BIS – Page 9 – Digital Finance Analytics (DFA) Blog

A Revised Basel Framework – State of Play

We have an update on the Basel Committee’s work to finalise the global regulatory framework from William Coen, Secretary General. He spoke on “Bank capital: a revised Basel framework” at a panel discussion at the 2016 Annual Membership Meeting of the Institute of International Finance, Washington DC, 7 October. The objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks.

Our goal is to finish by the end of the year. The Committee’s post-crisis reforms have been comprehensive and wide-ranging. I am pleased to say that we are close to finalising these reforms, which will provide clarity and certainty to supervisors and market participants.

Second, the bulk of the outstanding reforms relate to reducing excessive variability in risk-weighted assets. A high degree of variability in capital ratios has been demonstrated across a number of empirical studies by the Committee, academics and analysts. The Committee’s objective is to restore the credibility of the risk-based capital framework, which is an integral element of the Committee’s post-crisis reforms.

This is not an exercise in increasing regulatory capital requirements, although I do not rule this out as a possible outcome for outlier banks.

Finally, maintaining a risk-sensitive framework is an important objective, but this has to be carefully balanced with the need for simplicity and comparability.

Progress in finalising the Basel Committee’s reform agenda

The Basel Committee’s policy development process

So where do we stand and what remains to be done? Since late last year, we have published four consultative documents that would revise the current standards for: (i) the standardised approach for credit risk; (ii) operational risk; (iii) the internal ratings-based (IRB) approaches for credit risk, including a potential “output floor”; and (iv) the leverage ratio. The Committee received and analysed comments from a wide range of stakeholders. In parallel with the consultative process, we launched a comprehensive cumulative quantitative impact study (QIS). This allows us to test different scenarios and combinations of scenarios.

The comments we review and the results of our QIS are important inputs to this process – we spend a considerable amount of time assessing these inputs. But we are also aware of their limitations and bias. Data quality, in particular, is a challenge and, even under the best of circumstances, there will always be an element of bias in the data. This is understandable: our exercises often require data that are not readily accessible, and banks must therefore estimate certain outcomes based on the data that are available. In short, QIS exercises are a labour-intensive, painstaking process for banks and for bank supervisors but an essential part of our policy development process. The cumulative QIS exercise will allow the Committee to make a well informed judgment on the overall impact of its remaining reforms and on the component pieces of that package.

A package of proposals

Let me say a few words about each part of the package we will finalise by year-end. I stress the word “package” since there are clearly trade-offs associated with the various policy levers. For example, the more weight that is placed on using standardised approaches to calculating risk-weighted assets, the less weight that is needed on other policy levers, such as input and output floors.

Standardised approach for credit risk¹ – In the two consultations the Committee conducted on this topic, we explicitly noted that our intention was to improve the standard’s risk sensitivity. The intention was not to increase overall regulatory capital requirements. The Committee intends to adhere to this objective. This does not mean that there will be no changes in capital requirements. Indeed, if we achieve our objective, then capital requirements on riskier exposures should increase, while decreasing for lower risk exposures.

Internal ratings-based approaches² – Our March consultative paper expressed concern about banks’ modelling practices and the degrees of freedom in estimating risk components such as probably of default, loss-given-default and exposure at default. The Committee proposed to remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes. This objective can be achieved through various combinations of approaches, which the Committee is still assessing.

At the aggregate level, credit risk accounts for on average three quarters of a bank’s minimum capital requirements. Operational risk,³ on the other hand, accounts for an average of around 15% of minimum capital requirements. The Committee is considering adjustments to the March consultation paper on operational risk. I expect that the fundamental elements of the revised operational risk framework will be maintained (ie combining a simple accounting proxy of operational risk with a bank’s internal loss data). Nevertheless, the Committee is considering refinements to the methodology that go in the direction of simplifying the framework and enhancing its robustness.

Output floor – Discussions are still under way to replace the existing transitional capital floor based on the Basel I framework that the Committee, in 2009, agreed to keep in place.⁴ The floor is meant to mitigate model risk and measurement error stemming from internally modelled approaches and would place a limit on the benefit a bank derives from using its internal models for estimating regulatory capital.

There are several other elements of the Basel III package that the Committee will finalise by year-end, including the leverage ratio exposure measure and a surcharge for global systemically important banks.⁵ The Committee is also finalising the treatment of credit valuation adjustment (CVA) risk. CVA risk is complex but on average accounts for only 2% of minimum capital requirements and is significant for a relatively small number of banks. We are carefully weighing the benefits of a risk sensitive treatment for this risk with the associated complexity and global applicability.

I would also like to say a few words about the Committee’s market risk rules as, similar to CVA, the contribution of market risk to minimum capital requirements is relatively low (ie on average less than 5%) and of particular relevance for a small number of large banks. The Committee has compiled frequently asked questions and is developing responses to these FAQs to provide greater clarity on how the standard is expected to work in practice. The Committee is considering the impact of the new market risk rules as part of its regular QIS monitoring exercises, and is continuing its work on the P&L attribution test, which is a key determinant of whether a bank can use internal models for market risk or is required to apply the standardised approach.

Impact of the final reforms

So what will be the cumulative impact of these reforms? The answer, of course, depends on the final package of proposals that the Committee agrees to, and which is ultimately endorsed by Governors and Heads of Supervision (GHOS). I can reiterate that the objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks. So some banks which are genuinely outliers may face a significant increase in requirements as a result. We are studying the impact taking account of all the moving parts and (i) a variety of policy scenarios, (ii) different bank sizes and (iii) various business models.

But Australian Firms Have High DSR’s Too

Australian firms have some of the highest Debt Service Ratio’s in the world according to data from the Bank for International Settlements. Alongside the household Debt Service Ratios, which we discussed earlier BIS also published a series on the DSR’s of non-financial companies.

Australian and Canadian companies have the highest DSR’s and both show a strong upward trajectory. Many other countries have lower, and flatter profiles. The higher the DSR, the greater the strain on company cash flow.

This many well explain the relatively slow rise in additional debt being drawn down by Australian firms (other than funding for investment property!) and the knock-on effects of lower real productive growth.

We think DSR’s should be more widely studied as a bellwether for future economic performance.

New DSR Comparisons Confirms High Australian Household Debt

Australian households have the third highest, and rising debt service ratio, when compared to a wide range of advanced western economies, according to new data released by the Bank for International Settlements (BIS).

This is a timely update from BIS who calculated DSR’s for households and non-financial companies using data from countries national accounts. You can read about their approach here.

The comparative results are interesting, especially give low global interest rates. There are significant variations and the last results are to March 2016.

Australia is near the top of the DSR scores at 15.1, well behind Netherlands and just below Norway. Many other advanced economies are much lower. However, we also see a different trajectory in Australia, with stronger growth here, compared with a static or falling pattern elsewhere.

This is further evidence of the household debt problem here. Of course we had cash rate cuts later in the year, but debt has continued to rise, and our estimate is average household DSR currently sits around 16. If we are right, the rising trajectory has continued.

You can read our more detailed DSR analysis of Australian households, where we discuss the profile across postcodes.

“Helicopter money” – reality bites

Unconventional monetary policies are being used by many central banks across the world to try and address insipid growth and restart economic activity. As a result, central banks’ balance sheets have expanded. Now there are calls for them to go further, and distribute “helicopter money”. But is this wise?

Based on commentary by Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, and Piti Disyatat, Executive Director of the Puey Ungphakorn Institute for Economic Research, Bank of Thailand and featured in the Nikkei Asian Review; the answer is no!

Since the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. The measures have gone far beyond the typical pre-crisis mode of operation – controlling a short-term policy rate and moving it within a positive range – and have therefore come to be known as “unconventional monetary policies.” To be sure, some of these measures had already been pioneered by the Bank of Japan roughly a decade earlier in the wake of that country’s banking crisis and uncomfortably low inflation. But no one had anticipated that they would spread to the rest of the world so quickly and become so daring, testing the boundaries of the unthinkable.

As growth has remained disappointing and inflation stubbornly below targets, the range and size of these measures have increased. Hence the growing use of long-term liquidity support, large-scale asset purchases, sizable increases in bank reserves (so-called QE) and, of late, even the introduction of negative policy rates. In the wake of these measures, the central banks’ monetary base (cash and bank reserves) has ballooned in step with the overall size of their balance sheets (see graph).

With central banks delving further down into their box of unconventional tools, calls for them to take a deep breath and pull out “helicopter money” have intensified. What was just a thought experiment designed to shed light on how money affects the economy is now threatening to become a reality. Proponents of this tool – more soberly described as “overt money financing” of government deficits – see it as a sure-fire way to boost nominal spending by harnessing central banks’ most primitive power: their unique ability to create money at will. But can helicopter money work in the way its proponents claim? And is the balance of benefits and costs worth it? Our answer to both of these questions is no.

Proponents argue that helicopter money is special because it amounts to a permanent increase in non-interest bearing central bank liabilities (“money”) as the counterpart of the deficit. This form of financing is most effective because money is free and debt is not. Permanent monetary financing means less government debt and thus lower interest payments forever. All else equal, this saving should boost nominal demand, as there would be no need to raise additional taxes. Moreover, the argument continues, the central bank is then free to increase interest rates again whenever it wishes while the lower amount of debt outstanding will still yield savings. This is the best of all possible worlds: Demand is boosted without the collateral damage of prolonged exceptionally low interest rates.

Devil in the details

Or so it seems. But the devil is in the details.

As we have argued elsewhere, the reasoning may be correct in the stripped-down models people have in mind, but not in reality. In fact, the central bank faces a stark choice: Either helicopter money results in interest rates permanently at zero, so that control over monetary policy is lost forever, or else it is equivalent to either debt or to tax-financed government deficits, in which case it would not yield the additional boost. Since losing monetary policy control forever is not a feasible option, helicopter money is just fiscal policy dressed up.

The reason is hidden in an obscure but critical corner of the financial market. Contrary to what the stylized models suggest, it is not the amount of cash that determines interest rates but what the central bank does with bank reserves (commercial banks’ deposits at the central bank), over which it has a monopoly. Monetary deficit financing will, in effect, amount to an equivalent increase in bank reserves. If the central bank issued more cash than people demanded, the amount in excess of desired balances would inevitably be converted into bank deposits and then switched by banks into reserves (see in the graph how steadily and slowly cash grows, reflecting the demand for it). If the government issued checks, the same would happen. If the reserves are non-interest bearing – as they must be for helicopter money – the increase will inevitably also drive the short-term (overnight) rate to zero. This is because when the system as a whole has an excess of reserves, no one wants to be left holding it but someone must.

The problem arises once the central bank decides to raise interest rates again, as this, alas, would not be consistent with helicopter money. To do so, the central bank has only two options. Either it pays interest on those reserves at the policy rate, in which case this is equivalent to debt financing from the perspective of the consolidated public sector balance sheet – there are no interest savings. Or else it imposes a non-interest bearing compulsory reserve requirement to absorb the reserves, but this is equivalent to tax financing – someone in the private sector must bear the cost. While the tax would in the first instance fall directly on banks, they could decide to pass it on to their customers — for example, in the form of higher intermediation spreads.

Thus, either helicopter money comes at a prohibitive price – giving up control over monetary policy forever – or else, choreography and size aside, in its watered-down version it is not very different from what some central banks have already been doing: engineering temporary increases in reserves which may happen to coincide with increases in government deficits (a form of QE). Views about QE’s effectiveness differ, but we would be talking about “more of the same.” Such a policy already exploits the synergies between ultra-low interest rates and fiscal policy so as to enhance any expansionary impact that fiscal policy may have.

That said, choreography and size do matter. And they don’t speak in favor of the tool. Imagine policymakers went down this route, announcing that they were embarking on a “new” policy and explicitly linking the increase in reserves with higher public sector deficits. They could hide the inconvenient truth and renege on their promise not to raise rates. But this would hardly be an example of good policy, and in any case its effectiveness would at best be doubtful – the private sector would surely anticipate this possibility to some extent, thereby tempering the impact of the signal. Alternatively, policymakers could hope that the fanfare surrounding the tool would induce people to spend more. This is a possible but by no means obvious outcome. And in any case, unless the exercise is repeated over and over again on a large scale, its impact is likely to be only temporary.

And therein lies the danger. It is hard to imagine helicopter money not ending up in fiscal dominance, the outcome that would obviously be inevitable in its purest form, where interest rates are kept at zero forever. Sooner or later this could indeed erode the value of money, but at the cost of losing the public’s confidence in our monetary institutions – a trust so painfully gained over the years – and with unpredictable consequences. It would be a Pyrrhic victory.

AU$ Forex and Derivative Volumes Down

In April 2016, the Reserve Bank conducted a survey of activity in foreign exchange and over-the-counter (OTC) interest rate derivatives markets in Australia. Using data from the BIS and the RBA summary, here is a snapshot. This was part of a global survey of 52 countries, coordinated by the Bank for International Settlements (BIS). Similar surveys have been conducted every three years since 1986.

Globally, the Australian dollar remains the fifth most traded currency, although its share of turnover decreased by 1½ percentage points to around 7 per cent.

The AUD/USD remains the fourth most traded currency pair, having also accounted for a slightly decreased share of global turnover.

Activity in Australia’s foreign exchange market has moderated since the previous survey in April 2013. Total turnover fell by around 25 per cent, compared with a 5 per cent decrease in global turnover over the same period.

Nonetheless, the Australian foreign exchange market remains the eighth largest in the world.

Activity in Australian OTC interest rate derivatives markets declined markedly over the three-year period, primarily reflecting a decline in turnover of forward rate agreements.

The BIS data highlights the high volume of US$ Swaps, relative to other currencies. AUD is in fourth position.

The USA and UK dominate the derivative markets, with Australia in seventh position.

The preliminary results of the global turnover survey and links to other participating jurisdictions’ results are available from the BIS website. More detailed results for the Australian market are available on the 2016 BIS Triennial Survey Results – Australia page.

The BIS will also publish global data on outstanding OTC derivatives as at June 2016 in November.

The Reserve Bank will publish Australian data on outstanding OTC derivatives at that time.

BIS, FSB and IMF publish elements of effective macroprudential policies

The International Monetary Fund (IMF), Financial Stability Board (FSB) and Bank for International Settlements (BIS) released today a new publication on Elements of effective macroprudential policies. The document, which responds to a G20 request, takes stock of the international experience since the financial crisis in developing and implementing macroprudential policies and will be presented to the G20 Leaders’ Summit in Hangzhou.

Following the global financial crisis, many countries have introduced frameworks and tools aimed at limiting systemic risks that could otherwise disrupt the provision of financial services and damage the real economy. Such risks may build-up over time or arise from close linkages and the distribution of risk within the financial system.

Experience with macroprudential policy is growing, complemented by an increasing body of empirical research on the effectiveness of macroprudential tools. However, since the experience does not yet span a full financial cycle, the evidence remains tentative. “The wide range of institutional arrangements and policies being adopted across countries suggest that there is no ‘one-size-fits-all’. Nonetheless, accumulated experience highlights – and this paper documents – a number of elements that have been found useful for macroprudential policy making,” the publication says. These include:

A clear mandate that forms the basis for assigning responsibility for taking macroprudential policy decisions.

Adequate institutional foundations for macroprudential policy frameworks. Many of the observed designs give the main mandate to an influential body with a broad view of the entire financial system.

Well-defined objectives and powers that can foster the ability and willingness to act.

Transparency and accountability mechanisms to establish legitimacy and create commitment to take action.

Measures to promote cooperation and information-sharing between domestic authorities.

A comprehensive framework for analysing and monitoring systemic risk as well as efforts to close information gaps.

A broad range of policy tools to address systemic risk over time and from across the financial system.

The ability to calibrate policy responses to risks, including by considering the costs and benefits, addressing any leakages, and evaluating responses. In financially integrated economies, this includes assessing potential cross-border effects.

The document includes some data on the use of macroprudential tools; illustrative examples of institutional models for macroprudential policymaking; and a brief summary of some of the empirical literature on the effectiveness of macroprudential tools.

“Usage” counts the number of countries using the various instruments that comprise each group. Assuming that once a country introduces an instrument, it continues using it, the charts show usage of the various groups of instruments.

Institutional arrangements adopted by a country are shaped by country-specific circumstances, such as political and legal traditions, as well as prior choices on the regulatory architecture. While there can therefore be no “one size fits all” approach, in practice, there has been an increasing prevalence of models that assign the main macroprudential mandate to a well-identified authority, committee, or interagency body, generally with an important role of the central bank. While each of these models has pros and cons, any one model can be buttressed with additional safeguards and mechanisms.

Model 1: The main macroprudential mandate is assigned to the central bank, with its Board or Governor making macroprudential decisions (as in the Czech Republic, Ireland, New Zealand and Singapore). This model is the prevalent choice where the central bank already concentrates the relevant regulatory and supervisory powers. Where regulatory and supervisory authorities are established outside the central bank, the assignment of the mandate to the central bank can be complemented by coordination mechanisms, such as a committee chaired by the central bank (as in Estonia and Portugal), information sharing agreements, or explicit powers assigned to the central bank to make recommendations to other bodies (as in Norway and Switzerland).

Model 2: The main macroprudential mandate is assigned to a dedicated committee within the central bank structure (as in Malaysia and the UK). This setup creates dedicated objectives and decision-making structures for monetary and macroprudential policy where both policy functions are under the roof of the central bank, and can help counter the potential risks of dual mandates for the central bank (see further IMF 2013a). It also allows for separate regulatory and supervisory authorities and external experts to participate in the decision-making committee. This can foster an open discussion of trade-offs that brings to bear a range of perspectives and helps discipline the powers assigned to the central bank.

Model 3: The main macroprudential mandate is assigned to an interagency committee outside the central bank, in order to coordinate policy action and facilitate information sharing and discussion of system-wide risk, with the central bank participating on the committee (as in France, Germany, Mexico, and the US). This model can accommodate a stronger role of the Ministry of Finance (MoF). Participation of the MoF can be useful to create political legitimacy and enable decision makers to consider policy choices in other fields, e.g. when cooperation of the fiscal authority is needed to mitigate systemic risk.

Central Banks, The Road Ahead

In a speech entitled “The changing role of central banks“, given by François Groepe, Deputy Governor of the South African Reserve Bank, at the University of the Free State, Bloemfontein, he highlights there are limits to what these institutions can achieve, and there are challenging times ahead.

The past few years have been extremely challenging, both domestically and internationally. The aftershocks of the global financial crisis of 2008-09 have persisted. The advanced economies are still struggling to recover on a sustained basis, while the emerging markets, initially the main engine for the recovery, have fallen out of favour in the past four years, as the Chinese economy has slowed and brought commodity prices down with it.

Low growth is not the only issue. We are seeing increasingly widespread discontent about rising income and wealth disparities in many countries, where the fruits of growth have not been equitably shared and have been aggravated by persistently low growth.

The initial responses to the financial crisis involved both monetary and fiscal policy loosening. But fiscal space was eroded very soon as debt ratios rose to unsustainable levels. This placed a near impossible burden on monetary policy, which persists to this day.

Referring to the post-crisis focus on central banks, Mohamed El-Erian appropriately titled his most recent book The only game in town. Today, I would like to highlight the role that central banks can play in the economy and, perhaps more importantly, point out the limits to what central banks can do. It is important to understand these limits because, I would argue, the biggest risk to central bank independence is the possible backlash from being unable to deliver on unreasonable expectations. Central bank mandates have expanded – perhaps appropriately so – but there are limits to what monetary policy was designed to achieve. Central banks cannot be, and should not be regarded as, “the only game in town”.

Later he makes the point that centrals banks are less insulated from the political arena.

The main argument for independence is that it minimises the politicisation of monetary policy decision-making and avoids what is known as the “political interest rate cycle”. This refers to the incentive of politicians to lower interest rates in advance of elections. The argument is that an operationally independent central bank does not have to bow to such pressures.

The global crisis has created challenges for central banks that could undermine this seemingly comfortable insulation from the political arena. The expanded mandate of financial stability in itself may have implications for their independence, while the other possible objectives – such as financial inclusion and direct finance – imply political decisions being made by unelected officials.

Compared to financial stability decisions, decisions on monetary policy, while not easy, are more straightforward and better understood by the public. They usually involve the use of one tool, namely the interest rate, and there is a clear objective. The financial stability mandate is more complicated, as it is a shared responsibility. It generally involves government in crisis resolution, particularly when public funds are involved, and the policy tools are more directed at particular sectors; it may therefore be more politically sensitive as the distributional impacts are more apparent than in the case of monetary policy. Furthermore, as has been argued in a paper published by the International Monetary Fund, financial stability is difficult to measure but financial stability crises are evident, so policy failures are observable, unlike successes. As has been noted in the IMF paper, “central banks would find it difficult (even ex post facto) to defend potentially unpopular measures, precisely because they succeeded in maintaining financial stability”. Whichever failures may be perceived on the financial stability front have the potential to undermine monetary policy independence through a general loss of credibility of the central bank.

In conclusion, we are living in challenging times. Central banks are called on to do more and more, and are still called on to provide solutions to the low-growth environment we find ourselves in. But, as I have argued, although central banks play an important role in the economy and society at large, there are limits to what they can do – and these limits are not always well understood. Mohamed El-Erian argues that while we should give central banks due credit, their effectiveness is waning given the limited number of tools available to them. He argues that the world has come to a critical junction, and faces a choice of two roads. One road “involves a restoration of high-inclusive growth that creates jobs, reduces the risk of financial instability, and counters excessive inequality. It is a path that also lowers political tensions, eases corporate governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats. The other road is one of even lower growth, persistently high unemployment, and still worsening inequality. It is a road that involves renewed global financial instability, fuels political extremism, and erodes social cohesion as well as integrity”.

This is a sombre warning – and relevant both domestically and at the global level. It is clear what the preferred road is. Taking it requires political leadership and political will. This is not a responsibility that can be abdicated to central banks.

BIS issues revised securitisation framework

The Basel Committee on Banking Supervision today published an updated standard for the regulatory capital treatment of securitisation exposures. By including the regulatory capital treatment for “simple, transparent and comparable” (STC) securitisations, this standard amends the Committee’s 2014 capital standards for securitisations. This securitisation framework, which will come into effect in January 2018, forms part of the Committee’s broader Basel III agenda to reform regulatory standards for banks in response to the global financial crisis and thus contributes to a more resilient banking sector.

The crisis highlighted several weaknesses in the Basel II securitisation framework, including concerns that it could generate insufficient capital for certain exposures. This led the Committee to decide that the securitisation framework needed to be reviewed. The Committee identified a number of shortcomings
relating to the calibration of risk weights and a lack of incentives for good risk management.

(i) Mechanistic reliance on external ratings;
(ii) Excessively low risk weights for highly-rated securitisation exposures;
(iii) Excessively high risk weights for low-rated senior securitisation exposures;
(iv) Cliff effects; and
(v) Insufficient risk sensitivity of the framework.

The above shortcomings translate into specific objectives that the revisions to the framework seek to achieve: reduce mechanistic reliance on external ratings; increase risk weights for highly-rated securitisation exposures; reduce risk weights for low-rated senior securitisation exposures; reduce cliff effects; and enhance the risk sensitivity of the framework.

In July 2016 the Basel Committee on Banking Supervision published an updated standard for the regulatory capital treatment of securitisation exposures that includes the regulatory capital treatment for “simple, transparent and comparable” (STC) securitisations. This standard amends the Committee’s 2014 capital standards for securitisations.

The capital treatment for STC securitisations builds on the 2015 STC criteria published by the Basel Committee and the International Organization of Securities Commissions. The standard published today sets out additional criteria for differentiating the capital treatment of STC securitisations from that of other securitisation transactions. The additional criteria, for example, exclude transactions in which the standardised risk weights for the underlying assets exceed certain levels. This ensures that securitisations with higher-risk underlying exposures do not qualify for the same capital treatment as STC-compliant transactions.

The Committee has revised the hierarchy as part of the Basel III securitisation framework, to reduce the reliance on external ratings as well as to simplify it and limit the number of approaches.

The SEC-IRBA is at the top of the revised hierarchy. The underlying model is the Simplified Supervisory Formula Approach (SSFA) and it uses KIRB information as a key input. KIRB is the capital charge for the underlying exposures using the IRB framework (either the advanced or foundation approaches). In order to use the SEC-IRBA, the bank should have the same information as under the Basel II SFA: (i) a supervisory-approved IRB model for the type of underlying exposures in the securitisation pool; and (ii) sufficient information to estimate KIRB.

A bank that cannot calculate KIRB for a given securitisation exposure would have to use the SECERBA, provided that this method is implemented by the national regulator. A bank that cannot use the SEC-IRBA or the SEC-ERBA (either because the tranche is unrated or because its jurisdiction does not permit the use of ratings for regulatory purposes) would use the SEC-SA, with a generally more conservative calibration and using KSA as input. KSA is the capital charge for the underlying exposures using the Standardised Approach for credit risk. A slightly modified (and more conservative) version of the SEC-SA would be the only approach available for resecuritisation exposures. In general, a bank that cannot use SEC-IRBA, SEC-ERBA, or SEC-SA for a given securitisation exposure would assign the exposure a risk weight of 1,250%.

The revised Basel III securitisation framework represents a significant improvement to the Basel II framework in terms of reducing complexity of the hierarchy and the number of approaches. Under the revisions there would be only three primary approaches, as opposed to the multiple approaches and exceptional treatments allowed in the Basel II framework.

Further, the application of the hierarchy no longer depends on the role that the bank plays in the securitisation – investor or originator; or on the credit risk approach that the bank applies to the type of underlying exposures. Rather, the revised hierarchy of approaches relies on the information that is available to the bank and on the type of analysis and estimations that it can perform on a specific transaction.

The mechanistic reliance on external ratings has been reduced; not only because the RBA is no longer at the top of the hierarchy, but also because other relevant risk drivers have been incorporated into the SEC-ERBA (ie maturity and tranche thickness for non-senior exposures).

In terms of risk sensitivity and prudence, the revised framework also represents a step forward relative to the Basel II framework. The capital requirements have been significantly increased, commensurate with the risk of securitisation exposures. Still, capital requirements of senior securitisation exposures backed by good quality pools will be subject to risk weights as low as 15%. Moreover, the presence of caps to risk weights of senior tranches and limitations on maximum capital requirements aim to promote consistency with the underlying IRB framework and not to disincentivise securitisations of low credit risk exposures.

Compliance with the expanded set of STC criteria should provide additional confidence in the performance of the transactions, and thereby warrants a modest reduction in minimum capital requirements for STC securitisations. The Committee consulted in November 2015 on a proposed treatment of STC securitisations. Compared to the consultative version, the final standard has scaled down the risk weights for STC securitisation exposures, and has reduced the risk weight floor for senior exposures from 15% to 10%.

The Committee is currently reviewing similar issues related to short-term STC securitisations. It expects to consult on criteria and the regulatory capital treatment of such exposures around year-end.

The Euro Zone’s Inflation Problem

Dr Jens Weidmann, President of the Deutsche Bundesbank, highlighted the low inflation expectations within the Euro Zone, predicting no more than a gradual increase in inflation to 1.6 % this year, with 1.7 % growth assumed for each of the coming two years.

The global economy is on a moderate growth path. Though its momentum is weaker now than we had expected a little over half a year ago, the fears that prevailed in the financial markets every now and then did not materialise. However, right now we are seeing a shift in the dynamics of growth. In the emerging markets, where the situation had clouded over perceptibly at the beginning of the year, the situation is stabilising to a degree. The recessionary tendencies plaguing Russia have died down, although a sustainable recovery is not yet in sight. In China, growth prospects repeatedly required downward revisions in the past. The shift in growth seen thus far, though, is consistent with China’s transition to a more services-oriented, domestically driven economic model; if we look at it that way, we have no cause for anxiety.

And those countries which derive a large proportion of their value added from commodity exports are likely to benefit from the latest recovery of commodity prices, especially the significant increase in oil prices. By contrast, the United States and United Kingdom recently saw a slight deceleration of growth, with US growth being curbed by the oil industry delaying investment, amongst other factors. Private consumption was also on the weak side in both countries.

On the other hand, the euro area got off to a good start in 2016. Gross domestic product grew by a healthy 0.6 % on the quarter. Lively domestic demand, which benefited from low oil prices and the accommodative monetary policy, was a pillar of the upturn. However, another decisive factor was the surprisingly mild weather at the start of the year, which boosted, above all, the construction sector. The strong first-quarter growth should therefore not be extrapolated to the year as a whole.

On aggregate, the euro-area economy’s growth path is still only tepid at present. The latest Eurosystem staff projection has the euro-area economy growing by 1.6 % this year, with 1.7 % growth assumed for each of the coming two years.

Economic growth in Germany is looking relatively similar, even though the situation – seen, for instance, in terms of capacity utilisation and labour market indicators – is significantly better than in the rest of the euro area. Our country did, after all, post respectable first-quarter growth of 0.7 %. However, even in Germany, aggregate economic growth will peter out somewhat as the year progresses. Bundesbank economists are expecting growth of 1.7 % this year. Owing to the difficult external environment, growth is projected to decelerate temporarily to 1.4 % for 2017 before then climbing back up to 1.6 % in 2018.

Monetary policy

For us as central bankers, macroeconomic analysis is, of course, not an end in itself. After all, our mandate is not to steer the economy but instead to maintain price stability. Economic growth, however, is one determinant of enterprises’ capacity utilisation and their scope for raising prices. It also indicates how much leeway wage bargainers have in wage negotiations.

Inflation rates have been very low for some time now in many currency areas, and the euro area is no exception. Here, inflation is even in negative territory; in May, prices were down by 0.1 % on the year. In the past two years, it was mainly the sharp fall in commodity prices, particularly oil prices, which pushed inflation down. However, the impact of a change in oil prices will automatically be washed out of the inflation rate over time. And the recent rise in oil prices is helping to speed up this process somewhat.

However, the low inflation rates in the euro area are not just an outcome of the fall in oil prices. Core inflation, i.e. the price index adjusted to exclude energy and food prices, is likewise relatively low. The muted domestic price pressures measured in this manner also show that some euro-area economies are recovering only gradually and that unemployment levels in those countries are still very high.

Seeing as the euro-area economic recovery is only tepid, the Eurosystem projections foresee no more than a gradual increase in inflation to 1.3 % next year and 1.6 % in 2018.

In view of this muted price outlook, an accommodative monetary policy is appropriate at present, though reasonable people can disagree about the specific design of the non-standard measures. There is one thing I would like to stress, though: Our definition of price stability requires the target inflation rate to be achieved over the medium term. This will give us enough time to see how the adopted monetary policy measures will impact on price movements, especially since, as I have been pointing out time and again, the Eurosystem is still something of a novice when it comes to applying non-standard monetary policy, and the risks and side-effects of the ultra-accommodative monetary policy are growing over time.

Why Have Interest Rates Fallen So Far in Asia-Pacific?

As we highlighted recently, global interest rates are lower than they have been for many years, and appear to be locked into a “new normal” which could be close to zero. It is important to understand the mechanisms which have led to this situation, because it is quite possible that the normal assumptions underlying monetary policy (cut rates to stimulate growth; lift rates to control inflation) no longer apply. If this were true, new approaches would be needed, and current unorthodox strategies would need to be re-calibrated. Could it be that demographic shifts and financial sector developments actually explain the shifts, rather than asset price or GDP growth? If true, low rates won’t solve the underlying issues.

The IMF finds that “real interest rates worldwide have declined substantially since the 1980s”. Recent work, (King and Low 2014) estimate a “world real interest rate” and find that the weighted rate has declined from a peak of 4.93% in the first quarter of 1992 to ‒0.48% in the second quarter of 2013. Bernanke (2015) observes the exceptionally low global interest rates, both short- and long-term, are not a “short-term aberration” but a long-term trend.

Timely then, that The Bank for International Settlements (BIS) has just released a staff working paper “Understanding the changing equilibrium real interest rates in Asia-Pacific”, which studies the evolution of the equilibrium real interest rate (i.e. natural or neutral interest rate) in Asia-Pacific.

There are several competing theories behind the decline in equilibrium real interest rates. First, globalisation, especially trade and financial integration have helped forge a global market where domestic factors have begun to play a less prominent role. Financial integration implies that a larger share of global savings is channelled into cross-border financing of investment. In this vein, Bernanke (2005) proposes the “global savings glut” hypothesis, whereby the real interest rate falls to equilibrate the market for global saving as desired saving outstrips desired investment, and saving originating in China and other emerging economies holds down long-term interest rates. Caballero (2006) suggests the existence of a “safe asset shortage” due to rising global demand, as in emerging economies with rapid growth and high savings, there is limited availability of local safe assets in their undeveloped capital markets.

Second, many economists link the apparent decline in equilibrium real interest rates to a “new normal” world of lower potential output and trend growth, manifested in sluggish growth persisting in the major economies following the financial crisis. This has often been attributed to, among other factors, a secular deficiency in aggregate demand, significant financial frictions, unfavourable demographic trends, ebbing innovations, debt overhang, and insufficient structural policies. This may lead to “secular stagnation”, as a low and declining rate of population growth and a slower pace of technological advance result in lower returns, less investment and consumer spending, creating a situation of persistently inadequate demand. This leads to a declining natural rate of interest.

Related to this new-normal slow growth scenario is the “new neutral” thesis focussing on the exceedingly low real policy rates in many advanced and emerging economies alike. McCulley (2003) considers the US natural rate much lower than commonly assumed. In Clarida’s (2014) view, central banks now operate in a world where average policy rates are set well below their pre-crisis levels, a direct consequence of the “global leverage overhang and moderate rates of potential trend growth”. Clarida (2015) suggests that global factors have played a key role, with the lower US neutral policy rate driven by a slowdown in “global potential growth”, and “a persistent excess of global saving relative to desired investment opportunities”.

There have been so far very few attempts to estimate and assess the equilibrium real interest rates for the emerging economies, even less for the emerging Asia. The paper the examines the relationship between the long-run component of real interest rate and those of population characteristics, globalisation, and a range of macroeconomic and financial variables (e.g. credit and asset prices) as well as trend growth in the evolution of the natural interest rates in the region to determine whether these factors may account for the changes over time and differences across countries in the natural rate estimates.

Several results emerge. First, simple estimates suggest that except for China, and also Thailand since 2005, the natural interest rate has declined substantially in Asian-Pacific economies since the early or mid-1990s, by over 4 percentage points on average. In many economies the rate has turned negative. The tendency has become more accentuated in the 2000s, especially since the onset of the global financial crisis and the Great Recession. Second, the natural interest rate estimates vary significantly over time and across the economies. Third, the association seems to be broad and strong between the natural interest rate and the low-frequency trend components of demographic and global factors in Asia-Pacific, but it appears to be weak between the natural interest rate and trends in asset prices, credit-to GDP ratio and trend growth in many economies in the region. In most cases, the natural interest rate does seem to be correlated with broadly measured long-term financial sector development, and trends in saving rate and investment ratio.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.