Digital Finance Analytics (DFA) Blog – Page 1053

Australian Population Now 23.4m And Ageing

The ABS just released their preliminary demographic statistics to end March 2014. Australia’s total population increased by 388,400 people to reach 23.4 million by the end of March 2014, with a growth rate of 1.7 per cent, a continuation of the average annual growth rate for the past three years. Natural increase contributed 156,900 people to Australia’s population in the year to 31 March 2014, consisting of 306,500 births and 149,600 deaths. Net overseas migration contributed 231,500 to the population over the same period, accounting for 60 per cent of Australia’s total growth.

All states and territories recorded positive population growth in the year ended 31 March 2014. Western Australia continued to record the fastest growth rate of all states and territories at 2.5%. Tasmania recorded the slowest growth rate at 0.3%. New South Wales and Victoria continued to experience high population growth going against the trend of slowing annual growth around Australia – the population of New South Wales and Victoria grew by 114,500 and 108,800 respectively. Net overseas migration (NOM) was the main contributor to both New South Wales and Victoria’s population growth, accounting for 67 and 57 per cent of the states’ growth respectively. The NOM contribution to Victoria’s growth is below the Australian rate of 60 per cent, which highlights the recent increase in net interstate migration to the state. We’re also seeing fewer people moving to Queensland and Western Australia. Queensland recorded one of its lowest annual gains on record, slowing by 65 per cent in five years. Meanwhile, New South Wales recorded its lowest annual interstate loss in nearly 30 years and Victoria recorded its highest annual gain on record.
There is a significant skew towards older Australians, as can be seen by the relative movement from 1971, by age bands. In fact in absolute numbers, those under 20 years grew the slowest whilst those aged 40-69 grew the fastest. This has a profound impact on the community, with those planning to retire well ahead of new workers ready to join the workforce – yet youth unemployment is very high, as we discussed recently.

We can also look at the splits in percentage terms, which shows again these trends. In 1971, the fiftieth point was 27 years, today it is 38 years, and rising.

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.

Mortgage Stress Coming To A Household Near You

We have updated our mortgage stress models, to take account of the latest tranche of economic data, including falling real incomes, potential uplifts in capital requirements and inflation running hot, so creating the need to lift interest rates; and demand for property continuing to go ahead of supply. Our recent post the Anatomy of Mortgage Stress explains our modelling assumptions, and importantly the definitions of stress we are using. We also explained why households are highly vulnerable to mortgage stress, because of larger loans, and flat incomes in our article If The Worm Turns. Today we will look at our projections out to 2017, once we factor in these various drivers. It is only one scenario, but this is our central case.

We use a series of questions to diagnose mortgage stress focusing on owner occupied households. Through these questions we identify two levels of stress – Mild and Severe.

Mild = households maintaining repayments, but by reprioritising expenditure, borrowing more on loans or cards, and refinancing
Severe = households who are behind with their repayments, are trying to sell, are trying to refinance, or who are being foreclosed

First we will look at the Australia-wide projections. We expect to see stress amongst first time buyers lift considerably from its current relative low levels. If rates do rise, unemployment stays high, and incomes continue to languish, then by 2017, we think that 40% of first time buyers will be in mortgage stress. Many who brought in the 2008-2009 boom are likely to be hardest hit. More recently the number of first time buyers has fallen to a long term low, so the number of more recent first time buyer households in stress will be lower.

We can look at the state variations. We see that VIC and QLD first time buyers are more likely to be impacted, whilst SA households less so, with WA and NSW first time buyer households sitting in the middle. This is partly a function of absolute house prices, and partly a function of income and unemployment trends across the states. We did not include the smaller states on the chart, but they are included in the average.

Finally, we look at the other, non-first time buyer households. Many continue to pay more than the minimum monthly mortgage repayments, taking advantage of the current low rates so they have some protection. However, as rates and unemployment bites, some households who have held property for some time will also experience stress. By 2017 up to 15% of established households will be in stress in our central scenario.

Our research suggests there is an 18 month to 2 year grind between the onset of stress and households taking bold steps (or forced to) like selling up. Before that, they often get into the debt cycle of more credit card debt, refinancing, and a general hunkering down to try and keep the mortgage payments going. It is the broader economic impact of this refusal spend which will have a significant dampening impact on economic growth. In addition the outworking of stress leads to selling a property, so we would expect to being to see some forced sales in 2017 and beyond, another reason why we think house prices are likely to correct to more normal loan to income ratios.

In coming posts, we will look further at the state and postcode level data.

SME’s Business Grinds On

We have just received the latest findings from our Small and Medium Business surveys, which shows that many are still running hard to stand still and are unwilling or unable to borrow more. The sector is an important bell-weather for the broader economy, because nearly half of all Australian households are reliant in part or in full on income from the sector, as either an owner of a small business, or employed by one.

We asked them about their likelihood to borrow (slightly more than half need to fund their businesses from loans) and 28% were less likely to borrow than a year ago.

Barriers to funding included the inability to find a lender, lack of security for a loan, the expense of borrowing, or simply maxed out already based on cash flow.

The main requirement was for working capital, rather than funding for business growth. Finance for vehicles was down a little compared with last year.

The demand for working capital was driven by many reasons, but the length of time to get paid was most significant, followed by borrowing to pay GST or tax.

The average debtor days remains significantly higher than pre-GFC, and clearly extended days chimes with the need for more working capital.

Finally, there is a small rise in bank switching, but still many SME’s do not. More than 60% have never switched banks.

We will publish some more detailed analysis in later posts. Meantime, you can read about our SME research programme, and last report here.

Foreign Commercial Property Investment Significant – RBA

In the RBA Bulletin there is an interesting analysis of foreign property investors in the commercial sector. The FIRB publish data on approvals for proposed foreign investment on an annual basis. The value of these approvals has increased substantially in recent years, from $11 billion in 2009/10 to nearly $35 billion in 2012/13

Foreigners have accounted for around one-quarter of the value of commercial property purchases in Australia since 2008, up from one-tenth in the previous 15 years. In the first half of 2014, they purchased nearly $5 billion worth of commercial property, about 40 per cent of the value of properties that were sold. Net purchases (which also account for sales) by foreigners amounted to $4 billion in the first half of 2014, close to its level for all of 2013.

The recent increase in foreign investment has been most pronounced in the market for office property. Foreigners’ purchases have accounted for around one-third of the value of turnover of office buildings since 2008, with purchases consistently exceeding the value of foreign sales.

Since 2008, foreign buyers have accounted for 40 per cent of the value of purchases in New South Wales, compared with 20 per cent of turnover in Victoria, Queensland and Western Australia. Foreigners’ preference for New South Wales reflects their strong appetite for office buildings in the Sydney CBD, which industry participants attribute to the greater liquidity of the market and the large amount of prime-grade office space.

Foreigners from many parts of the world have become more active in Australian commercial property markets, although much of the rise in net investment in the past few years reflects an increase in purchases by investors based in Asia and North America. Net investment from Europe has also increased, albeit by much less.

They conclude that the available data indicates that foreign investment in commercial property has increased in recent years, with foreigners having accounted for around one-quarter of the value of commercial property purchases in Australia since 2008. The higher demand for Australian buildings has been broad based across a range of institutions from Asia and North America, although sovereign wealth funds and pension funds have accounted for a greater share of foreign investment more recently. Foreign buyers have typically purchased existing buildings, enabling domestic firms to sell assets for higher prices, supporting their financial position and freeing up capital to be used on new developments. To date, foreigners have shown a preference for purchasing office buildings in New South Wales, but analysts expect foreigners to spread into other markets as they become more familiar with Australia. In any case, foreigners’ acquisitions have benefited developers operating in several states and sectors, and so the indirect effects on construction activity have not been constrained to the New South Wales office market.

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.

Further High House Price Evidence – BIS

The BIS has published the latest data from their analysis of house prices across countries. “The BIS currently publishes more than 300 price series for 55 countries, among which it has selected one representative series for each country. For 18 countries, it also publishes series that span the period back to the early 1970s. House prices can serve as key indicators of financial stability risks, as property booms are often the source of vulnerabilities that lead to systemic crises.”

They show that in trend terms, after correcting for inflation and seasonality, Australian prices are relatively higher than other advanced countries. This is consisted with data from the IMF, Economist, and DFA’s own analysis. “Year-on-year residential property prices, deflated by CPI, rose by 9.5% in the United States and 6% in the United Kingdom. Real house prices also grew, by 7% in Canada, 7.7% in Australia and 2.2% in Switzerland, three countries that were less affected by the crisis, as well as in some countries that were severely affected by the crisis, such as Ireland (+7.2%) and Iceland (+6.4%)”.

They also show the relative benchmark between house price growth and price to rent. Here, overall average house price growth, after inflation, in Australia is close to zero over the last three years (because of averages across the states, the ABS shows how prices vary state by state), and Australia has high price to rent rations, but not the highest. This is because rents are more linked to interest rates and income growth than house prices directly.

Turning to their other measure, comparing house prices to income ratios (the measure we prefer as the best judge of house prices), we find that Australia is shown as the second highest, after Belgium, despite the close of zero growth in absolute prices, after inflation, in the past 3 years.

The codes for the various countries are listed below:

Their comments are important:

Work at the BIS has pointed to the early warning indicator properties of real estate prices. Leverage fuelled housing booms that turn into busts have so often been at the very heart of episodes of systemic distress. Historical experience has demonstrated that the interactions between rapidly growing house prices and excessive credit expansion are a tell-tale sign of the build-up of vulnerabilities in the household sector and the source of future losses for banks.

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.

Strong Investment Lending In Latest Finance Data

In the final element of the monthly series, the ABS today released their lending data for July. The total value of owner occupied housing commitments excluding alterations and additions rose 0.3% in trend terms and the seasonally adjusted series was flat. The trend series for the value of total personal finance commitments rose 0.4%. Revolving credit commitments rose 0.8% and fixed lending commitments rose 0.1%. The seasonally adjusted series for the value of total personal finance commitments fell 1.3%.

Revolving credit commitments fell 4.7%, while fixed lending commitments rose 1.5%. The trend series for the value of total commercial finance commitments rose 2.7%. Revolving credit commitments rose 5.1% and fixed lending commitments rose 1.6%. The seasonally adjusted series for the value of total commercial finance commitments rose 3.7% in July 2014, following a rise of 11.8% in June 2014. Fixed lending commitments rose 20.7%, following a rise of 0.8% in the previous month. Revolving credit commitments fell 25.9%, after a rise of 37.7% in the previous month. Looking at the data in more detail, we see the concentration of lending by the banks (and mainly the big four).

Within the commercial category, lending for housing investment by individuals was a significant element. Here is the absolute dollar amount by states, with a trend line, showing the relative strength in lending for investment purposes in NSW in particular, then VIC. The investment lending boom is not uniformly spread across the country. Another way to look at the data is on a per capita basis across each state. This chart shows the average amount per capita between January 2011 and July 2014. The movement is NSW in particular since May 2013 highlights both the volume and size of the average loans for investment purposes in NSW, compared with the other states. It is also worth noting the differences between NSW and some of the other states, especially TAS and SA, and we see WA, NT and VIC roughly marching together, behind the rabid pace set by NSW.