Tag: Fitch Ratings

Australia’s Interest-Only Cap Removal Won’t Spur Lending

The Australian Prudential Regulation Authority’s (APRA) macro-prudential easing on interest-only residential mortgages is unlikely to meaningfully affect loan growth, as tighter underwriting standards have become the most effective constraint on riskier types of lending, says Fitch Ratings.

The restriction that interest-only loans cannot exceed 30% of new mortgages, which APRA will remove from 1 January 2019 for most banks, was put in place in March 2017 as part of the regulator’s efforts to contain banking-sector risk amid rising house prices and high and increasing household debt. The cap initially had a strong impact, but banks have collectively been operating well below the limit over the previous year due to stronger underwriting standards. This partly reflects the regulatory focus on risk control and mortgage underwriting – with APRA strengthening serviceability testing, for example – while banks have also become more cautious as market conditions have toughened.

The benchmark will be removed for banks that have provided assurances on maintaining the strength of their underwriting standards, which was also a requirement for the removal of a cap on investor loan growth in April 2018. Most banks have provided these assurances.

Some banks could take advantage of the cap removal to gain market share in a slow credit-growth environment, but we expect no more than a small uptick in overall interest-only lending. Lending standards should continue to curb the pace at which interest-only loans are made available by banks. The weak housing market, especially in Sydney and Melbourne, is also a headwind to interest-only lending, as it will dampen investor demand and speculative buying. We forecast nationwide house prices to drop by 5% yoy in 2019.

Fitch expects Australian banks to continue tightening control frameworks and underwriting standards, especially around expense testing and income verification, which should support the quality of new mortgages. APRA plans to review banks’ risk controls and interest-only lending as part of a broader assessment of lending standards next year.

The interest-only lending cap is the last macro-prudential measure outstanding. Fitch maintains a negative outlook on Australia’s banking sector, as bank returns are likely to fall further in the near term on slowing mortgage credit growth – especially in the residential mortgage segment – further remediation and compliance costs associated with inquiries into the financial sector, higher wholesale funding costs and rising loan-impairment charges.


Does A Flatter Yield Curve Signal An Imminent U.S. Recession?

The risk of an imminent U.S. recession remains low despite the recent flattening of the U.S. yield curve, Fitch Ratings says.

“The underlying recession signals traditionally embodied by a yield curve inversion, namely high policy interest rates relative to long-term expectations of policy rates, and falling bank profitability and credit availability, are absent. Yield-curve flattening does nevertheless emphasize that the U.S. economic cycle is in a late stage of expansion.

The yield curve has been a good lead indicator of U.S. recessions. Each of the past nine recessions were preceded by a yield curve inversion when 10-year yields fell below one-year yields. The recent narrowing of the 10-year minus one-year spread to its lowest level since summer 2007 has prompted a debate about potential economic implications.

The yield curve has not yet inverted except at some shorter tenors. Our Global Economic Outlook  forecasts suggest that to be unlikely. We forecast the U.S. 10-year yield to end this year at 3.1% from 2.85% today and predict a year-end Fed Funds rate of 2.5%. We also see both the Fed Funds rate and 10-year yields rising broadly in tandem through 2019. Even if the yield curve inverts, there are reasons to discount this as a ‘red flag.’

The historical time lags between inversion and recessions have been highly variable, from six months to up to two years. The correlation between the yield curve and GDP growth has been far from perfect. While each recession has been preceded by an inversion, not every inversion has been followed by a recession. The relationship through the mid-1990s was very poor. Since early 2010 there has been a steady flattening while U.S. growth has remained broadly stable.

The flattening since 2010 was associated with massive central bank bond buying under Quantitative Easing (QE) programs reducing long-term yields. While the Fed has started to gradually unwind its Treasury holdings, they remain huge and continue to suppress long-term yields. Ongoing QE purchases by the European Central Bank and Bank of Japan have also likely reduced U.S. bond yields, albeit indirectly.

These distortions to bond pricing reduce the value of the curve as an independent, market-based signal of the monetary policy stance. We do not believe that U.S. monetary policy is tight in an absolute sense, which would be the typical interpretation from a flat or inverted curve, reflecting current policy interest rates that are below levels expected in the long run. The Fed Funds rate is still quite close to zero in real terms despite inflation being close to target and unemployment below sustainable levels.

Bank profits are also traditionally thought to help explain the predictive power of the yield curve. Curve-flattening is generally perceived as compressing net-interest margins (NIM) and reducing banks’ willingness to lend. However, U.S. banks NIMs have risen steadily over the past three years, partly helped by changing balance sheet structures, and little evidence shows any deceleration in private credit or decline in banks’ willingness to lend. An inversion would limit the capacity for banks to further increase net-interest income but there is little evidence of this having happened so far.

Solid consumer income, private investment momentum and an aggressively expansionary fiscal stance should all support strong U.S. GDP growth in the next 12 months. Nevertheless, the flattening yield curve is consistent with the U.S. economy being at a late stage in the cycle, with an unusually long expansion to date and growth currently well above Fitch’s estimate of U.S. supply-side growth potential of 1.9% Fitch expects U.S. growth to tail off quite sharply in 2020 to 2.0% (from 2.9% in 2018) as macro policy support is removed and supply side constraints start to bind”.

Cracks Appearing in Global Growth Picture as 2020 Headwinds Rise

Global growth is slowing and becoming less well-balanced, while downside risks are rising, particularly for 2020, says Fitch Ratings in its new Global Economic Outlook (GEO).

“The world economy is still expanding at a rapid pace, but cracks are starting to appear in the global growth picture,” said Fitch Chief Economist, Brian Coulton

“Eurozone growth outturns have disappointed once again, world trade is decelerating and the China slowdown is now fact, not forecast,” added Coulton.

Growth dynamics within the three main economies have become more divergent, with US growth still rising on a year-on-year basis, while growth in the eurozone and China is falling.

A historically tight US labour market and the ongoing fiscal boost to growth from higher government spending will keep the Fed on a course for three more rate hikes in 2019 despite a softer external environment. US GDP growth remains on track to reach around 3% this year. While we expect growth to slow next year, the economy will still expand at an above-trend pace of 2.6%.

But downgrades to the eurozone growth outlook, which continue a pattern seen in the last few editions of the GEO, and stubbornly low core inflation now look likely to persuade the ECB to hold off from raising interest rates until 2020. We are no longer forecasting the ECB to raise rates in 2019. This will help provide further support to the US dollar, keeping pressure on emerging markets (EMs), where financing conditions have tightened significantly.

Our base case remains a soft landing for global growth in 2020 as US fiscal support fades. But downside risks – from a faster-than-expected tightening of global financial conditions as central bank liquidity shrinks, or an escalation in market fears about eurozone fragmentation – have increased. Notably, this year has shown the capacity for tightening global liquidity to adversely affect the growth outlook, particularly for EMs. Trade protectionism also remains a key downside risk despite some recent more positive news flow on the US/China trade war, with the announcement of fresh negotiations and a 90-day extension of the deadline before the next increase in US tariffs.

Fitch’s December 2018 GEO sees global growth forecasts unchanged for this year and next, with growth peaking in 2018 at 3.3% before moderating to 3.1% in 2019 and then falling below 3% in 2020. Forecasts for eurozone growth in 2018 and 2019 have been revised down to 1.9% and 1.7%, respectively (compared with 2% and 1.8% in the September GEO). EM growth forecasts for 2019 and 2020 have also been cut, partly reflecting tighter financial conditions in India, Indonesia and Turkey. Our forecasts for China have not changed in this edition of the GEO, but the slowdown we have been expecting for a while is now materialising.

EU Bail-in Rule Exposes Medium-Sized Banks’ Senior Creditors

The provisional agreement on minimum levels of bail-inable subordinated debt in the EU’s Bank Recovery and Resolution Directive (BRRD) may leave senior creditors of medium-sized banks more exposed if those banks fail, Fitch Ratings says. This could include, in extremis, wholesale depositors.

Minimum subordinated debt requirements may be amended to apply only to global systemically important banks (G-SIBs) and “top-tier” banks with assets above EUR100 billion, according to a statement from Gunnar Hoekmark, the EU Parliament’s rapporteur, on his website last Thursday. This would be consistent with a draft proposal discussed by the European Council in May.

As we noted in May, limiting bail-able debt requirements to the largest banks could mean medium-sized banks’ senior creditors miss out on the protection that subordinated debt buffers would provide. The agreement could make it more difficult to apply the EU’s bail-in framework to medium-sized banks, for example if there were legal challenges from bondholders that are bailed in while equally ranking creditors (such as wholesale depositors) are not.

Alternatively, if equally ranking retail bondholders and wholesale depositors were bailed in alongside institutional bondholders, this could create financial stability risks. The European Commission will assess whether all deposits should be preferred in an insolvency by December 2020.

The protection provided by minimum requirements is reflected in our bank ratings. Once subordinated bail-in and other unused debt buffers junior to preferred senior debt (for instance, unused additional Tier 1 and Tier 2) have been sufficiently built up, senior ranking debt can be rated one notch above the senior bail-inable debt.

The EUR100 billion cut-off is particularly relevant to less-concentrated banking systems, for example in Italy and Spain, and to smaller EU countries. For banks below the threshold, it could be challenging and costly to issue large amounts of subordinated debt, particularly for smaller banks that are less frequent borrowers in the debt capital markets. This is likely to explain why southern EU member states want to limit the application of minimum subordination requirements to avoid forcing any but the largest banks to build subordinated debt buffers.

For this reason, we expect the final rules will give national resolution authorities the option to request subordinated minimum required eligible liabilities and own funds (MREL) for banks which they deem systemic – but this will not be automatic, as it is for the top-tier banks and GSIBs. This will lead to variations in the approaches of EU member states to ensuring banks have sufficient loss-absorbing debt.

The provisional agreement to amend the BRRD also proposes a discretionary cap for the requirement for subordinated MREL at 27% of a bank’s total risk exposure. This would limit the associated costs for large systemic banks, but would leave their senior creditors less well protected in the event of outsized losses. The full rules, as part of the broader EU banking legislation package, are now likely to emerge before the end of this year.

Australian Banks’ Earning Pressure to Continue in 2019

The earnings of Australia’s four major banks are likely to fall further in the near term due to slowing credit growth, especially in the residential mortgage segment, and further remediation and compliance costs associated with inquiries into the financial sector, including the Royal Commission, says Fitch Ratings. The banks reported an aggregate decline in profitability in their latest full-year results.

Slower growth puts pressure on the banks to increase lending margins to maintain profitability. However, intense regulatory and public scrutiny of the sector, as well as strong competition, may make it difficult for the banks to reprice loans and pass on the recent increase in wholesale funding costs, as evidenced from the latest financial results. Net interest margins are therefore unlikely to improve in the short term.

The major banks made provisions for client remediation costs during the last financial year in response to the initial findings from the Royal Commission. Fitch expects some remediation costs to flow into the 2019 financial year as the banks continue to investigate previous behaviour. Meanwhile, compliance and regulatory costs to address shortcomings are likely to rise, despite the banks simplifying their business and product offerings. The banks also remain susceptible to fines and class actions as a result of the banking system inquiries.

The four major banks – Australia and New Zealand Banking Group (ANZ, AA-/Stable/aa-), Commonwealth Bank of Australia (CBA, AA-/Negative/aa-), National Australia Bank (NAB, AA-/Stable/aa-) and Westpac Banking Corporation (Westpac, AA-/Stable/aa-) – reported aggregated statutory full-year profit of AUD29.4 billion, a decrease of 0.8% from a year earlier, while cash net profit was down by 6.5%. CBA’s financial year ended June 2018, while ANZ’s, NAB’s and Westpac’s ended September 2018. The drop in aggregate profit was driven by slower lending growth, customer remediation charges and higher funding costs, especially in the second half of the financial year, as expected by Fitch. These pressures were partly offset by a benign operating environment that limited impairment expenses across the board.

All four banks reported lower or steady loan impairment charges during the reporting period. However, 90-day-plus past-due loans increased slightly, reflective of pressure on household finances from sluggish wage growth. Impairments are likely to rise from current historical lows due to the cooling housing market and high household leverage, which make households more susceptible to shocks from higher interest rates and unemployment. The ongoing tightening of banks’ risk appetites and underwriting standards should, however, support asset quality in the long term.

Common equity Tier 1 (CET1) ratios are broadly in line with the 10.5% threshold that regulators define as “unquestionably strong”. Banks have to achieve this level by 1 January 2020. ANZ reported a CET1 ratio of 11.4%, the highest of the major banks. ANZ is undertaking a share buyback and is likely to announce further capital management plans once it has received proceeds from recent divestments and asset sales. Westpac recorded a CET1 ratio of 10.6% and therefore already meets the new minimum requirement ahead of the deadline.

CBA reported a CET1 ratio of 10.1% at June 2018, which incorporates the AUD1 billion additional operational risk charge put in place following an independent prudential inquiry published in May 2018. However, this will translate to a pro forma CET1 ratio of 10.7% after already-announced divestments. NAB’s CET1 ratio is 10.2%, but we expect it to meet the 2020 deadline, with its capital position likely to be supported by an announced discounted dividend reinvestment plan and the potential sale of its MLC wealth-management business.

US Banks to See Diminishing Returns from Rising Rates

US banks should begin to see less and less benefit to earnings from rising short-term interest rates over the coming quarters, Fitch Ratings says. Net interest margins (NIMs) have continued to expand on a year-over-year basis due to the ongoing ability to lag funding costs relative to loan and investment portfolio repricing.

However, Fitch expects funding cost betas (or the proportion of the change in funding costs relative to the change in short-term interest rates) to continue to accelerate over the remainder of 2018 and into 2019. This could result in margin expansion stalling or even eventually reversing, which has begun in some markets driven by strong competition for both loans and deposits. Moreover, if longer-term interest rates continue to float upward and housing supply remains tight, Fitch expects to see further diminished levels of revenue generated from mortgage-banking operations across the industry.

Given how low rates were for so long, most U.S. banks had positioned their balance sheets to be asset sensitive. Banks that had been more asset sensitive at the beginning of the Fed tightening cycle were generally rewarded with margin expansion. By and large, these banks have shorter duration loan and investment portfolios, as well as strong core deposit franchises. Consequently, funding cost betas have remained lower relative to earning asset betas.

However, as low-or-no-cost deposits continue to either roll off balance sheets or rotate into higher cost deposit products such as money market savings accounts or certificates of deposits (CDs), returns from rising rates could diminish over time. Moreover, as the competitive environment for loans continues, Fitch believes loan spreads could remain tight, resulting in lower earning asset betas as short-term rates increase.

As seen below, in the past two tightening cycles, funding costs proved more sensitive to increasing rates than asset yields. This is in contrast with what has been experienced in the current tightening cycle so far, but funding cost betas have begun to close the gap.

Banks with low loan-to-deposit ratios should be able to maintain some flexibility to choose between repricing deposits and allowing some deposit runoff, which could allow for modest NIM expansion. On the other hand, those seeking to grow deposits to fund loan growth are likely to see funding costs continue to rise.

Rising rates, along with tight supply in the housing market, should also continue to pressure the revenue generated by and subsequent net income from mortgage operations at U.S. banks. Mortgage originations fell 16% at JPMorgan and 22% at Wells Fargo in 3Q18 on a year-over-year basis. Smaller mortgage competitors such as Hilltop Holdings saw originations fall 8% year over year and pre-tax income within the segment fall over 60%, weighing on the company’s overall earnings performance.

The Mortgage Bankers Association forecasts mortgage originations to fall 6% in total for 2018 (led by a 24% drop in refinancings) after a 17% decline in 2017. Lower originations should result in continued fee income pressure and lower production margins as the industry right sizes its overcapacity.

Taken together, these two factors have the potential to reverse the NIM and revenue expansion that most banks have been experiencing going into 2019. Still, Fitch does not believe there will be broad ratings implications for US banks from NIM expansion stalling or even compressing, nor due to less profitable mortgage operations. Moreover, continued benign asset quality as well as better operating efficiency driven by digitization efforts could contribute to stable earnings performance over coming quarters.

Fitch Affirms Australia ‘AAA’

Fitch Ratings just related their outlook for Australia, and they affirm Australia at ‘AAA’.  They argue that our banking system is sound, the household debt issues are manageable, and the house price correction will be orderly. So that’s OK then…

They also say that the ongoing Royal Banking Commission should not affect bank credit ratings immediately, but could raise compliance and regulatory costs, and weigh on credit growth. The Royal Commission would be credit positive for the sector in the long-term by bolstering the regulatory environment and maintaining high prudential standards.

 

KEY RATING DRIVERS

Australia’s ‘AAA’ rating is underpinned by an effective policymaking framework that has supported 27 consecutive years of GDP growth in the face of substantial external, financial, and commodity price shocks. The government’s credible commitment to fiscal consolidation from a debt level that is broadly in line with the current ‘AAA’ median also supports the rating.

Fitch expects real GDP to expand by 3.3% in 2018, following a jump in growth during the first half of the year, which compares favourably against the current ‘AAA’ median of 2.7%. Above-trend growth is underpinned by a strong global economy, resilient consumption, and increasing investment. We forecast growth to ease towards trend, reaching 2.8% in 2019 and 2.7% in 2020 on slower global growth and softer consumption. Rising public infrastructure investment will support near-term growth, particularly as the drag from declining mining investment fades.

Australia’s fiscal position strengthened over the past year, bolstered by a cyclical upswing in revenue and sustained spending restraint under the government’s budget repair strategy. The general government (federal, state, and local) deficit narrowed to an estimated 1.2% of GDP in the fiscal year ending June 2018 (FY18), from 2.4% in FY17. Consolidation will continue, but at a more modest pace, with the general government deficit falling to 0.4% of GDP by FY20.

The federal government remains firmly committed to its target of an underlying cash balance by FY20 and surplus by FY21. Fitch forecasts that these targets will be achieved, although performance is sensitive to growth outcomes. Nonetheless, the government will use some of the recent fiscal gains. For instance, in addition to the personal tax cuts passed in July, the government has proposed bringing forward the already legislated reduction in the small business tax rate to 25% by five years to 2021.

Fitch estimates that Australia’s gross general government debt ratio peaked at 41.3% of GDP in FY18 and will begin a steady downward trajectory during the current fiscal year. Australia’s debt ratio is slightly above the 2018 ‘AAA’ median of 39.2% of GDP after increasing by nearly 22pp since 2010 due to sustained fiscal deficits, which eroded what was a strength in the country’s fiscal position relative to peers.

Frequent changes in political leadership have not undermined Australia’s economic or fiscal trajectory, but could complicate the government’s ability to advance policy proposals to address medium-term challenges. In August, Scott Morrison became the sixth prime minister since 2010, following the ousting of Malcolm Turnbull in a Liberal party leadership challenge. Subsequently, preliminary results show the Liberal party led coalition lost its majority in an October by-election triggered by Turnbull’s resignation, which could constrain policymaking in coming months, with federal elections not due until May 2019. There is general cross-party consensus for fiscal consolidation, including the return to surplus by FY21, though the composition of deficit reduction and some other economic priorities could change in the event of a Labor party victory.

Monetary policy is likely to remain accommodative in the absence of significant wage growth or inflationary pressure. Fitch expects the Reserve Bank of Australia (RBA) to raise rates only gradually, with one 25bp hike next year and two 25bp hikes in 2020. The increasing interest rate differential with the US has led to a large depreciation in the Australian dollar against the US dollar. Australia has the highest net external debtor position among ‘AAA’ peers, but most external liabilities are denominated in local currency or hedged, limiting exchange rate risk. Banks, however, have seen an uptick in wholesale funding costs, due in part from tightening global financial conditions.

High household debt, at 190.5% of disposable income in 2Q18, remains a potential risk for the economic outlook and financial stability. An interest rate or employment shock could impair households’ ability to service their debts and lead to lower consumption. Mortgage rates have risen by about 10bp in the previous few months to reflect higher wholesale funding costs, but given our gradual path for RBA tightening, mortgage rates are not likely to increase rapidly unless banks face substantial external funding pressure. Many households maintain large mortgage offset accounts that can be drawn down to service debt and smooth consumption in the case of a shock, but newer borrowers and more financially weak households would be vulnerable.

Fitch expects the ongoing house-price correction to remain gradual and orderly. Housing markets are cooling nationally, particularly in Sydney and Melbourne, where prices have fallen by 6% and 3% yoy, respectively. Much of the slowdown appears driven by lower investor demand, due in part to targeted macroprudential policies. Continued population growth and low interest rates should support house prices. However, a sharp house-price drop, for instance, from a larger pullback in investor demand, reduced credit availability, or an economic shock, could exacerbate risks posed by high household debt.

Australia’s banking system scores ‘aa’ on Fitch’s Banking System Indicator (BSI), among the highest of any sovereign. Recent stress tests by Fitch show the system is well positioned to manage potential housing-market shocks. Sound prudential regulation has improved the resilience of bank balance sheets by strengthening underwriting standards and limiting exposure to riskier mortgage products. The ongoing Royal Banking Commission should not affect bank credit ratings immediately, but could raise compliance and regulatory costs, and weigh on credit growth. The Royal Commission would be credit positive for the sector in the long-term by bolstering the regulatory environment and maintaining high prudential standards.

Slowing growth in China, exacerbated by rising trade tensions with the US, poses an additional risk to Australia’s economic outlook. Australia is a large exporter to China, although the bulk of exports are consumed domestically, which mitigates much of the direct impact of trade tensions between China and the US. If the Chinese authorities respond to a slowdown through infrastructure stimulus, Australian commodity exports could receive a near-term boost.

Trade Wars and Regulation Threaten Australia’s House Prices

Falling house prices have prompted half of Australia’s fixed-income investors to nominate a domestic housing market downturn as the top risk to the country’s credit markets over the next 12 months, according to Fitch Ratings‘ 4Q18 fixed-income investor survey.

House prices have been pushed lower by regulations and tighter lending standards, but external threats posed by trade wars also loom. Investors are concerned the trade wars may adversely affect China, with negative flow-on effects for a number of Australia’s other Asian trading partners. This led 82% of investors to expect Australian house prices to decline by between 2% and 10% over the next 12 months. However, broader economic deterioration is not envisaged, as 97% of investors believe unemployment will remain below 6.5% through to mid-2020.

More than 60% of investors responding to our 4Q18 survey believe commercial bank lending standards will tighten for high-yield corporates, SMEs and retail sector borrowers over the next 12 months in the wake of a Banking Royal Commission. At the same time, there is a noticeable rise in the proportion on investors expecting fundamental credit conditions to deteriorate for financials – up to 66%, from 48% in our 2Q18 survey.

Shareholder oriented activities remain the preferred use of cash for Australian corporates, according to 78% of survey respondents. This has been a consistent finding across our surveys to date, but 4Q18 survey investors indicated that corporates may have an increased appetite for M&A as a use for cash.

A majority of Australian fixed-income investors expect spreads to widen in four asset classes over the next 12 months: financials, non-financial corporates, structured finance (RMBS and ABS) and unrated. Likewise, when asked what they are willing to pay across a range of asset classes, investors indicated that a sustained period of compression appears to be coming to an end in seven of ten asset classes surveyed.

The 4Q18 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD500 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Fitch’s 4Q18 fixed-income investor survey was conducted between 27 August and 10 September 2018. This survey is unique in the Australian context, reflecting the partners’ strong ties with the local investor community.

Euribor Deadline Uncertainty for SF, Covered Bonds, Banks

The approaching deadline for Euribor to become compliant with the EU Benchmark Regulation (BMR) is creating significant uncertainty for the euro-denominated floating rate assets and liabilities of structured finance transactions, covered bonds and banks, Fitch Rating says. If Euribor does not become compliant, the benchmark could no longer be used as a reference rate for new contracts from the start of 2020 and could only be used for legacy contracts with regulatory approval.

The Belgian Financial Services and Markets Authority is not expected to assess whether Euribor, which is in the process of being reformed, will become BMR compliant until late 2019. Euribor’s planned hybrid calculation method is being put in place with the aim of meeting the BMR requirements, but it is not yet clear if the change will result in compliance.

Various sectors could be affected if BMR compliance is not reached. Most eurozone structured finance notes reference Euribor, as do a substantial amount of covered bonds issued for repo transactions and euro-denominated bank debt. In contrast, corporate and public sector entities in the eurozone issue floating rate bonds to a lesser extent.

Euribor is also a common reference rate for leveraged and SME loans and commercial mortgages throughout Europe. Most residential mortgages in Finland, Greece, Ireland, Italy, Portugal and Spain are Euribor-based along with smaller proportions in other markets. Shifting to an alternative rate for contracts without long-term fall-back provisions could be particularly difficult given consumer protection laws.

If it does not become BMR compliant, the Belgian FSMA could allow Euribor to continue to be used in legacy contracts. It could also force bank panel participation for up to two years. This would allow some time for an alternative benchmark to be established and adopted by market participants. Work has begun on developing a term rate from a soon-to-be selected alternative euro risk-free rate to become a fall-back or possible replacement rate. But if the ECB’s new euro short-term rate (ESTER) is chosen as the favoured alternative, this two-year period could still be tight as much of the work is unlikely to progress before ESTER’s daily publication starts from 2H19.

If Euribor is deemed BMR compliant, a risk to investors and issuers is that a revised Euribor could have an absolute level or volatility that is different to the current rate. This could see disputes of contracts signed based on the pre-reform Euribor. Increased volatility or different absolute levels could also increase basis risk or prepayment rates, which could affect excess spread for structured finance and covered bonds.

Any potential future rating action for structured finance and covered bonds would depend on how seamlessly Euribor-based bonds, loans and hedges make the transition to either a revised and BMR-compliant Euribor or a fall-back reference rate. The following factors would have an impact on the rating analysis: contractual fall-back provisions, how technical and administrative challenges are addressed, other credit protection and the remaining weighted average lives after 2019 of assets and liabilities exposed to Euribor risks.

Bank and non-bank financial institutions may see non-traded interest rate risks increase if they are unable to re-price their variable-rate loans in line with changes to their funding. But we expect mainstream and specialist lenders should have some scope to pass on any short-term unexpected price adjustments. If replacement term structures do not come on-stream sufficiently quickly or lack liquidity, this could also increase traded market risks. While this could in theory affect capital adequacy requirements or stress-test results, it is likely to be immaterial.

Swaps and swap replacement provisions in structured finance and covered bonds could also be at risk from the tight timeframe for Eonia replacement. Eonia is used for valuations of Euribor-based swaps and will not become BMR-compliant.

China’s Policy Easing to Stop Short of Credit Stimulus

China’s recent measures to support the economy mark a shift in the policy stance towards easing and away from the previous singular focus on addressing financial risks, says Fitch Ratings. Easing is likely to stop short of the type of credit stimulus that could add significantly to economic imbalances, but this remains a risk that could have negative implications for the sovereign rating.

A series of loosening measures have been announced over recent months in response to signs that previous tightening has had an overly blunt effect on the economy, exacerbated by risks from trade tensions with the US. Easing measures have included reserve-requirement ratio cuts, liquidity injections, dilution of some recent macro-prudential tightening measures, and circulars that call for more accommodative fiscal policy and other forms of support to the real economy.

The authorities appear eager to avoid another large-scale stimulus, reflecting the sheer scale of the economy’s indebtedness, the prominence of the deleveraging drive and the designation of financial de-risking as one of three “critical policy battles”. Moreover, our baseline scenario is that an aggressive policy response is unlikely to be necessary to meet the authorities’ stated growth objectives, with growth forecast to slow only gradually – to 6.6% in 2018 and 6.3% in 2019 from 6.9% in 2017.

However, the continuing importance of medium-term growth targets suggests that a significant loosening of policy cannot be ruled out in the event of a macroeconomic shock or a slowdown that is sharper than we expect. Rising trade tensions raise the likelihood of such a policy response. We do not see the US tariffs already imposed on USD50 billion of Chinese goods as large enough to revise our China growth forecasts, but the imposition of a further round of US tariffs on USD200 billion in goods, as threatened by the US administration, could have a material effect.

The deleveraging campaign had succeeded in essentially stabilising macro-leverage ratios, with a particularly strong impact on riskier, less transparent lending within the shadow-banking sector. Downward pressure on the rating could emerge over time if we were to assess that a reversal of policy settings could result in a further build-up of the economy’s vulnerabilities. Policy easing is only at a nascent stage, and we last affirmed China’s ‘A+’/Stable sovereign rating in March 2018. The policy stance is among the key sensitivities that we will continue to monitor.