Home Lending Rose to $1.47 Trillion in May

The RBA lending aggregates for May 2015 tell the ongoing story of housing lending dominated by investment loans, and housing becoming an ever larger proportion of total bank debt. Total bank lending stock grew to $2.4 trillion in May, with $1.47 trillion in housing, growing at 0.42% in the month, business lending up 0.35% to $792 million and personal lending (excluding housing) down a little to $141 million. Overall housing lending was 61.1% of all bank lending (excluding government loans) – an all time high.

Lending-May-2015-RBALooking more closely at housing, the $1.47 trillion was split into owner occupied lending of $958 million, up 0.42% in the month, and investment lending of $508m, up 0.81%, showing again the disproportionate focus on investment property.

Housing-Lending-May-2015-RBAWe can but reiterate our two key points. First, housing lending is squeezing out productive lending to business, and in so doing continues to inflate banks balance sheets, and house prices, neither productive economically speaking; whilst business finds it hard to get the support it needs to create productive growth. In the context of a mining slow down, this is a serious problem, which will not be addressed by $20k capital write-offs. Capital rules favour home lending too much.

Second, the distortions created by ever larger bands of property investors, makes it harder for younger families to buy a home – indeed many are going direct to the investment sector in a bid to get a look in. However, those who analyse relative risks in an investment portfolio versus an owner occupied portfolio indicate there are higher risks in the investment pools, especially in a down turn. These risks are not recognised by the current Basel rules, and such risks are not currently priced into investment loans.

The data so far does not demonstrate any impact from the “tighter” APRA rules for investment lending, maybe next month? Even if one or two banks slow their investment lending growth rates and tighten their underwriting criteria, others will happily step in.

Are Interest Rates Stuck At Historic Lows?

In a speech at the Open University, The Bank of England’s Chief Economist, Andy Haldane explores why interest rates in advanced economies have got “stuck” and how policymakers should respond. Highly relevant given the recent BIS report which said there was too much reliance on risky low interest rate monetary policy.

Official interest rates in the major economies remain stuck at unprecedentedly low levels. Central banks have made vigorous attempts to dislodge them, including through special liquidity schemes, asset purchases and forward guidance. Yet interest rates remain stuck. This stickiness in interest rates has surprised both policymakers and financial markets. After they hit their floor, financial markets expected official rates in the US to unstick in 6 months, in the UK in 10 months, in Japan in 13 months and in the euro-area in 14 months. But they have remained stuck: in Japan for over 20 years and in the US, the UK and the euro-area for over 6 years. Indeed, the expected time to lift-off remains as many months away today as when rates first hit their floor: in the US 9 months, in the UK 10 months, in the euro-area 34 months, in Japan 72 months. In Australia, rates are as low as they have been in living memory, and some advocate further cuts still.

Real-Interest-RatesAndy explores two possible factors that may have contributed to current low levels of interest rates: “dread risk and recession risk. The first generates an elevated perception of risk, the second an asymmetric balance of risk. Both are relevant to explaining the path of interest rates, the likely fortunes of the economy and the optimal setting of monetary policy.”

The effects of dread risk have, Andy argues, “proved lasting and durable.” The fear of a further financial crisis and the risk-averse behaviours that follow help “explain the sluggishness of the recovery, and the adhesiveness of interest rates, since the crisis.” And, “if the past is any guide, these scars may heal only slowly.”

In a discussion of recession risk, Andy considers what we can expect for future growth on the basis of past trends. He finds that “the probability of an expansion lasting for longer than 10 years is, on past evidence, less than 10%.”

“If a recession were to strike in the period ahead, a relevant question for monetary policy is how much room for manoeuvre might be necessary to cushion its effects.” Comparing the magnitude of previous loosening cycles to the current path of the yield curve Andy finds, “recession probabilities exceed interest rate threshold probabilities by a factor of anywhere between 1.5 and 4.”

“Put differently, based on these estimates there is a considerably greater chance of interest rates needing to be cut to their floor to meet recessionary needs than of them gliding back to levels that could safely cushion a recession. Even after interest rates have lifted off from their floor, it is more likely than not they may return there over a ten-year horizon.”

What, therefore, are implications for monetary policy of continued dread and recession risk? Using the forecast from the May Inflation Report Andy has updated the interest rate trajectories he produced earlier this year. “As then, they suggest the optimal path for interest rates involves an immediate cut in rates for about a year, which pushes inflation back to target and closes the output gap. Thereafter, interest rates rise gradually in line with the market curve.”

However, the trajectories are illustrative and may “underplay the effects of risk” such as the dread risk and recession risk he has focused on here. He argues these risks have led to a cautious response to the recovery by both households and, to some extent, businesses which may “skew growth risks to the downside”. As a result, while April’s wage data was “encouraging news… one swallow does not a summer make.” “Wage growth is causing some fluttering, but not in this dovecote.”

This, in combination, with the downside risk to the MPC meeting its 2% inflation target two years hence, gives Andy “considerable sympathy” with the argument that interest rates should be “lower for longer” to manage the risks from raising rates too soon. A rate rise “however modest” would be a further example of bad news to already cautious consumers: “A policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow.”

This leads Andy to conclude: “my judgement on the appropriate monetary stance in the UK is relatively little altered from earlier in the year. The current level of interest rates remains, in my view, appropriate to assure the on-going recovery and to insure against potential downside risks to demand and inflation. Looking ahead, I have no bias on either the size or direction of future interest rate moves.”

Five things you need to know about the IMF’s stance on Greece

From The Conversation.

As negotiations go down to the wire, the IMF is once again being cast in the role of dictator. It is the enforcer of controversial structural reforms to a country experiencing severe economic distress, the social consequences of which have been disastrous over the last seven years. In many ways, however, the IMF is used as a scapegoat for promoting unpopular policy choices by the elected politicians and unelected bureaucrats of the eurozone who are well aware of the organisation’s fundamental commitment to favouring fiscal consolidation.

As the June 30 deadline approaches for Greece’s €1.5 billion debt repayment, here are the five key things to know about the IMF’s position.

1. Keeping the eurozone in tact

Keeping the eurozone together is a paramount concern for IMF negotiators. They will therefore almost certainly not recommend that Greece consider taking the nuclear option of abandoning the euro, which would be the likely result of defaulting on its debts.

This is because of the risk of systemic instability. And also because of the potential for eurozone rules to act as an external constraint on future economic policy choices in Greece – which the IMF has long seen as in need of further structural reforms and greater fiscal discipline.

Plus the organisation has a long history of exhibiting a status quo bias whenever it has been faced with the possibility of regional monetary distintegration, such as in the case of the ruble zone during 1991-93.

2. Reputational costs

The IMF is acutely aware of the reputational costs it faces if it is blamed for a sovereign default by Greece – let alone if Greece is eventually forced out of the euro. Here, the stakes involved with the terms of the Greek bailout, and whether or not Greece remains in the euro, differ markedly for the IMF compared with its “Troika” partners, the European Central Bank and the European Commission.

After the IMF took the lead in coordinating a multilateral response to the Asian financial crisis in 1997-98 it shouldered most of the blame for policy mistakes that inflamed the crisis. This motivated many countries to shun the organisation over the next decade until the onset of the global financial crisis in 2008.

The IMF’s Lagarde must take into account other eurozone economies. EPA/Olivier Hoslet

There can be no real winners from the high stakes poker match between Greece, the EU, and the IMF that has been running since the Syriza-led coalition came to power in January. But how the IMF’s reputation fares in the aftermath of the eurozone crisis will have a significant impact on its future crisis management role, both in Europe and beyond.

This is one of the reasons behind the IMF’s decision in 2013 to publicly admit to making notable errors in underestimating the damage that the initial round of austerity policies in 2010-11 would do to the Greek economy. This acknowledgement helped to place a small amount of distance between the IMF’s position and the apparent commitment of EU leaders to austerity-at-any-cost, while reducing the potential for the IMF to be used as the scapegoat for mistakes also made by its Troika partners.

A concern with protecting its reputation is also why the IMF has been at pains to emphasise in press briefings that it has pushed for “social fairness and social balance” in the design of reforms to the Greek pension system.

3. Greece’s commitment to structural reform

How flexible the IMF will be in reaching a compromise with the Greek government depends in large part on how they assess Greece’s commitment to implementing structural economic reforms.

Over the five months since it was elected, the Syriza government has demonstrated little or no political will for implementing major overhauls of the pensions system and the tax system, which are key concerns for the IMF.

A broader issue here is the IMF’s principle of “uniformity of treatment” for borrowers. There will inevitably be internal debates over how much the IMF should compromise with Greece over its bailout terms. But this principle constrains how flexible the organisation can be seen to be for any individual country, to avoid future borrowers also demanding softer loan conditions such as through looser policy targets or a slower pace of structural reforms.

4. Views on tax reform

The IMF’s long-standing views on tax reform also limit its flexibility towards Greece’s recent proposals for tax rises. Here, as in other countries, the IMF is seeking a substantial broadening of the tax base through the expansion and simplification of consumption taxes.

It is concerned that tax increases alone cannot plug the fiscal gap in a country with a notoriously leaky tax system. Though much of Syriza’s proposed changes may increase tax revenue in the short-term, the IMF is more interested in structural reform of the tax system that can help in shaping long-term policy.

In the meantime, cutting public spending in Greece, from the IMF’s perspective, is both easier for the government to achieve as a stopgap solution and is a better indicator for the country’s creditors of the government’s political commitment to implementing painful reforms.

5. Leadership

During the four years that former French finance minister Christine Lagarde has served as the IMF Managing Director, her public comments on Greece have gradually moved towards recognition of the need for debt relief. This is a significant shift from the organisation’s official position in 2010-11, and has expanded the negotiating space available to the IMF. Meanwhile it has placed pressure on its Troika partners to deliver some form of debt relief down the track.

Yet despite growing acknowledgement that debt relief will need to be part of any long-term agreement to achieve fiscal stability in Greece, this is only likely to be formally placed on the negotiating table after the government first agrees to a comprehensive package of structural reforms.

The end game

As the negotiations over Greece’s economic future enter the end game, the chasm between the debtor country and its creditors remains both wide and deep. The carrot of debt relief is only likely to materialise once substantial progress is made on implementing the structural reforms that have been deemed unacceptable by Greece’s Syriza government.

It is hard to imagine how a workable long-term solution can be fudged at this stage of the process. This would need either the creditors relaxing their demands for continued austerity or the government caving in and accepting the structural reforms it campaigned against in the election in January. The former is highly unlikely, given the signal this would send to other economies. The latter seems equally unlikely and if it happens might result in the collapse of the government and fresh elections, starting the messy process of muddling through negotiations all over again.

Author: André Broome, Associate Professor of International Political Economy at University of Warwick

Now the Greek people will decide

From The Conversation.

Greece will hold a referendum on July 5 on whether the country should accept the bailout offer of international creditors. The government’s decision to reject what was on offer and call the referendum is ultimately an attempt to take charge of its domestic policy and reaffirm its credibility with voters.

Although Greece is hard strapped for cash this is clearly a political decision with profound consequences for the future of the European Union. It is also the right one.

This is not merely useful as a negotiating tactic for obtaining a better deal with its creditors, as many commentators might suggest. The coalition of the left, Syriza, had no choice but to oppose further measures that would lock its economy into a deflationary spiral, the trappings of which are destroying Greek society.

The Greek position

Elected with the mandate to end the savage austerity policies already imposed, Syriza could hardly accept the further cuts demanded. These include cuts in income support for pensioners below the poverty line and a VAT hike of up to 23% on food staples. Even more onerous was the demand that Greece should deliver a sustained primary budget surplus of 1% for 2016, gradually increasing to 3.5% in the following years when its economy has already been contracting for six years.

By most counts the austerity policies imposed by Greece’s creditors in 2010 in exchange for the bailout money (of €240 billion) have been an abject economic and moral failure. The International Monetary Fund itself has acknowledged “a notable failure” in managing the terms of the first Greek bailout, in setting overly optimistic expectations for the country’s economy and underestimating the effects of the austerity measures it imposed.

The former IMF negotiator, Reza Moghadam, has acknowledged the fund’s erroneous projections about Greek growth, inflation, fiscal effort and social cohesion. The debt is now almost 180% of Greece’s GDP, up from 120% when the bailout program began. And this is mainly due to the fact that GDP has contracted by 25%, rather than the significantly lower projections by the IMF. The shrinking of the economy and rising unemployment levels have exceeded those that hit the US in the financial crisis of the 1930s.

The human and social costs have been even more staggering in Greece. Incomes have fallen by an average of 40%, and the unemployment rate reached 26% in 2014 (and higher than 50% for youth). With hundreds of thousands of people depending on soup kitchens, and thousands of suicides in the years 2010-2015, the moral case for debt forgiveness seems just as strong as the technical one based on economics.

The creditors’ offer

Yet in the terms presented to Greece by their creditors there is no commitment to reducing Greece’s crippling debt (which all commentators acknowledge is unrepayable). Nor is there any tangible proposal for rebuilding the Greek economy.

Germany, France, and the EU, aided by the IMF and ECB, continue to insist on implementing policies that have so manifestly failed Greece. They do so to avoid having to justify the massive bailouts of their own financial systems – shifting the burden from banks to taxpayers – if Greece fails to make the repayments. The leading EU partners must not be seen to act leniently towards Greece as this might encourage anti-austerity parties Spain and elsewhere.

Leader of Spain’s anti-austerity party, Podemos, Pablo Iglesias, rallying with Alexis Tsipras. EPA/Orestis Panagiotou

Broken Europe

But the social and political costs of these policies have put the legitimacy of the entire European integration project in question. By being locked into austerity policies, Europe is tearing itself apart.

This brings to the fore the faulty institutional framework that has exacerbated these issues. European integration was conceived by a set of elites, while many EU citizens have never fully embraced the idea: the EU tends to be regarded as an economic entity rather than a cultural or social one. The “ever closer union” remains an aspiration, while EU institutions patch up compromises between its most powerful members.

The ill-thought and haphazard implementation of the common currency is perhaps the most costly compromise of all. The Greek government is therefore right to ask for generous debt relief to allow the economy to have a fresh start in exchange for reforms that will address the perennial problems of corruption and inequality that bedevil Greek society.

The right decision

Greece has many problems – including unfair taxation (64% of taxes are paid by salaried employees and pensioners), corrupt elites who have governed the country for at least four decades with fellow European governments repeatedly turning a blind eye to their flouting of rules, and the oligarch-owned media which are neither independent nor free. But accepting the bailout would only feed into the system that got Greece into this crisis.

Meanwhile, the newcomer to Greek politics, Syriza, has been told it will only receive the funds agreed under the previous bailout terms if it is ready to implement further policies that will decimate the poor and impoverish the middle class even more. Cutting pensions, many of which are already below the eurozone average when almost one in two of them are facing poverty, would be a mistake.

So would conceding to the firing of an additional 150,000 public sector workers when their overall headcount has already been reduced by 161,000 since 2010 – a 19% reduction, according to the IMF.

Contrary to popular belief, the number of public sector employees as a percentage of the workforce in Greece is 14% below the OCED average, but austerity has had an even more disastrous impact on employment in the private sector, with an estimated 400,000 businesses closing down in the past five years.

No country has ever succeeded in emerging from financial crisis by means of austerity. Further austerity would have made the impossibly bad situation that Greece is in worse still. In rejecting the creditors’ further demands, the Greek government stands for the working people of Greece – and Europe too.

Author: Marianna Fotaki, Network Fellow, Edmond J Safra Center for Ethics, Harvard University and Professor of Business Ethics at University of Warwick,

Path to Grexit tragedy paved by political incompetence

From The Conversation.

Since our last episode, the crisis in Greece has escalated further. Negotiations between the government and its creditors collapsed over the weekend, and restrictions on bank withdrawals will now follow.

The next step is for the government to issue the equivalent of IOUs to pay salaries and pensions. The country is seemingly on the slippery slope to exiting the euro.

Many of us doubted that it would come to this. In particular, I doubted that it would come to this.

Nearly a decade ago, I analyzed scenarios for a country leaving the eurozone. I concluded that this was exceedingly unlikely to happen. The probability of a Grexit, or any Otherexit, I confidently asserted, was vanishingly small.

My friend and UC Berkeley colleague Brad DeLong regularly reminds us of the need to “mark our views to market.” So where did this prediction go wrong?

Why a euro exit didn’t make sense

My analysis was based on a comparison of economic costs and benefits of a country exiting the euro. The costs, I concluded, would be severe and heavily front-loaded.

Raising the possibility, however remote, of exit from the euro would ignite a bank run in said country. The authorities would be forced to shutter the financial system. Economic activity would grind to a halt. Losing access to not just their savings but also imported petrol, medicines and foodstuffs, angry citizens would take to the streets.

Not only would any subsequent benefits, by comparison, be delayed, but they would be disappointingly small.

With the government printing money to finance its spending, inflation would accelerate, and any improvement in export competitiveness due to depreciation of the newly reintroduced national currency would prove ephemeral.

In Greece’s case, moreover, there is the problem that the country’s leading export, refined petroleum, is priced in dollars and relies on imported oil, which is also priced in dollars. So much for the advantages of a depreciated currency.

Agricultural exports for their part will take several harvests to ramp up. And attracting more tourists won’t be easy against a drumbeat of political unrest.

What went wrong?

How did Greece end up in this pickle? Some say that the specter of a bank run was no longer a deterrent to exit once that bank run started anyway due to the deep depression into which the Greek economy had sunk.

But what is remarkable is how the so-called bank run remained a jog – it was still perfectly manageable until the Greek government called its referendum on the terms of the bail out deal offered by international creditors, negotiations broke down and exit became a real possibility.

Nonperforming loans — ones that are in default or close to it — were already rising, to be sure, but the banks still had all the liquidity they needed. The European Central Bank supported the Greek banking system with emergency liquidity assistance (ELA) right up to the very end of June. Only when Greece stopped negotiating did the Central Bank stop increasing ELA. And only then did a full-fledged bank run break out.

So I stand by the economic argument. Where I need to mark my views to market, however, is for underestimating the role of politics. In particular, I underestimated the extent of political incompetence – not just of the Greek government but even more so of its creditors.

In January Syriza had run on a platform of no more spending cuts or tax increases but also of keeping the euro. It should have anticipated that some compromise would be needed to square this circle. In the event, that realization was strangely late in coming.

And Prime Minister Alexis Tsipras and his government should have had the courage of its convictions. If it was unwilling to accept the creditors’ final offer, then it should have stated its refusal, pure and simple. If it preferred to continue negotiating, then it should have continued negotiating. The decision to call a referendum in midstream only heightened uncertainty. It was a transparent effort to evade responsibility. It was the action of leaders more interested in retaining office than in minimizing the cost to the country of the crisis.

A hard lesson learned

Still, this incompetence pales in comparison with that of the European Commission, the ECB and the IMF.

The three institutions opposed debt restructuring in 2010 when the crisis still could have been resolved at low cost. They continued to resist it in 2015, when a debt write-down was the obvious concession to Mr Tsipras & Company. The cost would have been small. Pretending instead that Greece’s debts could be repaid hardly enhanced their credibility.

Instead, the creditors first calculated the size of the primary budget surpluses that Greece would have to run in order to hypothetically repay its debt. They then required the government to raise taxes and cut spending sufficiently to produce those surpluses.

They ignored the fact that, in so doing, they consigned the country to an even deeper depression. By privileging their own balance sheets, they got the Greek government and the outcome they deserved.

The implication is clear. Never underestimate the ability of politicians to do the wrong thing. I will try to remember next time.

Author: Barry Eichengreen, Professor of Economics and Political Science at University of California, Berkeley

Basel III Stable Funding Disclosure Standards Will Improve Bank Transparency – Moody’s

According to Moody’s, the Basel III disclosure standards which were finalised recently, are positive for creditors of internationally active banks because they will improve transparency into bank funding, allowing investors to assess the adequacy and reliability of funding for a bank’s least-liquid assets, including loans.

Detailed NSFR disclosure is positive for bank investors evaluating a bank’s liquidity and stable funding position since the ratio is distinct from the LCR, measuring a different type of funding risk. The LCR measures whether banks hold enough high-quality liquid assets (HQLA) that could be liquidated to cover stressed cash outflows (e.g., deposit outflows and maturing liabilities that cannot be rolled over) over a 30-day period. The NSFR measures whether funding of longer duration adequately supports less liquid longerterm assets such as loans.

The NSFR template aligns with the LCR disclosure template, which for investors provides some consistency in evaluating short- and long-term liquidity risks. Both, for example, require disclosure of stable and less stable retail deposits, and wholesale deposits used for operational purposes. These disclosures are used to calculate stressed cash outflows in the LCR, and in the NSFR are categories of available stable funding. The Basel Committee noted that in formulating the template, it balanced usability of disclosure with “undesirable dynamics during stress.” Although the Basel Committee did not specify exactly how it achieved the trade-off in the disclosure framework, this has likely restricted funding transparency to some degree.

In addition to a standardized reporting template, the NSFR disclosure standards require qualitative disclosures that are important in evaluating a bank’s stable funding position. The disclosure of interdependent assets and liabilities, which are assigned 0% required stable funding and available stable funding factors in the NSFR calculation, is key because the interdependency is judged by national discretion and could drive significant differences in ratios across banks. The disclosures also will describe drivers of changes in the NSFR categories across reporting periods, which should help investors understand how a bank’s NSFR has changed over time.

BIS Warnings Must Be Heeded

The 85th Annual Report from the Bank for International Settlements has just been released. This is an important document because in its economic chapters the authors attempt to get to grips with some of the critical issues creating uncertainty in the global economy and the financial system.  Here is a summary of the main arguments.

Chapter I: Is the unthinkable becoming routine?

Globally, interest rates have been extraordinarily low for an exceptionally long time, in nominal and inflation-adjusted terms, against any benchmark. Such low rates are the most remarkable symptom of a broader malaise in the global economy: the economic expansion is unbalanced, debt burdens and financial risks are still too high, productivity growth too low, and the room for manoeuvre in macroeconomic policy too limited. The unthinkable risks becoming routine and being perceived as the new normal. This malaise has proved exceedingly difficult to understand. The chapter argues that it reflects to a considerable extent the failure to come to grips with financial booms and busts that leave deep and enduring economic scars. In the long term, this runs the risk of entrenching instability and chronic weakness. There is both a domestic and an international dimension to all this. Domestic policy regimes have been too narrowly concerned with stabilising short-term output and inflation and have lost sight of slower-moving but more costly financial booms and busts. And the international monetary and financial system has spread easy monetary and financial conditions in the core economies to other economies through exchange rate and capital flow pressures, furthering the build-up of financial vulnerabilities. Short-term gain risks being bought at the cost of long-term pain. Addressing these deficiencies requires a triple rebalancing in national and international policy frameworks: away from illusory short-term macroeconomic finetuning towards medium-term strategies; away from overwhelming attention to near-term output and inflation towards a more systematic response to slowermoving financial cycles; and away from a narrow own-house-in-order doctrine to one that recognises the costly interplay of domestic-focused policies. One essential element of this rebalancing will be to rely less on demand management policies and more on structural ones, so as to abandon the debt-fuelled growth model that has acted as a political and social substitute for productivity-enhancing reforms. The dividend from lower oil prices provides an opportunity that should not be missed. Monetary policy has been overburdened for far too long. It must be part of the answer but cannot be the whole answer. The unthinkable should not be allowed to become routine.

BIS-85-1Chapter II: Global financial markets remain dependent on central banks

Accommodative monetary policies continued to lift prices in global asset markets in the past year, while diverging expectations about Federal Reserve and ECB policies sent the dollar and the euro in opposite directions. As the dollar soared, oil prices fell sharply, reflecting a mix of expected production and consumption, attitudes to risk and financing conditions. Bond yields in advanced economies continued to fall throughout much of the period under review and bond markets entered uncharted territory as nominal bond yields fell below zero in many markets. This reflected falling term premia and lower expected policy rates. The fragility of otherwise buoyant markets was underscored by increasingly frequent bouts of volatility and signs of reduced market liquidity. Such signs were perhaps clearest in fixed income markets, where market-makers have scaled back their activities and market-making has increasingly concentrated in the most liquid bonds. As other types of players, such as asset managers, have taken their place, the risk of “liquidity illusion” has increased: market liquidity appears ample in normal times, but vanishes quickly during market stress.

BIS-85-2 Chapter III: When the financial becomes real

Plummeting oil prices and a surging US dollar shaped global activity in the year under review. These large changes in key markets caught economies at different stages of their business and financial cycles. The business cycle upswing in the advanced economies continued and growth returned to several of the crisis-hit economies in the euro area. At the same time, financial downswings are bottoming out in some of the economies hardest-hit by the Great Financial Crisis. But the resource misallocations stemming from the pre-crisis financial boom continue to hold back productivity growth. Other countries, less affected by the crisis, notably many EMEs, are experiencing different challenges. The shift in global conditions has coincided with slowing output growth and peaks in domestic financial cycles. There is the danger that slowing growth in EMEs could expose financial vulnerabilities. Better macroeconomic management and more robust financial structures, including longer debt maturities and reduced exposure to currency risk, have increased resilience. But the overall amount of debt has increased and the shift from banks to capital market funding could raise new risks.

BIS-85-3Chapter IV: Another year of monetary policy accommodation

Monetary policy continued to be exceptionally accommodative, with many authorities easing or delaying tightening. For some central banks, the ultra-low policy rate environment was reinforced with large-scale asset purchase programmes. In the major advanced economies, central banks pursued significantly divergent policy trajectories, but all remained concerned about the dangers of inflation running well below inflation objectives. In most other economies, inflation rates deviated from targets, being surprisingly low for some and high for others. The deviation of inflation from expected levels and questions surrounding the sources of price changes underscore an incomplete understanding of the inflation process, especially regarding its medium- and long-term drivers. At the same time, signs of growing financial imbalances around the globe highlight the risks of accommodative monetary policies. The persistence of those policies since the crisis casts doubt on the suitability of current monetary policy frameworks and suggests that resolving the tension between price stability and financial stability is the key challenge. This puts a premium on accounting for financial stability concerns much more systematically in monetary policy frameworks.

BIS-85-4Chapter V: The international monetary and financial system

The suitable design of international monetary and financial arrangements for the global economy is a long-standing issue. A key shortcoming of the existing system is that it tends to heighten the risk of financial imbalances, leading to booms and busts in credit and asset prices with serious macroeconomic consequences. These imbalances often occur simultaneously across countries, deriving strength from international spillovers of various types. The global use of the dollar and the euro allows monetary conditions to affect borrowers well beyond the respective issuing economies. Many countries also import monetary conditions when setting policy rates to limit interest rate differentials and exchange rate movements against the major currencies. The global integration of financial markets tends to reinforce these dynamics, by allowing common factors to drive capital flows and a common price of risk to move bond and equity prices. Policies to keep one’s own house in order by managing financial cycles would help to reduce such spillovers. In addition,
central banks need to better internalise spillovers, not least to avoid the effects of their actions spilling back into their own economies. Moving beyond enlightened self-interest would require international cooperation on rules constraining domestic policies.

BIS-85-5Chapter VI: Old and new risks in the financial landscape

Risks in the financial system have evolved against the backdrop of persistently low interest rates in advanced economies. Despite substantial efforts to strengthen their capital and liquidity positions, advanced economy banks still face market scepticism. As a result, they have lost some of their traditional funding advantage relative to potential customers. This adds to the challenges stemming from the gradual erosion of interest income and banks’ growing exposure to interest rate risk, which could weaken their resilience in the future. By contrast, EME banks have so far benefited from market optimism amid buoyant conditions that may be masking the build-up of financial imbalances. For their part, insurance companies and pension funds have faced ballooning liabilities and muted asset returns. Asset-liability mismatches are weakening institutional investors and threaten to spill over into the real economy. As these investors offload risks onto their customers and banks retreat from traditional intermediation, asset managers are taking on an increasingly
important role. Regulatory authorities are carefully monitoring the financial stability implications of the growing asset management sector.


Does Easing Monetary Policy Increase Financial Instability?

An IMF working paper “Does Easing Monetary Policy Increase Financial Instability?” looks at the interaction between monetary and macro-prudential policies.

Using modelling, they show that that real interest rate rigidities have a different impact on financial stability depending on the sign of the shock hitting the economy. In response to positive shocks to the risk-free interest rate, real interest rate rigidity acts as an automatic macro-prudential stabilizer. This is because higher debt today associated with lower interest rates (relative to the flexible interest rate case) is offset by lower interest repayments, resulting in higher net worth and lower probability of a crisis in the future. In contrast, when the risk-free rate is hit by a negative shock, real interest rate rigidity leads to a relatively higher crisis probability through the same mechanisms working in reverse (borrowing and consumption are relatively lower today, but they are offset by relatively higher debt service tomorrow, resulting in lower future net-worth and higher crisis probability).

In addition, they show that when the interest rate is the only policy instrument to address both the macroeconomic and the financial friction, and a shock that lowers interest rates hits the economy, a policy trade-off emerges. This is because the two frictions require interventions of opposite direction on the same instrument. Other instruments, however, may be at the policy-maker’s disposal in order to achieve and maintain financial stability.

An implication of their analysis is that the weak link in the U.S. policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective regulatory framework aimed at preserving financial stability.

Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.


Supervisory Stress Testing of Large Systemic Financial Institutions – The Fed

Interesting speech by Fed Vice Chairman Fischer on supervisory stress testing of large systemic financial institutions.

Stress testing has become a cornerstone of a new approach to regulation and supervision of the largest financial institutions in the United States. The Federal Reserve’s first supervisory stress test was the Supervisory Capital Assessment Program, known as the SCAP. Conducted in 2009 during the depths of the financial crisis, the SCAP marked the first time the U.S. bank regulatory agencies had conducted a supervisory stress test simultaneously across the largest banking firms. The results clearly demonstrated the value of simultaneous, forward-looking supervisory assessments of capital adequacy under stressed conditions. The SCAP was also a key contributor to the relatively rapid restoration of the financial health of the U.S. banking system.

The Fed’s approach to stress testing of the largest and most systemic financial institutions has evolved since the SCAP, but several key elements persist to this day. These elements include, first, supervisory stress scenarios applicable to all firms; second, defined consequences for firms deemed to be insufficiently capitalized; and third, public disclosure of the results.

The Fed has subsequently conducted five stress test exercises that built on the success of SCAP, while making some important improvements to the stress test processes. The first key innovation was the development of supervisory models and processes that allow the Fed to evaluate independently whether banks are sufficiently resilient to continue to lend to consumers and to businesses under adverse economic and financial conditions. This innovation took place over the course of several exercises and was made possible by the extensive collection of data from the banks. These data have allowed supervisors to build models that are more sensitive to stress scenarios and better define the riskiness of the firms’ different businesses and exposures.

The second innovation since the SCAP was the use of the supervisory stress test as a key input into the annual supervisory evaluation of capital adequacy at the largest bank holding companies. The crisis demonstrated the importance of forward-looking supervision that accounted for the possibility of negative outcomes. By focusing on forward-looking post-stress capital ratios, stress testing provides an assessment of a firm’s capital adequacy that is complementary to regulatory capital ratios, which reflect the firm’s performance to date. Although we view this new approach to capital assessment as a significant improvement over previous practices, we are aware that the true test of this new regime will come only if another period of significant financial or economic stress were to materialize–which is to say that we will not have a strong test of the effectiveness of stress testing until the stress tests undergo a real world stress test. The same comment, mutatis mutandis, applies to the overall changes in methods of bank regulation and supervision made since September 15, 2008.

Third, supervisory stress testing has been on the leading edge of a movement toward greater supervisory transparency. Since the SCAP, the Fed has steadily increased the transparency around its stress testing processes, methodologies, and results. Before the crisis, releasing unfavorable supervisory information about particular firms was unthinkable–for fear of setting off runs on banks. However, the release of the SCAP results helped to calm markets during the crisis by reducing uncertainty about firm solvency. Indeed, only one of the 10 firms deemed to have a capital shortfall was unable to close the identified gap on the private markets. Our experience to date has been that transparency around the stress testing exercise improves the credibility of the exercise and creates accountability both for firms and supervisors. That said, too much transparency can also have potentially negative consequences, an idea to which I will turn shortly.

With the benefit of five years of experience, the Fed is continuing to assess its stress testing program, and to make appropriate changes. Examples of such changes to date include the assumption of default by each firm’s largest counterparty and the assumption that firms would not curtail lending to consumers and businesses, even under severely adverse conditions. As part of that assessment process, we are also currently seeking feedback from the industry, market analysts, and academics about the program.

Supervisory stress testing is not a static exercise and must adapt to a changing economic and financial environment and must incorporate innovations in modeling technology. Work is currently underway on adapting the stress testing framework to accommodate firms that have not traditionally been subject to these tests. The Dodd-Frank Act requires the Fed to conduct stress tests on non-bank financial institutions that have been designated as systemically important by the FSOC–the Financial Stability Oversight Council. Three of the currently designated financial institutions are global insurance companies. While distress at these firms poses risks to financial stability, particularly during a stressful period, certain sources of risk to these firms are distinct from the risks banking organizations face. A key aspect of this ongoing work includes adapting our current stress testing framework and scenarios to ensure that the tests for non-bank SIFIs–systemically important financial institutions–are appropriate.

Another area where work continues–and will likely always continue–is the Fed’s ongoing research aimed at improving our ability to estimate losses and revenues under stress. Supervisors have both to develop new approaches that push the state of the art in stress testing and to respond as new modeling techniques are developed or as firm activities and risk concentrations evolve over time. For example, forecasting how a particular bank’s revenue may respond to a severe macroeconomic recession can be challenging, and we continue to seek ways to enhance our ability to do so.

Supervisory stress testing models and methodologies have to evolve over time in order to better capture salient emerging risks to financial firms and the system as a whole. However, the framework cannot simply be expanded to include more and more aspects of reality. For example, incorporating feedback from financial system distress to the real economy is a complex and difficult modelling challenge. Whether we recognize it or not, the standard solution to a complex modeling challenge is to simplify–typically to the minimum extent possible–aspects of the overall modelling framework. However, incorporating feedback into the stress test framework may require simplifying aspects of the framework to a point where it is less able to capture the risks to individual institutions. Even so, one can imagine substantial gains from continued research on stress testing’s role in macroprudential supervision and our understanding of risks to the financial system, such as knock-on effects, contagion, fire sales, and the interaction between capital and liquidity during a crisis.

Finally, let me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke’s words, a “model monoculture,” in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This–making it easier to game the test–is the potential negative consequence of transparency that I alluded to earlier.

We also value different approaches for designing scenarios and conducting stress tests. In the United States, in addition to supervisory stress testing, large financial firms are required to conduct their own stress tests, using their own models and stress scenarios that capture their unique risks. In evaluating each bank’s capital planning process, supervisors focus on how well banks’ internal scenarios and models capture their unique risks and business models. We expect firms to determine the risks inherent to their businesses, their risk-appetite, and to make business decisions on that basis.

RBNZ Updates On Basel III

The NZ Reserve Bank today published an article in the Reserve Bank Bulletin that describes the Reserve Bank’s implementation of the Basel III capital requirements. It is one of the clearest articulation of Basel III that we have read, and is recommended to those seeking to get to grips with the complexity of the evolving capital requirements. In addition, you can read our article on Basel IV (the next iteration) here.

The GFC highlighted several shortcomings in the policies and practices of some financial institutions, particularly in North America and Europe, and in the regulatory requirements for banks in respect of capital. In the lead-up to the GFC, some financial institutions were highly leveraged (that is, their assets were funded by high levels of debt as compared to equity), with capital that proved insufficient to absorb the losses that they incurred. In several countries, governments provided funds to support failing banks, effectively protecting holders of certain capital instruments from bearing losses, which came at a cost to taxpayers. The complexity of capital rules, interaction with national accounting standards, and differences in application resulted in inconsistencies in the definition of regulatory capital across jurisdictions. Further, insufficient capital was held in respect of certain risks. This made it difficult for the market to assess the true quality of banks’ regulatory capital and led some market participants to turn to simpler solvency assessment methods.

The BCBS responded with new requirements for bank capital, collectively known as Basel III, which built on the existing frameworks of Basel I and Basel II. Basel III strengthens the minimum standards for the quality and quantity of banks’ capital, and aims to reduce bank leverage and improve the risk coverage of the Basel Capital Accords. One of the purposes of Basel III is to make it more likely that banks have sufficient capital to absorb the losses they might incur, thus reducing the likelihood that a bank will fail, or that a government will be called on to use taxpayer funds to bail out a bank. Basel III also introduced an international standard on bank liquidity. Overall, these requirements increase resilience in the financial sector and reduce the probability of future systemic collapses of the financial sector.

The RBNZ Bulletin article explains the rationale behind the Basel III capital requirements, identifies and discusses their significant features, explains how the Reserve Bank has applied the requirements in New Zealand, and examines the development of the New Zealand market for instruments meeting the Basel III definition of capital.

The changes to the Capital Accord brought into effect by Basel III included: enhancing the requirements for the quality of the capital base;increasing the minimum amount of capital required to be held against risk exposures; requiring capital buffers to be built up in good times that can be drawn down in times of economic stress; introducing a leverage ratio requirement; and enhancing the risk coverage of the capital framework. Draft international minimum standards for liquidity were also proposed for the first time as part of the Basel III package. The liquidity requirements are not discussed in this article. The Basel III capital standards have been widely adopted worldwide. The Reserve Bank has largely adopted the Basel III capital requirements. As New Zealand banks were well capitalised at the time Basel III was issued, the Reserve Bank was able to put the Basel III capital requirements in place in New Zealand ahead of the timetable set by the BCBS for Basel III implementation.