Tag: BIS

Guidelines for identifying and dealing with weak banks released by the Basel Committee

The Basel Committee on Banking Supervision today published the final Guidelines for identifying and dealing with weak banks.

Weak banks are a worldwide phenomenon. They pose a continuing challenge for bank supervisors and resolution authorities in all countries, regardless of the political structure, financial system and level of economic and technical development. All bank supervisors should be prepared to mitigate the incidence of weak banks and deal with them when they occur.

A weak bank can be defined in various ways. In this report, it is “one whose liquidity or solvency is impaired or will soon be impaired unless there is a major improvement in its financial resources, risk profile, business model, risk management systems and controls, and/or quality of governance and management in a timely manner”. In cases where a bank is no longer viable, or likely to be no longer viable, and has no reasonable prospect of becoming viable once again, the authorities should resolve the institution without severe systemic disruption and without exposing taxpayers to loss, while protecting its critical functions. It may well be that the bank as a legal entity ceases to exist, but it should do so in a way that seeks to ensure continuity of access to the critical functions necessary to maintain financial stability and confidence in the financial system.

In the light of the significant post-crisis developments in financial markets and the regulatory landscape, the Committee has updated its 2002 Supervisory guidance on dealing with weak banks. Key changes include:

  • emphasising the need for early intervention and the use of recovery and resolution tools, and updating supervisory communication policies for distressed banks;
  • providing further guidance for improving supervisory processes, such as incorporating macroprudential assessments, stress testing and business model analysis, and reinforcing the importance of sound corporate governance at banks;
  • highlighting the issues of liquidity shortfalls, excessive risk concentrations, misaligned compensation and inadequate risk management; and
  • expanding guidelines for information-sharing and cooperation among relevant authorities.

Part I of the report discusses the underlying supervisory preconditions for dealing with weak banks and techniques that will allow the supervisor to identify problems. These phases include preparatory work on recovery and resolution issues. Part II concerns the corrective measures available to turn around a weak bank and, for resolution authorities, tools for dealing with failing or failed banks.

A consultative version of this paper was published for comment in June 2014.

BIS Warnings Must Be Heeded

The 85th Annual Report from the Bank for International Settlements has just been released. This is an important document because in its economic chapters the authors attempt to get to grips with some of the critical issues creating uncertainty in the global economy and the financial system.  Here is a summary of the main arguments.

Chapter I: Is the unthinkable becoming routine?

Globally, interest rates have been extraordinarily low for an exceptionally long time, in nominal and inflation-adjusted terms, against any benchmark. Such low rates are the most remarkable symptom of a broader malaise in the global economy: the economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited. The unthinkable risks becoming routine and being perceived as the new normal. This malaise has proved exceedingly difficult to understand. The chapter argues that it reflects to a considerable extent the failure to come to grips with financial booms and busts that leave deep and enduring economic scars. In the long term, this runs the risk of entrenching instability and chronic weakness. There is both a domestic and an international dimension to all this. Domestic policy regimes have been too narrowly concerned with stabilising short-term output and inflation and have lost sight of slower-moving but more costly financial booms and busts. And the international monetary and financial system has spread easy monetary and financial conditions in the core economies to other economies through exchange rate and capital flow pressures, furthering the build-up of financial vulnerabilities. Short-term gain risks being bought at the cost of long-term pain. Addressing these deficiencies requires a triple rebalancing in national and international policy frameworks: away from illusory short-term macroeconomic finetuning towards medium-term strategies; away from overwhelming attention to near-term output and inflation towards a more systematic response to slowermoving financial cycles; and away from a narrow own-house-in-order doctrine to one that recognises the costly interplay of domestic-focused policies. One essential element of this rebalancing will be to rely less on demand management policies and more on structural ones, so as to abandon the debt-fuelled growth model that has acted as a political and social substitute for productivity-enhancing reforms. The dividend from lower oil prices provides an opportunity that should not be missed. Monetary policy has been overburdened for far too long. It must be part of the answer but cannot be the whole answer. The unthinkable should not be allowed to become routine.

BIS-85-1Chapter II: Global financial markets remain dependent on central banks

Accommodative monetary policies continued to lift prices in global asset markets in the past year, while diverging expectations about Federal Reserve and ECB policies sent the dollar and the euro in opposite directions. As the dollar soared, oil prices fell sharply, reflecting a mix of expected production and consumption, attitudes to risk and financing conditions. Bond yields in advanced economies continued to fall throughout much of the period under review and bond markets entered uncharted territory as nominal bond yields fell below zero in many markets. This reflected falling term premia and lower expected policy rates. The fragility of otherwise buoyant markets was underscored by increasingly frequent bouts of volatility and signs of reduced market liquidity. Such signs were perhaps clearest in fixed income markets, where market-makers have scaled back their activities and market-making has increasingly concentrated in the most liquid bonds. As other types of players, such as asset managers, have taken their place, the risk of “liquidity illusion” has increased: market liquidity appears ample in normal times, but vanishes quickly during market stress.

BIS-85-2 Chapter III: When the financial becomes real

Plummeting oil prices and a surging US dollar shaped global activity in the year under review. These large changes in key markets caught economies at different stages of their business and financial cycles. The business cycle upswing in the advanced economies continued and growth returned to several of the crisis-hit economies in the euro area. At the same time, financial downswings are bottoming out in some of the economies hardest-hit by the Great Financial Crisis. But the resource misallocations stemming from the pre-crisis financial boom continue to hold back productivity growth. Other countries, less affected by the crisis, notably many EMEs, are experiencing different challenges. The shift in global conditions has coincided with slowing output growth and peaks in domestic financial cycles. There is the danger that slowing growth in EMEs could expose financial vulnerabilities. Better macroeconomic management and more robust financial structures, including longer debt maturities and reduced exposure to currency risk, have increased resilience. But the overall amount of debt has increased and the shift from banks to capital market funding could raise new risks.

BIS-85-3Chapter IV: Another year of monetary policy accommodation

Monetary policy continued to be exceptionally accommodative, with many authorities easing or delaying tightening. For some central banks, the ultra-low policy rate environment was reinforced with large-scale asset purchase programmes. In the major advanced economies, central banks pursued significantly divergent policy trajectories, but all remained concerned about the dangers of inflation running well below inflation objectives. In most other economies, inflation rates deviated from targets, being surprisingly low for some and high for others. The deviation of inflation from expected levels and questions surrounding the sources of price changes underscore an incomplete understanding of the inflation process, especially regarding its medium- and long-term drivers. At the same time, signs of growing financial imbalances around the globe highlight the risks of accommodative monetary policies. The persistence of those policies since the crisis casts doubt on the suitability of current monetary policy frameworks and suggests that resolving the tension between price stability and financial stability is the key challenge. This puts a premium on accounting for financial stability concerns much more systematically in monetary policy frameworks.

BIS-85-4Chapter V: The international monetary and financial system

The suitable design of international monetary and financial arrangements for the global economy is a long-standing issue. A key shortcoming of the existing system is that it tends to heighten the risk of financial imbalances, leading to booms and busts in credit and asset prices with serious macroeconomic consequences. These imbalances often occur simultaneously across countries, deriving strength from international spillovers of various types. The global use of the dollar and the euro allows monetary conditions to affect borrowers well beyond the respective issuing economies. Many countries also import monetary conditions when setting policy rates to limit interest rate differentials and exchange rate movements against the major currencies. The global integration of financial markets tends to reinforce these dynamics, by allowing common factors to drive capital flows and a common price of risk to move bond and equity prices. Policies to keep one’s own house in order by managing financial cycles would help to reduce such spillovers. In addition,
central banks need to better internalise spillovers, not least to avoid the effects of their actions spilling back into their own economies. Moving beyond enlightened self-interest would require international cooperation on rules constraining domestic policies.

BIS-85-5Chapter VI: Old and new risks in the financial landscape

Risks in the financial system have evolved against the backdrop of persistently low interest rates in advanced economies. Despite substantial efforts to strengthen their capital and liquidity positions, advanced economy banks still face market scepticism. As a result, they have lost some of their traditional funding advantage relative to potential customers. This adds to the challenges stemming from the gradual erosion of interest income and banks’ growing exposure to interest rate risk, which could weaken their resilience in the future. By contrast, EME banks have so far benefited from market optimism amid buoyant conditions that may be masking the build-up of financial imbalances. For their part, insurance companies and pension funds have faced ballooning liabilities and muted asset returns. Asset-liability mismatches are weakening institutional investors and threaten to spill over into the real economy. As these investors offload risks onto their customers and banks retreat from traditional intermediation, asset managers are taking on an increasingly
important role. Regulatory authorities are carefully monitoring the financial stability implications of the growing asset management sector.

BIS-85-6

Net Stable Funding Ratio Disclosure Standards – BIS

The Bank for International Settlements has released the template to be used by banks to report their Net Stable Funding Ratio (NSFR). This is a further layer of regulation designed to bolster financial stability.  Supervisors will give effect to the disclosure requirements set out in this standard by no later than 1 January 2018. Banks will be required to comply with these disclosure requirements from the date of the first reporting period after 1 January 2018. The disclosure requirements are applicable to all internationally active banks on a consolidated basis but may be used for other banks and on any subset of entities of internationally active banks to ensure greater consistency and a level playing field between domestic and cross-border banks. The disclosure of quantitative information about the NSFR should follow the common template developed by the Committee.

The fundamental role of banks in financial intermediation makes them inherently vulnerable to liquidity risk, of both an institution-specific and market nature. Financial market developments have increased the complexity of liquidity risk and its management. During the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite meeting the capital requirements then in effect – experienced difficulties because they did not prudently manage their liquidity. The difficulties experienced by some banks arose from failures to observe the basic principles of liquidity risk measurement and management.

In 2008, the Basel Committee on Banking Supervision responded by publishing Principles for Sound Liquidity Risk Management and Supervision (the “Sound Principles”), which provide detailed guidance on the risk management and supervision of funding liquidity risk. The Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards aim to achieve two separate but complementary objectives. The first objective is to promote the short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets (HQLA) to survive a significant stress scenario lasting for 30 days. To this end, the Committee published Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools. The second objective is to reduce funding risk over a longer time horizon by requiring banks to fund their activities with sufficiently stable sources of funding in order to mitigate the risk of future funding stress. To achieve this objective, the Committee published Basel III: The Net Stable Funding Ratio. The NSFR will become a minimum standard by 1 January 2018. This ratio should be equal to at least 100% on an ongoing basis. These standards are an essential component of the set of reforms introduced by Basel III and together will increase banks’ resilience to liquidity shocks, promote a more stable funding profile and enhance overall liquidity risk management.

This disclosure framework is focused on disclosure requirements for the Net Stable Funding Ratio (NSFR). Similar to the LCR disclosure framework,4 this requirement will improve the transparency of regulatory funding requirements, reinforce the Sound Principles, enhance market discipline, and reduce uncertainty in the markets as the NSFR is implemented.

It is important that banks adopt a common public disclosure framework to help market participants consistently assess banks’ funding risk. To promote the consistency and usability of disclosures related to the NSFR, and to enhance market discipline, the Committee has agreed that internationally active banks across member jurisdictions will be required to publish their NSFRs according to a common template. There are, however, some challenges associated with disclosure of funding positions under certain circumstances, including the potential for undesirable dynamics during stress. The Committee has carefully considered this trade-off in formulating the disclosure framework contained in this document.

The disclosure requirements set out in this document are applicable to all internationally active banks on a consolidated basis but may be used for other banks and on any subset of entities of internationally active banks to ensure greater consistency and a level playing field between domestic and cross-border banks.

Banks must publish this disclosure with the same frequency as, and concurrently with, the publication of their financial statements (ie typically quarterly or semi-annually), irrespective of whether the financial statements are audited.

Banks must either include the disclosures required by this document in their published financial reports or, at a minimum, provide a direct and prominent link to the completed disclosure on their websites or in publicly available regulatory reports. Banks must also make available on their websites, or through publicly available regulatory reports, an archive (for a suitable retention period as determined by the relevant supervisors) of all templates relating to prior reporting periods. Irrespective of the location of the disclosure, the minimum disclosure requirements must be in the format required by this document (ie according to the requirements in Section 2).

Making Residential Rental Markets Work for Financial Stability

In an address by Stefan Gerlach, Deputy Governor (Central Banking) of the Central Bank of Ireland, at the Twenty-First Dubrovnik Economic Conference, Dubrovnik, he discussed the rise of the rental market, and the potential implications for financial stability, with specific reference to what happened in Ireland post the GFC. There are some important observation for Australia.

He concludes that economies that experienced boom-bust cycles in housing, such as Croatia and Ireland, suffered disproportionately in the financial crisis. There were numerous reasons for this large impact, many of which are, by now, very familiar. However, it is less frequently noted that those economies with deeper rental markets suffered less. While the specifics of housing policy are outside the remit of central banks, it is incumbent for us to draw attention to issues that relate to financial stability. To reduce the risk and the amplitude of future housing cycles, housing policy needs to consider also financial stability issues. In this regard, it seems particularly important to promote a well-developed rental market as a genuine alternative to ownership, and an attractive investment proposition for potential landlords. While many households may continue to buy rather than rent, we need to make sure that this choice reflects their preferences and does not merely reflect a poorly functioning rental market.

4. The role of mortgage debt in a financial crisisThere are of course also a number of social benefits from owner-occupancy which need to be kept in mind. For instance, owner-occupancy represents the purchase of an asset and, since mortgage loans are amortised in Ireland, therefore leads to wealth accumulation. This can be particularly helpful in retirement, when reduced income can be offset by the lower cost of outright ownership of housing. In addition, studies have shown that homeowners are more engaged in social and political activities, have more positive assessments of their neighbourhoods, better psychological health and higher educational attainments.  Surveys in the US show that homeowners believe their neighbourhoods are safer and better places to raise children.

But while the benefits of owner-occupancy are well documented, there is a much less well-known flipside to this coin: the risks associated with financially vulnerable households taking on the financial burden of house purchase. Let me now discuss this issue.

In Ireland the burden of the current crisis has fallen squarely on the young, many of whom bought property at the top of the market. The perception that one must get “on the property ladder” as soon as possible that was a particular feature of the boom years, but also a consequence of the poorly functioning rental market in Ireland, has had implications for younger families. Many of these are now left with unsuitable properties for their housing needs (for example, one bedroom apartments that are not satisfactory for growing families), and with debts that they could no longer service when salaries declined and unemployment rose during the economic downturn. Moreover, negative equity and mortgage arrears may make it difficult for them to move in pursuit of new, or better paid, employment. While desirable and beneficial for many, homeownership does come together with important risks that many neglected before the onset of the crisis.

A particular concern in this regard is the fact that the risk of becoming unemployed or experiencing income losses is not evenly shared across society. Younger and less experienced workers, and those who work in industries that are sensitive to the business cycle, such as the construction sector, are particularly exposed to the risk of unemployment.

The crisis has disproportionately affected unemployment rates among younger age cohorts in Ireland. Graduate salaries have declined significantly since 2007, which has long-term implications for the earning potential of young people. Employment in the sectors most vulnerable to the economic cycle, such as construction, has been most adversely affected by the crisis.

Thus, the lack of a deep and well-functioning rental market forces all households, including those at a relatively high risk of unemployment, into the property market. While the great majority of borrowers are credit worthy and will service their loans, unemployment and income loss, which may be caused by the unemployment of a spouse or partner, have been important determinants of mortgage arrears in Ireland.  Banks in economies with very high house ownership rates may therefore experience high credit losses in a downturn.

The resulting link between highly-indebted and financially more vulnerable households and the banking sector can create a cycle which is both self-reinforcing in good times with expectations of increasing capital values increasing equity and enabling greater indebtedness, and in bad times as both banks and households suffer losses.

What role can rental markets play? Buying a house using a mortgage is a risky leveraged investment that involves a household borrowing several times its annual income to buy an asset with an uncertain future value. Such investments should only be entered into by those that understand the risks and feel able to assume them. Moreover, the rental market can alleviate the risk of capital loss and negative equity, increase labour mobility and thus facilitate the adjustment following adverse economic shocks. From a financial stability perspective it is therefore important that households that worry about the risks of homeownership have the option, if they wish, to rent a property that provides the type and quality of housing, and security of tenure, that they require. Let me next turn to the rental market.

5. The private rental market

It is clear that in Ireland, in contrast to elsewhere in Europe, renting a home is not seen as a long-term option for households. Indeed, results from a recent survey show that over 70 per cent of private rental tenants would prefer to own their own property, and just 17 per cent wish to rent long-term.  While this may reflect a cultural preference, or the benefits of homeownership, it seems more than likely that the type, quality, affordability and, in particular, security of tenure of private rented accommodation also plays an important role.

What can be done to make renting a more attractive long-term alternative to homeownership? I believe that there are three aspects to this problem: first, the rental market structure, particularly in terms of security of tenure, can play a role. Second, the investment horizons of landlords are important. A culture whereby the market is dominated by landlords seeking an income stream over the long term, rather than a capital gain in the short run, can help raise the attractiveness of renting in a number of ways. Finally, in many countries, policies aim to specifically incentivise homeownership, to the detriment of the rental market.

5.1 Security of tenure

A particular concern in Ireland is the absence of long-term rental contracts; while households may wish to stay for long periods in their accommodation, rental contracts in Ireland are predominantly of a year’s duration. This leads to a wide-spread lack of security of tenure. Indeed, a recent survey indicated that 23 per cent of private tenants in Ireland are afraid of losing their home. In addition, 32 per cent have no formal lease, even though more than half have been living in their current accommodation for more than two years.  The risk and the associated costs of having to move may make households opt to purchase their own home and take on financial risks that they may feel they are not well placed to assume. Indeed, 29 per cent of tenants say that they would be more likely to rent long term if there was the possibility of a longer term lease. 14 Lengthening rental contracts therefore seems desirable. 15 Interestingly, research has shown that in countries with comparatively strong security of tenure and high rental rates, such as Germany and the Netherlands, security of tenure is seen to foster long-run demand for renting and rental investment, such that neither tenants nor landlords have sought to weaken security.

Why are rental contracts in Ireland of such short term nature? Ireland’s history of high and variable inflation and the lack of institutional investors in the rental market must both be important. In economies with a history of inflation, banks protect themselves by lending at flexible interest rates. In turn, with mortgage costs varying over time, renters protect themselves with short term contracts. In contrast, in economies with a history of low and stable inflation, mortgage lending tends to be for long maturities and rental contracts tend to be longer term.

Of course, Ireland’s history of inflation is now over. But lending arrangements change slowly. Overall, housing markets and financial stability in Ireland would benefit from borrowers having a wider choice of fixed rate loans.

5.2 Incentives of landlords

The lack of institutional investors in the rental market is also important. The Irish rental market is dominated by private households who let a single property.  The fact that they may need the dwelling for a family member, or may wish to sell it, is another factor that makes for short-term contracts and concerns about the security of tenure. Furthermore, buy-to-let properties have the highest rate of mortgage arrears. The latest figures from December 2014 show that over 25 per cent of buy-to-let mortgages are in arrears. Indeed, survey findings suggest almost 50 per cent of all landlords  cannot cover their loan repayments with rental income. Overall, 29 per cent of landlords intend to exit the market as soon as possible.

In contrast, institutional investors, such as pension funds and insurance companies, have very long investment horizons and have strong preferences for tenants who stay for an extended period of time, since finding new tenants and refurbishing apartments for them is costly.  Institutional investors can bring a standardised, professional approach to the management of entire buildings of apartments, aiding the supply of suitable accommodation in popular areas. This suggests that attracting more institutional investors would promote a well-functioning rental market that is so important for financial stability. 21 Furthermore, these investors are likely to be less leveraged and have more diversified portfolios than individuals owning one or two rental properties, and are thus better able to withstand an economic downturn.

There is a wide variety of government intervention in rental market, from the direct provision of social housing to the regulation of the private rented sector. Because moving is costly and disruptive, the tenant-landlord relationship is inherently asymmetric. Regulation, if designed well, can therefore improve outcomes. That said, poorly thought out regulation, in particular rent controls, can have adverse effects by reducing the supply of rental properties and discouraging new construction and the maintenance of existing rental properties. Getting housing regulation “right” – a task outside the central bank’s remit – is important.

5.3 Policies favouring home-ownership

Home-ownership brings many benefits, and it is understandable that there are policies in place to enable house purchase; I have already outlined the potential benefits in terms of asset accumulation and social advantages associated with home-ownership. However, some policies aimed at enabling people to gain from the benefits of home-ownership have the effect of worsening the situation of those who either choose not to be homeowners, or cannot afford to be so.

One important issue that influences households’ choices between buying and renting property is tax policy. In many countries it is generally favourable towards homeownership. Examples of favourable taxation treatment of housing include the exemption of imputed rental income on principal homes from income tax calculations, tax relief of mortgage interest payments, exemptions of capital gains from the sale of principal homes, and the use of outdated housing values for property taxes.

A favourable tax treatment of homeownership risks encouraging excessive leverage and housing investment, leading to the development of macroeconomic and financial imbalances. 23 It can also tempt households that are worried about the risks inherent in mortgage borrowing into house ownership. Overall, it seems desirable for tax policy to be neutral between homeownership and renting. To this end, it is important to note that tax relief on mortgage payments have been phased out since the crisis, and a recurrent property tax has been introduced, in Ireland.

Basel Committee Consults on Interest Rate Risk in the Banking Book

The Basel Committee on Banking Supervision has issued a consultative document on the risk management, capital treatment and supervision of interest rate risk in the banking book (IRRBB). This consultative document expands upon and is intended to ultimately replace the Basel Committee’s 2004 Principles for the management and supervision of interest rate risk.

The Committee’s review of the regulatory treatment of interest rate risk in the banking book is motivated by two objectives: First, to help ensure that banks have appropriate capital to cover potential losses from exposures to changes in interest rates. This is particularly important in the light of the current exceptionally low interest rate environment in many jurisdictions. Second, to limit capital arbitrage between the trading book and the banking book, as well as between banking book portfolios that are subject to different accounting treatments.

The proposal published presents two options for the capital treatment of interest rate risk in the banking book:

(i) a Pillar 1 (Minimum Capital Requirements) approach: the adoption of a uniformly applied Pillar 1 measure for calculating minimum capital requirements for this risk would have the benefit of promoting greater consistency, transparency and comparability, thereby promoting market confidence in banks’ capital adequacy and a level playing field internationally; alternatively,

(ii) an enhanced Pillar 2 approach: a Pillar 2 option, which includes quantitative disclosure of interest rate risk in the banking book based upon the proposed Pillar 1 approach, would better accommodate differing market conditions and risk management practices across jurisdictions.

The Committee is seeking comments on the proposed approaches, which share a number of common features. Comments are sought by 11 September 2015.

Credit Risk Management – BIS Recommendations

The Bank for International Settlements has published a report from The Joint Forum “Developments in credit risk management across sectors: current practices and recommendations.” The Joint Forum was established in 1996 under the aegis of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) to deal with issues common to/across the banking, securities and insurance sectors, including the regulation of financial conglomerates.

In 2013 the Joint Forum undertook a survey of supervisors and firms in the banking, securities and insurance sectors globally in order to understand the current state of credit risk (CR) management given the significant market and regulatory changes since the financial crisis of 2008. Credit risk is generally defined as the risk that a counterparty will fail to perform fully its financial obligations, and can arise from multiple activities across sectors. For example, CR could arise from the risk of default on a loan or bond obligation, or from the risk of a guarantor, credit enhancement provider or derivative counterparty failing to meet its obligations.

Fifteen supervisors and 23 firms responded to the survey, representing the banking, securities and insurance sectors in Europe, North America and Asia. The surveys were not meant to be a post-mortem of the events leading up to the financial crisis, but rather a means to provide insight into the current supervisory framework around credit risk and the state of CR management at the firms, as well as implications for the supervisory and regulatory treatments of credit risk. The survey aimed to update previous Joint Forum work, most recently a 2006 paper, and used that date as the benchmark when asking about changes. The survey asked questions regarding:

  • products posing challenges to CR management
  • new credit risk transfer tools
  • market developments and regulatory/statutory changes affecting CR management and the resulting changes in firm CR management practices
  • changes in key operations, risk management, internal control and governance frameworks with respect to CR management
  • changes in the use of models to aggregate credit risk
  • changes in supervision of CR management
  • changes in collateral risk

Based on the analysis of the responses from the supervisor and firm surveys and subsequent discussions with firms, the following themes emerged. Also detailed below are recommendations for consideration by supervisors.

1. Propelled by the experience of 2008 and by regulators, firms have improved their management of credit risk in areas such as governance and risk reporting. Risk aggregation has also become more sophisticated since the financial crisis. Regulatory requirements such as the Basel framework and stress testing have been one driver of the modelling enhancements. Firms highlighted increased reliance upon stress testing using their internal models. Against this background, some supervisors cautioned that there is a risk that some credit risk management or regulatory capital models may not adequately capture risk-taking.

Recommendation 1: Supervisors should be cautious against over-reliance on internal models for credit risk management and regulatory capital. Where appropriate, simple measures could be evaluated in conjunction with sophisticated modelling to provide a more complete picture.

2. In the current low interest rate environment, there is a “search for yield” by some firms across sectors. This manifests itself in an increase in firms’ risk tolerance in a variety of different products such as auto lending by banks, increasingly risky assets in the investment portfolio for life insurers, and the syndicated leveraged loan market. Lower-quality assets with lower-rated counterparties could generate more credit risk.

Recommendation 2: With the current low interest rate environment possibly generating a “search for yield” through a variety of mechanisms, supervisors should be cognisant of the growth of such risk-taking behaviours and the resulting need for firms to have appropriate risk management processes.

3. Over-the-counter (OTC) derivatives, both cleared and uncleared, are a significant source of credit risk at financial institutions across sectors. As a result of both regulation and firm practices, firms are increasing the amount of initial margin they collect from trading counterparties for uncleared trades, and central counterparties (CCPs) in many jurisdictions are implementing risk management standards intended to ensure that they collect adequate financial resources from their member firms.

Recommendation 3: Supervisors should be aware of the growing need for high-quality liquid collateral to meet margin requirements for OTC derivatives sectors, and if any issues arise in this regard they should respond appropriately. The Parent Committees should consider taking appropriate steps to promote the monitoring and evaluation of the availability of such collateral in their future work while also considering the objective of reducing systemic risk and promoting central clearing through collateralisation of counterparty credit risk exposures that stems from non-centrally cleared OTC derivatives.

4. The increase in central clearing of OTC derivatives has clear benefits by reducing risk to individual counterparties, as articulated by both supervisors and firms. The consequence of this is to shift and concentrate credit risk to CCPs. Many firms have responded by increasing analysis of and reporting on CCPs.

Recommendation 4: Supervisors should consider whether firms are accurately capturing central counterparty exposures as part of their credit risk management.

 

Residential Property Prices Increased Significantly YOY in Real Terms 4Q14 – BIS

The Bank for International settlements released their latest cross-country house price database. They highlight the volatile nature of property, and longer term, contrasts the rise and rise we have seen in Australia, with very different stories elsewhere. Between 2007 and now, prices in real terms are still lower than they were then in US, UK and Japan. In Australia, and Canada, they are higher. Real residential property prices had almost doubled in Brazil and had risen by 80% in India; but they had declined by almost one third in Russia.

“In the fourth quarter of 2014, residential property prices increased significantly year on year in real terms (ie deflated by the CPI) in several advanced economies. They grew by 3–5% in Australia, Canada and the United States, and by around 10% in Sweden and the United Kingdom. Real prices increased by 1% in the euro area, although there were important disparities among member states: they rose by 16% in Ireland and more moderately in Germany and Spain, but continued to decline in France, Greece and Italy. Prices also fell in Japan. The picture was also mixed among major emerging market economies. Property price inflation remained strong in India, and to a lesser extent in South Africa and Turkey, but prices continued to fall in China and Russia.

BIS-PPty-May-2015-1From a longer-term perspective, residential property prices generally peaked in real terms in 2006–07 in most advanced economies. Since the end of 2007, they had decreased by 14% in the euro area, reflecting a fall of around 40% in Greece, Ireland and Spain, and by 23% in Italy, partly offset by a price increase in Germany. As of the fourth quarter of 2014, real prices were also still well below their 2007 levels in the United States (by 13%) and, to a lesser extent, Japan and the United Kingdom. Most other advanced economies, such as Australia, Canada, Norway, Sweden and Switzerland, had registered a significant rise in property prices over the previous seven years. Among major emerging market economies, real residential property prices had almost doubled in Brazil and had risen by 80% in India; but they had declined by almost one third in Russia.”

BIS-PPty-May-2015-2

 

The Impact of Evolving Financial Regulation

The BIS published an interesting report on how financial regulation is evolving. In short, significantly more capital will be required as the screws are tightened, or in other words capital rules have been too lax. These changes will have an impact on monetary policy; sometimes limiting credit availability; it will impact asset prices; weaken the relationship between policy rates and real-life interest rates; and make the banks reliance on the central bank stronger. It also provided a good summary of changes proposed under Basel III.

Financial regulation is evolving, as policymakers seek to strengthen the financial system in order to make it more robust and resilient. Changes in the regulatory environment are likely to have an impact on financial system structure and on the behaviour of financial intermediaries that central banks will need to take into account in how they implement monetary policy. Against this background, in February 2014, the Committee on the Global Financial System (CGFS) and Markets Committee (MC) jointly established a Working Group – co-chaired by Ulrich Bindseil (European Central Bank) and William Nelson (Federal Reserve Board) – to assess the combined impact of key new regulations on monetary policy.

The BIS has now released their report which presents the Group’s findings. It is based on information from a range of sources, including central bank case studies as well as structured interviews with private sector market participants. It argues that the likely impacts of the new financial regulations on financial institutions and markets should have only limited and manageable effects on monetary policy operations and transmission. Hence, as necessary, central banks should be able to make adjustments within their existing policy frameworks and in ways that preserve policy effectiveness. These adjustments will tend to differ across jurisdictions according to the financial systems and policy frameworks in place. Specific implications, and examples of potential policy responses, are set out and elaborated in the report.

The report’s findings can be characterised in terms of five distinct sets of implications. In addition, more general effects of the emerging regulatory environment that are independent of specific macroeconomic conditions can be differentiated from those that pertain in the context of the current environment of low policy rates. All of these, and examples of potential policy responses. In brief, they are as follows:

Safer financial systems and their implications for policymaking. The emerging regulatory environment will contribute to enhanced bank resilience, reducing the risk of spillovers from the banking sector to the real economy, and is expected to limit the extent of liquidity and maturity transformation undertaken at banks. Therefore, if the regulations are effective, bank credit will be more stable on average, because credit cycles will be less severe and less frequent. At the same time, at some points of the credit cycle, the supply of bank credit for the non-financial sector will tend to be lower than it would be in the absence of the new regulations (and with everything else unchanged). Thus, to achieve the same economic outcomes, central banks may end up adopting a policy stance that is somewhat more accommodating during some parts of the cycle than would otherwise be the case.

Shifting asset price relationships and their implications for policy targets. As markets adjust to the new regulatory requirements, the equilibrium relationships between financial asset prices and central bank policy rates will shift, adding to the existing uncertainty around these relationships – at least during the transition period. As a result, central banks may need to adjust the settings of their policy instruments to achieve the same stance of monetary policy. A complicating factor is that different regulations, considered in isolation, can have consequences that go in opposite directions. Moreover, the interaction of these regulations could add to the difficulties in predicting their overall impact. As a result, central banks will need to monitor these changes and respond to them as they manifest themselves.

Reduced arbitrage activity and its impact on policy implementation. New regulations, such as the leverage ratio, may disincentivise certain low-margin arbitrage activities, such as banks’ matched repo book business. This reduction would tend to weaken, and make more uncertain, the links between policy rates and other interest rates, weakening the transmission of monetary policy impulses along the yield curve as well as to other asset prices relevant for economic activity. More difficult reserve demand forecasting. For central banks with an operational target of steering a short-term interest rate within a corridor system, if the rate paid on reserve balances is close to the interest rate on other types of high quality liquid assets (HQLA Level 1), small changes in interest rates could result in relatively large swings in reserve demand as banks substitute freely between reserves and these other assets. Additionally, new limits on counterparty concentration may mean that forecasts of the level of reserve balances will depend more strongly than in the past on the distribution of those reserves across counterparties. Similarly, with periodic calculation of regulatory ratios (such as at year- or quarter-ends), window dressing behaviour and associated movements in short-term interest rates are likely to intensify.

More central bank intermediation. Many of the new regulations will increase the tendency of banks to take recourse to the central bank as an intermediary in financial markets – a trend that the central bank can either accommodate or resist. Weakened incentives for arbitrage and greater difficulty of forecasting the level of reserve balances, for example, may lead central banks to decide to interact with a wider set of counterparties or in a wider set of markets. In addition, in a number of instances, the regulations treat transactions with the central bank more favourably than those with private counterparties. For example, Liquidity Coverage Ratio rollover rates on a maturing loan from a central bank, depending on the collateral provided, can be much higher than those for loans from private counterparties.

Effects specific to the current low interest rate environment. In addition to these more general implications, there are a number of effects for monetary policy that are specific to the current environment of low policy rates in the major advanced economies. For example, effects that tend to lower market interest rates relative to policy rates will support monetary policy in jurisdictions at the zero lower bound, but may hinder efforts to normalise the stance of policy. Effects that tend to raise market rates relative to policy rates will have the opposite consequence. Moreover, any temporary reduction of credit supply resulting from the new regulations and their phasing-in may imply the need for additional unconventional measures for central banks operating at the zero lower bound, with the added complication that some unconventional measures may make the new regulations more binding.

The four key regulations identified by the Working Group as being the most likely ones to significantly affect monetary policy implementation:

Liquidity Coverage Ratio. The stated objective of the LCR is to ensure that banks maintain an adequate level of unencumbered, high-quality liquid assets (HQLA) that can be converted into cash to meet their liquidity needs under a 30-day scenario of severe funding stress. It is defined as the ratio of the stock of HQLA (numerator) to net cash outflows expected over the stress period (denominator). The initial minimum requirement of 60%, effective January 2015, will be increased in a stepwise fashion to 100% by 2019. The HQLA definition groups eligible assets into two discrete categories (Level 1 and Level 2). Level 1 assets, which can be included without limit, are those with 0% risk weights for Basel II capital calculations, such as cash, central bank reserves and sovereign debt (which may be subject to haircuts). Level 2 assets, which can make up no more than 40% of the buffer, include assets with low capital risk weights as well as highly rated non-financial corporate and covered bonds, subject to a 15% haircut. (Under certain conditions, supervisors may choose to include additional asset types, termed Level 2B, up to a limit of 15% of the total HQLA stock and carrying haircuts of 25% or higher.) Net cash outflows, in turn, are calculated on the basis of agreed run-off and inflow rates that are applied to different sources of cash out- and inflows (with an aggregate cap of 75% of total cash outflows).

Net Stable Funding Ratio. The aim of the NSFR, which will be introduced as of January 2018, is to (i) limit overreliance on short-term wholesale funding, (ii) encourage better assessment of funding risk across all on-and offbalance sheet items, and (iii) promote funding from stable sources on a structural basis. The NSFR is defined as the ratio of available stable funding (ASF) to required stable funding (RSF), which needs to be equal to at least 100% on an ongoing basis. The numerator is determined by applying ASF factors to a bank’s liability positions, with higher factors assigned for longer maturities (according to pre-defined buckets: less than six months, between six and 12 months, and higher), and more stable funding sources. The denominator reflects the product of RSF factors and the bank’s assets, differentiated according to HQLA/non-HQLA definitions and by counterparty (financial/non-financial). Asset encumbrance generally results in higher RSF factors, especially for longer encumbrance periods (eg assets encumbered for a period of one year or more receive the maximum RSF factor of 100%, while central bank reserves have a factor of 0% (with discretion to apply a higher rate) and other Level 1 assets a factor of 5%). Differentiated RSF factors also apply according to whether assets are secured against Level 1 assets or not.

Leverage ratio. The Basel III minimum leverage ratio is intended to restrict the build-up of leverage in the banking sector, and to backstop the risk-based capital requirements with a simple, non-risk-based measure. Public disclosure of the regulatory LR by banks commenced on 1 January 2015. The final calibration and any further adjustments to the definition will be completed by 2017 with a view to migrating to a binding Pillar 1 requirement on 1 January 2018. The LR is defined as the ratio of Tier 1 capital to total exposures. The denominator consists of the sum of all onbalance sheet exposures, derivative positions, securities financing transactions and off-balance sheet items. As such, the total exposure measure includes central bank reserves and repo positions. Netting of cash legs (ie of receivables and payables) of repo exposures (with the same counterparty) is permitted under certain conditions, but netting across counterparties or of cash positions against collateral is not.

Large exposure limits. The large exposures (LE) framework of the Basel Committee on Banking Supervision (BCBS) is a set of rules for internationally active banks aimed at reducing system-wide contagion risk. It imposes limits on banks’ exposures to single counterparties in order to constrain the maximum loss a bank could face in the event of sudden counterparty failure. The framework is due to be fully implemented on 1 January 2019. Under the LE framework, a bank’s exposure to any single counterparty or group of connected counterparties cannot exceed 25% of the bank’s Tier 1 capital. A tighter limit of 15% is set for exposures between banks that have been designated as globally systemically important. While exposure measurement is aligned with the standardised approach under risk-based capital rules, exposures to sovereigns and central banks, as well as intraday interbankexposures, are exempt from the limit.

Basel III capital regulation includes a number of new elements to boost banks’ capital base. First, it incorporates a significant expansion in risk coverage, which increases risk-weighted assets. Specifically, it targets the instruments and markets that were deemed most problematic during the crisis – that is, trading book exposures, counterparty credit risk and securitised assets. This builds on the earlier approach under Basel II, which introduced differentiated risk weights (which are either internal model-based or set by regulation). A key differentiation from the perspective of monetary policy is that central bank reserves carry a zero risk weight under the risk-weighted standard, whereas the leverage ratio introduces an implied capital charge that is equal for all assets. Riskweighted capital charges also differ according to whether a transaction is secured or unsecured. Second, and critically, Basel III tightens the definition of eligible capital, with a strong focus on common equity. This represents a
move away from complex hybrid capital instruments that proved incapable of absorbing losses in periods of stress. A unique feature of Basel III is the introduction of capital buffers that banks can use without compromising their solvency, and surcharges, which counter individual banks’ contribution to systemic risk.

BaselIIIChartBISMay2015First, a conservation buffer is designed to help preserve a bank as a going concern by restricting discretionary distributions (such as dividends and bonus payments) when the bank’s capital ratio deteriorates. Second, a countercyclical buffer – capital that accumulates in good times and that can be drawn down in periods of stress – will help protect banks against risks that evolve over the financial cycle. Finally, a capital surcharge will be applied to global systemically important banks (G-SIBs), or banks with large, highly interconnected and complex operations, in order to discourage the concentration of risk. These international standards impose lower bounds on regulators: countries may choose to implement higher standards to address particular risks in their national contexts. Combining these elements will significantly increase banks’ capital requirements.

 

Domestic and Cross-border Spillovers of Unconventional Monetary Policies

Interesting remarks from Benoît Coeuré, Member of the Executive Board of the European Central Bank, at the SNB-IMF Conference “Monetary Policy Challenges in a Changing World”, Zurich today. The discussion centres of the risk of bubbles when interest rates are artificially low, and exacerbated by other unconventional monetary strategies, why investment property is attractive in these conditions, and how macroprudential should be used to manage these unintended consequences in the context of growth. An edited version follows:

In recent years, there has been an intense discussion, both at the national and the international level, about the  potential financial market implications of unconventional monetary policies. At the international level, policy makers have been particularly concerned with the surge in capital inflows, and the resulting exchange rate appreciation pressures in emerging markets. More recently, amid monetary policy normalisation in the United States and additional monetary policy easing in the euro area, including through the launch of the public sector purchase programme (PSPP), a new, but conceptually related discussion has emerged on the global financial market implications of diverging monetary policy cycles. At the national level, the main concerns were spillovers to equity and real estate markets, and the worries about the emergence of asset price bubbles as a result of unconventional policy measures.

Monetary policy always has unintended consequences, no matter where it is pursued. By altering short-term interest rates, central banks affect the inter-temporal decisions of households. Inter-temporal redistribution is at the heart of monetary policy that is aimed at ensuring price stability, and it thus has effects on the income distribution of savers and spenders.

But monetary policy also affects the distribution of income along the intra-temporal and spatial (cross-country) dimension. Changes in short-term interest rates affect consumption, savings and wealth in different ways, depending on the characteristics of individual households in different jurisdictions. But all these effects can be considered temporary, indirect and unintended, i.e. a side effect of a strategy that is aimed at ensuring price stability in the economy.

That said, it would be a logical fallacy to conclude that all domestic spillovers are acceptable. Bubbles are a case in point. Bubbles are a possible, but not an inevitable result of unconventional monetary policies. And if they are welcome at all, then only in a severely constrained, second-best world. But in this case, we should ask ourselves how we can overcome the constraints that prevent better policy outcomes, rather than settling for bubbles to temporarily mask the constraints.

Facing the threat of a persistent low-growth and low-inflation environment and a binding floor on standard policy rates, many central banks have resorted to unconventional measures. These measures were aimed at further pushing down nominal interest rates along the maturity spectrum to track the secular decrease in the natural, “Wicksellian” real rate of interest. Thereby, they helped induce firms and households bring forward their investment and consumption spending in comparison with that in a no policy-change scenario and, ultimately, bring the natural rate back to more normal levels.

I am convinced that there is no alternative for us than acting this way in order to deliver on our mandate. Yet, there is a danger associated with the temporary, yet potentially extended period where low interest rates are needed to stimulate investment and consumption. With real interest rates below potential growth, private agents may just borrow to purchase assets in limited or rigid supply (e.g. real estate property). In this dynamically inefficient world with structurally weak growth prospects, this may actually become an attractive way for savers to generate returns on their savings that investments in the productive sector are unable to generate.

In this case, we end up with a “rational bubble”. While unconventional monetary policy is not a necessary condition for this type of bubble to emerge, it may render it more likely – and more violent in the event of its materialising. So what are the consequences of such bubble?

In the short-term, it may indeed generate a temporary boost to the economy. And for a while this boost would be difficult to distinguish from the regular workings of asset purchase programmes, which actually embed asset price increases as a desired effect, which passes on the initial impulse to broader financing conditions via portfolio rebalancing. But this boost would ultimately be very costly. Not only does it does it come with welfare decreasing macroeconomic instability, but it also brings about an arbitrary redistribution of wealth that may, in the worst case, undermine social cohesion and trust that the central bank is acting within its narrow price stability mandate. And moreover, it can create financial stability risks elsewhere, generating negative spillovers from what should otherwise be a normal international adjustment process.

Against this background, it would be wrong to treat bubbles as a welcome replacement therapy to a sustainable growth model. Instead,  macroeconomic and structural policies have to set the necessary conditions so that investment in productive sectors becomes attractive again and investment in bubble-prone areas is discouraged, so that total factor productivity is increased and the natural rate of interest ultimately reverts to what is normal.

We take monetary policy decisions with a view to attaining our primary objective of price stability. Thereby, we establish a stable nominal anchor for the private sector, which in turn is a fundamental precondition for overall macroeconomic stability. Without prejudice to this objective, we take financial stability risk seriously and monitor closely whether severe imbalances are emerging in the financial sector. In this context, we consider the financial stability risks related to our policy measures to be contained. Should risks emerge, macro-prudential policy is best suited to safeguard financial stability. Macroprudential instruments can be targeted more efficiently to those sectors and countries where systemic risks may be materialising. Finally, we encourage national authorities to do whatever is in their power to place the euro area on a more dynamic growth path, thereby creating attractive investment projects that generate high, but fundamentally justified, returns. These are the conditions for unconventional monetary policies policies to bring economies back to a stable and sustainable growth path, both at home and abroad.

Basel IV – Is More Complexity Better?

In December 2014, The Bank For International Settlements issued proposed Revisions to the Standardised Approach for credit risk for comment. It proposes an additional level of complexity to the capital calculations which are at the heart of international banking supervision.  Comments on the proposals were due by 27 March 2015. These latest proposals, which have unofficially been dubbed “Basel IV”, is a continuation of the refining of the capital adequacy ratios which guide banking supervisors and relate to the standardised approach for credit risk. It forms part of broader work on reducing variability in risk-weighted asset. We want to look in detail at the proposals relating to residential real estate, because if adopted they would change the capital landscape considerably. Note this is separate from the proposal relating to the adjustment of IRB (internal model) banks. Whilst it aspires to simplify, the proposals are, to put it mildly, complex

For the main exposure classes under consideration, the key aspects of the proposals are:

  • Bank exposures would no longer be risk-weighted by reference to the external credit rating of the bank or of its sovereign of incorporation, but they would instead be based on a look-up table where risk weights range from 30% to 300% on the basis of two risk drivers: a capital adequacy ratio and an asset quality ratio.
  • Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate, but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage. Further, risk sensitivity would be increased by introducing a specific treatment for specialised lending.
  • The retail category would be enhanced by tightening the criteria to qualify for the 75% preferential risk weight, and by introducing a fallback subcategory for exposures that do not meet the criteria.
  • Exposures secured by residential real estate would no longer receive a 35% risk weight. Instead, risk weights would be determined according to a look-up table where risk weights range from 25% to 100% on the basis of two risk drivers: loan-to-value and debt-service coverage ratios.
  • Exposures secured by commercial real estate are subject to further consideration where two options currently envisaged are: (a) treating them as unsecured exposures to the counterparty, with a national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight according to a look-up table where risk weights range from 75% to 120% on the basis of the loan-to-value ratio.
  • The credit risk mitigation framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts, and updating corporate guarantor eligibility criteria.

Real Estate Capital Calculation Proposals

The recent financial crisis has demonstrated that the current treatment is not sufficiently risk-sensitive and that its calibration is not always prudent. In order to increase the risk sensitivity of real estate exposures, the Committee proposes to introduce two specialised lending categories linked to real estate (under the corporate exposure category) and specific operational requirements for real estate collateral to qualify the exposures for the real estate categories.

Currently the standardised approach contains two exposure categories in which the risk-weight treatment is based on the collateral provided to secure the relevant exposure, rather than on the counterparty of that exposure. These are exposures secured by residential real estate and exposures secured by commercial real estate. Currently, these categories receive risk weights of 35% and 100%, respectively, with a national discretion to allow a preferential risk weight under certain strict conditions in the case of commercial real estate.

Residential Owner Occupied Real Estate

In order to qualify for the risk-weight treatment of a residential real estate exposure, the property securing the mortgage must meet the following operational requirements:

  1. Finished property: the property securing a mortgage must be fully completed. Subject to national discretion, supervisors may apply the risk-weight treatment  for loans to individuals that are secured by an unfinished property, provided the loan is for a one to four family residential housing unit.
  2. Legal enforceability: any claim (including the mortgage, charge or other security interest) on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning the collateral must be such that they provide for the bank to realise the value of the collateral within a reasonable time frame.
  3. Prudent value of property: the property must be valued for determining the value in the LTV ratio. Moreover, the value of the property must not be materially dependent on the performance of the borrower. The valuation must be appraised independently using prudently conservative valuation criteria and supported by adequate appraisal documentation.

The current standardised approach applies a 35% risk weight to all exposures secured by mortgage on residential property, regardless of whether the property is owner-occupied, provided that there is a substantial margin of additional security over the amount of the loan based on strict valuation rules. Such an approach lacks risk sensitivity: a 35% risk weight may be too high for some exposures and too low for others. Additionally, there is a lack of comparability across jurisdictions as to how great a margin of additional security is required to achieve the 35% risk weight.

In order to increase risk sensitivity and harmonise global standards in this exposure category, the Committee proposes to introduce a table of risk weights ranging from 25% to 100% based on the loan-to-value (LTV) ratio. The Committee proposes that the risk weights derived from the table be applied to the full exposure amount (ie without tranching the exposure across different LTV buckets).

The Committee believes that the LTV ratio is the most appropriate risk driver in this exposure category as experience has shown that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the lower the loss incurred in the event of a default. Furthermore, data suggest that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the less likely the borrower is to default. For the purposes of calculating capital requirements, the value of the property (ie the denominator of the LTV ratio) should be measured in a prudent way. Further, to dampen the effect of cyclicality in housing values, the Committee is considering requiring the value of the property to be kept constant at the value calculated at origination. Thus, the LTV ratio would be updated only as the loan balance (ie the numerator) changes.

The LTV ratio is defined as the total amount of the loan divided by the value of the property. For regulatory capital purposes, when calculating the LTV ratio, the value of the property will be kept constant at the value measured at origination, unless an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value. Modifications made to the property that unequivocally increase its value could also be considered in the LTV. The total amount of the loan must include the outstanding loan amount and any undrawn committed amount of the mortgage loan. The loan amount must be calculated gross of any provisions and other risk mitigants, and it must include all other loans secured with liens of equal or higher ranking than the bank’s lien securing the loan. If there is insufficient information for ascertaining the ranking of the other liens, the bank should assume that these liens rank pari passu with the lien securing the loan.

In addition, as mortgage loans on residential properties granted to individuals account for a material proportion of banks’ residential real estate portfolios, to further increase the risk sensitivity of the approach, the Committee is considering taking into account the borrower’s ability to service the mortgage, a proxy for which could be the debt service coverage (DSC) ratio. Exposures to individuals could receive preferential risk weights as long as they conform to certain requirement(s), such as a ‘low’ DSC ratio. This ratio could be defined on the basis of available income ‘net’ of taxes. The DSC ratio would be used as a binary indicator of the likelihood of loan repayment, ie loans to individuals with a DSC ratio below a certain threshold would qualify for preferential risk weights. The threshold could be set at 35%, in line with observed common practice in several jurisdictions. Given the difficulty in obtaining updated borrower income information once a loan has been funded, and also given concerns about introducing cyclicality in capital requirements, the Committee is considering whether the DSC ratio should be measured only at loan origination (and not updated) for regulatory capital purposes.

The DSC ratio is defined as the ratio of debt service payments (including principal and interest) relative to the borrower’s total income over a given period (eg on a monthly or yearly basis). The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. The DSC ratio must be prudently calculated in accordance with the following requirements:

  1.  Debt service amount: the calculation must take into account all of the borrower’s financial obligations that are known to the bank. At loan origination, all known financial obligations must be ascertained, documented and taken into account in calculating the borrower’s debt service amount. In addition to requiring borrowers to declare all such obligations, banks should perform adequate checks and enquiries, including information available from credit bureaus and credit reference agencies.
  2. Total income: income should be ascertained and well documented at loan origination. Total income must be net of taxes and prudently calculated, including a conservative assessment of the borrower’s stable income and without providing any recognition to rental income derived from the property collateral. To ensure the debt service is prudently calculated, the bank should take into account any probable upward adjustment in the debt service payment. For instance, the loan’s interest rate should (for this purpose) be increased by a prudent margin to anticipate future interest rate rises where its current level is significantly below the loan’s long-term level. In addition, any temporary relief on repayment must not be taken into account for purposes of the debt service amount calculation.

Notwithstanding the definitions of the DSC and LTV ratios, banks must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of their residential real estate portfolio.

The risk weight applicable to the full exposure amount will be assigned, as determined by the table below, according to the exposure’s loan-to-value (LTV) ratio, and in the case of exposures to individuals, also taking into account the debt service coverage (DSC) ratio. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given residential real estate exposures must apply a 100% risk weight to such an exposure.

Basel-4-RE-WeightingsSome points to note.

  1. Differences in real estate markets, as well as different underwriting practices and regulations across jurisdictions make it difficult to define thresholds for the proposed risk drivers that are meaningful in all countries.
  2. Another concern is that the proposal uses risk drivers prudently measured at origination. This is mainly to dampen the effect of cyclicality in housing values (in the case of LTV ratios) and to reduce regulatory burden (in the case of DSC ratios). The downside is that both risk drivers can become less meaningful over time, especially in the case of DSC ratios, which can change dramatically after the loan has been granted.
  3. The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. That said, the Committee recognises that differences in tax regimes and social benefits in different jurisdictions make the concept of ‘available income’ difficult to define and there are concerns that the proposed definition might not be reflective of the borrower’s ability to repay a loan. Further, the level at which the DSC threshold ratio has been set might not be appropriate for all borrowers (eg high income) or types of loans (eg those with short amortisation periods). Therefore the Committee will explore whether using either a different definition of the DSC ratio (eg using gross income, before taxes) or any other indicator, such as a debt-to-income ratio, could better reflect the borrower’s ability to service the mortgage.
  4. There are no specific proposal to treat loans that are past-due for more than 90 days.

 Investment Loans

Bearing in mind that 35% of all loans are for investment purposes in Australia, the proposals relating to loans for investment purposes are important. So how will they be treated under Basel 4?

There are a number of pointers in the proposals, though its not totally clear in our view. First, we think the proposals would apply to separate loans where repayment is predicated on income generated by the property securing the mortgage, i.e. investment loans rather than a normal loans where the mortgage is linked directly to the underlying capacity of the borrower to repay the debt from other sources. Such loans might fall into a special commercial real estate category, specialist lending category, or a fall back to the unsecured category, each with different sets of capital weights.

The Committee proposes that any exposure secured with real estate that exhibits all of the characteristics set out in the specialised lending category should be treated for regulatory capital purposes as income-producing real estate or as land acquisition, development and construction finance as the case may be, rather than as exposures secured by real estate. Any non-specialised lending exposure that is secured by real estate but does not satisfy the operational requirements should be treated for regulatory capital purposes as an unsecured exposure, either as a corporate exposure or other retail exposure, as appropriate.

Specialised lending exposure, would be defined so if all the following characteristics, either in legal form or economic substance were met:

  1. The exposure is typically to an entity (often a special purpose entity (SPE)) that was created specifically to finance and/or operate physical assets;
  2. The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
  3. The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and
  4. As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

On the other hand, in order to qualify as a commercial real estate exposure, the property securing the mortgage must meet the same operational requirements as for residential real estate. If the loan is a commercial real estate category, the risk weight applicable to the full exposure amount will be assigned according to the exposure’s loan-to-value (LTV) ratio, as determined in the table below. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given commercial real estate exposure must apply a 120% risk weight.
LTVBasel-4-Commercial-LTVNote, if this LTV refers to market value, the threshold should be set at a lower level: eg 50%.

Where the requirements are not met, the exposure will be considered unsecured and treated according to the counterparty, ie as “corporate” exposure or as “other retail”. However, in exceptional circumstances for well developed and long established markets, exposures secured by mortgages on office and/or multipurpose commercial premises and/or multi-tenanted commercial premises may be risk-weighted at [50%] for the tranche of the loan that does not exceed 60% of the loan to value ratio. This exceptional treatment will be subject to very strict conditions, in particular:

  1.  the exposure does not meet the criteria to be considered specialised lending
  2. the risk of loan repayment must not be materially dependent upon the performance of, or income generated by, the property securing the mortgage, but rather on the underlying capacity of the borrower to repay the debt from other sources
  3. the property securing the mortgage must meet the same operational requirements as for residential real estate
  4. two tests must be fulfilled, namely that (i) losses stemming from commercial real estate lending up to the lower of 50% of the market value or 60% of loan-to value (LTV) based on mortgage-lending-value (MLV) must not exceed 0.3% of the outstanding loans in any given year; and that (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. This is, if either of these tests is not satisfied in a given year, the eligibility to use this treatment will cease and the original eligibility criteria would need to be satisfied again before it could be applied in the future. Countries applying such a treatment must publicly disclose that these and other additional conditions (that are available from the Basel Committee Secretariat) are met. When claims benefiting from such exceptional treatment have fallen past-due, they will be risk-weighted at [100%].

Implications and Consequences

We should make the point, these are proposals, and subject to change. But it would mean that banks using the standard approach to capital could no longer just go with a 35% weighting, rather they will need to segment the book based on LTV and servicability at a loan by loan level. Investment loans may become more complex and demand higher capital weighting. The required data may be available, as part of the loan origination process, but additional processes and costs will be incurred, and it appears net-net capital buffers will be raised for most players. The capital would be determined using two risk drivers: loan-to-value and debt-service coverage ratios with risk weights ranging from 25 percent to 100 percent. Investment loans may require different treatment, (and the RBNZ discussion paper recently issued may be relevant here, where investment loans are handled on a different basis.)

Finally, a word about those banks on IRB. Currently, under their internal models, they are sitting on an average weighting of around 17% (compared with 35% for standard banks). There are proposals to lift the floor to 20% minimum, and the FSI Inquiry recommend higher. Indeed, Murray called for the big banks to lift the average mortgage risk weighting to a range of 25% to 30%. This would bring them closer to the average mortgage risk weighting used by Australia’s regional banks and credit unions, though as described above, these, in turn, may change. Incidentally, the Bank of England thinks 35% is a good target. Basel 4 will also reduce the variance between standardised banks and those using their own models by requiring the internal models not to deviate from the RWA number in the standardised model by a certain amount: the so-called “capital floor”.

Interestingly the US is focussing on an additional measure, The Tier 1 Common measure, which is unweighted assets to capital, and has set a floor of 5%, or more.  The Major Banks in Australia carry real, or non-risk-weighted, equity capital of just 3.7% of assets. Some banks are leveraged over seventy times the equity capital to loans, which is scarily high, but then the RBA (aka the tax payer) would bail them out if they get into trouble, so that’s OK (or not). This means that just $1.70 in assets will now support a $100 loan.

We wonder if the ever more complex models being proposed by Basel are missing the point. Maybe we should be going for something simpler. Many banks of course have invested big in advanced models to squeeze the capital lemon as hard as they can. But stepping back we need approaches which allow greater ability to compare across banks, and more transparent disclosure so we can see where the true risks lay. Certainly capital buffers should be lifted, but we suspect Basel 4, despite the best of intentions,  is going down the wrong alley.