the others. Competition amongst the big players is hot, with significant discounts and special offers available to lure prospective borrowers. Lending growth is still well behind property price rises in most centres.

In terms of relative market share, WBC has 32% of all Investment loans, and CBA 26.9%. On the Owner Occupied loans, CBA has 27.2% of the market and WBC 21.4%.

Looking at portfolio movements, in the past month, WBC has been lending the most, note also Macquarie is active as it continues its strategy to grow its retail business.

Another way to look at this growth pattern is by month on month percentage movements. Relatively, Macquarie is the most aggressive, followed by AMP bank.

Turning to the other data in the statistics, on the deposit side, balances grew by 0.75%, to $1.749 trillion. This is a slowing from the previous 1.02%, perhaps reflecting falls in average deposit rates relative to other investments.

In terms of monthly movements, nab has been the most aggressive amongst the larger banks, together with HSBC from the smaller players. Relatively speaking, Suncorp, Rabobank and Bendigo went backwards.

Looking at relative shares, CBA has 24.2%, WBC 21.0% and nab 17.6%. This chart highlights the concentration in the big four, with a combined 78.4% of all deposits. With deposits backed by the government guarantee, these might be viewed as government back funds, and this helps to prop up the credit ratings of the major players. The Australian Government has guaranteed deposits up to $250,000 in Authorised Deposit-taking Institutions at the moment. There is a case to review this, and we wonder if the FSI report, due soon will mention it.

Finally, Cards. The balances on cards are at $40 billion, just $130m up from last month.

CBA has 27.9% of the market, Westpac 22.9% and ANZ, 19.6%. The big four have combined 84%, and with Citigroup’s 10%, the five have close to 95%.

So, in summary, deja vu. Hot investment lending, industry concentration, and large deposit balances guaranteed.

Household Incomes And Property Segmentation

In the current discussions about macroprudential, stimulated by the RBA comments last week and likely to be stoked further as the RBA appears before the Senate Banking Committee on Thursday, many are claiming that household balance sheets and incomes are supporting the growth in house prices, and so no intervention is needed. The chair of the Banking Committee Sam Dastyari is “concerned about the unanticipated consequences of the Reserve Banks’s view-change on the sustainability of the housing boom and whether it needed to interfere with bank lending”.

The debate has shifted to first time buyers, and not wishing to put further barriers in the way of the small number able to enter the market at prices which are already too high. They may be missing the point. First, the increase in household wealth is directly linked to the rise in house prices (a weird piece of feedback here, as prices rise, households are more wealthy, so can accommodate higher prices – spot the chicken and egg problem?). In addition, wealth is growing thanks to stock market movements (though down recently) driven partly by the US and European low rates and printing money strategies. This will reverse as rates are moved to more normal levels later. Superannuation, the third element is of course savings for retirement, so cannot be touched normally (there are exceptions, and no, first time buyers should not be allowed to use their super to get into the property market). More first time buyer incentives won’t help.

But, we have been looking at household incomes, after inflation, at a segment level. We segment based on property ownership, and you can read about the DFA segments here. On average, across all households, income growth is falling behind inflation. This is the ABS data from June 2014. In the past few months, real income is going backwards, before we consider rising costs of living.

However, at a segment level, the situation is even more interesting, and diverse. Those wanting to buy, but unable to enter the market are seeing their incomes falling sharply, inflation adjusted, making the prospect of buying a house more unlikely. We are seeing the number of households in this group rising steadily, see our Property Imperative Report.

First time buyers, those who have, or are purchasing for the first time, are also seeing income falling in real terms, more sharply than the average. This is why we are predicting a higher proportion of first time buyers will get into mortgage stress, especially if interest rates are increased. This is one reason why loan to income ratios for this group are high.

Then looking at holders, their incomes are moving closer to the average. Holders have no plans to change their property, many have mortgages.

Refinancers, are hoping to lock in lower rates, though we note the forward rates are now higher than they were, which may suggest the lowest deals are evaporating. One of the prime motivations for switching in this segment is to reduce outgoings, not surprising when we see incomes falling faster than the average in real terms.

Now, looking at Up Traders, we find their incomes are rising more quickly than the average. Up Traders have been active recently. They have the capacity to service larger loans. They will be purchasing primarily for owner occupation.

Down Traders have incomes rising more quickly, thanks to investment income, and there still about one million households looking to sell and move into a smaller property, releasing capital in the process. They are also active property investors, directing some of their released capital in this direction, either direct, or via super funds.

Investors also have incomes which are rising faster than the average, so no surprise they are active in the market, seeking yields higher than deposits, and taking advantage of negative gearing. We continue to see a small but growing number of investors using super funds for the transaction.

So, the segmental analysis highlights how complex the market is, and that there are no easy fixes. Any rise in interest rates would hit first time buyers very hard. Demand from investors (the foreign investment discussions is only a sideshow in my view) will be sustained, with the current policy settings. Raising interest rates will not help much on this front, because interest will be set against income. So macroprudential controls on investment loans makes more sense.

One option would be to differentially increase the capital buffers the banks hold for investment loans, making their pricing less aggressive, and the banks more willing to lend to suitable owner occupiers and businesses, which is what we need. Trimming demand for investment properties may help to control prices.

The bottom line though is that many years of poor policy are coming home to roost, on both the supply and demand side. A number of settings need to be changed, as discussed before.

My Recent Thoughts On House Prices

I did an interview for the ABC, on the RBA Financial Stability Review. Here is the transcript, courtesy of the ABC. The link to the interview, and my longer interview can be found at the ABC site.

By way of context, a quick reminder of current house price trends from the Economist:

CHRIS UHLMANN: The Reserve Bank (RBA) has given its strongest warning yet that a dangerous property price bubble in Sydney and Melbourne could destabilise the economy.

It’s now ramping up talks with other regulators to introduce lending controls to head off the risk of a damaging correction in prices.

With more I’m joined by our business editor, Peter Ryan.

And Peter, these warning have been around for the past year. Is the Reserve Bank starting on the back foot?

PETER RYAN: Well, this was certainly very strong language from the RBA yesterday that investment in Australian property is now becoming “unbalanced” and that the speculation increases the potential for current stellar prices to fall.

Now the RBA is now worried about the broader impact of any correction or a hard landing and how that would hurt not just the speculators but average Australians whose biggest single investment is usually the family home.

The property analyst Martin North says unless the RBA intervenes with tighter controls, there could be a correction in the range of 20 to 25 per cent and that some borrowers could find themselves overwhelmed in debt – in other words facing negative equity.

MARTIN NORTH: Property prices have been high for a long period of time so this is not just a little bubble. This is a long term systemic issue.

So what’s been happening is it’s been sucking a lot of money from people’s pockets out to pay the mortgage, right? Secondly, people have been committing to buy at the top of the market and so if prices were to move down, a lot of people who’ve bought relatively recently would be out of the money and that’s very significant.

A lot of those are investors – and investors will change their tune quite quickly, you know, particularly if capital growth is no longer in the sector. So yeah, this is a very unstable situation.

Also, the banks have a huge exposure to property, probably one of the highest exposures in the world and that means that whatever happens to the property market is going to impact not only individuals but also the banks as well.

PETER RYAN: If there was a correction and those property speculators decided to sell while they could and the market was flooded with properties, what impact would that have on the general market?

MARTIN NORTH: We will probably see a downward swing and that downward swing would gain quite a lot of momentum. I wouldn’t be surprised to see prices slipping by 20 to 25 per cent. It will probably self-correct a little bit beyond that but it’s that, it’s that sort of slide down and then up which is the problem.

PETER RYAN: And that of course is a huge problem for borrowers who bought at the top of the market, borrowed too much and are now over their heads in debt.

MARTIN NORTH: The real issue there of course is all the people will find that they’re in negative equity at a point. In other words, they can’t then sell. So we could find the situation where people are trying to sell, are being forced to sell. That will tend to drive prices further down, probably languish for quite some time because we have to correct back to long term averages between income and property prices in my view.

So this is more like I think the early signs of some of the things that happened in the US prior to the GFC.

CHRIS UHLMANN: Property analyst Martin North.

So Peter, can we expect to see action on lending controls from the Reserve Bank?

PETER RYAN: Well, the RBA governor Glenn Stevens is speaking in Melbourne later today and as always his comments will be scrutinised on perhaps when and how the RBA might intervene to prevent any property bubble bursting.

CHRIS UHLMANN: Business editor Peter Ryan, thank you.

Macroprudential Tools could prove useful – RBA

In a speech in Melbourne, the RBA governor, Glenn Stevens said macroprudential tools could prove useful in helping to control the exuberant housing market. That said, he was still skeptical about their effectiveness.

He made the point that whilst monetary policy can’t solve every problem (i.e. interest rates alone) and there may be a need to take other steps if “at the margins they are helpful,”he didn’t consider macroprudential tools a simple solution to the problem, referred to in yesterdays Stability Review of strong investment lending. A reminder of the latest data, which we discussed recently.

He reiterated his concerns about the risks of investment loans, and highlighted the potential risks later, echoing yesterdays report.

No mention of macroprudential as a fad this time, which I guess is a step in the right direction. The IMF and OECD seem more convinced of the effectiveness of macroprudential. DFA’s view is we need them, and soon, alongside changes to negative gearing, and increased capital buffers.

It is interesting to note that U.S. regulators have announced that large banks will be required to hold more liquid capital to ensure they do not get into difficulty in a downturn. According to Reuters the eight biggest U.S. banks must boost capital levels by a total of $68 billion under these new rules. These rules are stricter than those under Basel III, and the banks have complained they will be put at a competitive disadvantage. They will need to hold tier one assets of 5%.

RBA On Housing Lending in Financial Stability Review

The RBA just released their Financial Stability Review for September 2014. They made a number of comments on Housing Lending, which I have collated in a more digestible form here.

INVESTMENT LENDING

Household credit growth has picked up, almost entirely driven by investor housing credit, which is growing at its fastest pace since late 2007. The willingness of some households to take on more debt, combined with slower growth in incomes, means that the debt-to-income ratio has picked up a little in the past six months. The increase in household risk appetite is most evident in the continued strength of investor activity in the housing market. The momentum in investor housing activity has been concentrated in Sydney and (to a lesser extent) Melbourne. Investor housing loan approvals are almost 90 per cent higher in New South Wales than they were two years ago and are 50 per cent higher over the same period in Victoria. As a share of approvals, both are back around previous peaks. By contrast, the momentum in the owner-occupier market appears to have slowed over the past six months or so, with loan approvals to owner-occupiers little changed. Some potential first home buyers are likely to have been priced out of parts of the market by investors, who typically have higher incomes and are therefore able to bid up prices. The broad-based reduction in grants to first home buyers for established housing since late 2012 has also contributed to reduced demand from these buyers.

Strong investor demand can be a sign of speculative excess, with the risk that additional speculative demand can amplify the cycle in housing prices and increase the potential for prices to fall later. This is particularly the case if that demand is largely based on unrealistic expectations of future price growth, perhaps extrapolated from recent experience. A speculative upswing in demand can also be damaging if it brings forth an increase in construction on a scale that leads to a future overhang of supply. This risk is more likely to arise in particular local markets than at the national level. Nationally, Australia is a long way from an oversupply of housing and some increase in supply is to be expected in response to higher prices, which should also help to temper those rising prices.

CREDIT GROWTH

Growth in banks’ domestic lending has lifted over the past six months, after a few years of modest growth (Graph 2.5). Housing credit expanded at an annualised rate of around 7 per cent over the six months to July 2014; growth in investor credit continued to strengthen and at nearly 10 per cent reached its fastest pace since 2007, well above the rate for owner-occupiers. Business credit growth also picked up, although it continues to be weighed upon by subdued non-mining business investment. The pick-up in credit growth has been accompanied by stronger price competition in some loan markets. The ongoing improvement in bank funding conditions, including for smaller banks, has aided price competition. It will be important for banks’ own risk management and, in turn, financial stability that they do not respond to revenue pressures by loosening lending standards, or making ill-considered moves into new markets or products. Banks need to ensure that loans originated in the current environment can still be serviced by borrowers in less favourable circumstances – for instance, at higher interest rates or during a period of weaker economic conditions. Furthermore, banks should be cautious in their property valuations, and conscious that extending loans at constant loan-to valuation ratios (LVRs) can be riskier when property prices are rising strongly, as is currently the case in some commercial property and housing markets.

MORTGAGE COMPETITION

In the residential mortgage market, price competition for new borrowers has intensified. Fixed rates have been lowered in recent months. According to industry liaison, a number of lenders have also extended larger discounts on their advertised variable rates and broadened the range of borrowers that receive these discounts. Banks are offering other incentives to attract new borrowers, including fee waivers, upfront cash bonuses or vouchers. In addition, some banks recently raised their commission rates paid to mortgage brokers. However, reports from banks and other mortgage market participants suggest that, in aggregate, banks’ non-price lending standards, such as loan serviceability and deposit criteria, have remained broadly steady over recent quarters. This seems to be supported by APRA data on the composition of banks’ housing loan approvals, which suggest that the overall risk profile of new housing lending has not increased. It is noteworthy that the industry-wide share of ‘low-doc’ lending continues to represent less than 1 per cent of loan approvals, while the share of loans approved with an LVR greater than 90 per cent has fallen over the past year (see ‘Household and Business Finances’ chapter). That said, strong investor activity in the housing market has meant that the share of investor loans approved with LVRs between 80 per cent and 90 per cent has risen.

INTEREST ONLY LOANS

The shares of interest-only loans for both investors and owner-occupiers have also drifted higher, and average loan sizes (relative to average income) have increased. The increase in interest-only share of banks’ new lending, which has continued to increase for both investors and owner-occupiers in 2014, might be indicative of speculative demand motivating a rising share of housing purchases. Consistent with mortgage interest payments being tax-deductible for investors, the interest-only share of approvals to investors remains substantially higher than to owner-occupiers. According to liaison with banks, the trend in interest-only owner-occupier borrowing has been largely because these loans provide increased flexibility to the borrower. It does not necessarily mean that borrowers are taking on debt that they may not be able to service if both interest and principal repayments are made. Rather, some of these borrowers are likely to be building up buffers in offset accounts. In any case, APRA’s draft Prudential Practice Guide emphasises that a prudent authorised deposit taking institution would assess customers’ ability to service principal and interest payments following the expiry of the interest-only period. More broadly, consumer protection regulations require that lenders do not provide credit products and services that are unsuitable because, for example, the consumer does not have the capacity to meet the repayments.

Future housing loan performance is likely to at least partly depend on labour market performance. Although forward-looking indicators of labour demand have generally improved since last year, they remain consistent with only moderate employment growth in the near term.

LENDING STANDARDS

Although, in aggregate, bank housing lending standards do not appear to have eased lately, a crucial question for both macroeconomic and financial stability is whether lending practices across the banking industry are conservative enough for the current combination of low interest rates, strong housing price growth and higher household indebtedness than in past decades. Moreover, lending to investors is expanding at a fast pace, which could be funding additional speculative activity in the housing market and encourage other (more marginal) borrowers to increase debt. Lending growth is varied across geographical markets and individual lenders, which may suggest a build-up in loan concentrations and therefore correlated risks within the banking industry. The Reserve Bank’s assessment is that the risk from the current strength in housing markets is more likely to be to future household spending than to lenders’ balance sheets. However, the direct risks to banks will rise if current rates of growth in investor lending and housing prices persist, or increase further. In light of the current risks, APRA has increased the focus of its supervision on banks’ housing lending. Specifically, it has:

• begun a regular supervisory survey of a broader range of risk indicators for banks with material housing lending

• released a draft Prudential Practice Guide (PPG) for housing lending that outlined expectations for banks’ risk management frameworks, serviceability assessments, deposit criteria and residential property valuations.1 By way of example, prudent serviceability assessments are seen to involve: an interest rate add-on to the mortgage rate, in conjunction with an interest rate ‘floor’, to ensure the borrower can continue to service the loan if interest rates increase; a buffer above standard measures of household living expenses; and the exclusion, or reduction in value, of uncertain income streams. While much of the guidance in the PPG is already common practice within the industry, it is nonetheless important that practices are not deficient at even a minority of lenders

• written to individual bank boards and chief risk officers asking them to specify how they are monitoring housing loan standards and ensuing risks to the economy

• assessed the resilience of banks’ housing loan (and other) portfolios to large negative macroeconomic shocks, including a severe downturn in the housing market, as part of its regular stress testing of banks’ balance sheets.

In addition, the Reserve Bank is discussing with APRA, and other members of the Council of Financial Regulators (CFR), further steps that might be taken to reinforce sound lending practices, particularly for lending to investors.

PREPAYMENT OF MORTGAGES

The proportion of disposable income required to meet interest payments on household debt has stabilised accordingly, at around 9 per cent. Households continue to take advantage of lower interest rates to pay down their mortgages more quickly than required. The aggregate mortgage buffer – balances in mortgage offset and redraw facilities – has risen to be around 15 per cent of outstanding balances, which is equivalent to more than two years of scheduled repayments at current interest rates. Prepayment rates and the proportion of borrowers ahead of schedule on their mortgage repayments are also high according to liaison with banks. Part of this prepayment behaviour has been due to some banks’ systems not automatically changing customer repayment amounts as interest rates have declined, while in many cases households have not actively sought to reduce their repayments. This might be a sign that household stress is currently limited. The household saving ratio, although trending down a little lately, remains high at just under 10 per cent. Households’ aggregate balance sheet position has continued to improve in recent quarters: real net worth per household is estimated to have increased by 4 per cent over the year to September 2014.

SECURITISATION

One area of shadow banking activity in Australia that warrants particular attention is non-bank securitisation activity, given strengthening investor risk appetite as well as the connections between this activity, the housing market and the banking system (through the various support facilities provided by banks). As discussed, RMBS issuance has picked up since 2013 and spreads have narrowed, including for non-bank issuers (i.e. mortgage originators). Mortgage originators tend to have riskier loan pools than banks; this is partly because they are the only suppliers of non-conforming residential mortgages, which are typically made to borrowers who do not meet the standard underwriting criteria of banks. These originators currently account for about 2 per cent of the Australian mortgage market (not all of which is non-conforming), and so have limited influence on competition in the mortgage market and the housing price cycle. Even so, it is useful to monitor any signs of greater non-bank activity, as this could signal a broader pick-up in risk appetite for housing.

LENDERS MORTGAGE INSURANCE

Lenders mortgage insurers (LMIs) are specialist general insurers that offer protection to banks and other lenders against losses on defaulted mortgages, in return for an insurance premium. LMIs’ profitability improved in the first half of 2014, with the industry posting a return on equity of about 14 per cent, up from an average of around 10 per cent over the preceding few years. The number and average value of claims on LMIs has declined recently in response to the buoyant housing market, as well as previous improvements in underwriting standards. In addition, some LMIs have recently increased their premium rates. In May, the largest LMI, Genworth Australia, successfully listed on the ASX, with around one-third of the company now independently owned. Also, in August QBE announced plans to partially float its subsidiary, which is the other major LMI in Australia. Share market listing will subject the relatively concentrated Australian LMI industry to greater market scrutiny and increase its access to domestic capital markets; such developments could be beneficial to financial stability given the LMI industry’s involvement in the credit creation process and linkages to the banking system.

Capital Rules Likely To Be Sharpened

In an important speech given today by Wayne Byres, Chairman of APRA, “Perspectives on the Global Regulatory Agenda”, there are some important pointers which indicate to me that we should expect some changes to the capital regulatory framework quite soon. We highlighted the capital questions recently.

Whilst talking about the global agenda, he did confirm the FSI Inquiry view that local and global cannot be separated. Whilst Basel III was focusing on systemically important banks, the current agenda is to minimise the impact of bank failure. He comments that the role of internal models now being used by the large banks to calculate capital requirements is being questioned. “The Chairman of the Basel Committee has made it clear that there is a problem, and something must be done about it”. APRA recently indicated that the route would likley be an increase in the risk weightings.

Next he discussed the need to bolster the ability of banks to handle losses should they arise.

Finally, he also highlighted concerns about bank culture, and the incentives which drive behaviour within these organisations.

These are important issues, and as we showed, the major Australian banks now hold less capital to assets than they did before the GFC, and before Basel II and III were implemented. This is a concern.

How might this play out?

Well, we would expect banks using the advance internal methods of capital calculation will be required to hold more capital than they do today. This will reduce their ability to lend, and raise the costs of loans to borrowers. Second, we would expect the concept of creating additional categories of capital using subordinated instruments to be blocked (many of the banks have been calling for this, as it would reduce their capital costs further). Finally, we we expect lending standards to be examined, and especially serviceability, or loan to income criteria be established.

Whether this will be triggered by the findings from FSI, or directly by APRA is an open question. But it looks to me as if capital just got more expensive for the large players. Some would say, better late then never!

But strangest of all is the apparent disconnect between the RBA minutes today which highlighted the banks strong capital position, and the APRA discussions. They cannot both be right.

RBA And Property Speculation

The RBA published the notes from their last meeting today. The theme was similar to previous ones, “Members considered that the most prudent course was likely to be a period of stability in interest rates,” but in the variations, there was a sub-text relating to property prices. I have extracted just those paragraphs:

Members noted that Australian banks continued to report improving asset performance and strong profits, which had contributed to further increases in their capital ratios. Australian banks and non-banks had both benefited from easier wholesale funding conditions globally. This in turn had encouraged stronger competition in lending for housing and to large businesses, but members noted that this had not, to date, led to a general easing in mortgage lending standards and policies. For investors in housing, the pick-up in housing credit growth had been more pronounced than for owner-occupiers, with investor demand particularly strong in Sydney and, to a lesser extent, Melbourne.

Members further observed that additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later. The main risks in such a scenario would likely be to the stability of the macroeconomy rather than the financial system, particularly if households were to react to declines in their wealth by cutting back on their spending. Members were also updated on some of the recent actions by the Australian Prudential Regulation Authority in this area.

Members noted that commercial property markets in Australia had also been quite buoyant recently. Australian property had been yielding higher rental returns than were available overseas, which had attracted strong demand from both local and foreign investors. This had boosted prices even though rents for some types of commercial property had declined. In contrast, demand for finance from other parts of the business sector remained subdued, although business credit growth had picked up a little in recent months.

Members noted that the current setting of monetary policy was accommodative. Interest rates remained very low and had declined a little for borrowers since the cash rate was last changed. Investors continued to look for higher returns in response to low rates on safe instruments and were accepting more risk in doing so. Credit growth had picked up, including to businesses. Credit growth for investor housing was running at around 10 per cent per annum. Housing prices were continuing to increase in the larger cities and members considered that the risks associated with this trend warranted ongoing close observation. On the other hand, the exchange rate remained above most estimates of its fundamental value, particularly given the declines in key commodity prices and, overall, had offered less assistance to date than would normally be expected in achieving balanced growth in the economy.

I would tell the story rather different:

Banks have reduced the capital held against their growing pool of mortgage debt, so we hope the new advanced methods of capital calculation will support any risk of a down-turn. Still, the growth in investment lending at 10% is probably not an issue, after all, banks lending standards are just fine, no concerns apparently about the fact that half of new lending in the month was for investment purposes, nor the rise in interest only loans, or loans outside normal approval criteria. House prices continue to rise fast in (some of the cities) but we will just watch what happens, despite all the data showing prices are out of kilter with income, and other measures. Remember that interest rates are at rock bottom, well below the long term trend. They will correct at some point, and when the average mortgage rate is 7%, the chickens are likely to come home to roost. This is the key to potential falling prices later as with income growth below inflation, any lift in rates would have direct macroeconomic effects on borrowing households.

The Capital Conundrum

A cornerstone of banking regulation and control is the application of capital ratios, which acts a brake on their ability to write more loans. The rules are set by the Bank of International Settlement, but they may be interpreted by local regulators, like APRA in Australia to take account of local conditions. BIS has no direct control. The calculations can be quite complex, because the rules offer the banks various options based on their sophistication, risk profile, and other factors.

Recently there has been a renewed focus on capital, triggered by a series of events.

The FSI interim report made the point that smaller banks were at a competitive disadvantage in Australia because of differences in the capital required, and hinted that in the final report, they may recommend some changes.
Some of the large players responded by suggesting that smaller banks should be allowed to move towards the more complex capital mechanisms, thus enabling them to complete. Others have suggested that the right move would be to lift the required ratios amongst the big four, who all use versions of the advanced capital scheme.
In response APRA provided a further submission to the FSI inquiry, which went into significant detail around the question of capital.
Meantime, Christopher Joye has published two posts showing that capital for the Australian large banks, in absolute terms had fallen, thanks to the move to the more advanced basis, since the GFC, despite all the talk (from banks and regulators) that capital had lifted. His latest was called “The inconvenient truth about our banks”.
Two of the investment banks came out recently with estimates that revised capital arrangements might cost the industry between 12 and 24 billion.
In a recent speech on macroprudential tools, the Head of The Monetary and Economic Department, BIS said “DTI ratios and, to a lesser extent perhaps, LTV ratios are comparatively more effective than increases in loan provisions or capital requirements.” This raises the question – is capital the best regulatory tool?

So, today we wanted to spend time today on this important capital issue.

First, the capital adequacy ratio (CAR) is simply the ratio between a bank’s core capital and it risk-weighted assets. It is a mechanism to protect depositors by limiting the banks’ ability to lend. Note that in banking language, assets are loans made by the bank, and liabilities are monies received by the bank. So deposits are a liability (because the bank will need to pay the deposit funds back at some point and interest meantime), whereas Loans are assets because they generate income for the bank).

Core capital is divided into tier 1 and tier 2 capital. Tier 1 capital (which includes things like paid up capital, disclosed reserves, after adjustments for intangibles and losses) is essentially capital which a bank may loose without having to cease trading; whilst Tier 2 capital (which undisclosed reserves, hybrid capital and subordinated debt etc.) offers less protection for depositors than Tier 1 capital but can absorb losses if the bank is wound up.

Assets of various types will hold different weightings. For example under the original Basel I capital guidelines loans to governments may be regarded as riskless (debatable in some cases?) and so are rated 0%, secured housing loans were assigned a 50% risk weighting, whereas other lending categories were weighted 100%.

The recent changes under Basel II and Basel III (yet to be fully implemented) extended the regulatory framework, and tweaked the capital weightings. In addition, in October 2012, the Basel Committee finalised its framework for dealing with domestic systemically important banks (D-SIBs). The D-SIB framework in Australia focuses only on the larger banks, APRA has determined that Australia and New Zealand Banking Group Limited; Commonwealth Bank of Australia; National Australia Bank Limited; and Westpac Banking Corporation are D-SIBs.

APRA’s recent second submission to the Murray Inquiry cover a range of capital-related issues. Here are some important extracts.

The average risk weight for residential mortgage exposures for ADIs using the standardised approach is currently in the order of 39 per cent; the comparable figure under the internal ratings based (IRB) approach is around 18 per cent. These figures are, however, not directly comparable.

The more risk-sensitive IRB approach generates, on the whole, a lower capital requirement for residential mortgage exposures than the standardised approach.

If smaller ADIs were to successfully obtain approval for use of the IRB approach for their credit portfolios, it is unlikely that the average risk weight for residential mortgage exposures for these ADIs would automatically settle at the same level as that of the major banks.

The Basel framework does not allow for the selective implementation of the IRB approach across individual credit portfolios. This stance is critical for protecting against cherry picking; it would also undermine the ability of ADIs to demonstrate they meet the use test.

Other options canvassed in the Interim Report involve changes to risk weights under the standardised approach, which would be contrary to the Basel framework.

The Interim Report suggests that ‘standardised risk weights do not provide incentives for the ADIs that use them to reduce the riskiness of their lending’. This is not the case in Australia: a simple tiered system of risk weights already exists. By way of example, consider a standard residential mortgage loan with no mortgage insurance. If the loan-to valuation ratio (LVR) is greater than 90 per cent, the loan receives a 75 per cent risk weight. Capital requirements decrease by one third (i.e. to a 50 per cent risk weight) if the LVR is reduced below 90 per cent and by a further third (i.e. to a 35 per cent risk weight) if the LVR is reduced below 80 per cent. There are also incentives for ADIs to obtain mortgage insurance; in general, risk weights for higher LVR loans are reduced by around one quarter if mortgage insurance is obtained.The opposite is true for non-standard loans, where risk weights relative to standard loans are increased by 25 to 50 per cent.

The effect of this tiering of risk weights is that under a minimum Common Equity Tier 1 (CET1) capital ratio of 7 per cent, ADIs with low-risk housing portfolios, i.e. all loans receiving a 35 per cent risk weight, could operate with leverage of around 40:1. It is not, therefore, correct to conclude that the standardised approach to credit risk is insensitive to risk.

If the Inquiry concludes that it is appropriate for APRA to consider a narrowing of the differential in risk weights for residential mortgage exposures between the standardised and IRB approaches to credit risk, the only proposed option in the Interim Report that would ensure continued compliance with the internationally agreed Basel framework would be to increase the average risk weight used by banks operating under the IRB approach.

Increasing IRB risk weights could be accomplished in various ways, including further increases to APRA’s minimum LGD requirement for residential mortgage exposures, or preferably through revised technical assumptions within the IRB framework. This issue should be considered in the context of the broader work being undertaken by the Basel Committee, as the impact of changes to risk weights needs to be carefully analysed. Greater prescription in IRB estimates may reduce incentives ADIs currently have to invest the resources and management attention required to model these estimates accurately. It may also make risk weights potentially less risk sensitive, and may change relative capital requirements across asset classes. Any considerations on this issue also need to be viewed within the context of the Inquiry’s deliberations regarding the positioning of Australia’s prudential framework relative to the global median.

So, with that in mind let’s look at the current state of play, using the APRA quarterly statistics, last published to June 2014. First, we calculated the ratio between the gross loans outstanding, and the Tier 1 capital held, over time. We see that the big four, relative to their loan portfolios, hold lower capital buffers than their competitors. Note this is a calculation based on the ratio of the value of gross loans made, and capital held under Tier 1, so excludes any capital weighting as the normal capital calculations do.

Next, because the big four are dominant – holding more than 85% of all lending, we will look at these players specifically. The chart below shows the growth in gross assets (loans) from Jun 2004, and the relative growth in housing lending, now 62% of all loans for the majors are housing related. Next we show the tier 1 capital ratio’s as calculated using IRB Basel, showing a rise to over 10% since 2004. On the other hand, a calculation of the ratio of capital to assets shows no change, so in absolute terms Joye is right, the big banks hold less capital now against their loans than they did.

Then we can look at the mix of property loans to total loans in more detail. It has risen by 10% since 2004, so the banks are more highly exposed to the property market than ever, (before we even start to consider whether they hold investment paper from buying securitised assets issued by the smaller players and non-banks.) If we look at the ratio of capital to housing loans, again we see a fall, thanks to the IRB system which Basel allows.

So, to conclude. First, it is true the big banks hold less capital against their loans than they did, thanks to the adoptions of IRB methods. This is in line with the global formulas and the banks here are fully capital compliant. Indeed on some measures Australia is more conservative in its application of the Basel formula than some other countries. One recent analysis indicated that if we applied the rules used in the UK to Australian Banks, total capital held could rise by 2-3%. That would lift the total capital levels (tier 1 and tier 2) to 14-15%, but this is still below the 17.5% targeted by the UK. Other suggest we need to be more conservative to be fully compliant. A 2012 IMF working paper said:

“The four major Australian banks have capital well about the regulatory requirements with high quality capital. While their headline capital ratios are below the global average for large banks in a sample of advanced and emerging market economies, Australia’s more conservative approach in implementing the Basel II framework implies that Australian banks’ headline capital ratios underestimate their capital strength. For example, a comparison with Canadian banks highlights the impact of Australia’s more conservative approach. The four major Australian banks are well-positioned to meet the higher capital requirements under Basel III, and with the improvements in their funding profiles since the global financial crisis they are making good progress toward meeting the Basel III liquidity standards. Stress tests calibrated on the Irish crisis experience show that the banks are largely able to withstand sizable shocks to their exposure to residential mortgages. However, combining residential mortgage shocks with corporate losses expected at the peak of the global financial crisis would bring down the banks ’ average total capital ratio below the regulatory minimum. Given high bank concentration and market uncertainty, therefore, the merits of higher capital requirements need to be considered for systemically important domestic banks, taking into account the currently evolving international standards”.

So, second, we in Australia have levels of capital lower than some other countries, even allowing for local variations.

Third, smaller players in Australia are operating in an environment, where they are holding more capital relative than the large players because of different capital rules, so they are at a competitive disadvantage. Lowering capital for these players is not the answer, the only option would be to lift the target for the larger players.

Next, the big four are heavily leveraged into property, to the point where we think there is a strong argument to insist the banks hold significantly more capital, to ensure financial stability, especially given their leverage to sky high property prices at the moment. Holding capital however costs, and holding more will reduce payouts to shareholders, and perhaps even lift rates to borrowers. We will see what The Murray Inquiry comes up with in due course.

One final thought, it appears to me that APRA has latitude under the D-SIB rules to raise the capital buffers further, this may be one neat method to address some of the capital concerns. In addition, perhaps macroprudential tools could be used to take some of the burden off capital controls, this seems to be advocated by BIS.