Tag: Financial Stability

How To Deal With Failed Banks (And The Risks Around Bail-Ins)

The IMF has published an excellent piece on their blog, which sharply defines the issues around bank bail-out and bail-in should a bank fail.

The trouble is the “bail-in” route which they define as targetting “Sophisticated Investors” such as super funds, effectively means a indirect risk to households who save via their superannuation, and of course there is the risk that even deposits could be grabbed as is explicitly stated in New Zealand.

The IMF argues that the risk of bail-in means prospective investors should see a premium to cover the risk, in the returns they get from their investments. But it seems to me in an attempt to deflect risks away from governments being forced to bail-out a bank, once again the end user of financial services products are effectively taking the risks, and creating a moral hazard, where banks and governments can pass the buck.

Watch my previous video:

During the global financial crisis, policymakers faced a steep trade-off in handling bank failures. Using public funds to rescue failing banks (bail-outs) could weaken market discipline and lead to excessive risk taking—the moral hazard effect.

Letting private investors absorb the losses (bail-ins) could destabilize the financial sector and the economy as a whole—the spillover effect. In most cases, banks were bailed out.

This created public resentment and prompted policymakers to introduce measures to shift the burden of bank resolution away from taxpayers to private investors.

Resolving a failing bank should rely on bail-ins: private stakeholders should bear the losses.

Our recent study, also featured in an Analytical Corner in the 2018 Spring Meetings, looks at the question of what to do when a bank fails.

We advocate a resolution framework that carefully balances the moral hazard and spillover effects and improves the trade-off. Such a framework would make bail-outs the exception rather than the rule.

Balancing moral hazard and spillover effects

Not all crises are alike. Some are isolated, with little or no spillover effect. In those cases, bail-outs would merely create moral hazard. Resolving a failing bank should rely on bail-ins: private stakeholders should bear the losses.

Other crises are systemic, and affect all corners of an economy or many countries at the same time.

The destabilizing spillovers associated with bank failures in such a situation would justify the use of public resources: moral hazard still exists but is bearable compared to the alternative of a severe crisis that hurts all, including those without a stake in the troubled bank.

So, the framework should commit to using bail-ins in most cases and allow use of public funds only when the risks to macro-financial stability from bail-ins are exceptionally severe.

Improving the trade-off

The best way to avoid such dilemmas is to reduce spillovers and the need for bail-outs in the first place. This can be achieved through two mutually re-enforcing mechanisms.

The first mechanism is reducing the likelihood of crises and minimizing costs should a crisis occur. This translates into having a more resilient banking system: less leverage and risk taking, and more capital and liquidity. Then the odds that a bank runs into trouble are smaller. And, if there is trouble, banks can absorb the losses without help from the government.

The second mechanism is making the bail-in option viable. The problem is that policymakers may make the promise to bail in a troubled bank but, in a crisis, they will be tempted to bail them out. So people will not believe that bail-ins will happen and continue to expect bail-outs.

This is the worst of both worlds, because it has spillover and moral hazard effects.

How do policymakers make a credible commitment that there really will be bail-ins?

First, ensure that banks have enough buffers to absorb losses and clarify upfront which investor claims (such as bonds and deposits) will in the event of failure be written down and in what order. Second, only allow sophisticated investors who can understand and absorb the losses to hold these bail-in-able claims. Third, improve systemic banks’ resolvability by periodic assessments, living wills that spell out how the bank will be resolved, and domestic and cross-border drills to assess the impact of a threat.

Turning to the other side of the trade-off, how do we limit moral hazard?

First, credibly commit to using bail-outs only in exceptional cases and on a temporary basis with a clear exit plan. Second, use public funds only after those that can absorb the losses have been bailed in. Third, recover these bail-out funds after the storm has passed and ensure that all is executed in a transparent, accountable manner.

The way forward

Reforms since the crisis have improved the trade-off by seeking to make bail-ins a credible option and to make bail-outs less likely.

New frameworks—such as those in the United States and the European Union—introduce comprehensive powers to resolve banks, including through bail-ins. These measures also seek to contain spillovers from bail-ins by ensuring that banks have adequate buffers to absorb losses, and aim to make them more resolvable via effective resolution planning.

We support the ongoing reform agenda and stress that resolution frameworks should minimize moral hazard. That said, we also emphasize the need to allow for sufficient, albeit constrained, flexibility to be able to use public resources in systemic crises—when spillovers are deemed likely to severely jeopardize macro-financial stability.

APRA Says Financial System Is Just Fine

In his opening statement to the Senate Economics Legislation Committee, Wayne Byres, APRA Chairman said  that Australians can be reassured that the industry is financially sound, and that the financial system is stable.

So that’s OK then!

When I last addressed this Committee, I outlined some of the many ways APRA is accountable to both the Parliament and the Australian people. These measures are crucial for APRA to maintain the trust of industry and the public as we aim to fulfil our mandate as a prudential regulator, promoting financial safety and thereby protecting the interests of bank depositors, insurance policyholders and superannuation members.

The core of APRA’s mission is safety and soundness. Clearly, some of the revelations emerging from the Royal Commission have been disturbing and go to the heart of whether financial institutions treat their customers fairly. However, while institutions have a great deal of work to do to restore trust, I want to emphasise that Australians can be reassured that the industry is financially sound, and that the financial system is stable. That reflects considerable policy reform and hands-on supervision, over a long period of time, designed to build strength and resilience. We don’t know when the next period of adversity will arrive or what will trigger it, but when it does arrive we need to have done what we could to strengthen the financial system so that it can continue to provide its essential services to the Australian community when they are needed most.

The importance of accountability has been one of our key themes this year, and was front and centre with the release in April of our review of executive remuneration practices in large financial institutions. Incentives and accountability can play an important role in driving positive outcomes such as growth, innovation and productivity, and also in deterring behaviours or decisions that produce poor risk-taking and damaging results. Our review found that while policies and processes existed within institutions to align remuneration with sound risk outcomes, their practical application was often weak. We have indicated that we are minded to strengthen the prudential framework to give better effect to the principles we want to see followed – less rewards based on narrow and mechanical shareholder metrics, and greater exercise of Board discretion to judge senior executive performance more holistically. But we have also urged institutions to push ahead with their own improvements, notwithstanding some investor opposition, in light of the long-term commercial benefits that can flow from better remuneration practices.

A lack of accountability for poor outcomes was a theme that also emerged in the Final Report of the Prudential Inquiry into the Commonwealth Bank of Australia, which was released earlier this month. The Report is clear and comprehensive, and provides a strong message – not just to CBA but to the entire financial services industry – about the importance of cultivating a robust risk culture, especially when it comes to non-financial risks. We are keen that the Report will be seen not just a road map for CBA, but a useful guide for all institutions in relation to strengthening governance, culture and accountability.

Residential mortgage lending is another area where APRA has been lifting industry standards. Although there remains more to do before we are ready to significantly dial back our supervisory intensity, there has been a lift in industry lending practices. As a result, last month we announced we would remove the 10 per cent investor growth benchmark for those lenders who could provide a range of assurances as to the quality of their lending standards and practices now and into the future.

Superannuation is an area where APRA consistently emphasises the need for trustees, regardless of size or ownership structure, to go beyond compliance with minimum regulatory requirements and aim to deliver the best possible outcomes for members. In this vein, we have just released the results of two thematic reviews of superannuation licensees; on board governance and the management of related parties. Both reviews noted improvements in industry practices in recent years, but also found more work was needed to address some longstanding weaknesses, including finding ways to bring fresh ideas, perspectives and skills onto trustee boards. Our post-implementation review of 2013’s Stronger Super reforms, launched last week, should also provide us additional insights on how the prudential framework is performing, and whether any adjustments would help to better achieve our objectives. Many of the findings in the Productivity Commission report into superannuation released this week are consistent with APRA’s approach to supervising RSE licensees. In particular, they align with APRA’s focus on enhancing the delivery of member outcomes through our engagement with trustees with “outlier” underperforming funds and products.

Technology is rapidly changing the way financial institutions operate. In all likelihood, the financial system will look very different in five years’ time relative to the way it looks today. Much of that change will bring benefits to the community, in the form of new competitors, products and ways of access. But it will also bring risks, and the accelerating threat of cyber-attacks to regulated entities has prompted APRA to recently propose its first prudential standard on information security. Industry consultation is ongoing, but we hope to implement the new cross-industry standard from 1 July next year. This is an issue which is only going to grow in importance.

Continuing to look ahead, APRA’s preparations are well advanced for the commencement of the Banking Executive Accountability Regime (BEAR), which will begin in just over a month. The BEAR largely strengthens APRA’s existing powers to identify and address the prudential risks arising from poor governance, weak culture, or ineffective risk management. However, I have made the point previously that while important, the BEAR alone will not remedy perceived weakness in financial sector accountability, and we have encouraged all regulated entities – not just ADIs – to use the new regime as a trigger to genuinely improve systems of governance, responsibility and accountability.

Finally, APRA is continuing to provide relevant information to the Royal Commission to help it in its inquiries.  In addition, APRA and the Australian financial system more broadly, will be subject to intensive scrutiny from the International Monetary Fund in the weeks ahead as part of its 2018 Financial Sector Assessment Program (FSAP). The FSAP will examine in quite some detail financial sector vulnerabilities and the quality of regulatory oversight arrangements in Australia. As ever, APRA will fully cooperate with our international reviewers, and look forward to their report card, including any recommendations on how we could perform our role more effectively in the future.

With those opening remarks, we would now be happy to answer the Committee’s questions.

Our Own Version Of Sub-Prime?

The RBA has released their Financial Stability Review today. It is worth reading the 70 odd pages as it give a comprehensive picture of the current state of play, though through the Central Bank’s rose-tinted spectacles!

They home in on the say $480 billion interest only mortgage loans due for reset over the over the next four years, which is around 30 per cent of outstanding loans. Resets to principal and interest will lift repayments by at least 30%. Some borrowers will be forced to sell.

This scenario mirrors the roll over of adjustable rate home loans in the United States which triggered the 2008 sub-prime mortgage crisis. Perhaps this is our own version!

We have previously estimated more than $100 billion in these loans would now fail current tighter underwriting standards.

One area of potential concern is for borrowers at the end of their current IO period. Much of the large stock of IO loans are due to convert to P&I loans between 2018 and 2021, with loans with expiring IO periods estimated to average around $120 billion per year or, in total, around 30 per cent of the current stock of outstanding mortgage credit. The step-up in mortgage
payments when the IO period ends can be in the range of 30 to 40 per cent, even after factoring in the typically lower interest rates charged on P&I loans.

However, a number of factors suggest that any resulting increase in financial stress should not be widespread. Most borrowers should be able to afford the step-up in mortgage repayments because many have  accumulated substantial prepayments, and the serviceability assessments used to write IO loans incorporate a range of buffers, including those that factor in potential future interest rate increases and those that directly account for the step-up in payments at the end of the IO period.

Moreover, these buffers have increased in recent years. In addition to raising the interest rate buffer, APRA tightened its loan serviceability standards for IO loans in late 2014, requiring banks to conduct serviceability assessments for new loans based on the required repayments over the residual P&I period of the loan that follows the IO period.

Prior to this, some banks were conducting these assessments assuming P&I repayments were made over the entire life of the loan (including the IO period), which in the Australian Securities and Investments Commission’s (ASIC’s) view was not consistent with responsible lending requirements. As a result, eight lenders have agreed to provide remediation to borrowers that face financial stress as a direct result of past poor IO lending practices.

However, to date, only a small number of borrowers have been identified as being eligible for such remediation action. Some borrowers have voluntarily switched to P&I repayments early to avoid the new higher interest rates on IO loans, and these borrowers appear well placed to handle the higher repayments.

Some IO borrowers may be able to delay or reduce the step-up in repayments. Depending on personal circumstances some may be eligible to extend the IO period on their existing loan or refinance into a new IO loan or a new P&I loan with a longer residual loan term. The share of borrowers who cannot afford higher P&I repayments and are not eligible to alleviate their situation by refinancing is thought to be small.

In addition, borrowers who are in this situation as a result of past poor lending practices may be eligible for remediation from lenders. Most would be expected to have positive equity given substantial housing price growth in many parts of the country over recent years and hence would at least have the option to sell the property if they experienced financial stress from the increase in repayments. The most vulnerable borrowers would likely be owner-occupiers that still have a high LVR and who might find it more difficult to refinance or resolve their situation by selling the property.

Looking more broadly  at household finances, they say that the ratio of total household debt to income has increased by almost 30 percentage points over the past five years to almost 190 per cent, after having been broadly unchanged for close to a decade.

Australia’s household debt-to-income ratio is high relative to many other advanced economies, including some that have also continued to see strong growth in household lending in the post-crisis period, such as Canada, New Zealand and Sweden.

Household debt in these economies is notably higher than in those that were more affected by the financial crisis and experienced deleveraging, including Spain, the United Kingdom and the United States. While Australia’s high level of household indebtedness increases the risk that some households might experience financial stress in the event of a negative shock, most indicators of aggregate household financial stress currently remain fairly low (notwithstanding some areas of concern, particularly in mining regions). In addition, total household mortgage debt repayments as a share of income have been broadly steady for several years.

Note of course this is because interest rates have been cut to ultra-low levels, and should rates rise, payments would rise significantly.

The RBA says that default rates on mortgages (More than $1.7 trillion) is low, but concedes higher in the mining heavy states.

Then they defend the situation by saying that household wealth is rising (though thanks mainly to inflated property values, currently beginning to correct), and continue to cite out of date HILDA survey data from 3 years ago to demonstrate that the share of households experiencing financial stress has been the lowest since at least the early 2000s. But this is so old as to be laughable, remembering the interest rates and living costs have risen, and incomes are flat in real terms.

And they argue again that households are prepaying on their mortgages. We agree some are, but not those in the stressed category. Averaging data is a wonderful thing!

Finally, a word on the profitability outlook of the banks.

Despite the recent lift, analysts are cautious about the outlook for profit growth. The recent benefits to profit growth from a widening of the NIM and falling bad debt charges are expected to fade, especially if short-term wholesale spreads remain elevated. The financial impact of the multiple inquiries into the financial services sector remains a key uncertainty, including the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the Productivity Commission’s Inquiry into Competition in Australia‘s Financial System, and the Australian Competition and Consumer Commission’s Residential Mortgage Products Price Inquiry. There is the potential that these will result in banks having to set aside provisions and/or face penalties for past misconduct or perhaps (more notably) being constrained in the operation of parts of their businesses.

This uncertainty around banks’ future earnings has weighed on their share prices, which have underperformed global peers (although Australian banks still have higher price-to-book ratios). The decline in share prices has also seen banks’ forward earnings yields (a proxy for their cost of equity capital) further diverge from that of the rest of the Australian market since mid 2017 (Graph 3.8). Banks’ current forward earnings yields remain a little above their pre-crisis average, despite a large decline in risk-free rates since then.

Early warning indicators of banking crises: expanding the family

The Bank for International Settlements has just published a special report on Early Warning Indicators Of Banking Crises.

Household and international debt (cross-border or in foreign currency) are a potential source of vulnerabilities that could eventually lead to banking crises. We explore this issue formally by assessing the performance of these debt categories as early warning indicators (EWIs) for systemic banking crises. We find that they do contain useful information. In fact, over the more recent subsample, for household and cross-border debt indicators the information is similar to that of the more commonly used aggregate credit variables regularly monitored by the BIS. Confirming previous work, combining these indicators with property prices improves performance. An analysis of current global conditions based on this richer information set points to the build-up of vulnerabilities in several countries.

Early warning indicators (EWIs) of banking crises are typically based on the notion that crises take root in disruptive financial cycles. The basic intuition is that outsize financial booms can generate the conditions for future banking distress. The narrative of financial booms is well understood: risk appetite is high, asset prices soar and credit surges. Yet it is difficult to detect the build-up of financial booms in real time and with reasonable confidence. It is here that EWIs come in.

Table 4 takes a closer look at the status of the various indicators as of June 2017. Cells are marked in red if the indicator has breached the threshold for predicting at least two thirds of the crises. Those marked in amber correspond to the lower threshold required to predict at least 90% of the crises. This avoids a false sense of precision and captures the very gradual build-up in vulnerabilities. Asterisks indicate that the corresponding combined credit-cum-property price indicator has breached its critical threshold. The picture that emerges is a varied one.

Aggregate credit indicators point to vulnerabilities in several jurisdictions Canada, China and Hong Kong SAR stand out, with both the credit-to-GDP gap and the DSR flashing red. For Canada and Hong Kong, these signals are reinforced by property price developments. The credit-to-GDP gap also flashes red in Switzerland, whereas the total DSR flashes red in Russia and Turkey.

Credit conditions are also quite buoyant elsewhere. Credit-to-GDP gaps and/or the total DSR send amber signals in some advanced economies, such as France, Japan and Switzerland, as well as in several emerging market economies (EMEs). In Indonesia, Malaysia and Thailand, as well as some other countries, property price gaps underscore this signal.

Some jurisdictions also exhibit some signs of high household sector vulnerabilities. In Korea, Russia and Thailand, the household sector DSR flashes red (Table 4, third column). In Thailand, the red signal for the household DSR is underlined by the property price indicator. Property prices have also been in elevated in Sweden and Canada, which exhibit an amber signal for the household DSR.

The cross-border claims indicator supports the risk assessment for several countries and flags some potential external vulnerabilities for others (Table 4, fourth column). The indicator flashes red for Norway, and is amber for a number of economies.

While providing a general sense of where policymakers may wish to be especially vigilant, these indicators need to be interpreted with considerable caution. As always, they have been calibrated based on past experience, and cannot take account of broader institutional and economic changes that have taken place since previous crises. For example, the much more active use of macroprudential measures should have strengthened the resilience of the financial system to a financial bust, even if it may not have prevented the build-up of the usual signs of vulnerabilities. Similarly, the large increase in foreign currency reserves in several EMEs should help buffer strains. The indicators should be seen not as a definitive warning but only as a first step in a broader analysis – a tool to help guide a more drilled down and granular assessment of financial vulnerabilities. And they may also point to broader macroeconomic vulnerabilities, providing a sense of the potential slowdown in output from financial cycle developments should the outlook deteriorate.

This Is Why Markets Have Gotten Jumpy

Back in April 2017, the IMF released a Financial Stability Report update which said that “in the United States, if the anticipated tax reforms and deregulation deliver paths for growth and debt that are less benign than expected, risk premiums and volatility could rise sharply, undermining financial stability”.

They said that more than 20% of US firms would find it hard to service their debts, if rates rose – and yes, now rates are rising! This puts pressure on companies, and on their banks.  This is no “flash crash”, it’s structural!

Under a scenario of rising global risk premiums, higher leverage could have negative stability consequences. In such a scenario, the assets of firms with particularly low debt service capacity could rise to nearly $4 trillion, or almost a quarter of corporate assets considered.

The number of US firms with very low interest coverage ratios—a common signal of distress—is already high: currently, firms accounting for 10 percent of corporate assets appear unable to meet interest expenses out of current earnings (Panel 5).

 

This figure doubles to 20 percent of corporate assets when considering firms that have slightly higher earnings cover for interest payments, and rises to 22 percent under the assumed interest rate rise. The stark rise in the number of challenged firms has been mostly concentrated in the energy sector, partly as a result of oil price volatility over the past few years. But the proportion of challenged firms has broadened across such other industries as real estate and utilities. Together, these three industries currently account for about half of firms struggling to meet debt service obligations and higher borrowing costs (Panel 6).