RBA Trading Economic Growth Against Sydney Property

In Glenn Stevens Opening Statement to House of Representatives Standing Committee on Economics today, we get a glimpse of the drivers to lower interest rates. In addition, they are prepared to cut rates even if it leads to more growth in the Sydney property market to drive growth, even if that lever is now less powerful than previously.

Since the hearing in August last year, the economy has continued to grow at a moderate, but below-trend pace. Inflation as measured by the CPI has been affected by movements in energy prices and government policy changes, but even aside from these effects, inflation is low and appears likely to remain so.

The international context is one in which the global economy likewise is growing, but according to most observers at a pace a little below its longer-run average. There are some notable differences in performance by region. The US economy has picked up momentum, growing above trend with a falling unemployment rate. China’s economy met its growth target in 2014. A slightly lower target seems likely to be set for 2015, perhaps something like 7 per cent. But that would still be robust growth for an economy of China’s size. On the other hand, the euro area and Japan have recorded lower growth rates than expected a year ago.

Commodity prices have fallen, in some cases quite sharply. These trends appear to reflect primarily major increases in supply, with some moderation in demand playing a role. That would appear to be the case for iron ore and oil prices (and, prospectively, liquefied natural gas prices, which are typically tied to oil prices). Base metals prices, where few significant supply changes have occurred, have fallen by much less.

So there has been what economists refer to as a ‘positive supply shock’: more of the product is available with lower prices. The effect of this on individual countries will vary, depending on whether they are a producer or a consumer of such raw materials. On the whole for the global economy, however, this is a positive development.

Inflation is quite low in a range of countries, and very low in some. The decline in energy prices is temporarily pushing headline CPI inflation rates even lower.

The very low interest rates in evidence around the world when we last met have fallen further. This has been most pronounced in Europe, where yields on long-term German sovereign debt have fallen to be about the same as those in Japan. German sovereign debt has recently traded at negative yields for terms as long as 5 years. Official deposit rates are negative in the euro area, and the European Central Bank has announced a large-scale asset purchase program – colloquially referred to as ‘quantitative easing’. The euro has depreciated. Some surrounding countries to which funds tend to flow in anticipation of further depreciation – such as Switzerland – have reduced interest rates to significantly below zero and indeed 10-year Swiss government debt has traded at a negative yield. The Swiss National Bank took the decision to remove the cap on the Swiss franc, as it assessed that the size of the intervention likely to be required to hold it was becoming just too large. This move occasioned considerable turbulence in foreign exchange markets.

Meanwhile, the US Federal Reserve, faced with a strengthening US economy and having ended its asset purchase program last year, is expected to begin a gradual process of lifting its policy rate in a few months from now. So the monetary policies of the major jurisdictions look like they will be heading in differing directions. This means there is ample potential for further turbulence in financial markets this year.

The falls in prices for key export commodities are lowering Australia’s terms of trade and hence the purchasing power of our national income. This is a well-understood mechanism and has been the subject of much discussion. It will continue to constrain income growth for households and mining companies, and revenues for both state and federal governments, over the period ahead.

Resource export shipments are increasing strongly, as the capacity put in place by the period of high investment is put to use. At the same time, the high levels of capital spending by the resources sector, which had been a strong driver of domestic demand for several years, peaked during mid 2012 and turned down. All indications are that this downswing will accelerate this year. That has always been our forecast. The recent declines in commodity prices don’t change it, though they do reinforce that this trend is well and truly under way.

The various areas of domestic demand outside mining investment are mixed. Dwelling construction is rising strongly and commencements of new dwellings will reach a new high over the coming 12 months. Consumer spending is responding both to income trends and financial incentives, which are pulling in different directions. Growth in wages, by historical standards, is quite subdued. This and the fall in the terms of trade is working to restrain growth in disposable incomes. Working the other way, the fall in petrol prices, assuming it persists, is adding noticeably to the real incomes of consumers. Increased asset values, which push up gross measures of wealth, and low interest rates are also working to push consumption up relative to income. The net effect of these opposing forces is producing moderate, though not strong, consumption growth.

Meanwhile, at this point non-mining business investment spending is still very subdued. While several key fundamentals are in place for stronger performance, clear signs of a near-term strengthening remain unconvincing at this stage. This is a weaker outcome than we had expected six months ago. Public sector final spending – about one-fifth of aggregate demand – is fairly subdued, and the intent of governments, as you know, is to restrain their own spending over the period ahead. The lower exchange rate is likely to help export volumes outside the resources sector, and of late better trends have been observed in some services export categories including tourism and education.

Overall, growth in non-mining economic activity has picked up, but is still a little below average. Our expectation had been that a further pick-up would occur in 2015. When we reviewed our forecasts in late January, we didn’t feel that growth in the recent past had been materially different from what we had estimated a few months ago. But when we tried to look ahead, we concluded that there were fewer signs of a further pick-up in non-mining activity than we had hoped to see by now. As a result, the revised forecasts we took to the February Board meeting embodied a longer period of below-trend growth, and a higher peak in the rate of unemployment, than earlier forecasts. They also suggested that inflation was likely to remain pretty low over the forecast horizon. The inflation outlook was revised slightly lower, in part reflecting the effect of declining oil prices as well as the weaker outlook for economic activity.

At its meeting in February the Board considered that this revised assessment – that is, sub-trend growth for longer, a higher peak in the unemployment rate, slightly lower inflation – warranted consideration of some further adjustment to monetary policy, after a fairly long period during which the cash rate had remained steady. These were incremental changes to the outlook but all in a consistent direction.

Another factor in our consideration was dwelling prices, which have continued to increase. Price rises in Sydney are very strong, and they are pretty solid in Melbourne. On the other hand they are much more mixed elsewhere. Excluding Sydney, the rise for Australia as a whole over the past year was about 5 per cent. That is a healthy pace but not alarming, and some cities have seen price falls. Developments in the Sydney market remain concerning, but in the end we did not see these trends as overwhelming a case for a further easing in monetary policy that was made on more general grounds.

I note that, on the regulatory front, APRA has announced its supervisory approach to managing the potential risks posed by the rise in lending to investors in housing. This involves more intense scrutiny of investor loan portfolios growing at over 10 per cent per year, with the possibility, ultimately, of additional capital being required if APRA deems it necessary. APRA has also reiterated its expectations for other elements of lending standards such as interest rate buffers and floors. And ASIC has begun a review of interest-only lending in the context of consumer protection legislation. The Bank welcomes these steps and will keep working with other regulators in these areas.

The Board is also very conscious of the possibility that monetary policy’s power to summon up additional growth in demand could, at these levels of interest rates, be less than it was in the past. A decade ago, when there was, it seems, an underlying latent desire among households to borrow and spend, it was perhaps easier for a reduction in interest rates to spark additional demand in the economy. Today, such a channel may be less effective. Nonetheless we do not think that monetary policy has reached the point where it has no ability at all to give additional support to demand. Our judgement is that it still has some ability to assist the transition the economy is making, and we regarded it as appropriate to provide that support.

The forecasts published last week in the Statement on Monetary Policy assume a lower path for interest rates and a lower exchange rate than both earlier forecasts and the ones the Board responded to at the February meeting. These are assumptions rather than forecasts or commitments to a course of action.

It is worth noting that, despite concerns at various times about whether the exchange rate would adjust appropriately to our changing circumstances, it has been doing so over the period since we last met with the Committee. Against the US dollar it has fallen by around 17 per cent since our last hearing. The US dollar itself has been rising against all currencies, of course, so much of this movement is an American story rather than an Australian one. Against a basket of relevant currencies the Australian dollar has fallen by less, but the decline is still about 11 per cent since August. Further adjustment is probably going to occur.

One other development since our last meeting with the Committee was the final report of the Financial System Inquiry. This was quite a wide-ranging report and there is now a further period of consultation. I simply note that the Inquiry did not find major problems in the financial system, but did make recommendations about capital, to enhance the resilience of the banking system, and about loss-absorbency more broadly in the context of resolution. These will be mostly in the province of APRA to consider. The Inquiry also made some observations about payments matters, generally supporting the steps the Payments System Board has taken since its inception in 1998, and pointing to some areas where further steps may be appropriate. The Payments System Board will be considering these matters at its meeting next week.

Launch of the Official Australian Renminbi Clearing Bank

Glenn Stevens spoke at the launch yesterday. The launch of a local RMB clearing bank in Australia is an important event. It should make it easier to make RMB for payments, especially for larger transactions. It should establish a more direct connection  with the liquidity in RMB which is provided by China’s central bank, the People’s Bank of China (PBC). Next, it will facilitate access to China’s Real-time Gross Settlement System (CNAPS), making it will be easier to track and confirm when payments to China reach their recipients. Finally, as it develops, it has the potential to reduce risks via access to fiduciary accounts structures maintained by the PBC on behalf of its clients. In addition, more broadly, the establishment of an RMB clearing bank underscores the international importance of Sydney as an Asian financial centre and strengthens the bilateral relationships. Now, it is up to local businesses to grasp the opportunity to transact in RMB in Australia.

Today’s events mark an important step in the further development of a local renminbi – or RMB – market. But more than that, they mark one more step in a lengthy and very important journey that has seen the flowering of trade relations between China and Australia, and which promises benefits from the maturing of financial ties.

On its own, the key direct benefit of the official Australian RMB clearing bank is that it can more efficiently facilitate transactions between Australian firms and their mainland Chinese counterparts using the Chinese currency. Bank of China (Sydney)’s ‘official’ status – which was granted by the People’s Bank of China (PBC) – affords it more direct access to the Chinese financial system, with flow-on effects for local financial institutions and their customers.

But an official Australian RMB clearing bank also confers some indirect benefits on the Australian financial sector and its customers, particularly when viewed as one element of a broader range of initiatives.

In particular, the establishment of the clearing bank helps to raise awareness among Australian firms that the local financial system has the capacity to effect cross-border RMB transactions on their behalf. This is important, because over the long run, Chinese firms may increasingly wish their trade with Australian firms to be settled in RMB. To be sure, today the bulk of global trade is settled in US dollars. But with China now a very large trading nation, and continuing to grow into a ‘continental sized’ economy, it would be surprising if at some point we do not see much more use of China’s currency for trade purposes. Already its usage is growing quickly, if only from a small base. So Australian firms and the Australian financial system need to be well prepared.

To that end, the RBA has been directly involved in several initiatives, with the aim in each instance being to ensure that there are mechanisms in place that allow the private sector to increase its use of the Chinese currency as and when it chooses to do so. This of course included the signing of a Memorandum of Understanding with the PBC to enable the establishment of an official RMB clearing bank in Australia, in November last year following the G20 Leaders’ Summit in Brisbane.

In addition, there was the establishment of a bilateral local currency swap line with the PBC in 2012, which is designed to provide confidence to both Chinese and Australian financial institutions that appropriate RMB and AUD liquidity arrangements are in place in the event of dislocation in the market.

More recently, there was the negotiation of a quota to allow financial institutions based in Australia to invest in approved mainland Chinese securities under the Renminbi Qualified Foreign Institutional Investor Scheme – better known as RQFII.

Finally, I note the RBA has invested a small proportion of Australia’s foreign currency reserves in RMB.

Official initiatives like these help to lay the groundwork. But ultimately, the development of an RMB market in Australia will depend on the extent of benefit the private sector sees in using RMB for trade settlement and investment purposes. It is worth noting that private sector-led initiatives are now becoming increasingly important drivers of the RMB market’s development. For example, forums such as the Australia-Hong Kong RMB Trade and Investment Dialogue and the ‘Sydney for RMB’ Working Group are beginning to have a more prominent role in raising awareness of the financial sector’s capacity to conduct RMB business and in identifying any further market development issues that may need to be addressed.

Did HSBC Help Wealthy Clients Evade Tax?

Claims that Britain’s biggest bank helped wealthy clients cheat the UK out of millions of pounds in tax via HSBC’s private bank in Switzerland have been made. HSBC may faces criminal investigations. The suggestion, based on leaked documents, is that they allowed clients to withdraw cash, often in foreign currencies of little use in Switzerland, marketed schemes likely to enable wealthy clients to avoid European taxes, colluded with some clients to conceal undeclared “black” accounts from their domestic tax authorities and provided accounts to international criminals, corrupt businessmen and other high-risk individuals.

Whilst a numbered bank account is now illegal in most western countries, it is still part of Switzerland’s banking system. This dates from 1934. Article 47 of the Federal Act on Banks and Savings Banks made it a criminal offence to disclose the identity of clients. A depositor’s true identity will be known to only a select group of employees, and in order to withdraw cash or make a wire transfer, the account holder is asked for a codeword. A breach of professional confidentiality, even for retired bankers or those who have had their licence revoked, is punishable by three years in jail. By 2018, Switzerland has committed to an automatic exchange of information about individual accounts, taxes, assets and income along with 50 other nations under an OECD agreement.

New CEO Announces New Structure At Westpac

On his first day as the Westpac Group CEO, Brian Hartzer today confirmed his Executive team and their responsibilities, and detailed some of his immediate priorities for the Group.

There are no changes to the individuals within the Executive team.  However, some responsibilities and reporting lines have changed.  These include:

  • As a division, Australian Financial Services (AFS) will no longer exist, with the CEOs of Westpac Retail & Business Banking, St.George Banking Group and BT Financial Group will now report directly to Mr Hartzer.
  • The Technology function will now report directly to the Group CEO (previously reported to the Chief Operating Officer
  • All retail product development, marketing and analytics functions previously within AFS, along with Group-wide operations, will now be the responsibility of the Chief Operating Officer
  • David McLean has been appointed as the CEO of Westpac New Zealand.  Mr McLean has been acting CEO of Westpac New Zealand since August 2014

Mr Hartzer also today outlined his key priorities for the Group.

“We have a clear customer-centric strategy, which has consistently delivered. We are building good momentum and have a number of growth opportunities that over time will help us to continue to increase the value of our franchise. These include digitally transforming our business, increasing our investment in wealth, business banking and Asia, and working more closely with innovation industries and disruptive technologies that are transforming our economy. At the same time, we will continue to improve productivity, and make sure that our risk and business practices continue to set the standard for sustainability, in line with changing regulatory and community expectations. Above all we will continue to invest in our people and the distinctive strength of Westpac’s culture, delivering a service revolution for our customers and strong, consistent, returns for shareholders.”

ECB’s QE Unlikely to Kick-Start Bank Loan Growth – Fitch

The ECB’s quantitative easing programme is unlikely to materially boost eurozone banks’ earnings or kick-start lending in the bloc, Fitch Ratings says. But it does reduce downside risk from prolonged deflation. Any positive impact on banks is likely to be temporary unless their balance sheets are freed up for more lending or structural reforms raise real and sustainable economic growth.

We think QE is unlikely to stimulate lending in the eurozone’s crisis-hit economies, despite the start of rebalancing and recovery in some countries. The economic outlook is still fragile, so demand for credit is likely to remain subdued, and tighter regulatory requirements are making loan growth more difficult for banks.

Banks have to hold an increasing amount of regulatory capital against the loans they extend as Basel III rules are phased in. The bar is also being raised by the ECB in its role as the new single supervisor – it recently communicated its Pillar 2 expectations for buffer capital to each of the banks. They will also have to build debt and capital buffers to meet new total loss-absorbing capacity (TLAC) and minimum requirement for own funds and eligible liabilities (MREL) rules. Gearing up bank balance sheets through loan expansion runs contrary to these regulatory pressures.

Some banks may be able to generate more trading income, as the ECB’s accommodative policy should push down bond yields and encourage trading flow. Gains on any sales of sovereign bond holdings by banks are likely to be limited because yields have continued to fall in recent months. Any revenue benefits from sovereign bond sales and trading will probably be offset by lower margins from a flatter yield curve, so the balance is likely to be neutral or even slightly negative for profitability.

Many banks in northern Europe are already awash with liquidity, so lower bond yields would only distort credit pricing there even more. Weaknesses in some of the economies, such as Germany and France, which grew 1.2% and 0.4%, respectively, yoy in 3Q14, are likely to keep investment appetite, and therefore loan demand, muted, especially for good-quality corporates, despite even cheaper potential funding rates.

Southern European banks could benefit more from QE, but the impact would depend on the pricing of their sovereign debt portfolios and the extent to which these are booked as held-to-maturity assets. But there could be some rebalancing of sovereign debt portfolios and banks are likely to look to lock in some gains. Loan expansion is even less likely in southern Europe, as most banks there are still strengthening balance sheets, gradually reducing impaired loans and dealing with legacy assets.

If the ECB’s actions do not ward off deflation, eurozone banks would come under more pressure from dampening earnings, increasing non-performing loans and weakening collateral values.

Wholesale Financial Market Reform

In a speech in London entitled “Realigning private and public interests in wholesale financial markets: the Fair and Effective Markets Review” given by Andrew Hauser, Director of Markets Strategy, Bank of England, and head of the Fair and Effective Markets Review secretariat; there is an interesting description of why Wholesale Financial Markets became relatively under-regulated, and the dimensions of reform now being considered to address this under-regulation. This is important, not just in the UK. The issues raised are universally relevant.

I’m here primarily to talk about the Fair and Effective Markets Review, a joint initiative by the Bank of England, the Financial Conduct Authority (FCA) and HM Treasury, launched by the Governor of the Bank of England and the Chancellor last June. The aim of the Review is to reinforce confidence in wholesale fixed income, currency and commodity markets – or ‘FICC’ for short – in the wake of LIBOR, FX and other appalling cases of misconduct that have come to light since the height of the financial crisis. The Review is interested in three key questions. First, what were the root causes of this behaviour? Second, how far have the steps taken by firms and regulators since the crisis gone to put things right? And, third, what remains to be done?

Before describing the work of the Review in more detail, I want to take a bit of a step back and ask why it is that we are here at all. And that’s not as strange a question as it might first seem, because for a long period the phrase ‘wholesale banking conduct’ was thought to be something of an oxymoron. Wholesale markets were seen as being (for the most part) deep and liquid – and therefore hard to manipulate – and involving professional, well-informed, forward-looking counterparties, who could both look after their own interests, and sustain overall market integrity, through the operation of robust market discipline. To put it bluntly, firms knew that an attempt by them to abuse the interests of others in the market today could be punished by the removal of large quantities of lucrative business tomorrow. And that knowledge was thought to be the most powerful way of sustaining broadly well-functioning and sound markets. ‘Caveat emptor’ never meant ‘anything goes’ – wholesale markets have always been subject to the law on competition, fraud and misrepresentation; and the regulatory perimeter has been progressively extended across many wholesale businesses in recent years. But the size of the regulatory rulebook, and the degree of supervisory intensity, has tended to be much more modest than in markets and activities involving less well-informed retail customers.

The potential power of market discipline in maintaining market integrity has a strong intellectual appeal. If it works in the way described, it allows wholesale markets – crucial to a well-functioning global economy – to operate without the cost of too many regulatory rules. And, crucially, it delivers strong alignment between what matters for the private business success of financial market firms, and what matters for good conduct. Even where market discipline is strong, regulators still play an important role – but more as referees, with yellow or red cards to use in extremis. In such a world, the strongest constraint on the conduct of wholesale market participants comes from the knowledge that if they act inappropriately they lose the business. If they lose the business, they lose their bonuses. And, if misconduct goes too deep, firms go bust. So the incentives to make money and to ensure good conduct are aligned, and operate primarily through the business line.

Those responsible for ensuring good conduct – probably the business heads – don’t have to struggle to make themselves heard in annual pay rounds or beg traders to read manuals or attend courses. We could debate for some time whether there was a historic ‘golden age’ when the real world actually worked like this. But it clearly has not done so in recent years, which have seen a sequence of appalling market abuses involving collusion, manipulation of benchmarks and other financial market prices, structuring assets in ways designed deliberately to undermine the interests of end-investors, deliberate mis-valuation of large scale positions, and the abuse of private information for personal or corporate gain. No amount of counterparty sophistication – that key plank of the ideal model I discussed earlier – can protect you against collusion. Measured in terms of regulatory fines and damaged reputations, the cost has been large enough. But more profound still has been the damage to public trust in FICC markets, which in turn has impaired their effective operation, created uncertainty among intermediaries, investors and other end-users, diverted huge amounts of management and financial resources, and materially increased the compensation required for taking risk. Everyone recognises that these markets matter too much to the global financial system to leave these problems untouched. And that is why we are all here today.

The behaviours that have come to light strike many as being deeply immoral, and have triggered an extensive public debate about the role of ethics in banking. But what I find even more striking is that few, if any, of those behaviours were even in the firms’ own economic interests, properly construed. Quite apart from issues of social responsibility or regulatory compliance, they were bad business, and bad for the markets in which they operated. In some cases, trading desks in one part of the firm benefited at the expense of others in the same firm; in others, practices that were profitable on one day likely led to losses on others; and, more generally, persistent market misconduct risked giving firms, or entire markets, the reputation of being akin to the ‘wild west’. How did this happen? Part of the answer is that firms lost control of their trading teams, or mis-incentivised them. Conflicts of interest were allowed to range unchecked. And traders were put in positions where they could cause mortal damage to their firms’ franchises for, at best, modest profit opportunities. Now, as a direct result, firms’ senior management are being assailed with advice, demands, and ‘shoulds and shouldn’ts’ from every direction. But, for those who still believe in the basic market discipline story, the real question is: how did firms so fundamentally misunderstand their own long-term interests – and those of the markets in which they operated and on which the global economy relies? And how can those interests be re-established? In one sense, the supervisory and regulatory interventions seen since the crisis, together with the huge enforcement fines, may be seen as substitutes for the incentives to good conduct that the market failed to deliver. But if those interventions are not to have to become ever more draconian over time, we must also find ways to re-energise the discipline of the market – to return to what Governor Mark Carney has termed ‘true’ markets – free from collusion, manipulation, abuse of private information, transparent, open and competitive.

Now all of this may seem a bit high-falutin’ compared to some of the more practical questions on the agenda of this conference. Shouldn’t we just get on with finding practical steps to ensure that bad guys don’t again imperil firms’ livelihoods and reputations? Certainly that is a crucial part of it. But a repeated theme stressed to us throughout the Fair and Effective Markets Review consultation, and heard again at this conference, has been the importance of ensuring that the new structures being put in place to manage conduct are aligned with the business, and not in some sense parallel to, or outside of, it. Structures that fail to meet this test may be considered crucial today, when memories of the crisis and the enormous fines that followed are still fresh. But the risk is they get progressively de-emphasised as memories fade, budget rounds come and go, and new priorities emerge. There is currently an enormous focus on conduct in most firms, as there was after previous historical bouts of market abuse. But all of you know the challenges that can arise in trying to drive through lasting change: getting particular business lines to think outside their silos; securing adequate Board time for conduct discussions; ensuring conduct gets an appropriate weight in annual bonus round discussions – even where it conflicts with revenue considerations; or getting trading staff to attend training courses. There is at least a risk that the current focus on conduct risk may turn out to be like that annual New Year’s Resolution to visit the gym every day, refreshed no doubt sincerely every January, but looking a little threadbare by mid-year… The only way to ensure that This Time Is Different is to ensure that (a) effective market disciplines are re-established, and (b) that conduct risk management is intimately aligned with (indeed, arguably identical to) the successful running of the business, rather than something (to overstate for effect) that is done primarily to look good to the world, the regulator, or others. In that regard I found Chris Severson’s discussion of the parallel between naval aviation and banking conduct on the first day of this conference very revealing. Navy pilots don’t obsess over safety for appearance’s sake, or out of fear of a fine or court-martial from the authorities. They do it because if you’re not safe, you (or others) die. We need to ensure that incentives are similarly aligned in banking. Traders will never face the same threat to life and limb as fighter pilots. But nothing focuses the mind as effectively as the knowledge that professional demise for themselves and their teams is a real possibility if they don’t conduct themselves properly. As a recent report by Oliver Wyman put it, to get proper engagement from the frontline, conduct risk management needs to be described as good business practice rather than compliance with rules. Achieving that will require a joint effort by market participants and the public authorities – and that is a key guiding principle of our Review.

To understand why public and private incentives seem to have diverged in recent years, it is helpful to start from the ideal model I described earlier and ask where it might have broken down. When we began our Review last summer, I – perhaps naively – thought it might prove difficult to identify potential root causes. In fact, the challenge has been to limit the possible explanations to a manageable number. To help structure our analysis, therefore, the Review’s consultation document is based around the framework shown in the table below.Supervisory-Framework

The vertical axis on the Table lists six key potential sources of abuse or vulnerability. Three relate to the structure of markets, and three to the conduct within them. The horizontal axis of the Table is important too. Market participants have sometimes argued to us that the main failing in recent years was by regulators, who should have been more vigilant for the abuse perpetrated by a handful of ‘bad apples’, and tougher in prosecuting it. In fact, as Minouche Shafik, the Chair of the Review, has argued, the scale of the problem clearly extends beyond a few bad apples4. But even if that were not the case, I am not sure how often those making these points have thought through the consequences of espousing this view. Market participants are far closer to the day-to-day operation of markets than regulators can ever hope to be; market discipline, as I have argued, is a potent force if properly engaged; and, to put it politely, we do not tend to be overwhelmed with requests from the industry for tougher, more intrusive (and inevitably more expensive) regulation. Recommendations for further, targeted, regulatory interventions must remain part of the Review’s toolkit. But a key message we want to get across is that many of the solutions could more plausibly lie in the hands of the market, guided or catalysed by the authorities where required. In that regard we are fortunate to have the services of a dedicated Market Practitioners Panel, chaired by Elizabeth Corley of Allianz Global Investors, and consisting of senior business heads from the buy-side, sell-side and end user communities, together with infrastructure providers and independent experts. Let me briefly highlight a few of the areas in which the ideal model might have broken down, using Table A as a guide.

The first row, grandly titled ‘market microstructure’, posits that some wholesale markets may not be as deep, liquid or transparent as the ideal suggests. A key issue in the LIBOR abuses, for example, was that the benchmark was based on an exceedingly thin underlying market for unsecured interbank borrowing. Markets for some other FICC products, such as some types of corporate bonds for example, can also be highly illiquid – and, partly as a result, transparency levels can also be relatively low. Thin or ‘dark’ markets can be easier to manipulate.

The second row of the Table asks whether a lack of effective competition or market discipline may have played a role in recent abuses. Both the LIBOR and the FX misconduct cases involved striking examples of collusion between traders – indeed in the case of FX in particular, it is hard to see how any market manipulation would have been possible in such deep and liquid markets without it. Increased concentration and horizontal integration in wholesale markets in recent years may also have increased the scope of potential conflicts of interest and reduced the ability of market users to shop around – which as I mentioned earlier is such a crucial part of the historical market discipline paradigm. Many, if not most, of the recent major cases of misconduct in FICC markets, highlighted weaknesses in the design of benchmarks – which is the third and final structural category in the Table. The flaws were remarkably varied, and depended significantly on the design of individual benchmarks – LIBOR for example was insufficiently grounded in actual transactions, the WMR FX benchmark had too narrow a window, and precious metals benchmarks were insufficiently transparent. A common feature however was that the design, technology and governance arrangements around measures that had once probably been adequate for small-scale usage had failed to keep pace with the massive increase in scale and diversification of their usage, creating opportunities for abuse or misconduct that were unlikely to have been as evident when the measures were first created. There has been rapid evolution in FICC market structures under all three categories in recent years, driven by both regulatory and technological change. Under market microstructure, the G20 commitments on OTC derivatives, MiFID2 in Europe and Dodd-Frank in the US, the new post-crisis Basel capital and leverage requirements, and intense pressure on revenues and costs are all driving FICC markets towards a more transparent, standardised, agency-based trading model. Under competition, the highly integrated investment bank business model has become less economic than it once was, and multiple electronic platforms are competing for new business. And under benchmarks, there has been a massive push from regulators and administrators to strengthen the design and oversight of key measures – including the Wheatley reforms to LIBOR, the IOSCO standards for benchmarks, the Financial Stability Board (FSB) reviews of interest rate and FX benchmarks, and the Fair and Effective Markets Review’s own recommendations to bring a further seven major benchmarks into UK legislation, which have been accepted by Government. The challenge for and effective market conditions over time. Or whether further steps are needed to ensure that market discipline can again play a full role in maintaining good standards of market conduct.

The lower half of the Table covers conduct issues in FICC markets, and therefore has a more direct bearing on the issues being discussed at this conference. The fourth row asks whether the standards that market practices should adhere to have been sufficiently clear, or well understood, in FICC markets. As you will all be aware, any effective conduct programme has to start with a clear description of the behaviours that you as a firm expect to see from your staff. Enforcement cases – of which there have regrettably been many in recent years – provide one clear set of anchors for this work. But how clear are you about the appropriate standards in less egregious cases? How do you identify or promulgate appropriate ‘case law’ in FICC markets? Are the various market codes currently in existence helpful, or do they need strengthening? And is the regulatory perimeter in the right place, whether in spot FX markets or elsewhere? Once appropriate standards have been established, the fifth row of the Table asks how you establish clear accountabilities within your organisation, how you monitor and control those accountabilities, and how you ensure that incentives are appropriately aligned with good behaviour. Much of our discussion yesterday fell under this heading – and no surprise because it was arguably failings in this area more than any other that drove recent misconduct. As some of the enforcement notices vividly illustrate, either by design or by neglect, some traders were able to behave in ways that directly harmed the reputations of their own firms. How was this allowed to happen? Had responsibility for oversight been delegated too far from the so-called First Line of Defence (or trading heads)? Were incentives appropriately aligned? Were some firms Too Big to Fail, or Too Big to Manage? And how did Boards monitor conduct across their organisations?

The final row in the Table highlights the importance of having effective tools for identifying and punishing misbehaviour. Often this is seen as being primarily the responsibility of regulators – but as I think everyone now recognises that is far too much of a ‘hands off’ attitude for something that can threaten a firm’s very survival. Regulation provides a crucial backstop. But regulators have neither the data nor the resources to spot every misdemeanour – and supervisory and enforcement actions cannot substitute for developing an appropriate culture within individual firms. What surveillance tools can firms themselves install and operate? How do you develop a culture in which whistleblowing is encouraged, and decisive action is taken against breaches of standards? Is it still too easy for misbehaving traders to avoid censure by changing employers? And how and when should firms consider making disciplinary cases public as a means of sending a clear signal? As with market structure, a great deal of change is underway in an attempt to strengthen conduct. We have heard about all the supervisory work underway by the FCA. The United Kingdom has introduced, or is in the process of introducing, major new rules on remuneration, on the responsibilities of Senior Managers, and on criminal sanctions for benchmark manipulation. The FSB and the major central banks have promulgated new standards for behaviour in FX markets. We heard from Sir Richard Lambert about the important work of the Banking Standards Review Council. And, as we have been discussing over the past two days, firms have themselves invested substantial sums in new conduct risk processes. Much has been achieved since the peak of the financial crisis, on both the regulatory and private side. A key role of the Fair and Effective Markets Review is to take stock of that progress, and celebrate it where it is appropriate to do so. At the same time however some of the behaviours highlighted in the recent enforcement cases occurred worryingly recently – and in areas which seem surprisingly close, both physically and functionally, to very similar abuses in LIBOR and elsewhere that had occurred, in some cases in the same companies, only shortly before. At the very least that raises questions about the ability of firms to learn from past mistakes and think laterally about the lessons for other parts of their business. It has been encouraging to hear over the past two days about some of the ways that firms are now seeking to tackle those challenges. A question for the Review is whether these changes have gone far enough, or whether we need to provide further support to those efforts, working collaboratively with market participants wherever possible, when we produce our final recommendations in June.

To return to where I came in, we need markets to work well, in the interests of everyone. The purpose of the Fair and Effective Markets Review is not to hinder the operation of wholesale markets unnecessarily, but to return them to fairer and more effective operation. To be crystal clear, markets characterised by collusion, manipulation or abuse of private information are not working effectively. The potential power of market discipline means that, where we can work with the grain of markets, we will. Reform to internal control processes is essential, and the discussions at this conference are encouraging in that regard. But as conference participants have repeatedly emphasised, processes that operate in parallel to, or isolated from, the business, focusing on regulatory compliance, or simply preventing the re-emergence of old vulnerabilities, will not survive over the cycle – they will die out as memories fade, budget rounds come and go, and those who never believed in them spot their moment and strike. The tests are – do they work with the grain of the business and markets in which their firms operate? Do they have the engagement of senior management, because they matter to the business – not only when the supervisory lights are on, but also when they are off? Do trading staff understand they have to be involved – not because they are expected to, but because it is essential to being successful? Achieving that alignment is essential to us all – and I hope that the Fair and Effective Markets Review can play its part in that process.

The Debt Trap

In a speech given by Mark Carney, Governor of the Bank of England in Dublin, entitled “Fortune favours the bold” there is a good summary of the debt trap which is underlying the current economic environment. The speech describes how the debt trap was set, and how it is wagging the market dog.

Setting the debt trap

Building the debt that now weighs on our economies was the work of a generation. In the decade before the crisis, private financial balances became unsustainable. UK households borrowed 4% of GDP year after year; Irish households at more than twice that rate. Household debt peaked close to 100% of GDP in the UK, and 120% in Ireland. This borrowing was largely for consumption and real estate investment rather than businesses and projects that would generate the earnings necessary to service those obligations. Property prices soared as a result. Such excesses were possible because a decade of non-inflationary, consistent expansion turned initially well-founded confidence into dangerous complacency. Beliefs grew that globalisation and technology would drive perpetual growth, and that the omniscience of central banks would deliver enduring stability.

With a growing conviction that financial innovation had transformed risk into certainty, underwriting standards slipped from responsible to reckless and bank funding strategies from conservative to cavalier. Financial innovation made it easier to borrow. Bonus schemes valued the present and discounted the future. Banks operated in a heads-I-win-tails-you-lose bubble and were capitalised for perfection. And a steady supply of foreign capital from the global savings glut – and in Ireland’s case, the initial euphoria of European Monetary Union – made it all cheaper. When the Minsky moment finally struck, debt tolerance decisively turned and the kindness of strangers evaporated. UK households swung from borrowing 4% of GDP annually to saving 2% of GDP. The comparable swing in Ireland was more than twice as large.

In the wake of the crisis, three truths came back to the fore.

  • First, while asset prices rise and fall, debt endures.
  • Second, the distribution of debt and assets matters.
  • And third, it is very hard to reduce high debt in one sector or region without at least temporarily increasing it in another.

The debt tail is wagging the market dog.

These realities continue to weigh on the European financial system. It is often argued that the world is awash with liquidity and excessive risk taking. And yet the rain is falling unevenly on the plain leaving some regions parched and others sodden. Savings aren’t flowing freely to the areas that need them the most. This is certainly true in the euro area, where many savings are trapped and much of finance remains fragmented. The result is demand compression, weighing on the outlook for growth and sustaining fears that another major adverse shock is possible. Risk appetite is more fleeting than median growth forecasts suggest. The constellation of asset price moves since last summer bears this sober assessment out. Yields on sovereign bonds have fallen across all maturities. France hasn’t borrowed this cheaply since the ‘50s – the 1750s. Real rates are negative as far as the eye can see, suggesting perpetually anaemic growth.

In the past six months, estimates of the equity risk premium have risen by over 100bps in the UK and the euro area back to levels last seen in the heart of the crisis. In addition, the probability of large declines in equity prices implied by options prices rebounded during 2014. This all suggests that investors may be attaching some probability to very bad outcomes, possibly the tail risk of economies becoming stranded in a debt trap. This market view is mirrored in elevated corporate caution. Investment remains subdued and businesses continue to build cash in many advanced economies. This is one reason why the so-called ‘equilibrium’ real interest rate is negative in many advanced economies, though it has risen and is possibly now positive in others like the UK. Reflecting these real dynamics, central bank interest rates have had to be set at extraordinarily low levels and supplemented by large scale asset purchases simply for monetary policy to
remain neutral.

Escaping a debt trap requires a suite of measures including structural reforms to boost productivity. But above all an economy needs to be able to channel all available savings – household, corporate and foreign – to those sectors willing and able to spend.

CPI Down To 1.7%

According to the ABS, the Consumer Price Index (CPI) rose 0.2% in the December quarter 2014, following a rise of 0.5% in the September quarter 2014. The CPI is trending down at the moment.

CPI-Dec-2014-ALL

The most significant price rises this quarter were for domestic holiday travel and accommodation (+5.8%), tobacco (+4.8%) and new dwelling purchase by owner-occupiers (+1.1%), These rises were partially offset by a fall in automotive fuel (–6.8%). Global oil markets continue to experience oversupply, which resulted in continued falls in oil prices. In Australia, average unleaded petrol prices reached a low of $1.17 per litre in December 2014, the lowest recorded average daily price since February 2009.

The CPI rose 1.7% through the year to the December quarter 2014, following a rise of 2.3% through the year to the September quarter 2014.

The fall in CPI may stimulate calls for the RBA to cut rates, but given that oil price falls already acts as a quasi rate cut, DFA believes a further cut in official rates is not required. The lower dollar and stable unemployment data also suggests there is no need for cuts, indeed, the next movement should be upwards.

Global Liquidity, House Prices and the Macroeconomy

The Bank of England just published a research paper on “Global liquidity, house prices and the macroeconomy: evidence from advanced and emerging economies“. This paper compares house price cycles in advanced and emerging economies using a new quarterly house price data set covering the period 1990-2012 and models the impact of changing global liquidity, broadly understood as a proxy for the international supply of credit by aggregating bank-to-bank cross-border credit flows.  They find that house prices in emerging economies grow faster, are more volatile, less persistent and less synchronised across countries than in advanced economies. They suggest that house prices amplify the response to global liquidity shocks in both advanced and emerging economies, but through different mechanisms. In advanced economies, arguably by boosting the value of housing collateral and hence supporting more household borrowing; whereas in emerging markets, by generating a lower default risk and a more appreciated exchange rate that support the international borrowing capacity of the economy.

They observe that the exchange rate seems to have a traditional shock absorbing role in advanced economies and collateral valuation effect in emerging economies. Indeed, studying the interaction between house prices and the exchange rate in models with both domestic and international financial friction may be an interesting area of future research.

Cyber Resilience: A Financial Stability Perspective

Andrew Gracie, Executive Director, Resolution, Bank of England, spoke at the Cyber Defence and Network Security conference, London on Cyber Resilence and its impact on financial stability. He argues that cyber is an ever-present threat and firms need to stand ready to manage this risk. And just as cyber has changed the world for firms, it has also changed the landscape for authorities; so they need to adapt their approach to operational resilience of the financial sector as a whole. He outlines two areas of focus for the regulators. First, dialogue with the main industry firms, and second, with their agreement, stress testing and simulations to test response frameworks. Indeed, a joint testing programme between US and UK governments and authorities will start this year. This is because cyber knows no borders and the significant operational inter-linkages between systems cross borders and it reflects the growing dialogue with the US and others as to how best to manage the risk to financial stability from cyber. He also makes three observations:

  1. Cyber has changed the rules: existing operational resilience arrangements are often geared to dealing with physical threats. These still matter. But cyber changes the game. Cyber is a dynamic, intelligent and adaptive threat. In the cyber arms race, costs are stacked in favour of the attacker, not the defender. To meet the challenge, organisations need to have policies and processes that are dynamic, intelligent and adaptive too. This means investment in capability to identify threats and detect cyber attacks. Without this situational awareness it is hard to determine and achieve appropriate maturity levels for cyber defence and to allocate resources effectively to meet the threat.
  2. Cyber is not a minority sport for technologists only: Of course the first line of defence is critical and we still need IT specialists who understand the technical challenges cyber presents. But good cyber resilience is about much more than technology. It is about culture too and this means people and processes. All parts of an organisation need to understand cyber risk and their responsibilities towards improved cyber hygiene. This includes Board level engagement. Front line business areas need to understand and own the risk. Management of cyber vulnerabilities needs to feature in strategic planning.
  3. Cyber requires effective and regular testing: Of people, processes and technology. Industry investment in cyber is significant but testing the effectiveness of this investment has not kept pace. Assurance is often based on audits and control sampling which is not sufficient, not least because of the challenge for internal audit departments to keep pace with change in this area. And of course, given the dynamic nature of the threat, such tests should take place on a regular basis.

Finally, he highlights that firms need to cooperate not compete in this space. With that in mind, the regulators are working with industry to strengthen arrangements for information sharing, reviewing existing forums for tactical information sharing and supplementing them where necessary with arrangements for more strategic information sharing including on good practice.