Tag: Fitch

Bank Profits Under Pressure – Fitch

AAP says Australia’s major banks face soft profit growth amid growing macroeconomic risks linked to low interest rates and government tax policy, according to Fitch. However. the agency has reaffirmed the ratings of all four major Australian banks at AA- with a Stable Outlook.

The credit rating agency believes low interest rates and government tax policies have likely contributed to risks that include rising household debt and diminishing housing affordability related to strong house price growth.

“Pockets of Australia’s property market may encounter potential oversupply of new residential housing and hurt house prices in those areas,” Fitch says.

“However, a stable labour market and historically low interest rates should limit the impact on the banks’ asset-quality.”

Fitch expects housing price rises to moderate to about 2% in 2016 due to tightened mortgage underwriting standards for investors and non-resident borrowers.

It highlighted continued challenges for Commonwealth Bank, Westpac, National Australia Bank and ANZ from the downturn in the resources sector, which has already led to an increase in bad loans in WA and Queensland.

“Fitch expects soft profit growth in 2016, mainly reflecting asset competition, low interest rates, moderate credit growth and rising impairment charges,” Fitch said in a statement on Friday.

ANZ has already cut its interim dividend after its first-half profit slumped by nearly a quarter, Westpac this month lifted first-half cash earnings a below-expectations 3.3 per cent, and Commonwealth Bank lifted first-half cash earnings 3.9 per cent back in February.

NAB posted the best results of the big four, lifting cash earnings 6.5 per cent following the disposal of its unprofitable UK business.

However, Fitch said a stable labour market and historically low interest rates should limit the negative impact on banks’ asset quality should residential property prices decline in some areas due to potential oversupply.

The agency also forecast a continuation of tightened underwriting criteria imposed last year.

“Some portfolios, such as resources, are likely to continue experiencing asset-quality pressure due to weak commodity prices, which Fitch does not expect to improve in the short-term,” Fitch said.

“However, the banks’ exposures to mining and dairy remain manageable relative to total exposures.”

Fitch said a hard landing for the Chinese economy could hit the big Australian banks, but that such a scenario is not its base case.

Australia Budget Is Credit Neutral, Fiscal Plans Are Key – Fitch

From Fitch Rating.

Australia’s 2016-2017 budget is broadly neutral for the country’s public finances, which are consistent with the sovereign’s ‘AAA’ rating, Fitch Ratings says. A credible consolidation strategy, rather than absolute debt and deficit levels, remains a key sovereign rating consideration.

We expected weaker nominal income growth to constrain tax revenues and slow fiscal consolidation when we affirmed Australia’s ‘AAA’/Stable sovereign rating in March. Weaker terms of trade, weighing on economic performance and pushing back fiscal consolidation timelines, have been a regular feature of recent fiscal announcements.

The projected underlying cash balances in the budget are similar to those in the December Mid-Year Economic and Fiscal Outlook (MYEFO), despite improvement in the terms of trade. The budget assumes an iron-ore price of USD55/tonne, up from USD39 in the MYEFO, but the benefits to the nominal GDP growth outlook have been more than offset by weaker global economic conditions and lower price and wage inflation. Changes to economic parameters and other variations are expected to widen the combined underlying cash deficit by AUD8.1bn (0.5% of 2015-16 GDP) over the four years to 2019-20, whereas policy decisions will modestly narrow the deficit by AUD1.7bn (0.1% of 2015-16 GDP) over the same period.

The underlying cash deficit for 2016-17 is projected at AUD37.1bn, or 2.2% of GDP, slightly wider (0.2% of GDP) than the AUD33.7bn in the MYEFO. The government projects the underlying cash deficit to narrow to 0.3% in 2019-20, no change to the MYEFO. Revenue growth, while weaker than previously projected, is expected to drive the fiscal consolidation. Commonwealth net debt is still expected to fall after 2017-18, albeit from a slightly higher peak. Projections for state and local government deficits are wider than we had anticipated, at 0.3% of GDP in 2017-2018 compared to 0.1% projected in last year’s budget.

The economic flexibility afforded by Australia’s low government debt ratio is an important support for the ‘AAA’ sovereign rating. Gross general government debt/GDP remains below the ‘AAA’ median (34.5% of GDP in 2015, versus 42.8%). The public balance sheet has acted as a shock absorber against the sharp fall in terms of trade due to falling commodity prices over the past four years.

A credible fiscal consolidation strategy, responsive to economic conditions, would help preserve fiscal buffers against potential shocks facing the Australian economy, both domestic (eg the risk of a housing market bust) and external (eg another fall in iron ore prices, or a more pronounced China slowdown). If there were a lasting improvement in economic parameters, for example a better outlook for the terms of trade, we assume the authorities would allow the deficit to narrow more quickly. The Reserve Bank of Australia’s 25bp rate cut on Tuesday may also support growth.

We also assume greater consolidation efforts should the structural deficit prove wider than anticipated. The government’s estimate of the structural deficit has narrowed, but forecasting is subject to significant uncertainties around the outlook for private investment, productivity and export competitiveness. The nation’s debt-carrying capacity could be enhanced if the government’s Enterprise Tax Plan and National Infrastructure Plan are able to unlock improvements in trend growth.

The broad political support for fiscal responsibility means we do not expect a significant change in fiscal strategy following the elections that are likely to be held in early July, although the policy mix may change.

The False Promise of Helicopter Money

From FitchRatings.

One of the most prominent questions concerning the global economy today is whether monetary policy is approaching the limit of its effectiveness. Inflation remains well below target in the eurozone and Japan, despite aggressive quantitative easing (QE) and negative policy interest rates, and both the euro and yen have appreciated against the US dollar since the start of the year.

The problem with the debate is that it has focused solely on the effectiveness of policies, without considering the need for prudence.The credibility and independence of monetary authorities are essential to the effectiveness of their policies. And yet some of the proposals being fielded call for central banks to stray further into uncharted territory, expanding and extending their deviation from careful balancesheet management. This could inflict reputational damage that may be difficult to rectify, with real financial and economic consequences.

The direct impact of unconventional monetary policy is apparent and largely as expected (with the exception of the recent appreciation of the euro and yen). Liquidity in banking systems is ample, and borrowing costs have declined, even turning negative for some governments. But the expected second-order effects – increased economic activity and inflation – have not materialized. As a result, despite the fact that headline inflation is being dragged down by low commodity prices, a near-consensus has emerged that additional easing is required.

Options Point to Central Banks, This Time with Helicopters

Monetary policy is not the only option for further easing, but it is the most likely. Structural reforms to support growth typically have long gestation periods, and the economic dislocations that accompany them reduce their political appeal. Further fiscal easing is at least partly constrained by record-high levels of government debt, which will take many years to bring down.

When it comes to monetary policy, however, the options are similarly limited. Even monetary policymakers acknowledge that QE is subject to diminishing returns, while adverse effects on the banking system limit the scope for setting policy rates too deeply negative. As a result, an old idea, first proposed by Milton Friedman in 1969, is making a comeback: “helicopter money.” Advocates envisage central banks creating money and distributing it directly to those who would spend it, resulting in immediate increases in demand and inflation.

Because households might choose to save some of the money, contemporary suggestions center on helicopter money being transferred to governments, to invest in infrastructure projects or other demand-enhancing initiatives. Variations call for central banks to buy perpetual government bonds that pay no interest or to convert existing bond holdings into something similar.

Seigniorage and Sound Central Bank Finances Are Co-dependent

Such proposals are troubling for many reasons. The direct funding by central banks of fiscal deficits or purchases of government debt would result in the monetization of fiscal policy. Monetization unambiguously weakens central banks’ balance sheets by adding assets that carry no real value (claims on government that will never be repaid), offset by liabilities (newly created money) generated to acquire them.

Advocates of helicopter money rely on two claims. Some believe that policy can be calibrated to stop short of inflicting meaningful harm, usually because the resulting improvement in economic conditions will obviate the need for continued stimulus. For others, central banks’ balance sheets are not a constraint, because the exclusive ability to create additional unlimited and cost-free liabilities guarantees longterm profitability.

There are problems with both claims. Relying on a calibrated approach counts on stimulus being withdrawn before any evidence of concern over the central bank’s finances appears. But there is no certainty that monetized fiscal spending will spark an economic recovery. Nor can it be known beforehand that expansionary fiscal policy would be curtailed if economic prospects do not improve. In fact, in the absence of negative public or market commentary on central-bank finances, the fiscal authorities may be tempted to expand their use of cost-free funding in what looks from their perspective very much like the proverbial “free lunch.”

There are also serious reasons to doubt the claim that seigniorage – the profit to central banks from having zero-cost liabilities (and at least some income-generating assets) – would guarantee profitability in the long term. Never in the post-Gold Standard era has there been greater focus on the limits of monetary policy. This focus could easily turn to the health of central banks’ balance sheets if they continue to expand. The concept of seigniorage is poorly understood outside a relatively small community; it should not be used as the first line of defense.

None of this comes as news to central banks, which attach the utmost importance to their reputation for having robust finances, carefully managing risk, and ensuring the soundness of money. Indeed, the financial prudence that underpins policy credibility and confidence in central banks is ultimately what makes seigniorage possible. Only institutions that are perceived as financially viable can expect their liabilities to be held by others as assets; central banks are no exception.

At stake is the value of money. Helicopter money, would transfer risk from the balance sheet of governments to those of central banks, blurring the lines between policies, institutions, and their relative autonomy. Its appeal lies in being able to exploit the unique financial structures of central banks. But there are limits beyond which confidence in the financial integrity of central banks – and consequently the soundness of money – will be undermined.

Those limits are of course impossible to identify in advance. But at a time of heightened sensitivity to the implementation and effectiveness of monetary policy, it would be a mistake to embark on a path that jeopardizes central banks’ very viability.

Australian Mortgage Arrears Stay Near Record Lows

Australian mortgage arrears have reached the lowest fourth quarter level in 11 years after declining 20bp year-on-year (yoy) to 0.95% in the quarter ended December 2015, Fitch Ratings says. The level of arrears in 4Q15 reflected strong house price growth, low unemployment, low standard variable rates and low inflation.

Self-employed borrowers continue to experience financial difficulties despite positive serviceability factors as indicated by the Low-doc Dinkum Index, which recorded a 32bp increase in 30+ days arrears to 7.29% in 4Q15.

The annualised loss rate remained low in 4Q15 at 0.02%, unchanged for the third quarter in a row. Fitch expects an uptick in losses over 2016 as property price growth moderates. In the year to March 2016, property price growth in the combined capital cities was 6.4%, slowing from the double-digit growth experienced over much of 2H15.

Losses are likely to remain limited, despite the likely slowdown in property price growth, because of tighter serviceability assessments recommended by the Australian Prudential Regulation Authority and the Australian Securities & Investments Commission. The introduction of measures, such as interest-rate floors, means borrowers should have more buffers to withstand increases in interest rates and unemployment, and a slowdown in the housing market.

The changes to underwriting standards are positive for holders of newer vintage RMBS transactions, especially in the current low-interest-rate and high house price environment that has fuelled household borrowing.

Fitch’s Dinkum RMBS Index tracks the arrears and performance of the mortgages underlying Australian residential mortgage-backed securities (RMBS).

Marketplace Lender Enthusiasm Confronts Market Realities – Fitch

After an extended period of rapid growth and increasing acceptance for marketplace lenders globally, several market dynamics are testing the business model’s long-term viability, Fitch Ratings says. These changes are forcing marketplace lenders to seek alternative funding sources, expand their product offerings, modify their underwriting approaches and address heightened regulatory scrutiny.

The challenges underscore the unproven nature of the marketplace lender business model – which was originally premised on funding loans primarily via retail investor demand – through the economic cycle. The extent to which marketplace lenders can navigate these challenges without adversely impacting their risk profiles and profitability will determine the sector’s long-term success.

A sustained period of historically low interest rates prompted an increased funding appetite among banks and other institutional investors for marketplace loans. As institutional demand waned in recent months, marketplace lenders began to seek alternative funding sources to sustain loan originations. For example, Social Finance (SoFi) recently launched a quasi-captive hedge fund purposed with investing in loans originated by SoFi as well as other marketplace lenders.

Some marketplace lenders also responded to reduced funding availability by raising loan pricing to attract funding; however, this reduces the competiveness of marketplace lenders’ lending rate (if the cost is passed to the borrower) or adversely impacts profitability (if the lender absorbs the cost). Passing higher funding costs through to borrowers is also harder to implement for lenders targeting higher quality borrowers.

The marketplace lender business model has yet to endure either a full interest rate cycle or credit cycle, so the resilience of current models under rising interest rates and/or rising credit losses is uncertain. Pockets of recent credit underperformance beyond initial expectations have likely contributed to the ongoing refinement of underwriting models, including further de-emphasizing of the use of traditional FICO scores in certain instances. Marketplace lenders are also exploring product expansion into adjacent lending products such as mortgages, small business loans, and autos, which Fitch views as tacit acknowledgement that business models, as currently constituted, may not have the diversity to flourish if core product growth is constrained.

Marketplace lenders’ rapid growth has attracted heightened regulation and legal risk (Madden v. Midland), which may force changes to loan pricing and risk sharing, as evidenced by recent changes implemented at Lending Club with respect to its relationship with WebBank. In this case, LendingClub gave up a portion of its revenue to WebBank in an effort to preserve its exemption from state-specific usury rate caps.

Fitch considers greater regulatory oversight to be inevitable with the distinctions between marketplace lenders and traditional lenders continuing to blur as marketplace lenders adapt their funding models to economic realities.

Several US federal and state regulators have begun to seek more information about the marketplace lending industry with the expectation of producing a more formal regulatory framework. LendingClub, Prosper Marketplace and Funding Circle established an industry trade group, the Marketplace Lending Association, to respond to regulatory scrutiny and establish certain industry operating standards.

Likewise, the regulatory environment has begun to evolve outside of the US. For example, regulators in China seem poised to tighten oversight of the industry given the rapid growth in loans originated in that region over the past few years and the degradation in credit performance that has ensued, driving some lenders out of business.

Less Model Reliance Should Reduce Bank Ratio Variation – Fitch

The Basel Committee on Banking Supervision has proposed that banks should stop using models to calculate capital for some hard-to-model portfolios and face significant constraints on model usage for others. If adopted, this should reduce variation in capital adequacy ratios across banks, says Fitch Ratings. But this increases the need for the Committee to develop a more risk-sensitive standardised approach (SA).

The proposals, published earlier this month for consultation until 24 June, eliminate the use of Internal Ratings Based (IRB) models for low-default exposures to banks, financial institutions, and large corporates with assets in excess of EUR50bn. This means that all banks would use the revised SA for calculating risk weightings on these asset types.

Low-default portfolios are difficult to model because data is limited and historic default experience is low. Such data is needed for reliable IRB modelling. Although not included in these proposals, sovereign exposures are also regarded as low default, and we think it is likely that the Committee might adopt a similar approach for this portfolio once its sovereign risk-weight review is concluded.

The Committee’s proposals would still allow IRB modelling for exposures to smaller corporates and for retail customers, subject to restrictions to narrow the range of outcomes.

For example, proposals to increase minimum probability of default (PD) assumptions for retail mortgages to 5bp from 3bp could increase risk weights on these portfolios by 50% if all else remains equal. For corporates with revenues above EUR200m but assets below EUR50bn, models are still allowed, but loss-given default assumptions (LGD) on unsecured senior lending will be fixed at 45%. Currently, banks can use internal model estimates to calculate capital charges for these exposures that may be less conservative. The introduction of a minimum floor to the models will mean outputs are more comparable across banks.

For the first time, the Committee revealed its thoughts on the calibration of an aggregate permanent risk-weighted, asset-capital floor based on the revised SA, to be in the range of 60% to 90%. This will limit the benefit to banks from lower risk weights generated by their IRB models, compared with the revised SA weightings.

If the Committee’s proposals are adopted, the revised SA will become far more important than the IRB approach for calculating capital requirements. Reducing banks’ reliance on internal models could boost public confidence in regulatory capital ratios, and enable creditors to make better informed decisions.

Banks have developed IRB models at significant cost and we expect them to lobby hard to maintain incentives to continue to use the modelled approaches. The Committee does not intend to raise overall capital requirements for banks, but we think these proposals could lead to an increase in capital requirements for low-risk weight portfolios. Some banks might question their continued investment in internal models, although we think many might still use them for their own risk management. We think this would be useful because models can create more robust risk-management frameworks.

An earlier Basel Committee study signalled notable differences in how banks estimate key model parameters including PD and LGD for the same exposures. The review concluded that a significant source of risk-weighted asset variation was due to different modelling choices between banks, such as the definition of default, and adjustment for cyclical effects. In contrast, the SA reduces variability because it prescribes set risk weights for different risk categories.

China Banks’ Profitability Pressures to Continue in 2016 – Fitch

Major Chinese banks’ results for 2015, which are due to be released next week, should show continued subdued earnings growth amid margin compression and asset deterioration, says Fitch Ratings.

Fitch expects these trends to continue in 2016, underscoring our negative sector outlook. Chinese bank profits are likely to decline this year unless authorities relax the minimum NPL provisioning requirement of 150%.

System-wide net profit for China’s banking sector grew by only 2.4% in 2015 as net interest margins declined by around 12bp to 2.53%. A combination of interest-rate cuts and worsening asset quality will continue to have an impact on profitability in 2016. The quarterly run-rate in reported NPLs decelerated in 4Q15, while we believe this is due partly to more substantial NPL write-offs/disposals towards the end of the year as banks struggled to meet their provisioning requirements.

The provision coverage ratio at state banks and joint-stock banks had fallen to 172% and 181%, respectively, on average by end-2015. The need to maintain this ratio above 150% will restrain earnings growth in 2016 – unless this ratio is relaxed. The floor could also encourage further under-reporting of NPLs.

Reports from local media today suggest that the authorities are considering lowering the provisioning requirement to 130%-140% for selected banks. Fitch believes a relaxation would run counter to a need for conservative provisioning at a time when asset quality is deteriorating and the concerns around the true level of NPLs in the system. That said, such changes in regulations in isolation should not have major rating implications as our analysis takes into account factors and performance trends beyond reported profitability figures.

The reduction in the interest burden for borrowers following successive rate cuts and other monetary loosening through 2015 should keep reported NPLs below 2% for most banks. The system-wide NPL ratio and “special-mention” loan ratio were 1.67% and 3.79%, respectively, at end-2015, up from 1.25% and 3.11% a year ago. The trend in overdue loans may paint a more interesting picture, though, as Chinese banks tend to report very similar NPL ratios despite varying levels of overdue loans.

Furthermore, changes in investment income or revaluation reserves may also signal deterioration in the quality of non-loan credit, especially in mid-tier banks. This may take the form of investment receivables representing a growing share in the asset mix.

Loss-absorption trends could be a key rating driver for most banks while profitability and asset quality weaken and pressure on provisioning increases. Major Chinese banks were key issuers of Additional Tier 1 (AT1) instruments in 2015, owing to increased pressure to shore up capital due to balance-sheet growth and slowing profitability. However, as long as assets continue to grow at a rapid pace and profitability remains subdued, there will be little underlying improvement in core capitalisation levels. Such capitalisation pressures continue to weigh on Fitch’s assessment of Chinese banks’ Viability Ratings, especially those of the mid-tier banks.

The expansion of non-interest income is likely to be a key earnings driver in 2015-2016, especially for mid-tier banks, driven by strong card and underwriting fees as well as the sale of wealth management products (WMPs). But Fitch views excessive reliance on WMPs as risky for banks, and a significant shift in the business towards this area could lead to increased credit and liquidity risks.

Fitch Affirms Australia at ‘AAA’; Outlook Stable

Fitch Ratings has affirmed Australia’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at ‘AAA’. The Outlook is Stable. Australia’s senior unsecured foreign- and local-currency bond ratings are also affirmed at ‘AAA’. The Country Ceiling is affirmed at ‘AAA’ and the Short-Term Foreign Currency IDR at ‘F1+’.

KEY RATING DRIVERS
The affirmation of Australia’s sovereign ratings reflects the following factors:

– Australia’s ‘AAA’ rating is underpinned by the economy’s high income, strong institutions and effective governance. The free-floating exchange rate, credible monetary policy framework, low public debt and growing recognition of the Australian dollar as a reserve currency allow the economy to adjust to changing economic conditions.

– GDP growth of 2.5% in 2015 was marginally slower than a year earlier, but still outpaced the median of 1.8% for ‘AAA’ rated sovereigns. A thriving services sector and strong residential investment is helping the economy rebalance away from mining-driven growth, although a recovery in non-mining investment remains elusive. Fitch expects low interest rates to continue fuelling consumption growth, resulting in GDP growth of 2.6% in 2016. Residential investment growth could decelerate from the current fast pace over the next two years, but should be partly offset by a pickup in state infrastructure investment. Increasing production of natural gas and greater spending on education and tourism from non-residents should support export growth. Fitch expects a smaller drag on GDP growth from falling mining investment in 2017, helping push GDP growth up to 2.9%.

– Australia depends more on primary commodity exports, particularly to China, than ‘AAA’ peers. Exposure to Chinese households through the service sector and capital flows is also increasing. A severe slowdown in China, although not Fitch’s base case, could have a widespread negative economic impact. Other downside risks to Fitch’s economic forecasts include continued weakness of non-mining business investment and a sharper than expected property market slowdown. Maintaining the recovery in iron ore prices year-to-date could result in an upside risk to Fitch’s forecasts.

– Despite resilient GDP growth, a sharp fall in the terms of trade has weighed on nominal income growth, reducing tax revenues and slowing the expected pace of fiscal consolidation. As such, the government does not expect an underlying cash surplus until the fiscal year ending June 2021 (FY21). Fitch estimates Australia’s gross general government debt (GGD) at 34.5% of GDP in FY15, still 9.1pp below the ‘AAA’ median of 43.6%. However, the difference has narrowed from 24.5pp in FY11, when Australia’s Foreign-Currency IDR was first upgraded to ‘AAA’. Fitch projects the GGD ratio to peak in FY17 should the budget deficit narrow in line with Fitch’s baseline scenario. However, a negative economic shock without offsetting policy actions could lead to further deterioration in public finances.

– Fitch considers Australia’s external finances a longstanding structural weakness, with the largest net external debt relative to GDP in the ‘AAA’ rated category. Net external debt, including derivatives, increased to 61.0% of GDP in 2015 from 54.4% in the previous year. This is higher than the previous 2009 peak. Fitch expects the current account deficit to narrow only slightly from 4.6% of GDP in 2015 over the next two years and for net external debt to continue growing. A diversified pool of foreign investors willing to lend to Australian entities in local currency, sophisticated currency hedging and maturity mismatches in the financial sector are helping mitigate some of the external liquidity risks arising from Australia’s debt position and reduces the economy’s vulnerability against a sharp depreciation in the Australian dollar. However, a sustained reallocation of capital flows away from Australia by foreign investors could raise financing costs and put downward pressure on economic growth.

– The Australian banking system is one of the strongest globally on a standalone basis, based on Fitch’s Banking System Indicator (BSI) scoring mechanism. Fitch expects banking sector balance sheets to continue strengthening, with solid capitalisation and recently tightened underwriting standards offsetting slower profit growth and modest asset-quality pressures. However, household debt, at 184.6% of disposable income at end of September 2015, is high relative to peers and makes up the majority of banking system lending assets. Low interest rates, high mortgage offset account saving levels and a stable unemployment rate is helping maintain debt sustainability. But a sharp economic downturn, particularly one accompanied by widespread unemployment and a sudden reversal of house prices after two years of strong growth, could lead to banking sector losses and a higher risk that support is required through the sovereign balance sheet. Fitch considers such a scenario a tail-risk and assumes house price growth will moderate to 2% in 2016 from 8% in 2015.

RATING SENSITIVITIES
The Outlook is Stable, as Fitch does not currently anticipate developments that pose a high likelihood of a rating change. However, future developments that could individually or collectively result in a ratings downgrade include:

– A sustained widening of the fiscal deficit without remedial policy actions, leading to continued upward trajectory of the general government debt-to-GDP ratio.

– A negative external shock, such as a continued rapid decline in the terms of trade following a severe slowdown in China. This could lead to a sharp increase in the current account deficit and/or a sustained reallocation of foreign capital.

– A sharp economic downturn, which could also be triggered by external events, leading to widespread household defaults, banking system distress and the materialisation of contingent liabilities on the public balance sheet.

KEY ASSUMPTIONS
-The global economy performs broadly in line with Fitch’s Global Economic Outlook, particularly China, which has become a key destination for Australian exports. Fitch expects the Chinese economy to grow by 6.2% in 2016.

– Fitch assumes an average iron ore price of $45 per tonne in 2016 and 2017, $50 per tonne in 2018 (62% Fe CFR China reference).

Basel Credit Risk Proposals Evolve, Consistency Elusive – Fitch

The Basel Committee on Banking Supervision’s second set of proposals to update the standardised approach to credit risk, published in December 2015, represents a change of approach that will improve risk sensitivity. But the regime proposes to retain flexibility for national regulatory implementation and bank risk weighting. This means that comparing capital ratios across banks and countries will continue to be elusive, says Fitch Ratings.

If the proposals are implemented, there will be two separate risk weighting approaches. One will use external credit ratings and the other will rely on standardised assessments. Capital adequacy ratios will vary, depending on which methodology is used, and this will make it difficult to preserve consistency and simplify comparison of output ratios.

The use of credit ratings for assessing bank and corporate credit exposures, scrapped under Basel’s original proposals, has been reinstated. We think this is an improvement because credit ratings serve as important credit risk benchmarks and have been effective in assessing relative credit risk. They can also be effective in fostering consistency. The external credit rating based approach (ECRA) maps credit ratings to a number of risk weight buckets and is currently used by the majority of the Basel Committee’s 27 national members.

Some countries however, notably the US, prohibit the use of credit ratings for regulatory purposes. Basel proposes that banks in these countries use a new standardised credit risk assessment (SCRA) approach. Under the SCRA, bank and corporate exposures will be split into categories and risk weighted according to the specific characteristics of the counterparty.

Risk weights calculated for bank exposures using either the ECRA or SCRA could vary because banks have to undertake mandatory due diligence when using credit ratings. This could lead to a bank assigning a risk weighting at least one bucket higher (but not lower) than the “base” risk weight. The SCRA proposal also imposes a higher risk weight floor for bank exposures and applies larger haircuts to highly rated non-sovereign bonds than the ECRA. If implemented, this means US banks will see risk weights more than double on exposures to their US peers and will need to post or receive higher collateral on repurchase transactions over corporate securities, for example.

Basel is also proposing an overhaul of capital allocation to real estate lending, with more granular risk weights. Capital requirements for property development loans, buy-to-let (BTL) mortgages and more speculative real estate finance will be hiked to reflect greater risk. All mortgages will be capitalised at original loan to values (LTV) to inhibit cyclical changes to risk weights. But during times of rising property prices, lenders might encourage borrowers to refinance their loans, to reduce their own capital requirements. If the proposals are adopted, we think some banks, notably those heavily involved in high LTV BTL lending, will have adjust their business models.

The proposals discourage banks from lending in foreign currency and holding equity investments by increasing risk weightings. By requiring banks to recognise capital charges on unconditionally cancellable commitments, such as credit card and personal overdraft facilities, the most affected banks may reduce credit card limits or pass higher costs of capital to consumers.

China RRR Cut, Credit Growth Could Lead to Bank Risks – Fitch

The 50bp cut to the reserve requirement ratio (RRR) for Chinese banks on Tuesday, together with record loan growth in January, could point to an increasing likelihood that the authorities are shifting policy to enable more credit-fueled growth, says Fitch Ratings. Next week’s National People’s Congress meeting should provide further information on the direction of Chinese economic policy and structural reform. Fitch maintains that a return to sustained rapid lending growth by Chinese banks would be credit negative, with leverage in the economy already high.

Fitch expects that credit growth (based on Fitch’s Adjusted Measure of Total Social Financing, FATSF) will continue slowing in 2016, to 13%. This is a necessary part of the broader structural adjustment in China’s economy to achieve more sustainable growth. However, credit growth will still be running above nominal GDP growth, meaning that total leverage (as measured by FATSF/GDP) will continue to rise, to 260% by end-2016.

A government target, announced in October, to double the size of China’s economy by 2020 also implies continued credit-fueled growth as current consumption trends would not be able to support targeted GDP without additional leverage.

The People’s Bank of China (PBOC) lowered the RRR to 17%, effective on 1 March, and Fitch expects the move implies an injection of CNY688bn (USD105bn) of liquidity into the financial system. This was the first broad-based RRR cut since October, when the central bank also reduced the ratio by 50bp. The current level for the RRR is still high in both historical terms and in relation to other countries, so there could be room for further reductions this year.

This latest RRR cut is likely to be a reflection in part of the continued economic deceleration in China and ongoing concerns about growth risks. PMI data for February, released yesterday, showed a drop in manufacturing activity, with the index falling to 49 from 49.8 in January. This marked the lowest manufacturing PMI figure since February 2009. Notably, too, the services sector PMI fell to its lowest level since the 2008 global financial crisis, which could be signaling a broader-based slowdown.

In the near term, RRR cuts could boost bank earnings by allowing banks to reinvest the liquidity freed up from the PBOC. It will also enable banks to roll over more debt and continue the trend to shift loans back on balance sheet. However, Fitch expects that the overall earnings impact from the 50bp cut, or even the series of cuts enacted since the beginning of 2015, is not likely to be significant. Furthermore, rolling over more debt will only delay and not resolve an expected rise in NPLs. Fitch expects reported NPL and ‘special mention’ loan ratios to rise in 2016 to 2.5% and 4.3%, respectively, from 1.7% and 3.8% at end-2015.