Author: Martin North

Martin North is the Principal of Digital Finance Analytics

SMSF Advice Needs Significant Improvement

Many Self  Managed Super Funds (SMSF) trustees may not have received “best interest” advice with regards to their fund. This despite the considerable growth in the SMSF sector, which is driven, according to our research, by holders wanting to avoid retail fund fees, and greater control of their finances.

Around 90% of financial advice on setting up a self-managed super fund (SMSF) did not comply with relevant laws, a review by the Australian Securities and Investments Commission (ASIC) has found.

ASIC has released Report 575 SMSFs: Improving the quality of advice and member experiences and Report 576 Member experiences with self-managed superannuation funds.

ASIC reviewed 250 client files randomly selected based on Australian Taxation Office (ATO) data and assessed compliance with the Corporations Act’s ‘best interests’ duty and related obligations.

In 91% of files reviewed the adviser did not comply with Corporations Act’s ‘best interests’ duty and related obligations. The non-compliant advice ranged from record-keeping and process failures to failures likely to result in significant financial detriment. This included:

  • In 10% of files reviewed, the client was likely to be significantly worse off in retirement due to the advice;
  • In 19% of cases, clients were at an increased risk of financial detriment due to a lack of diversification.

ASIC Deputy Chair Peter Kell said the standard of advice on SMSFs must improve. ‘A healthy and robust SMSF sector is an important part of our super system. However, it is clear lots of people are setting up self-managed super funds without knowing whether this is the best option. The financial advice sector has significant work to do to lift their performance on this issue.’

ASIC will be taking follow up regulatory action, in particular where consumers have suffered detriment.

ASIC also conducted market research which included interviews with 28 consumers who had set up an SMSF and an online survey of 457 consumers who had set up an SMSF. Through this work we found a lot of people do not understand fully the risks of SMSFs, or their legal obligations as trustees.

In the online survey:

  • 38% of respondents found running an SMSF more time consuming than expected;
  • 32% found it to more expensive than expected;
  • 33% did not know the law required an SMSF to have an investment strategy; and
  • 29% mistakenly believed that SMSFs had the same level of protection as prudentially regulated superannuation funds in the event of fraud.

Mr Kell said, ‘Decisions about super are some of the most important a person can make. However, ASIC found there is a lack of basic knowledge of the legal obligations in setting up or running an SMSF. It is also concerning many people with an SMSF have not understood the importance of diversification, which puts their financial future at risk.’

ASIC also found some people had moved to SMSFs as a way to get into the property market, and were using it solely for this purpose without a wider investment strategy.

The interviews also identified a growing use of ‘one-stop-shops’ where the adviser has a relationship with a developer or a real estate agent whose products the person is encouraged to invest in. This put people at increased risk of getting poor advice that did not take account of their personal circumstances or is not given in their best interests.

ASIC’s findings are supported by the recent Productivity Commission super report which found smaller SMSFs (with balances under $1 million) delivered on average returns below larger funds, and that the costs for low-balance SMSFs are higher than for funds regulated by the Australian Prudential Regulation Authority (APRA).

ASIC’s SMSF report will inform its surveillance and regulatory work into the SMSF sector. ASIC will take enforcement action as appropriate, including ensuring licensees with non-compliant advisers undertake client review and remediation.

More broadly, ASIC and the ATO will have an increased focus on property one-stop-shops. This will include sharing data and intelligence, and ASIC taking enforcement action where it sees unscrupulous behaviour.

Hardship Customers Protected in New Credit Regime

The ABA says Australia’s four major banks have reached an agreement to protect vulnerable customers from being unfairly treated in the new mandatory Comprehensive Credit Regime.

The four major banks, who will be required to report the credit history of 50% of customers by the end of September, will not include customers who have reached agreement on hardship arrangements with their bank. This will continue for the first 12 months of the regime while the Attorney-General is conducting a review into this issue.

CEO of the Australian Banking Association Anna Bligh said this was a critical issue for Australia’s major banks who were united behind this arrangement to ensure all customers are treated fairly in what will be an important change in credit history reporting.

“Australia’s banks have been working closely with the Federal Government and other stakeholders to ensure we get this major reform right, without unfairly treating some customers, and implemented without delay,” Ms Bligh.

“Australia’s banks are fully behind this new regime and see the great benefit it can bring in helping customers quickly and easily get a great deal on their personal loans, home loans and credits cards. The four major banks are committed to meeting the start date of 30 September in accordance with the CCR regime.

“Currently if you have a great credit history, the only organisation who knows this is your bank.

“This new regime takes that powerful information and places it into the hands of customers who can ensure they get the best deal possible from a financial institution.

“As with all major reforms in banking it’s important we don’t leave people behind.

Those who have experienced hardship through no fault of their own such as losing a job, sickness, natural disasters or relationship breakdown need to be protected in this new regime.

“Unexpected events happen in life, which banks understand, therefore it’s important that we can discreetly show this on credit histories to make sure customers don’t have further difficulty in the future,” she said.

Kabbage Reaches a New Milestone of $5 Billion of Funding to Small Businesses In US

Very interesting release from Kabbage, highlights the growth of lending to small business online, and outside banking hours. Another example of the digital revolution well underway. 24/7 access rules…!

ATLANTA – June 28, 2018 – Kabbage, Inc., a global financial services, technology and data platform serving small businesses, reports its 145,000-plus small business customers accessed over 300,000 loans during non-banking hours, reaching a record total of more than $1 billion in funding. In total, Kabbage has now provided access to more than $5 billion in funding to its customers across America. The non-banking hour analysis illustrates how Kabbage’s fully automated lending solutions remove the age-old hurdle of normal business hours by offering companies 24/7 access to working capital online.

“The findings illuminate the true around-the-clock nature of business owners,” said Kabbage CEO, Rob Frohwein. “While we wish small business owners could reclaim their nights and weekends, we built Kabbage to allow business owners to access funds on schedules convenient to them, not us.”

Economic Impact of $5 Billion

A new report from the Electronics Transactions Association (ETA), in partnership with NDP Analytics, a Washington, D.C.-based economic research firm, finds that for every $1 provided to small businesses via online lending platforms, including Kabbage, results in $3.79 in gross output in local communities. The study provides context to how the new milestone of $5 billion provided through Kabbage has helped to stimulate the U.S. economy.

After-Hours Lending on the Rise

The total number of dollars accessed through Kabbage outside of typical banking hours increased more than 6,000 percent between 2011 and 2018. The growth illustrates small business owners are increasingly comfortable accessing capital online, and they rely on the convenience of managing cash flow needs any time of day, particularly outside of open business hours for most banks. Non-banking hours in this analysis represents the local time between 6 p.m. and 6 a.m. on the weekdays, and the full 48 hours over the weekends.

Weekday vs. Weekend Lending

The majority of after-hour lending (64 percent) was accessed during the work week, totaling $754 million. The remaining 36 percent occurred on Saturdays and Sundays, totaling $429 million. The data is a nod to the dedication of business owners as more than one-third extend their work weeks to handle cash flow needs even on the weekends.

About Kabbage

Kabbage, Inc., headquartered in Atlanta, has pioneered a financial services data and technology platform to provide access to automated funding to small businesses in minutes. Kabbage leverages data generated through business activity such as accounting data, online sales, shipping and dozens of other sources to understand performance and deliver fast, flexible funding in real time. With the largest international network of global-bank partnerships for an online lending platform, Kabbage powers small business lending for large banks, including ING and Santander, across Spain, the U.K., Italy and France and more. Kabbage is funded and backed by leading investors, including SoftBank Group Corp., BlueRun Ventures, Mohr Davidow Ventures, Thomvest Ventures, SoftBank Capital, Reverence Capital Partners, the UPS Strategic Enterprise Fund, ING, Santander InnoVentures, Scotiabank and TCW/Craton. All Kabbage U.S.-based loans are issued by Celtic Bank, a Utah-Chartered Industrial Bank, Member FDIC. For more information, please visit www.kabbage.com.

Trade Wars May Drive Rates Lower

As the spot light turns to the emerging trade wars with the USA, the impact may be to push bond rates lower, according to Moody’s. As a result, this may also mean the FED will not raise interest rates in the US as fast as expected. This might therefore in turn act to dampen rate rises in other countries.

A still-positive outlook for operating profits is now marred by considerable uncertainty. What may degenerate into an extended trade war of attrition could preserve financial market volatility indefinitely.

Given the global complexities of modern supply-chain management, a surprisingly large number of U.S.-based businesses may delay capital spending and staffing plans until trade-related uncertainties are sufficiently resolved. As it now stands, tariff-driven increases in material costs have compelled some companies to rein in employee compensation for the purpose of protecting profit margins. In addition, higher materials costs have been weighing on the credit quality of some manufacturers that use steel intensively.

Tariffs explain why year-to-date advances of 40% for the spot price of steel and 21% for the most actively traded lumber futures contract are so much greater than the accompanying 0.5% dip by Moody’s industrial metals price index (which excludes steel’s price). To the degree tariffs increase the costs of materials and inventories, businesses will tighten their control of other costs, the most prominent being employee compensation.

Relaxation of China’s Monetary Policy May Limit Upside for Fed Funds

Any trade war will require the use of all policy weapons. Recently, the Peoples Bank of China adopted a more accommodative monetary policy ostensibly in response to slower than expected domestic spending and a need to enhance systemic liquidity. The latter brings attention to difficulties arising from troubled loans. Though not specifically mentioned, one of the intentions of the latest relaxation of China’s monetary policy is to allow China to better withstand any loss of economic activity to a trade war.

Not to be overlooked is how the $521 billion of U.S. merchandise imports from China during the 12-months-ended April 2018 far exceeded the comparably measured $133 billion of U.S. merchandise exports to China.

Worth mentioning is how that imbalance includes billions of dollars of goods that are manufactured in China for U.S.-domiciled businesses. China is unrivaled as far as being a manufacturing platform for companies based in advanced economies. Thus, many American businesses and shareholders are vulnerable to tariffs imposed on imports from China.

In quick response to the relaxation of China’s monetary policy, the U.S. dollar rose to 6.604 yuan. Though the latter was the highest yuan price of the dollar since mid-December 2017, it was still -4.7% under December 2016’s average of 6.929 yuan. Of course, Chinese officials worry that expectations of a weaker yuan might prompt unwanted capital outflows from China.

Nevertheless, a wider interest rate gap between the U.S. and China would favor a cheaper Chinese currency versus the dollar. In turn, a depreciation by China’s currency vis-a-vis the dollar would offset part of any tariff-induced increase in the dollar price of U.S. imports from China.

All else the same, a costlier dollar exchange rate diminishes prospects for U.S. corporate earnings. The recent strengthening of the dollar against a broad array of currencies from both advanced economies and emerging market countries will reduce (i) the global price competitiveness of goods and services produced in the U.S. and (ii) the dollar value of foreign-currency denominated earnings from abroad.

On the positive side, a stronger dollar will lessen the risk of faster consumer price inflation. As a result, a stronger dollar can substitute for Fed rate hikes.

Ten-year Treasury Yield Is Less Likely to Have an Extended Stay Above 3%

In view of how recent rate hikes and a nearly 3% 10-year Treasury yield disrupted financial markets outside the U.S., the Federal Open Market Committee’s latest median projection of a 2.375% midpoint for fed funds by the end of 2018 may prove to be too high.

Recognizing the risks implicit to a possible trade war and the disinflationary effect of further dollar exchange rate appreciation, the futures market disputes the FOMC’s median projection for fed funds and recently assigned only a 44.2% probability to a year-end midpoint for fed funds that exceeds 2.125%. If other central banks pursue policies that facilitate dollar appreciation, the Fed may have no choice but to stretch out its planned normalization of U.S. monetary policy.

Just prior to the latest outbreak of trade-related stress, the 10-year Treasury yield closed at June 14’s 2.94%. Since then, the benchmark Treasury yield eased to a recent 2.83%. From the perspective of the accompanying 3.0% drop by the market value of U.S. common stock since June 14, the decline by the 10-year Treasury yield has not been especially deep.Nevertheless, a downwardly revised outlook for Treasury yields has prompted a 5.8% advance by the Dow Jones Utility index since June 14.

However, despite the possibility of lower than earlier expected mortgage yields, an index of housing-sector share prices has sunk by 5.1% since June 14. The latter brings attention to how trade related uncertainties and financial market volatility may force businesses to show restraint when it comes to staffing and employee compensation.

In turn, the upside for home sales may continue to be limited by the subpar financial condition of many lower- and middle-income households. The pitifully low 3.1% personal savings rate of the 12-monthsended April 2018 highlights the well below-average financial flexibility of many Americans. Implicit to such a very low average for the personal savings rate is the likelihood that 33% to 40% of U.S. households save an imperceptible, if any, amount of their after-tax income.

When a financially stronger middle class provided a hospitable breeding ground for the persistently rapid consumer price inflation of 1972-1981, the personal savings rate averaged a much higher 11.4%. Yes, consumer price inflation may spurt higher every now and then, but today’s average American consumer may lack the financial wherewithal necessary for the establishment of stubbornly rapid price inflation.

VIX and Baa Yield Spread Imply High-Yield Bond Spread Is Unsustainably Thin

Though a composite high-yield bond spread has widened from June 14’s 345 basis points to the 370 bp of June 27, the latter still remains well under the spread’s post September 2003 median of 460 bp. However, a recent VIX of 18.0 points was noticeably above its accompanying median of 15.9 points. In the event the VIX remains above 16.5 points, the high-yield spread is likely to widen to at least 425 bp.

A recent long-term Baa-grade industrial company bond yield spread of 198 bp that well exceeds its post September 2003 median of 178 bp reinforces the negative outlook for high-yield bonds. As inferred from the historical record, a 198 bp spread for the long-term Baa industrials has typically been associated with a 544 bp midpoint for the high-yield spread, which is much wider than the recent 370 bp. It was in 2007 that a well below trend high-yield spread was joined by a significantly above average Baa yield spread.

Since late 1987, the high-yield bond spread shows a very strong correlation of 0.92 with the long-term Baa industrial company bond yield spread.

A New Digital Bank IS Arriving…

As widely reported, a new digital bank with the name 86 400 is being set up in Australia and it is pitched by its founders as a potential “genuine alternative” to the big four banks. Their site went live, but it is only a placeholder.

This from Business Insider. British banking pioneer Anthony Thomson, the entrepreneur who co-founded the highly successful Metro Bank in the wake of the GFC (the UK’s first new high street bank in 150 years), and in 2014, the country’s first digital bank, the now publicly listed Atom, has set his sights on Australia with a new digital challenger bank.

Banking startup 86 400 (named after the seconds in a day) will launch in early 2019, and is wholly funded by the Sydney-based payments services company Cuscal, best known for rediATMs.

Thomson has signed on as chairman with former ANZ Japan CEO, Robert Bell as CEO. Cuscal Payments CIO Brian Parker takes on that role at 86 400.

The heavy-hitting management team also includes Westpac’s former digital GM, Travis Tyler; CBA’s former International Chief Risk Officer, Guy Harding, as CRO; and Cuscal’s former Head of Finance, Neal Hawkins, as CFO.

While the project has been set up and funded by Cuscal (which is part-owned by the likes of Bendigo Bank and Mastercard) – one of the key architects of the New Payments Platform (NPP), a real-time payments system – it will operate as a separate entity, with a separate board and team.

NPP is at the core of 86 400’s real-time banking pitch, something Thomson says the big banks “have been very slow to make available”.

The neobank will look to raise more than $250 million capital over the first three years of operation and will likely take additional shareholders on board.

Having raised more than $AU1 billion for his previous ventures, Thomson says 86 400 is his “best prepared, most capable and well-funded venture to date” and in “the unique position of not going out to look for money”.

And he’s not mucking around.

“I’m not here to build a small bank. We’re here to build a big bank,” he said.

Eight years on, Metro Bank is worth $AU1.95 billion with annual revenues in excess of $AU500 million, having floated in 2014.

By October last year, Atom – Thomson left the business in January – had around £900 million ($AU1.6 billion) in deposits, but lost £42 million ($AU75m) in 2016.

86 400’s app-based banking has been 18 months in development, with a team of 60 based in Sydney, amid conversations with Australian Prudential Regulation Authority (APRA) for a full banking license as an Authorised Deposit-taking Institution (ADI) expected by the end of the year.

It plans to launch in beta towards the end of 2018 before going public in the first quarter of 2019 with a transaction and savings account. It will operate on both iOS and Android smartphones.

The launch comes amid a litany of complaints about the behaviour of the Big Four banks at the royal commission into misconduct in the financial services sector.

Cuscal managing director Craig Kennedy, said the organisation put forward the idea because they believed “nobody in Australia is leveraging all of the capabilities available to maximise the banking experience on your mobile”.

Cuscal produced Australia’s leading white-label mobile banking app, and has led the way in digital banking solutions.

Thomson, who last year invested in Melbourne-based fintech startup, Timelio, said Australia needed another bank “because the big banks have treated customers really, really badly”.

“Look at the levels of dissatisfaction with the banks… all of the big banks have negative net promotor scores,” he said.

“I read a piece of data which really stuck in my mind. It was from the Australia Institute and said that 2.9% of Australian GDP goes to bank profits. So $3 out of every $100 hardworking Australians make in their businesses goes to the banks in profits. This is just enormous. It’s three times bigger than the UK – and I think the UK banks rip off their consumers.

“So I think there’s a real opportunity to create the first real alternative to the real banks. Someone who does put the customer first.”

Like other digital startups, part of the opportunity CEO Robert Bell sees is avoiding the baggage around the industry’s incumbents.

“Large banks have an enormous drag in terms of very big, costly legacy real estate/branch networks, legacy technology that’s very expensive to change. Most of their digital pieces have been add-ons,” he said.

“We’ve got the huge advantage that we’re starting from scratch.”

The heart of 86 400 is its investment in what Bell calls “digital working memory”. It’s data analysis that has the potential to warn you like a parent or spouse about when you’re being a spendthrift – budgeting for the avocado toast generation – with a predictive cashflow model.

“For example, helping customers know what there balance will be in one week’s time or four week’s time if the normal things that happen in their life happen over the next couple of weeks,” he said.

“No one gives any insight into what might happen in the future.”

Thomson says: “As we get to know you, and with your permission, we can use the data to better predict what your needs are going to be. So we know that in summer you go on holidays and your insurance comes up for renewal, we can start to model that and bring it to you attention in advance”.

If you’re the sort of person who runs out of cash three days before your next payday, it could come in handy to amend your spending habits.

Bell says 86 400 plans to launch with no or low fee accounts as “just the start”, promising “value customers have never had from a bank before”.

86 400’s launch could potentially take advantage of growing resentment towards the major banks in the wake of the royal commission.

While dissatisfaction may be growing, customer churn remains surprisingly low. However, the banks are facing something of the perfect storm of a potential margin squeeze from a likely rise wholesale funding costs ahead, at the same time that credit growth has risen faster than deposit growth in recent months.

The risk of out-of-cycle mortgage rate increases is rising in Australia, giving borrowers another reason to start shopping around.

While Thomson and Bell were keen to downplay any focus on interest rates for 86 400’s potential savers and borrowers, the neobank’s tech-focused low operating costs will negate pressure on its margins as it cases new business.

ASIC accepts variation to NAB enforceable undertaking to address inadequacies in its wholesale spot FX business

ASIC has accepted a variation to an enforceable undertaking provided by National Australia Bank Limited (NAB) relating to its wholesale spot foreign exchange (FX) business.

The variation imposes additional undertakings after an independent expert’s report identified significant deficiencies in NAB’s remediation program developed as part of the original EU, accepted in December 2016 (refer: 16-455MR).

Under the original EU, NAB was required to develop a program of changes to its existing systems, controls, monitoring, training and supervision of employees within its spot foreign exchange business to prevent, detect and respond to certain types of conduct. The program and its implementation was to be assessed by an independent expert.

In accordance with the EU, NAB provided its program of changes on 28 November 2017. On 29 March 2018, the independent expert reported on NAB’s spot foreign exchange program noting significant deficiencies regarding its:

  • Governance, Risk Management and Compliance Framework
  • Policies and Procedures
  • Risk Management Practices
  • Human Resource Management.

The independent expert also concluded that it was unable to complete the expert assessment of the program’s effectiveness required by the EU because NAB has made incomplete progress in designing items to be included in the program.

The expert’s report states ‘progress in developing the program has been slow’ and that the program ‘appears to have evolved iteratively during 2017, rather than through a well-defined process. For instance, there appears to have been no comprehensive risk assessment across NAB’s Spot FX business against the EU requirements and relevant regulatory standards and guidance.’

The variation of the EU imposes an additional undertaking on NAB to prepare an updated program that adequately addresses all required components. This updated program will then be subjected to further assessment by the independent expert. After these new undertakings are satisfied, NAB will be able to progress with the undertakings in the original EU.

Commissioner Cathie Armour said, ‘ASIC is disappointed with the delay in the development and assessment of a remediation program to address the conduct outlined in the EU. However, we are pleased that the process has been sufficiently robust to ensure any ongoing deficiencies have been identified and are being addressed, with oversight by an independent expert. ASIC’s ultimate objective is to ensure NAB has effective mechanisms in place to adequately train, monitor and supervise its employees to provide financial services efficiently, honestly and fairly’.

Background

The wholesale spot FX market is an important financial market for Australia. It facilitates the exchange of one currency for another and thus allows market participants to buy and sell foreign currencies. As part of its spot FX businesses, NAB entered into different types of spot FX agreements with its clients, including Australian clients.

Spot foreign exchange refers to foreign exchange contracts involving the exchange of two currencies at a price (exchange rate) agreed on a date (the trade data), and which are usually settled two business days from the trade date.

NAB Group Chief Risk Officer, David Gall, said NAB is firmly committed to working with ASIC to strengthen its Spot FX business.

“We welcome the feedback received from the independent expert in its initial report, which has helped us identify areas where we can do better to implement the program of changes,” Mr Gall said.

Australian Homebuyers Paid Out Over $21 billion In Stamp Duty Last Year

HIA’s Stamp Duty Watch report, released today, reviews the latest developments around stamp duty across Australia’s eight states and territories.

“Australian homebuyers paid out over $21 billion in stamp duty to state governments during the 2017/18 financial year – and the total cost of the tax is expected to get even bigger over the next few years,” explained HIA Senior Economist, Shane Garrett.

“The Report shows that revenue from stamp duty across the states and territories has doubled over the past 8 years. This has added considerably to the cost of buying a home and represents a real setback for affordability.

“The recent set of state Budgets envisage stamp duty revenues increasing by another 11 per cent over the next four years.

“This will involve homebuyers’ having their pockets drained to the tune of $23.1 billion annually by 2021/22 through stamp duty.

“State governments are more dependent on stamp duty than at any time in the last decade. Stamp duty is notoriously unstable and Australia’s largest states are heavily exposed to any downturn in duty receipts should economic conditions change.

“Housing affordability and the sustainability of government finances would both be winners if stamp duty was replaced by better revenue-raising designs. Australian governments really need to tackle this issue once and for all,” concluded Shane Garrett.

ASIC calls on retail OTC derivatives sector to improve practices

ASIC has called on participants in the retail over-the-counter (OTC) derivatives sector to improve their practices after recent ASIC activities showed their conduct fell short of expectations.

The products offered by retail OTC derivatives issuers in Australia include binary options, margin foreign exchange and contracts for difference.

A recent review of 57 retail derivative issuers identified a number of risks associated with the products offered to retail investors by OTC derivatives issuers.

Our review found that client losses in retail OTC derivatives trades seemed high, with the percentage of unprofitable traders being up to 80% for binary options, 72% for CFD traders and 63% for Margin FX traders. ASIC will examine this area further as part of its ongoing focus on the sector.

ASIC’s recent supervisory activities have also revealed sector-wide concerns about certain practices.

The most concerning practices ASIC has identified during in its supervision of the sector and highlighted in our recent reviews include:

  • actual client profits being inconsistent with marketing materials
  • a lack of transparency around pricing
  • risk management practices that relied on the use of client money were outdated and needed to be reviewed
  • some referral arrangements that may be in breach of conflicted remuneration requirements and referral selling prohibitions
  • some issuers that were providing wholesale services or allowing third parties to ‘white label’ their products did not have adequate risk management practices and operational capital to supervise counterparties and support their exposures.

Binary options may be the least transparent in terms of underlying pricing, strike prices and payout structures.

To address these risks, ASIC has called on issuers to:

  • review and update their risk management and client money practices; and
  • assess whether their arrangements with counterparties and referrers meet their AFS licence obligations.

ASIC Commissioner Cathie Armour said, ‘The retail OTC derivatives sector in Australia is an active and growing market, with an annual turnover of $11 trillion and over 450,000 investors. The integrity of the retail OTC derivatives sector is a key focus for ASIC. ASIC expects licensed issuers to conduct themselves appropriately and ensure consumers trade in retail OTC derivatives with a clear understanding of the products and the risks to which they’re exposed. We will be working with issuers to raise industry standards and improve compliance with their Australia financial services licence obligations.’

Read Report 579

Red Alert, From The Banker’s Banker

The Bank for International Settlements, Banker’s Bank has released their latest annual report. We looked at the section on how banks are fudging their ratios in our earlier post “Are Some Banks Cooking the Books?” But within its 114 pages, the BIS report also painted a worrying picture of where the global economy stands.

They say, economies are trapped in a series of boom-bust boom-bust cycles which are driving neutral interest rates ever lower and driving debt higher. The bigger the debt the worse the potential impact will be should rates rise (as they are thanks to the FED). Yet in each cycle “natural” interest rates are driven lower  Implicitly the current settings are wrong.

It is as clear an articulation of the underlying issues which are driving us towards the rocks, and at quite a clip. I still hold 2019 as the critical year, my four scenarios still seem about right, with risks biased towards more concerning outcomes.

Claudio Borio, the BIS’s chief economist said  “The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance”.

This is a dark warning, coming as it does from the organisation which is effectively the peak body for central bankers around the world.  This is no fringe movement. This is the brain of the banking system speaking!

In fact, the risks in the global monetary system remain from the Lehman crisis in 2008 and aggregate debt ratios are almost 40 percentage points of GDP higher than a decade ago.

The BIS report said: “Global US dollar funding markets are likely to be a key pressure point during any future market stress episode. There are significant roll-over risks, as sizeable parts of banks’ US dollar funding rely on short-term instruments (repos, and currency swaps).”

The BIS says central banks are on the horns of a dilemma. Do you lift rates sharply as the FED has done, or go slowly, both are fraught with difficulty.  They call this the ‘great unwinding’ of the debt laden stimulus, and again it seems we are in uncertain and uncharted territory. As the report says, “A strategy of gradualism is no panacea, as it may encourage further risk-taking”.  The gloom was overdone early last year but now exuberant investors may be making the opposite error, with the world 12 months further into a stretched financial cycle. Has sentiment has swung too far?

The truth is, those hoping to time global asset markets by waiting for the usual signs that the cycle has peaked risk being caught off guard. The deflationary forces of technology and a globalised labour force mean that trouble can creep up on them before inflation emits the usual warning signals.

The bank says under the precious “Phillips Curve” model, wage growth would pick up late in the cycle as the economy reached full employment. Wages would rise and inflation would pick up.  So then the Fed and other central banks would lift rates – boom-bust, and it would usually lead to a recession. But, now globalisation has killed the inflation warning signals. Then you have more than 2 billion people coming on stream into the global economy from China and Eastern Europe has dampened wage growth and as a result a substantial and lasting flare-up of inflation does not seem likely.

Instead the excess stimulus driven by low rates has simply gone into asset bubbles instead. It may look benign if inflation is low but the BIS argues that it is extremely damaging. The cycle ends with a financial crisis. Again.

In fact, my read is that the BIS are saying (in bankers speak perhaps) that the big central banks misread the globalisation era with too much stimulus letting assets booms run, but stepping in with maximum stimulus in busts.

The Fed and others have in effect drawn forward prosperity from the future. It takes ever lower real interest rates with each cycle to hold the system together. At some point interest rates will hit the limit.

So now the way ahead is fraught with danger, as rates are lifted, the risks of a financial crisis follow, and the prospect of a benign set of outcomes is now fading. The BIS says the only way for the world to dig itself out of this hole is to raise productivity from its current anaemic levels. Countries must reform and shift fiscal policy from consumption to investment.

And in a parting shot, the report says, the most destructive course is to undermine free trade itself and impose trade tariffs and other forms of protectionism. “Rolling back globalisation would be as foolhardy as rolling back technological change,” Mr Borio said.

 

Too Soon to Call China’s RRR Cut a Clear Sign of Easing

China’s two recent reserve requirement ratio (RRR) cuts amid slowing economic growth and rising trade risks have prompted market speculation that a new cycle of monetary easing is underway, but Fitch Ratings believes it is too early to conclude recent policy actions mark a clear reversion in stance.

A return to policy settings that add to the economy’s imbalances and vulnerabilities, such as credit stimulus, nevertheless remains a risk and could put downward pressure on China’s sovereign rating, as Fitch has previously stated.

The decision by the People’s Bank of China over the weekend to implement another 50bp RRR cut across much of the banking sector follows a targeted 100bp cut in April. The latest cut will release around CNY700 billion in reserves, effective on 5 July, bringing the combined net reserve injection to CNY1.1 trillion this year. The government has stressed that funds released by the latest cut should be used to support implementation of the debt-to-equity swap programme and small and micro-sized enterprise lending.

Fitch believes that the recent RRR cuts should be viewed in the context of liquidity management measures to ensure interbank funding conditions remain stable amid the ongoing crackdown on shadow banking. The authorities have previously relied on liquidity tools such as the medium-term lending facility, the pledged supplementary lending facility and the standing lending facility to provide liquidity in the face of weak base money growth, but an RRR cut should provide more permanent (and lower-cost) support. This should reduce liquidity risks for smaller banks, in particular, which are net liquidity takers and generally more reliant on shadow financing.

RRR cuts have previously coincided with policy loosening, but periods of clear easing (2008-2009, 2011-2012 and 2015) have also been marked by cuts to benchmark interest rates and a sustained decline in interbank rates, which have so far been absent (see chart). Meanwhile, the authorities continue to maintain a tighter bias towards macro-prudential policies and other financial regulations that aim to close regulatory loopholes, many of which are unlikely to be unwound at this stage, given the prominence the deleveraging campaign has taken at major policy meetings.

For now, Fitch’s expectation is that regulatory tightening will have a more powerful impact on credit growth than the additional liquidity generated by recent RRR cuts. Additionally, while further cuts are still possible, Fitch does not believe banks have sufficient capital to support aggressive asset expansion. That said, these adjustments do suggest that the authorities’ deleveraging drive has likely moved past its apex, and the swift deceleration in credit growth over the past year or so should soon begin to moderate.

Our baseline forecast is that GDP growth will slow during the second half of this year, due to deceleration in credit growth and a softening in the property market. Trade tensions with the US have not so far had a noticeable impact on exports, but could soon become a key policy consideration, given that a buoyant external environment has been an important contributor to China’s strong growth over the past year. If this dissipates, the authorities could be tempted to fall back on domestic stimulus to meet growth targets.

The authorities do have other policy tools beyond credit stimulus to shore up growth. Other forms of stimulus, including an on-balance-sheet fiscal stimulus, would not necessarily be ratings negative. Fitch estimates gross general government debt at less than 50% of GDP, in line with ‘A’ rated peers, which provides some room for fiscal easing. A recent State Council decision to lower taxes, which included a cut to value-added-tax rates, and plans to increase personal income tax deductions perhaps signal an initial step in that direction.