Monetary Policy Transmission

Christopher Kent, Assistant Governor (Economic), gave a speech in Canberra at the Australian National University entitled “Monetary Policy Transmission – What’s Known and What’s Changed“. In the speech he dissects the way in which changes to monetary policy flows on through the economy to households and firms.  Its a relevant discussion because the recent monetary easing has not so far translated into the desired outcomes in the current cycle. We think he is correct to assert that segmented analysis of households needs to be incorporated into the thinking, as based on our surveys we see that different household groups, are behaving in very different ways.

In responding to cyclical developments and inflation pressures, monetary policy has a significant influence on aggregate demand and inflation. The transmission of interest rates through the economy can be roughly described as follows. I’ll focus on an easing of monetary policy.

  1. The Reserve Bank lowers the overnight cash rate.
  2. Financial markets update expectations about the future path of cash rates and the structure of deposit and lending rates are quickly altered.
  3. Over time, households and firms respond to lower interest rates by increasing their demand for credit, reducing their saving and increasing their (current) demand for goods, services and assets (such as housing and equities).
  4. Other things equal, rising demand increases the prices of non-tradable goods and services. The price-setting behaviour of firms depends on demand conditions and the cost of inputs, including of labour. Higher aggregate demand leads to increased labour demand and a rise in wages.

The transmission mechanism depends crucially on how monetary policy affects households’ and firms’ expectations. Expectations about the future path of the cash rate will affect financial market prices and returns, asset prices and the expected prices of goods, services and factors of production (including labour). Expectations of more persistent changes in the cash rate will have larger effects.

The extent to which lower interest rates lead to extra demand will depend on how households and businesses alter their behaviour regarding borrowing and investing, as well as consuming and saving. These responses are often described as occurring via a number of different channels.

He concludes that monetary policy is clearly working to support demand, although it is working against some strong headwinds. These include the significant decline in mining investment, fiscal consolidation at state and federal levels and the exchange rate, which continues to offer less assistance than would normally be expected in achieving balanced growth in the economy. Model estimates that control for these and other forces provide tentative evidence that the monetary policy transmission mechanism, in aggregate, is about as effective as usual. However, it may be too early to pick up a statistically significant change using such models.

As usual, dwelling construction is growing strongly in response to low interest rates, and this is making some contribution to the growth of aggregate demand and employment. It may be that in parts of the country, any further substantial increases in residential construction activity might run up against some supply constraints, putting further upward pressure on housing prices. As the Bank has noted for some time now, large increases of housing prices, if accompanied by strong growth of credit and a relaxation of lending standards, are a potential risk for economic stability. Accordingly, the Bank is working with other regulators to assess and contain such risks that may arise from the housing market.

Consumption growth has picked up since 2013. But it is still a little weaker than suggested by historical experience. This may reflect a number of factors including some variation in the ways that the different channels of monetary policy are affecting households according to their stage in life. Some indebted households appear to be taking advantage of low interest rates to pay down their debts faster than has been the norm, perhaps in response to weaker prospects for income growth. Those relying on interest receipts may feel compelled to constrain their consumption in response to the relatively long period of very low interest rates. Meanwhile, the search for yield is no doubt playing a role in driving the strong growth of investor housing credit. This might provide some indirect support to aggregate demand, but this channel is not without risk.

In short, monetary policy is working. The transmission mechanism may have changed in some respects, and this could help to explain lower-than-expected growth of consumption and debt of late. But it is hard to be too definitive. To know more about this, it would be helpful to better understand the behaviours of different types of households using household-level data. To use a botanical analogy, to know more about a plant, it’s helpful to observe how its different types of cells work.

Perspectives on the Housing Debate

Last week amongst all the noise on housing there were some important segments from the ABC which made some significant contributions to the debate. These are worth viewing.

First Lateline interviewed the Grattan Institute CEO on the social and political impacts of housing policy, and also covered negative gearing.

Second The Business covered foreign investors, restrictions on investment lending and the implications for non-bank lenders who are not caught by the APRA “guidance”.

Third, a segment from Insiders on Sunday, dealing with both the economic arguments and the political backcloth.

Next a segment from Australia Wide which explores the tensions dealing with housing in a major growing city, Brisbane. No-one wants building near their backyard, so how to deal with population growth.


Latest Lending Aggregates All About Property

The ABS released their data for April. The total value of owner occupied housing commitments excluding alterations and additions rose 1.3% in trend terms  whilst the value of total personal finance commitments rose 0.5%.

Total commercial finance commitments rose 2.4%. Fixed lending commitments rose 3.4%, while revolving credit commitments fell 0.4%. The trend series for the value of total lease finance commitments rose 1.6% in April 2015.

Lending-Aggregates-April-2015We continue to see strong investment lending with more than half of residential loans in April going to investors.

Property-Lending-Aggrates-April-2015The proportion of commercial lending aligned to investment property rose and this explains much of the rise in commercial lending overall. Investment property lending is relatively unproductive, and makes little contribution to economic growth.


UK Bank Ring-Fence; More Flexible, Group Limits Unclear – Fitch

The implementation of bank ring-fencing in the UK continues a trend of dilution and flexibility by granting additional, albeit minor, concessions to the banks and remaining silent on the important subject of intra-group limits, says Fitch Ratings. The Prudential Regulation Authority’s (PRA) concessions in their end-May statement follow earlier watering-down of proposed rules for ring-fenced banks (RFB) by the UK government, which allowed more activities to be included within the ring-fence.

Fitch believes that only six of the largest UK retail banks will be subject to the ring-fencing rules, and of these only HSBC and Barclays are likely to have significant operations outside the ring-fence. Ultimately, the strength of the ring-fence will have rating implications for the entities within UK banking groups.

The PRA’s statement and near-final rules show that it is staying with the overall approach outlined in the October 2014 consultation. However, by clarifying that certain key aspects will be reviewed on a case-by-case basis and reminding the banks that it is possible to request waivers and modifications, the PRA has introduced additional flexibility. Banks may still have some room for manoeuvre because final rules will not be published until 3Q15 and banks will have until 2019 to comply.

Core issues such as the ‘large exposures limit’ on intra-group exposures between an RFB and the rest of its group and intra-group dividends are still open. UK banks argue that they need clarity to plan for future group treasury management and capital allocation. Under EU rules, the PRA could elect to limit large exposures to 10% of a RFB’s capital. We believe this tight limit would strengthen the ring-fencing and protect RFBs from riskier group activities.

Banks requested clarification about what types of subsidiaries can and cannot be owned by an RFB. A prescriptive list of permitted activities will not be published by the PRA, rather banks will have the opportunity to discuss subsidiary business lines with it on a case-specific basis. This could result in a broader range of permitted activities for RFBs, helping to diversify revenues and simplify operational functions, but also widen the net to include higher-risk business lines.

HSBC indicated recently that it intends to widen the scope of activities included in its RFB. The over-riding guideline is that a subsidiary should not expose the RFB to any risk affecting its ability to provide core activities in the UK. The relative size of subsidiaries will also be considered by the PRA under its ‘proportional’ approach, especially if these are undertaking activities largely unrelated to the RFB’s line of business.

RFBs must be able to take decisions independently and guidelines for board membership, risk management and internal audit arrangements aim to achieve this. Banks queried some of the board cross-membership restrictions and the PRA clarified that board membership rules do not apply to RFB sub-groups. This will make it easier for RFBs to fill the boards of their ring-fenced subsidiaries and affiliates.

Under its proportionality approach, the PRA can consider further waivers to governance arrangements, especially if compliance with the rules proves to be overly burdensome. Lloyds Banking Group is seeking a waiver on the requirement for its RFB, which will make up around 90% of the group, to have a different board of directors to that of its group. The PRA also clarified that RFBs are not prevented from relying on group services from other group entities, which is important if RFBs are to contain costs.

In our view, RFBs will still face some governance conflicts. The rules allow for some board members to be group employees, hold director positions in other group companies and independents can have occupied group positions subject to some restrictions. All board members can receive part of their remuneration in the form of listed shares in a group company. The practical implementation of governance rules will be important to ensure that the right balance is struck between achieving synergies between the RFB and the rest of its group and limiting the direct exposure, both financial and otherwise, to improve the resolvability of the group.

Limited Upside, Potential Downside from HSBC’s Pivot – Fitch

HSBC’s plan to redeploy resources to Asia, shrink its investment bank, and cut costs is unlikely to have a positive rating effect while being potentially negative over the long run, says Fitch Ratings. In particular, how HSBC manages its significant planned growth in China and south-east Asia could hurt the ratings if this leads to a higher overall risk profile and concentration.

The plan, announced as part of an Investor Update on 9 June, reinforces an earlier strategic plan from 2011 which was first updated in 2013 and focuses on several key themes. These include a regional focus on Asia and China, and operating a diversified universal banking model with three divisions of equal weight – Retail Banking and Wealth Management, Commercial Banking, and Global Banking and Market. Financial targets remain unchanged, including a return- on- equity target of above 10% based on a CET1 ratio of 12%-13% – both figures were adjusted earlier in the year.

The announced cost and capital reallocations would only provide a positive credit and ratings effect if HSBC outperforms on the execution of its strategy and at the same time boosts capitalisation significantly. In terms of maximising efficiencies, HSBC plans up to 25,000 job cuts – mainly from reducing back-office functions and through the use of digital technologies and automation. The cost savings will be reinvested, with the overall cost base remaining stable at USD32bn.

Positive factors are the plans to reduce a combined USD140bn in risk-weighted assets (RWAs) in the investment banking division through quicker reduction of legacy assets, selling assets that no longer meet their cost of capital, and focusing on transaction banking-type businesses and multi-product and multi-country relationships However, we view this as a natural extension of ongoing efforts to scale back investments that have become overly capital intensive.

HSBC confirmed that it would also exit Turkey and reduce its operations in Brazil to only a small presence, while holding on to its Mexican business. The capital released from the sales in Turkey and Brazil will be used mainly to finance growth in Asia, enhance transaction banking and building key trade hubs for example in places like Germany. HSBC has already retreated from several dozen retail markets since 2011, including India, Russia, Colombia, Thailand and South Korea. The bank is targeting an increase in investments of USD180bn-230bn in RWAs in the Pearl River Delta (PRD) in southern China and ASEAN countries, which will also involve quadrupling the PRD workforce over the medium term.

Extracting more value from its global network and from increasing the share of international client revenues – which it quantified at USD22bn or 40% of revenues in 2014 – would be positive for HSBC, but there are few details as yet as to how this will be measured and accomplished. In this regard, the bank emphasised that maintaining a substantial US presence is most critical for its transaction banking operations which generated revenue of USD16bn in in 2014.

HSBC restructuring shows universal banks are coming back down to earth – The Conversation

From The Conversation. HSBC’s decision to end its operations in Brazil and Turkey, and lay off around 10% of its workforce worldwide shows just how far it has come from the days of touting itself as “the world’s local bank”. Its strategy used to be to offer any financial service everywhere in the world. Whether you were in Shanghai, Sydney, Springfield or Southampton, you could access services such as personal banking, foreign exchange business banking and investment banking.

This model paid off for years. The bank provided impressive returns to investors, progressively extended its footprint, and even seemed to dodge the worst effects of the financial crisis.

HSBC was not alone in doing well by doing everything, anywhere. Its competitors have built similar business models during the last 20 years.

Merger mania wasn’t for customers

In the past, different financial services were provided by different organisations. You went to one company for insurance, one for investment banking, and one for personal banking. There were co-operatives, partnerships, publicly listed companies and privately held companies. Banks in each country looked completely different. This meant there was a verdant landscape of different kinds of financial service organisation.

But during the 1980s, all this changed. Retails banks started to provide a whole range of services they had not before, such as insurance. Then retail and investment banks began to merge. Building societies demutualised. Banks began to expand across the world. The result was that the world’s financial sector was dominated by a handful of gigantic players. There was also a business model mono-culture: a universal bank which provided almost every service to everyone in the world.

Banks claimed to do this because their customers wanted it. There certainly were a number of sophisticated global clients looking for global banking services. But the real reason for adopting this model had nothing to do with customers. By merging retail and investment banks and continually growing the size of the bank’s balance sheet, these global giants were able to effectively use the money deposited in their retail banks to engage in risky – but highly profitable – trading and investment activities.

This model paid off for many years. As big banks grew, they delivered double digit returns to their shareholders. But perhaps more importantly, they created a lucrative stream of bonuses for senior managers. They also pumped out tax income for governments which hosted them. It seemed everyone was winning.


That was until 2007, when the financial crisis struck. When this happened these global giants with massive balance sheets became a liability. It quickly became obvious that they were too big to fail. If a bank went down, they could threaten the global economy.

And we quickly learned too that they were too big to manage. In the long aftermath of the financial crisis, we discovered that CEOs of large banks (including HSBC) had no idea what was going on in parts of their far flung empires. We also found out they were too big to trust. The ongoing stream of revelations around wrongdoing in markets like foreign currencies and LIBOR – the rate at which banks lend each other short-term money – show that bad behaviour appeared endemic in certain parts of these global giants.

Now shareholders are beginning to ask whether these giant universal banks are too big to succeed. With costs of bad behaviour mounting and many lines of business less profitable than before, shareholders are asking whether big banks should be trying to be everything for everyone. It seems that the universal banking model has failed.

The announcement by HSBC that it is cutting 25,000 jobs across the world, 8,000 in the UK, selling operations in Turkey and Brazil and shrinking its investment bank are an important part of moving away from this model. Underneath this is the recognition the bank can’t do everything for anyone. Instead, if banks like HSBC are to be trusted, profitable and sustainable they need to focus on a few markets where they have genuine expertise.

A benefit for all?

A more focused bank may look appealing to investors and regulators. But if we are to believe recent research, a smaller banking sector may actually be good for the wider economy. However, this focus is unlikely to appeal to staff who will lose their jobs. The UK government must be rightly nervous about losing HSBC, which is one of the country’s biggest tax payers and an important employer. Many of the other large banks are engaging in similar processes of shrinking their scope and balance sheets.

But the big question which remains is whether closing a few lines of business and a little restructuring will do enough to bring back diversity to the banking sector. Creating real diversity in this sector probably means not just slightly smaller global banks – it means ensuring there are a wide range of business models. The risk is that we simply end up with a small number of global giants with oversized footprints. Creating new business models to replace the universal banks is one of the biggest challenges of our time.

Author: Andre Spicer Professor of Organisational Behaviour, Cass Business School at City University London


Westpac Restructures

Westpac announced a new, simplified organisational structure for its Australian retail and business banking operations designed to accelerate the Group’s customer focused strategy. Under the new structure, two new divisions are being created:

  • Consumer Bank – responsible for all consumer banking products and services under the Westpac, St.George, BankSA, Bank of Melbourne and RAMS brands. It will be led by George Frazis.
  • Commercial and Business Bank – responsible for serving small and medium enterprises, commercial and agri-business customers, as well as asset and equipment finance. Specialist business bankers will continue to operate under their respective brands. The division will be led by David Lindberg.

Each division will be responsible for improving the end-to-end service experience of their respective customer segments and will have dedicated product, marketing and digital capabilities. CEO Brian Hartzer said the simpler structure will clarify accountability and better align resources to customer segments, while maintaining the Group’s unique family of brands.

Consumer Bank

The distinct positions of each of Westpac’s brands-Westpac, St.George, BankSA, Bank of Melbourne and RAMS-will be preserved and supported by a dedicated product and marketing and digital capability. Under the new structure General Managers of each of the brands will report to George Frazis.

George Frazis is currently Group Executive, St.George Banking Group, a position he has held since April 2012. During the past three years, George has invigorated the St.George franchise and delivered strong returns for the Group.

George joined the Westpac Group in March 2009 as Chief Executive, Westpac New Zealand Limited. He is a highly experienced financial services executive, having previously been a group executive of National Australia Bank and a senior executive in Commonwealth Bank of Australia’s Institutional Banking Division.  George was previously a partner with the Boston Consulting Group and an officer in the Royal Australian Air Force.

Commercial and Business Bank

The new Commercial and Business Bank division, led by David Lindberg, will bring together specialised business bankers from each of the brands, equipment and asset finance businesses, as well as responsibility for business products, marketing and digital. This new operating division will ensure greater focus on business customers, an important area of growth for the Group.

David Lindberg is currently Chief Product Officer, responsible for the Group’s retail and business product and digital banking offerings across all brands. In this role, David has led the simplification of products and services, and has been responsible for the highly successful roll-out of Westpac Live. Prior to joining Westpac in 2012, David held senior executive positions in the Commonwealth Bank of Australia and ANZ. He commenced his career at First Manhattan Consulting Group, where he worked from 1999 to 2008.

Additional management changes

As a result of the new management structure, Jason Yetton, Group Executive, Westpac Retail & Business Banking is leaving Westpac to pursue other opportunities. Responsibility for all other divisions of the Group remains unchanged. The new structure will take effect immediately. However, given the Group has operated under the previous structure for almost three quarters of the year, it will report its full year to 30 September 2015 financial results under the previous organisational structure.


Basel Committee Consults on Interest Rate Risk in the Banking Book

The Basel Committee on Banking Supervision has issued a consultative document on the risk management, capital treatment and supervision of interest rate risk in the banking book (IRRBB). This consultative document expands upon and is intended to ultimately replace the Basel Committee’s 2004 Principles for the management and supervision of interest rate risk.

The Committee’s review of the regulatory treatment of interest rate risk in the banking book is motivated by two objectives: First, to help ensure that banks have appropriate capital to cover potential losses from exposures to changes in interest rates. This is particularly important in the light of the current exceptionally low interest rate environment in many jurisdictions. Second, to limit capital arbitrage between the trading book and the banking book, as well as between banking book portfolios that are subject to different accounting treatments.

The proposal published presents two options for the capital treatment of interest rate risk in the banking book:

(i) a Pillar 1 (Minimum Capital Requirements) approach: the adoption of a uniformly applied Pillar 1 measure for calculating minimum capital requirements for this risk would have the benefit of promoting greater consistency, transparency and comparability, thereby promoting market confidence in banks’ capital adequacy and a level playing field internationally; alternatively,

(ii) an enhanced Pillar 2 approach: a Pillar 2 option, which includes quantitative disclosure of interest rate risk in the banking book based upon the proposed Pillar 1 approach, would better accommodate differing market conditions and risk management practices across jurisdictions.

The Committee is seeking comments on the proposed approaches, which share a number of common features. Comments are sought by 11 September 2015.

Housing Finance Up In April Is Investment Driven

The ABS released their Housing Finance Statistics to April 2015 today. The trend estimate for the total value of dwelling finance commitments excluding alterations and additions rose 1.4% to $32,109 m.

Investment housing commitments rose 1.4% and owner occupied housing commitments rose 1.3%. This is a strong result, and ahead of expectations. We suspect investors are bringing purchase decisions forwards ahead of possible anticipated lending tightening later. Further evidence that the dial needs to be turned back.

Looking at the trends, more than half of new loans (excluding refinance were for investment purposes, and the value of refinancing continued to track higher as borrowers move on to the new lower rate offers.

HousingFinanceTrendsApril2015In trend terms, the number of commitments for owner occupied housing finance rose 0.7% in April 2015. In trend terms, the number of commitments for the purchase of new dwellings rose 1.1% and the number of commitments for the purchase of established dwellings rose 0.8%, while the number of commitments for the construction of dwellings fell 0.2%

HousingFinanceApril2015In original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments rose to 15.2% in April 2015 from 15.1% in March 2015. However, in NSW it was lower, at 11%, in an environment where investment lending is hot.

FTBApril2015However, the true first time buyer picture is more complex with a continued lift in FTB investors, as shown in the DFA adjusted picture. More than 4,000 FTB investors joined the ranks this month, a record, compared with about 7,000 OO FTB. If this continues, we expect investors to overtake OO FTB by the end of the year.


Restoring Trust in Basel IRB Models Will Take Time – Fitch

Greater comparability in capital requirements across EU banks is likely to take time, Fitch Ratings says. Meanwhile, doubts surrounding internal ratings-based (IRB) models are likely to continue to undermine trust in regulatory capital ratios.

The European Banking Authority’s (EBA) consultation on the future of the IRB approach, which closed last month, included proposals for detailed changes to IRB models. Fostering supervisory convergence lies within the EBA’s remit, but to address some of the consistency and comparability issues, legislative changes, particularly to the EU’s Capital Requirements Regulation, will be required. This is likely to take considerable time.

Greater consistency in the way capital ratios are calculated is especially important because almost all the world’s 30 global systemically important banks use IRB models, as do most of the EU’s systemically important banks. Market participants mistrust capital ratios generated using IRB models to calculate risk-weighted assets (RWA) in part because model input variation and definition inconsistencies make meaningful comparison of ratios across banks and countries very difficult.

The Basel Committee on Banking Supervision’s Regulatory Consistency Assessment Programme (RCAP) initiative is making slow progress in reducing RWA variability and there is limited transparency on which banks’ ratios might be overstated. For example, in April 2015, the Committee announced it had agreed to remove just six of around 30 national discretions from Basel II’s capital framework.

The Committee’s reluctance or inability to name the banks whose capital ratios are overstated undermines confidence in the IRB models generally. The Committee’s EU Assessment of Basel III regulations report, published last December under the RCAP, highlighted that the exclusion of sovereigns and other public-sector exposures from the IRB framework, plus liberal risk weights for SME exposures, as permitted in the EU, positively affected the capital ratios of five EU banks. It did not name any banks. We understand that disclosure may be difficult because banks often participate in initiatives voluntarily and the Committee has no legal means to force disclosure.

Unwillingness to name names is not new. In July 2013 the Committee reported on a hypothetical portfolio benchmarking exercise across 32 major international banking groups and found material differences in IRB-calculated RWAs. The names of the outlier banks were not made public. This was also the case in the EBA’s reports, which analysed the consistency of RWA across banks, published in December 2013. A benchmarking exercise of SME and residential mortgages highlighted substantial variations. Naming the banks would be useful for market participants as it could shed some light on the banks’ estimated default probabilities and loss expectations, allowing analysts to adjust reported capital ratios if required.

The Committee’s November 2014 G20 presentation outlined five policy proposals to reduce excessive variability in the IRB approach. We think the most significant initiative is the proposal to introduce some fixed loss given default (LGD) parameters. LGDs, which measure the losses a bank would incur if a borrower defaulted, taking into account mitigating factors such as collateral, are a key input into the IRB models.

The EBA’s discussions on the IRB approach appear to be gaining momentum but its proposed timeline for defining technical standards is set at end-2016. Harmonisation of the definitions of default, LGD, conversion factors, probability of default estimates and the treatment of defaulted assets is essential as a first step towards achieving capital ratio comparability. We think delays to the EBA’s proposed timetable are likely.