Tag: IMF

IMF sounds alarm on Aussie debt bubble

From Investor Daily. An excellent piece by James Mitchell.

The International Monetary Fund has recommended that APRA takes a forensic “deep dive” into the credit risk management frameworks of Australian banks.

The IMF has released its Financial Sector Assessment Program (FSAP) report on Australia. While the comprehensive review was generally positive towards the domestic economy and the role of the prudential regulator, it did warn of key risks to the financial system.

The IMF noted that stretched real estate valuations and high household debt pose macro-prudential risks to Australia. 

“House prices, after rising by about 70 per cent over the past decade at the national level, have now started to decline,” the report said. 

“The price appreciation following the global financial crisis had been even higher in Sydney and Melbourne, where prices had doubled on average over 10 years, though these two cities have also experienced sharper falls in recent months.

“Commercial real estate prices, particularly for office space, also rose sharply in the major cities over the past decade but have shown few signs of cooling as yet. Housing affordability linking incomes to prices is near all-time lows.”

The IMF noted that in recent years, benign credit conditions and the surge in house prices contributed to rapidly rising household leverage. Household debt currently stands at some 190 per cent of disposable income, around 25 basis points higher than in 2012, when the last FSAP report was produced.

The report noted that this is “very high by international standards”. Australian household debt-to-income levels are now almost twice as high as the United States and Japan and exceed the levels in the UK and Canada. 

While macro-prudential measures have contributed to the easing of pressures in the housing market, and a soft landing of the housing market is the most likely baseline, the IMF warned that there are risks of a stronger downturn. 

“A sharp correction in real estate markets could lead to a vicious feedback loop of falling real estate valuations, higher nonperforming loans, tighter bank credit, falling consumer confidence, and weaker growth, as happened during the global financial crisis (GFC),” the report said. 

“The impact on banks would be largely through credit losses as they all carry large exposures to the housing market and to CRE. Additionally, weaker banks could experience an outflow of customer deposits or a significant decline in wholesale funding.”

The IMF has recommended that APRA supervisors should continue scrutinising banks’ underwriting practices, particularly in retail loans (including residential mortgages) and in the commercial real estate lending sector.

Critically, the report recommends that APRA supervisors should consider undertaking periodic deep dives into banks’ credit risk management framework depending on the risks and controls of ADIs.

In addition to house prices and household debt, Australia’s financial system could be significantly impacted by a slowdown in China, the report warned. 

Rising global protectionism could provide one catalyst. 

“While Australian banks’ direct exposure to China is relatively small (about 4 per cent of overall claims), the economy has much larger exposure via the trade channel,” the report said. 

“One-third of Australian goods exports, including 40 per cent of commodities, go to China. Moreover, the growth of services exports to China in recent years has been particularly strong in the areas of tourism and education.

“A sharp slowdown in Chinese growth would lower Australian export revenues markedly. Banks would likely face higher losses on corporate lending, as well as on their broader credit portfolio due to the overall decline in economic activity.”

In its review of the Australian banking sector, the IMF observed that while ADIs are reasonably liquid, profitable and well capitalised, they have oriented their business models towards residential lending in recent years. 

While the IMF noted APRA’s efforts to cool residential lending via macro-prudential measures in recent years, the report noted that “significant structural vulnerabilities persist in the financial system”. 

“Household indebtedness remains very high, while banks’ portfolios continue to be concentrated and heavily exposed to the residential mortgage sector. 

“Banks are exposed to rollover risk on their overseas funding. Wholesale funding dependence has diminished but remains around one-third of total funding, of which nearly two-thirds is from international sources.”

The IMF noted that the Australian tax system provides incentives for leveraged investment by households, including in residential real estate that contributes to the elevated structural vulnerabilities. 

“There are also few signs of cooling in the commercial real estate sector where prices have risen sharply in recent years. While bank exposures to the sector are significantly smaller than to households, the sector is highly cyclical and typically experiences high default rates during severe downturns.”

Global Growth to Slow in 2019 – IMF

The IMF’s latest World Economic Outlook Update, January 2019, says that global growth in 2018 is estimated to be 3.7 percent, as it was last fall, but signs of a slowdown in the second half of 2018 have led to downward revisions for several economies. Specifically, growth in advanced economies is projected to slow from an estimated 2.3 percent in 2018 to 2.0 percent in 2019 and 1.7 percent in 2020.

Weakness in the second half of 2018 will carry over to coming quarters, with global growth projected to decline to 3.5 percent in 2019 before picking up slightly to 3.6 percent in 2020 (0.2 percentage point and 0.1 percentage point lower, respectively, than in the previous WEO). This growth pattern reflects a persistent decline in the growth rate of advanced economies from above-trend levels—occurring more rapidly than previously anticipated—together with a temporary decline in the growth rate for emerging market and developing economies in 2019, reflecting contractions in Argentina and Turkey, as well as the impact of trade actions on China and other Asian economies.

Specifically, growth in advanced economies is projected to slow from an estimated 2.3 percent in 2018 to 2.0 percent in 2019 and 1.7 percent in 2020. This estimated growth rate for 2018 and the projection for 2019 are 0.1 percentage point lower than in the October 2018 WEO, mostly due to downward revisions for the euro area.

  • Growth in the euro area is set to moderate from 1.8 percent in 2018 to 1.6 percent in 2019 (0.3 lower than projected last fall) and 1.7 percent in 2020. Growth rates have been marked down for many economies, notably Germany (due to soft private consumption, weak industrial production following the introduction of revised auto emission standards, and subdued foreign demand); Italy (due to weak domestic demand and higher borrowing costs as sovereign yields remain elevated); and France (due to the negative impact of street protests and industrial action).
  • There is substantial uncertainty around the baseline projection of about 1.5 percent growth in the United Kingdom in 2019-20. The unchanged projection relative to the October 2018 WEO reflects the offsetting negative effect of prolonged uncertainty about the Brexit outcome and the positive impact from fiscal stimulus announced in the 2019 budget. This baseline projection assumes that a Brexit deal is reached in 2019 and that the UK transitions gradually to the new regime. However, as of mid-January, the shape that Brexit will ultimately take remains highly uncertain.
  • The growth forecast for the United States also remains unchanged. Growth is expected to decline to 2.5 percent in 2019 and soften further to 1.8 percent in 2020 with the unwinding of fiscal stimulus and as the federal funds rate temporarily overshoots the neutral rate of interest. Nevertheless, the projected pace of expansion is above the US economy’s estimated potential growth rate in both years. Strong domestic demand growth will support rising imports and contribute to a widening of the US current account deficit.
  • Japan’s economy is set to grow by 1.1 percent in 2019 (0.2 percentage point higher than in the October WEO). This revision mainly reflects additional fiscal support to the economy this year, including measures to mitigate the effects of the planned consumption tax rate increase in October 2019. Growth is projected to moderate to 0.5 percent in 2020 (0.2 percentage point higher than in the October 2018 WEO) following the implementation of the mitigating measures.

For the emerging market and developing economy group, growth is expected to tick down to 4.5 percent in 2019 (from 4.6 percent in 2018), before improving to 4.9 percent in 2020. The projection for 2019 is 0.2 percentage point lower than in the October 2018 WEO.

  • Growth in emerging and developing Asia will dip from 6.5 percent in 2018 to 6.3 percent in 2019 and 6.4 percent in 2020. Despite fiscal stimulus that offsets some of the impact of higher US tariffs, China’s economy will slow due to the combined influence of needed financial regulatory tightening and trade tensions with the United States. India’s economy is poised to pick up in 2019, benefiting from lower oil prices and a slower pace of monetary tightening than previously expected, as inflation pressures ease.
  • Growth in emerging and developing Europe in 2019 is now expected to weaken more than previously anticipated, to 0.7 percent (from 3.8 percent in 2018) despite generally buoyant growth in Central and Eastern Europe, before recovering to 2.4 percent in 2020. The revisions (1.3 percentage point in 2019 and 0.4 percentage point in 2020) are due to a large projected contraction in 2019 and a slower recovery in 2020 in Turkey, amid policy tightening and adjustment to more restrictive external financing conditions.
  • In Latin America, growth is projected to recover over the next two years, from 1.1 percent in 2018 to 2.0 percent in 2019 and 2.5 percent in 2020 (0.2 percentage point weaker for both years than previously expected). The revisions are due to a downgrade in Mexico’s growth prospects in 2019–20, reflecting lower private investment, and an even more severe contraction in Venezuela than previously anticipated. The downgrades are only partially offset by an upward revision to the 2019 forecast for Brazil, where the gradual recovery from the 2015–16 recession is expected to continue. Argentina’s economy will contract in 2019 as tighter policies aimed at reducing imbalances slow domestic demand, before returning to growth in 2020.
  • Growth in the Middle East, North Africa, Afghanistan, and Pakistan region is expected to remain subdued at 2.4 percent in 2019 before recovering to about 3 percent in 2020. Multiple factors weigh on the region’s outlook, including weak oil output growth, which offsets an expected pickup in non-oil activity (Saudi Arabia); tightening financing conditions (Pakistan); US sanctions (Iran); and, across several economies, geopolitical tensions.
  • In sub-Saharan Africa, growth is expected to pick up from 2.9 percent in 2018 to 3.5 percent in 2019, and 3.6 percent in 2020. For both years the projection is 0.3 percentage point lower than last October’s projection, as softening oil prices have caused downward revisions for Angola and Nigeria. The headline numbers for the region mask significant variation in performance, with over one-third of sub-Saharan economies expected to grow above 5 percent in 2019–20.
  • Activity in the Commonwealth of Independent States is projected to expand by about 2¼ percent in 2019–20, slightly lower than projected in the October 2018 WEO due to the drag on Russia’s growth prospects from the weaker near-term oil-price outlook.

Risks to the Outlook

Key sources of risk to the global outlook are the outcome of trade negotiations and the direction financial conditions will take in months ahead. If countries resolve their differences without raising distortive trade barriers further and market sentiment recovers, then improved confidence and easier financial conditions could reinforce each other to lift growth above the baseline forecast. However, the balance of risks remains skewed to the downside, as in the October WEO.

Trade tensions. The November 30 signing of the US-Mexico-Canada free trade agreement (USMCA) to replace NAFTA, the December 1 US-China announcement of a 90-day “truce” on tariff increases, and the announced reduction in Chinese tariffs on US car imports are welcome steps toward de-escalating trade frictions. Final outcomes remain, however, subject to a possibly difficult negotiation process in the case of the US-China dispute and domestic ratification processes for the USMCA. Thus, global trade, investment, and output remain under threat from policy uncertainty, as well as from other ongoing trade tensions. Failure to resolve differences and a resulting increase in tariff barriers would lead to higher costs of imported intermediate and capital goods and higher final goods prices for consumers. Beyond these direct impacts, higher trade policy uncertainty and concerns over escalation and retaliation would lower business investment, disrupt supply chains, and slow productivity growth. The resulting depressed outlook for corporate profitability could dent financial market sentiment and further dampen growth (Scenario Box 1, October 2018 WEO).

Financial market sentiment. Escalating trade tensions, together with concerns about Italian fiscal policy, worries regarding several emerging markets, and, toward the end of the year, about a US government shutdown, contributed to equity price declines during the second half of 2018. A range of catalyzing events in key systemic economies could spark a broader deterioration in investor sentiment and a sudden, sharp repricing of assets amid elevated debt burdens. Global growth would likely fall short of the baseline projection if any such events were to materialize and trigger a generalized risk-off episode:

  • Italian spreads have narrowed from their October–November peaks but remain high. A protracted period of elevated yields would put further stress on Italian banks, weigh on economic activity, and worsen debt dynamics. Other Europe-specific factors that could give rise to broader risk aversion include the rising possibility of a disruptive, no-deal Brexit with negative cross-border spillovers and increased euro-skepticism affecting European parliamentary election outcomes.
  • A second source of systemic financial stability risk is a deeper-than-envisaged slowdown in China, with negative implications for trading partners and global commodity prices. China’s economy slowed in 2018 mainly due to financial regulatory tightening to rein in shadow banking activity and off-budget local government investment, and as a result of the widening trade dispute with the United States, which intensified the slowdown toward the end of the year. Further deceleration is projected for 2019. The authorities have responded to the slowdown by limiting their financial regulatory tightening, injecting liquidity through cuts in bank reserve requirements, and applying fiscal stimulus, by resuming public investment. Nevertheless, activity may fall short of expectations, especially if trade tensions fail to ease. As seen in 2015–16, concerns about the health of China’s economy can trigger abrupt, wide-reaching sell-offs in financial and commodity markets that place its trading partners, commodity exporters, and other emerging markets under pressure.

Beyond the possibility of escalating trade tensions and a broader turn in financial market sentiment, other factors adding downside risk to global investment and growth include uncertainty about the policy agenda of new administrations, a protracted US federal government shutdown, as well as geopolitical tensions in the Middle East and East Asia. Risks of a somewhat slower-moving nature include pervasive effects of climate change and ongoing declines in trust of established institutions and political parties.

All Time High Global Debt Looms Large Says IMF

The IMF has updated their Global Debt Database, and by including both the government and private sides of borrowing for the entire world, it offers an unprecedented picture of global debt in the post-World War II era.

The long view

  • Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita.
  • The most indebted economies in the world are also the richer ones. The top three borrowers in the world—the United States, China, and Japan—account for more than half of global debt, exceeding their share of global output.
  • The private sector’s debt has tripled since 1950. This makes it the driving force behind global debt. Another change since the global financial crisis has been the rise in private debt in emerging markets, led by China, overtaking advanced economies. At the other end of the spectrum, private debt has remained very low in low-income developing countries.
  • Global public debt, on the other hand, has experienced a reversal of sorts. After a steady decline up to the mid-1970s, public debt has gone up since, with advanced economies at the helm and, of late, followed by emerging and low-income developing countries.

Was 2017 different?

For 2017, the signals are mixed. Compared to the previous peak in 2009, the world is now more than 11 percentage points of GDP deeper in debt. Nonetheless, in 2017 the global debt ratio fell by close to 1½ percent of GDP compared to a year earlier. The last time the world witnessed a similar decline was in 2010, although it proved short-lived. However, it is not yet clear whether this is a hiatus in an otherwise uninterrupted ascending trend or if countries have begun a longer process to shed more debt. New country data available later in 2019 will tell us more about the global debt picture. For 2017, we divided up countries into three groups based on their debt profile and here’s what we found: 

  • Advanced economies: There has been a retrenchment in debt build-up among advanced economies. Private debt, although marginally on the rise, is well below its peak. Also, public debt in advanced economies experienced a healthy decline of close to 2½ percent of GDP in 2017. To find a similar reduction in public debt we need to go back a decade, when global growth was some 1¾ percentage points higher than today.
  • Emerging market economies: These countries continued to borrow in 2017, although at a much slower rate. A major shift occurred in China where the pace of private debt accumulation, although still high, decelerated significantly.
  • Low-income developing countries:  Public debt continued to grow in 2017 and, in some cases, reached levels close to those seen when countries sought debt relief.

Overall, the picture of global debt has changed as the world has changed. The data shows that a big part of the decline in the global debt ratio is the result of the waning importance of heavily-indebted advanced economies in the world economy.

With financial conditions tightening in many countries, which includes rising interest rates, prospects for bringing debt down remain uncertain. The high levels of corporate and government debt built up over years of easy global financial conditions, which the Fiscal Monitor documents, constitute a potential fault line.

So, as we close the first decade after the global financial crisis, the legacy of excessive debt still looms large.

IMF On The Australian Economy

The IMF has released their Concluding Statement of the 2018 Article IV Consultation Mission.  And, well, it gives a relatively clean bill of health, whilst talking of risks in the housing sector, a need for more financial risk oversight and suggests that supply side issues need to be addressed to ease affordability. In other words they are following the RBA mantra, no household debt problem here and APRA’s bank capital is unquestionably strong! We will see.

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

  • Australia’s recent strong growth is expected to continue in the near term, further reducing slack in the economy and leading the way to gradual upward pressure on wages and prices.
  • Despite recent strong growth and declining unemployment, it is not yet the time to withdraw macroeconomic policy support given remaining slack.
  • While Australia benefits from a robust regulatory framework, further bolstering of financial sector systemic risk oversight and financial supervision would be helpful.
  • The cooling of the housing market is welcome and can be weathered in a strong economy. Housing supply reforms will be critical to restoring housing affordability.

Australia is now on the final leg of its rebalancing and adjustment after the end of the commodity price and mining investment boom. Growth has picked up strongly to well above 3 percent in 2018, driven by business investment and private consumption, while the recent rebound in the terms of trade has been sustained. The strong economic momentum has resulted in further improvements in labor market conditions. Nonetheless, wage growth has remained weak, suggesting some remaining labor market slack. The disinflationary effects from continued strong retail competition still weigh on core inflation, while one-off declines in some administered prices have temporarily lowered headline inflation. After rising by 70 percent in the past ten years at the national level and by roughly 100 percent in Sydney and 90 percent in Melbourne, house prices have moderated recently in a cooling housing market. Several factors have contributed to the cooling, including tightening credit supply, increasing housing supply coming to the market, and easing foreign demand. Market dynamics have adjusted in the process.

The economy’s strong growth momentum is expected to continue in the near term. Private consumption growth is anticipated to remain buoyant, supported by strong employment gains. The rebound in non-mining private business investment and further growth in public investment is envisaged to offset a softening in dwelling investment. With growth above potential, the output gap will close and labor market slack will erode, eventually leading to upward pressure on wages and prices. Macroeconomic policies will then adjust, and growth is expected to moderate to that of potential in the medium term.

The balance of risks to economic growth is tilted to the downside with a less favorable global risk picture. A weaker-than-expected near-term outlook in China coupled with further rising global protectionism and trade tensions could delay full closure of the output gap, although there are also upside risks to the terms of trade in the near term. A sharp tightening of global financial conditions could spill over into domestic financial markets, raising funding costs and lowering disposable income of debtors, with the impact also depending on the response of the Australian dollar. On the domestic side, a stronger pickup in the non-mining business sector, larger spillovers from public infrastructure investment, and the Australian dollar depreciation in real effective terms over the past year could boost near-term growth more than projected. Domestic demand may equally turn out weaker if wage growth remained subdued or investment spillovers were smaller.

The housing market downturn is another source of risk. Under the baseline outlook, the correction remains orderly, reflecting a combination of continued strong underlying demand for housing in the context of population growth and no significant oversupply, the presence of other strong growth drivers, and a resilient banking sector continuing to extend credit to support economic growth. Nevertheless, other negative risk developments, as outlined above, could amplify the correction and lower domestic demand.

Notwithstanding recent strong growth, it is not yet the time to withdraw macroeconomic policy support given remaining slack. With the cash rate at 1.5 percent, monetary policy remains appropriately accommodative. Normalization should remain conditional on evidence of more substantive upward pressures on wages and prices, as inflation is still below the target range. The broadly neutral fiscal policy stance is welcome. With more limited conventional monetary policy space, a fiscal stimulus would likely need to be part of an effective overall policy response if major downside risks materialized.

With the economy expected to return to full employment, the government’s medium-term fiscal strategy appropriately aims to reach budget balance by FY2019/20 and run budget surpluses thereafter. Under the baseline outlook, this fiscal path would still be consistent with the Commonwealth and state governments continuing to run ambitious infrastructure investment programs and structural reforms in support of higher growth. The principle of running budget surpluses in good times has been a core element of fiscal strategies required under Australia’s fiscal framework, which has helped in preserving fiscal discipline and substantial fiscal space, notwithstanding shocks with protracted effects. Given the fiscal space, Australia remains in a position to respond flexibly in case large downside risks should materialize. A role for medium-term debt anchors as a complementary element in fiscal strategies might also be considered.

The Australian banks are well capitalized and profitable. Following the requirement for capital to be unquestionably strong, banks’ capital levels are high in relation to international comparators.

Managing financial vulnerabilities and risks from high household debt requires macroprudential policy to hold the course. Earlier prudential intervention by the Australian Prudential Regulation Authority has lowered the risks to financial stability from higher-risk household debt and other vulnerabilities, in particular reducing the share of investor and interest-only borrowing. This has supported the strengthening of lending standards and the increase in bank resilience. Nevertheless, heightened systemic risks remain from high household debt levels and banks’ concentrated exposure to mortgage lending. Given prospects of interest rates remaining low for some time, macroprudential policy should focus on expanding the available toolkit by addressing any data, legal and regulatory requirements and thus enhancing readiness to implement such measures if and when needed.

The Australian authorities have developed a robust regulatory framework, but further reinforcement in two broad domains would be beneficial.

  • The systemic risk oversight of the financial sector could be strengthened. The IMF’s Financial Sector Assessment Program (FSAP) recommends buttressing the financial stability framework by strengthening the transparency of the work of the Council of Financial Regulators on the identification of systemic risks and actions taken to mitigate them. Improving the granularity and consistency of data collection and provision would support the analysis of systemic risks and formulation of policy.
  • Financial supervision and financial crisis management arrangements should be further bolstered. The FSAP’s specific recommendations include increasing the independence and budgetary autonomy of the regulatory agencies, strengthening the supervisory approach, particularly in the areas of governance, risk management, and conduct, and enhancing the stress testing framework for solvency, liquidity, and contagion risks. The FSAP also recommends strengthening the integration of systemic risk analysis and stress testing into supervisory processes, completing the resolution policy framework and expediting the development of bank-specific resolution plans. Recent announcements of additional funding for the regulatory agencies are welcome.

The cooling of the housing market is welcome and contributes to improving housing affordability. In the absence of a sharp rise in unemployment, interest rates, or housing inventories, an orderly correction in housing prices will help contain macro-financial vulnerabilities. Pressures on housing affordability, which is critical for growth to remain inclusive, will be relieved in the process.

Housing supply reforms will be critical to restoring housing affordability, and progress has been ongoing. Planning, zoning, and other reforms affect supply and prices only with long lags, and underlying demand for housing is expected to remain robust. Housing supply reforms should, therefore, not be delayed because of the housing market correction. Progress has been made through better integration of policies across government levels through “city deals,” including for western Sydney and its new airport, and for Darwin. Some states should still take the opportunity for further consolidation in planning and zoning regulation. These policy efforts should be complemented by broader tax reforms that also address housing and land use. Such reforms would strengthen the effectiveness of supply-side measures and reduce structural incentives for leveraged investment by households, including in residential real estate.

There is scope to expand infrastructure spending further to stimulate productivity. Australia is a fast-growing economy supported by high population growth, and its infrastructure needs are also increasing rapidly. Even with the recent increase in the infrastructure spending envelope, an infrastructure gap will remain. Reducing the gap further would help in lowering congestion and increase the economy’s potential in the long term, as would improving the effective use of existing infrastructure. The improvements that have been made in the institutional framework for infrastructure planning and assessment support policy efforts in this respect.

Recent policy decisions should help encourage innovation. A reform of the research and development (R&D) tax credit system is with Parliament, aiming for a more efficient and targeted use of the tax credit. It will be complemented by higher funding for research infrastructure. The recommendations of the science agenda laid out in Australia 2030: Prosperity through Innovation are constructive and should be implemented, as envisaged in the government’s response to the report.

Energy policy should further reduce uncertainty for investment decisions. Governments have already made substantial progress on pricing and reliability issues. The clarification in due course of policies to achieve Australia’s greenhouse gas emissions target commitments will also help reduce uncertainty.

Broad tax reform to support productivity and inclusive growth would be desirable. The share of direct taxes in Australia’s federal tax revenue is higher than the average of OECD economies, and shifting from direct to indirect taxes would lower tax distortions and enhance productivity. The Commonwealth government has to date lowered company tax rates for SMEs and introduced personal income tax cuts. These reforms should be combined with reforms to raise the GST revenue, lower the company tax rate more broadly, and reduce tax concessions. To offset the regressive element from higher GST revenue, an income tax-based rebate scheme to reduce the negative impact on lower income groups should be considered.

Australia’s continued efforts toward further trade liberalization and promoting the global multilateral trading system are welcome. This includes supporting new WTO agreements and modernization efforts. The formal ratification of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (also known as CPTPP or TPP-11), which replaces the Trans-Pacific Partnership, sends a positive signal in a time of increasing global trade tensions

To “Bail-In” Or To “Bail-Out”, That Is Indeed The Question

We look at reports from the BIS and IMF, and discuss the issues around bail-in, including of deposits.

If you value our content please consider supporting our work via our Patreon page.

Banking Strategy
To "Bail-In" Or To "Bail-Out", That Is Indeed The Question



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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.

Financial Sector Cyber Risk Is Rising – IMF

Cyber risk has emerged as a significant threat to the financial system according to the IMFBlog. An IMF staff modeling exercise estimates that average annual losses to financial institutions from cyber-attacks could reach a few hundred billion dollars a year, eroding bank profits and potentially threatening financial stability.

Recent cases show that the threat is real. Successful attacks have already resulted in data breaches in which thieves gained access to confidential information, and fraud, such as the theft of $500 million from the Coincheck cryptocurrency exchange. And there is the threat that a targeted institution could be left unable to operate.

Not surprisingly, surveys consistently show that risk managers and other executives at financial institutions worry most about cyber-attacks, as in the graphic below.

Financial sector’s vulnerability

The financial sector is particularly vulnerable to cyber-attacks. These institutions are attractive targets because of their crucial role in intermediating funds. A successful cyber-attack on one institution could spread rapidly through the highly interconnected financial system. Many institutions still use older systems that might not be resilient to cyber-attacks. And a successful cyber-attack can have direct material consequences through financial losses as well as indirect costs such as diminished reputation.

Recent high-profile cases have increasingly put cyber risk on the agenda of the official sector—including international organizations. However, quantitative analysis of cyber risk is still at an early stage, especially due to the lack of data on the cost of cyber-attacks, and difficulties in modeling cyber risk.

Cyber risk has emerged as a significant threat to the financial system.
A recent IMF study provides a framework for thinking about potential losses due to cyber-attacks with a focus on the financial sector.

Estimating potential losses

The modeling framework uses techniques from actuarial science and operational risk measurement to estimate aggregate losses from cyber-attacks. This requires an assessment of the frequency of cyber-attacks on financial institutions and an idea of the distribution of losses from such events. Numerical simulations can then be used to estimate the distribution of aggregate cyber-attack losses.

We illustrate our framework using a data set covering recent losses due to cyber-attacks in 50 countries. This provides an example of how potential losses for financial institutions could be estimated. The exercise is difficult and is made even more challenging by major data gaps on cyber risk. Moreover, thankfully, there has yet been no successful, large-scale cyber-attack on the financial system.

Our results should thus be considered as illustrative. Taken at face value, they suggest that average annual potential losses from cyber-attacks may be large, close to 9 percent of banks’ net income globally, or around $100 billion. In a severe scenario—in which the frequency of cyber-attacks would be twice as high as in the past with greater contagion— losses could be 2½–3½ times as high as this, or $270 billion to $350 billion.

The framework could be used to examine extreme risk scenarios involving massive attacks. The distribution of the data we have collected suggests that in such scenarios, representing the worst 5 percent of cases, average potential losses could reach as high as half of banks’ net income, putting the financial sector at risk.

Such estimated losses are several orders of magnitude greater than the present size of the cyber insurance market. Despite recent growth, the insurance market for cyber risk remains small with around $3 billion in premiums globally in 2017. Most financial institutions do not even carry cyber insurance. Coverage is limited, and insurers face challenges in evaluating risk because of uncertainty about cyber exposures, lack of data, and possible contagion effects.

The way forward

There is much scope to improve risk assessments. Government collection of more granular, consistent, and complete data on the frequency and impact of cyber-attacks would help assess risk for the financial sector.

Requirements to report breaches—such as considered under the EU’s General Data Protection Regulation—should improve knowledge of cyber-attacks. Scenario analysis could be used to develop a comprehensive assessment of how cyber-attacks could spread and design adequate responses by private institutions and governments.

Further work is needed also to understand how to strengthen the resilience of financial institutions and infrastructures, both to reduce the odds of a successful cyber-attack but also to facilitate smooth and rapid recovery. There is also a need to build capacity in the official sector in many parts of the world to monitor and regulate such risks.

In sum, strengthening the regulatory and supervisory frameworks for cyber risk is needed, and efforts should focus on effective supervisory practices, realistic vulnerability and recovery testing, and contingency planning. The IMF is providing technical assistance to help member countries improve their regulatory and supervisory frameworks.

An Imbalance in Global Banks’ Dollar Funding

From The IMFBlog.

For companies and investors outside the United States, the dollar is often the currency of choice. Surprisingly, though, US banks play only a limited role in lending dollars to international borrowers. Most of the $7 trillion in banks’ dollar lending outside the United States is handled by banks based in Europe, Japan and elsewhere.

This is significant because these banks can’t easily tap the dollars deposited at their US subsidiaries to finance dollar lending outside of the country. Instead, the IMF’s recent Global Financial Stability Report found that they must rely heavily on less-stable funding sources to support their international dollar balance sheets, such as interbank deposits, commercial paper and swaps. The danger is that these sources of funding could dry up quickly in times of financial-market stress.

Global regulators have compelled banks to guard against such a loss of funding by improving their liquidity coverage ratios, a measure of banks’ ability to meet short-term fund outflows from reliable liquid assets.

Some banks may be overly reliant on potentially fragile cross-currency swap markets

These improvements applied to banks’ global consolidated balance sheets, which encompass their aggregate positions in all currencies. But a liquidity coverage ratio based on their international dollar balance sheets, which exclude US subsidiaries, reveals a different picture. This ratio is meaningfully below their consolidated liquidity ratio. An estimated stable funding ratio, a measure of stable funding relative to the level of loans, is similarly much lower for international dollar positions than for their overall balance sheets

Several forces are set to push up dollar funding costs. The US Treasury is issuing more T-bills, potentially putting upward pressure on the interest rates non-US banks must pay for short-term dollar funding. The new tax law is expected to encourage US corporations to repatriate cash and possibly shift cash out of bank funding instruments. And these developments are taking place against the backdrop of the Federal Reserve’s interest-rate increases and the gradual reduction of securities holdings on its balance sheet, which would ultimately lift funding costs for all borrowers. Not all banking systems are equally vulnerable to strains in funding markets. For example, our analysis suggests that dollar liquidity ratios at French and German banks are not as strong as their peers. Another concern is that some banks may be overly reliant on potentially fragile cross-currency swap markets. For example, swaps cover over 30 percent of Japanese banks’ dollar funding needs. While much of their swap borrowing is long-term, banks’ ability to access this type of funding may be compromised under stress conditions.

The combination of this market tightening and the international dollar balance sheet vulnerabilities discussed above could trigger funding problems in the event of market strains. Market turbulence may make it more difficult for banks to manage currency gaps in volatile swap markets, possibly rendering some banks unable to roll over short-term dollar funding.

Banks could then act as an amplifier of market strains if funding pressures were to compel them to sell assets in a turbulent market to pay liabilities that are due. Funding pressure could also induce banks to shrink dollar lending to non-US borrowers, thus reducing credit availability.

Over the past decade, global and national policymakers have strengthened regulatory frameworks governing banks’ consolidated solvency and liquidity positions. However, country-specific liquidity regulations, while helping to strengthen national financial systems, may inadvertently restrict the flow of liquidity within banking groups.

Looking ahead, banks should ensure that currency-specific liquidity risks within individual entities in their banking groups continue to be managed effectively. Regulators should address foreign currency liquidity mismatches through more disclosure, currency-specific liquidity standards, stress tests, and resolution planning. Central banks’ swap lines, which are already in place to provide foreign exchange liquidity in times of stress, should be maintained, as a last resort backstop.

The Global Links To Home Prices

The IMF’s latest Global Financial Stability Report April 2018, includes a chapter on housing.  They look at the global hike in home prices and attribute much of it to the globalisation of finance.

Australian cities are well up the list in terms of gains and also global impact. However, to me they missed the key link. It is the ultra-low interest rates result from QE, across many of these markets, either formally, or informally, which have driven the home prices higher; it is credit led. Sure credit can move across borders, but it was monetary policy which has created the problem.

The fall out of higher international finance rates will now flow directly to our doors, thanks to this same globalisation. Not pretty.  So they also warn of risks as this all unwinds.

The chapter finds an increase in house price synchronization, on balance, for 40 advanced and emerging market economies and 44 major cities.

Countries’ and cities’ exposure to global financial conditions may explain rising house price synchronization. Moreover, cities in advanced economies may be particularly exposed to global financial conditions, perhaps because they are integrated with global financial markets or are attractive to global investors searching for yield or safe assets.

Policymakers cannot ignore the possibility that shocks to house prices elsewhere will affect markets at home. House price synchronization in and of itself may not warrant policy intervention, but the chapter finds that heightened synchronicity can signal a downside tail risk to real economic activity.

Macroprudential policies seem to have some ability to influence local house price developments, even in countries with highly synchronized housing markets, and these measures may also be able to reduce a country’s house price synchronization. Such unintended effects are worth considering when evaluating the trade-offs of implementing macroprudential and other policies.

Reading Credit Flows for Crisis Signals

A timely warning from the IMF about the rapid growth in credit, especially to risky areas, just before a financial crisis. I suspect this is just where Australia is currently!

From The IMF Blog.

Supervisors who monitor the health of the financial system know that a rapid buildup of debt during an economic boom can spell trouble down the road. That is why they keep a close eye on the overall volume of credit in the economy. When companies go on a borrowing spree, supervisors and regulators may decide to put the brakes on credit growth.

Trouble is, measuring credit volume overlooks an important question: how much of that additional money flows to riskier companies – which are more likely to default in times of trouble—compared with more creditworthy firms? The IMF’s latest Global Financial Stability Report seeks to fill that gap by constructing measures of the riskiness of credit allocation, which should help policy makers spot clouds on the economic horizon.

Our researchers crunched 25 years of data for nonfinancial companies in 55 emerging and advanced economies. They found that when credit grows rapidly, the firms where debt expands faster become increasingly risky in relation to those with the slowest debt expansions. Such an increase in the riskiness of credit allocation, in turn, points to greater odds of a severe economic downturn or a banking crisis as many as three years into the future.

Extra dose

This buildup of lending to relatively less creditworthy companies adds an extra dose of risk – on top of the dangers that may come with the rapid growth of credit overall. Of course, lending to risky firms may be perfectly rational and profitable. But it can also spell trouble if it reflects poorer screening of borrowers or excessive risk-taking.

Fortunately, regulators can take steps to protect the financial system, if necessary. They can require banks to hold more capital or impose limits on bank loan growth, restraining their risk-bearing capacity and increasing their buffers. Ensuring the independence of bank supervisors, enforcing lending standards, and strengthening corporate governance by protecting minority shareholders can also help keep risks in check.

Why does more credit flow to risker firms in good times? It’s possible that investors are unduly optimistic about future economic prospects, leading them to extend credit to more vulnerable firms. If interest rates are unusually low, banks and investors may be tempted to lend money – in the form of loans or bonds – to riskier companies that pay relatively higher rates of interest. We have seen this “search for yield” in advanced economies in recent years because of the prolonged period of ultra-low interest rates. The riskiness of credit allocation may thus be a good barometer of risk appetite.

Global pattern

Our study found a clear global pattern in the evolution of this new measure of financial vulnerability. Starting at elevated levels in the late 1990s, the riskiness of credit allocation fell from 2000 to 2004, in the aftermath of financial crises in Asia and Russia and the dot-com equity bubble. From a historic low in 2004, riskiness rose to a peak in 2008, when the global financial crisis erupted. It then declined sharply before rising again to a level near its historical average at the end of 2016, the last available data point. Riskiness may have continued to rise in 2017 as market volatility and interest rates remained very low in the global economy.

The Global Financial Stability Report holds a clear lesson for policy makers and regulators: both the total volume of credit and the riskiness of its allocation are important. A period of rapid growth is more likely to be followed by a severe economic downturn if more of that credit is flowing to riskier firms. Policy makers should pay close attention to both measures – and take the appropriate steps when warning signals flash.