Australia’s big banks could still face increased mortgage risks

From Business Insider.

Among the major banks, Commonwealth Bank is least favoured due to its exposure to the mortgage market and the weakest capital position among its peers.

Big Australian banks could still face increased risk weightings on their mortgage loan books, regardless of this month’s international banking review.

That’s the view of Morgan Stanley analysts, who argue that Australia’s bank regulator, APRA, has the scope to enforce higher risk weightings to meet its own definition of an “unquestionably strong” capital position for the banks.

Higher risk weightings for mortgages would require the majors to increase their levels of Tier 1 capital in order to meet minimum capital ratio requirements.

The analysts highlighted comments by Brad Carr, director of banking prudential policy at the Institute of International Finance. Carr said that the Basel IV requirements wouldn’t be particularly onerous on Australian banks, given their already strong capital positions in comparison to international peers.

However, Morgan Stanley is of the view that APRA could use its authority domestically to enforce stricter capital requirements in addition to the Basel IV guidelines.

Referring to Basel IV as more of a minimum international standard, the analysts highlighted recent comments from APRA about higher lending risks and the high concentration of home loans in the asset portfolios of Australian banks.

Morgan Stanley says that for every 5% increase (from the current level of 25%) will require the big 4 Australian banks to raise another $3.3 billion worth of capital:

Of the Big 4, Morgan Stanley says Westpac is the most exposed to more stringent capital requirements, given the size of its home loan portfolio.

For a 5% risk weighting increase, Westpac would be required to raise another $1.2 billion, while on the other end of the spectrum ANZ would have to raise around $500 million.

ANZ remains the favoured pick of Morgan Stanley analysts, with superior earnings per share (EPS) to its peers and a strong capital position.

Why Talk of Bank Capital ‘Floors’ Is Raising the Roof

From The IMFBlog.

Calculating how much capital banks should hold is often a bone of contention between regulators and banks. While there has been considerable progress on reaching consensus on an international standard, one key issue remains unresolved. This is a proposal to establish a “floor,” or minimum, for the level of capital the largest banks must maintain.

Some financial institutions and national authorities question the need for a “floor,’’ arguing either that differences in business models or other elements of the global regulatory framework—notably limits on the amount of leverage banks may take on—make them redundant. We disagree. The floor reduces the chances that banks can game the system to reduce their capital buffers to levels that aren’t aligned with their risks. It is an essential element of global efforts to create a level playing field for banks operating across countries by strengthening common standards for regulation, supervision and risk management.

Why is the issue of calculating capital levels so important? Bank capital serves as a buffer available to absorb losses. When capital is depleted, deposits and other borrowed funds are put at risk, and this can lead to bank runs, bank failures and wider systemic distress. Banks should hold capital commensurate with the business risks they take and the risks they pose to the wider system.

Key element

The Basel Committee on Banking Supervision, which brings together regulators from 28 countries, establishes rules governing the appropriate level of capital. The current version of these rules, known as Basel III, is a key element of the international regulatory reform agenda put in motion following the global financial crisis of 2008.

Adopted in late 2010 for implementation over a seven-year period, Basel III has led to a significantly safer financial system. Not only are banks capitalized with more and higher-quality capital than before, they also meet new standards for liquidity risk (ensuring banks hold enough liquid assets to meet maturing liabilities in times of stress) and limits on leverage (how much banks can borrow relative to their capital.)

The largest global banks have been gradually allowed to use their own internal models to calculate capital needed for different types of risk. The Basel Accord of 1988, known as Basel I, used only standard risk weights provided by supervisors. In 1996, some banks were allowed to develop their own, internal models for evaluating market risk.

Safety net

Basel II, adopted in 2004, introduced both a standardized approach (similar to Basel I but using risk weights based on external credit ratings) and an internal ratings-based approach (based on banks’ own internal models). But it added a wrinkle: banks had to apply both approaches for a period of two to three years before being fully reliant on their internal models. And, in addition, capital levels had to be at least as conservative as a “floor” equivalent to 80 percent of the level calculated from standard risk weights.

The floor serves as a safety net to internal risk-based approaches. It gives banks and their supervisors time to intervene should changes be needed before signing off on the use of full-fledged internal models. Basel III kept the internal models from Basel II, but it did not keep the floor. The Basel committee now seeks to reintroduce the floor.

Why is the issue contentious? In testing whether the new method was being applied consistently across institutions in different countries, the Basel Committee found that banks with similar portfolios came up with very different capital requirements when they used internal models. This raised the possibility that some banks were underestimating the risks or gaming the models to deliver outcomes that required less capital. Hence addressing risk weight variability became a top priority.

To solve this problem, the Basel Committee considered several proposals:

  • Revising the standardized approach to better capture the riskiness of bank assets, making it a better complement to the internal risk-based approach;
  • limiting the use of the internal risk-based approach; and
  • implementing a floor to mitigate internal model risk and to make it easier to compare outcomes across banks.

The floor—though not new—would become a more permanent feature of the enhanced Basel III capital framework, based on the revised standardized approach. This approach offers the best of both worlds: the flexibility of the internal models combined with the minimum standard represented by the floor.

The discussion raging now is whether there is a need for a floor, given that the leverage ratio established under Basel III serves already as backstop. And if there is a floor, should it be set at 80 percent, as specified in Basel II, or some other level?

Banks’ concerns

Some banks using internal models worry that their capital requirements could go up if these floors were applied, which would reduce their profitability. The governing body of the Basel Committee, however, has emphasized that the enhancements to Basel III should not lead to a significant, overall increase in capital requirements across banks.

It is our view that the risk-weighted capital adequacy ratio, leverage ratio and output floors are all essential elements of a robust capital framework:

  • The capital adequacy ratio relates risk to capital, but it is complex and makes it difficult to compare capital outcomes among banks.
  • The leverage ratio constrains the overall ability of the bank to grow its balance sheet out of proportion to capital. It is not risk sensitive but is simple to calculate and provides a backstop to the risk-weighted capital ratio.

 The floor addresses the risk that a model may not perform as expected when banks use it to calculate capital. It allows banks to continue using more risk-sensitive approaches but constraints any unwarranted capital relief, while also making it easier to compare institutions through disclosure of the standardized approach outputs.

While we welcome the additional risk sensitivity that internal models bring, we remain cautious about their unconstrained use. Supervisory capacity to ensure effective prudential oversight of internal models remains a work in progress. At the same time, banks will always have incentives to game the models and reduce the amount of capital they hold. Indeed, a recent study by Federal Reserve economists finds manipulation of risk weights to be widespread.

Well-capitalized banks are more likely to lend to the real economy and less likely to indulge in excessive risk-taking that could threaten the stability of the financial system. This only strengthens the case for a robust capital framework.

Properly calibrated and carefully phased, the Basel III enhancements of a floor on risk models can help prevent excessive variability in capital outcomes and allow for meaningful comparison across institutions and countries, while still permitting for risk sensitive approaches to take hold. The capital floor is a linchpin of this system.

Tighter Property Regulations to Weigh on Hong Kong Banks

Fitch Ratings expects tighter regulations on property-related lending to have a material but manageable capital impact on Hong Kong banks.

The Hong Kong Monetary Authority has further tightened regulations on mortgages and bank lending to property developers that in turn extend mortgages outside the supervisory framework in an effort to cool the property market and strengthen the banks’ credit risk management.

We expect the growth in domestic residential mortgages, which accounted for 5.6% of system-wide assets at end-March 2017, to slow while direct lending to property developers (6.3%) may shrink.

Fitch estimates that increasing the risk weight on loans to property developers to 50% or 100% from an assumed 30%, coupled with an increase in the risk weight floor for residential mortgages to 25% from the current 15%, could reduce Fitch Core Capital ratios by at least 50 bp and up to 420 bp for banks that use the internal ratings-based approach.

The impact will be manageable as the new rules will be phased in and banks have maintained above-average capitalisation, supported by internal capital generation and one-off disposals.

Notwithstanding the above, Fitch revised the banking system outlook over the next 12 months to stable from negative on 11 May 2017 while the medium-term outlook for Hong Kong banks’ operating environment remains negative as the financial systems of Hong Kong and China continue their integration.

We expect short-term cyclical pressure on the banks’ financial performance to ease, based on positive signs in the domestic economy. Fitch expects annual GDP growth of around 2% in 2017 and 2018 for Hong Kong.

ANZ APRA Mortgage Risk Weight Up to 28.5%

The new risk weight for mortgages at ANZ will be around 28.5% according to information released today. This is higher than some expected, but still well below the 35-40% weighting of the regional banks, so continues to highlight the relative benefits the large players have. This is before the next round of discussion on risk weights we expect from APRA later in the year.

The rise in risk weights has been one of the main drivers of mortgage repricing, which is impacting all lenders in the sector to varying degrees.

In an ASX announcement on 8 August 2016, ANZ said that it expected the average risk weight for its Australian residential mortgage lending book would increase following changes by the Australian Prudential Regulation Authority (APRA) to capital requirements for Australian mortgages and a review by APRA of ANZ’s mortgage capital model.

APRA has now completed its review of ANZ’s mortgage capital model and approved the new model for Australian residential mortgages to be adopted from June 2017.

Adoption of the new model is expected to decrease ANZ’s Level 2 Common Equity Tier-1 ratio by 26 basis points based on ANZ’s balance sheet at 31 March 2017, representing an average risk weight applied to the Australian mortgage portfolio of a little over 28.5%.

This impact is consistent with ANZ’s 2017 capital management plan and no additional capital management actions are required as a result.

As indicated at ANZ’s First Half 2017 financial results, the Group expects APRA to make further changes to sector capital requirements through a clarification to the “unquestionably strong” capital framework.

Bank Stress Tests Are Not Up To The Job

An important IMF working paper, released today suggests that the standard stress test models used to assess risks in the banking system are likely to underestimate the impact of stress on bank solvency and financial stability because they do not consider the dynamics between solvency and funding costs.

The global financial crisis appears to have been a liquidity crisis, not just a solvency crisis. Yet the failure to adequately model interlinkages and the nexus between solvency risk and liquidity risk led to a dramatic underestimation of risks. Liquidity risk manifests primarily through a liquidity crunch as firms’ access to funding markets is impaired, or a pricing crunch, as lenders are unwilling to lend unless they receive much higher spreads.

A sudden increase in bank funding costs can have an adverse impact on financial stability through the depletion of banks’ capital buffers. To preserve financial stability, it is important to assess banks’ vulnerability to changes in funding costs. The reason is twofold. First, to the extent funding costs reflect counterparty credit risk, it is of particular interest for supervisors to determine the level of capital buffers that should be held to keep funding costs at bay if and when market conditions deteriorate. Second, funding costs are linked not only to banks’ initial capital position but also they determine their capital position going forward, paving the way for adverse dynamics. The magnitude of this effect is likely to depend on the bank’s behavioral reaction to rising funding costs. On the one hand, it may react by setting higher lending rates to its borrowers. Yet this action reduces the bank’s market share and its franchise value. On the other hand, the bank might not be able to passthrough additional funding costs to new lending so its internal capital generation capacity is reduced. Even if some pass-through is possible, the erosion of profits is likely to be
substantial given the shorter time to repricing of liabilities relative to assets with the margin impact on the carrying values of assets outweighing that of new asset generation.

“Bank Solvency and Funding Cost: New Data and New Results”  presents new evidence on the empirical relationship between bank solvency and funding costs. Building on a newly constructed dataset drawing on supervisory data for 54 large banks from six advanced countries over 2004–2013, we use a simultaneous equation approach to estimate the contemporaneous interaction between solvency and liquidity. Our results show that liquidity and solvency interactions can be more material than suggested by the existing empirical literature. A 100 bps increase in regulatory capital ratios is associated with a decrease of bank funding costs of about 105 bps. A 100 bps increase in funding costs reduces regulatory capital buffers by 32 bps. We also find evidence of non-linear effects between solvency and funding costs. Understanding the impact of solvency on funding costs is particularly relevant for stress testing. Our analysis suggests that neglecting the dynamic features of the solvency-liquidity nexus in the 2014 EU-wide stress test could have led to a significant underestimation of the impact of stress on bank capital ratios.

The results are also highly relevant for cost impact assessments of capital regulation, as the costs of higher capital requirements are partly offset by lower debt servicing costs.

Note: 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.

RBNZ Reviews Capital Adequacy Framework

The New Zealand Reserve Bank has announced it is undertaking a comprehensive review of the capital adequacy framework applying to locally incorporated registered banks over 2017/18. The aim of the review is to identify the most appropriate framework for setting capital requirements for New Zealand banks, taking into account how the current framework has operated and international developments in bank capital requirements.

The Capital Review will focus on the three key components of the current framework:

  • The definition of eligible capital instruments
  • The measurement of risk
  • The minimum capital ratios and buffers

The purpose of this Issues Paper is to provide stakeholders with an outline of the areas of the capital adequacy framework that the Reserve Bank intends to cover in the Capital Review, and invite stakeholders to provide initial feedback on the intended scope of the review, and issues that might warrant particular attention. As feedback is received and decisions are made, some of these issues might fall away or be given a lower priority.

Detailed consultation documents on policy proposals and options for each of the three components will be released later in 2017, with a view to concluding the review by the first quarter of 2018.

Basis and framework for capital regulation

The Reserve Bank has powers under the Reserve Bank Act 1989 to impose capital requirements on registered banks. The Reserve Bank exercises these powers to promote the maintenance of a sound and efficient financial system, and to avoid significant damage to the financial system that could result from the failure of a registered bank.

The capital adequacy framework for locally incorporated registered banks is set out mainly in documents BS2A and BS2B of the Reserve Bank’s Banking Supervision Handbook. The framework is based on, but not identical to, an international set of standards produced by the Basel Committee on Banking Supervision.

The framework imposes minimum capital ratios. These are ratios of eligible capital to loans and other exposures. Exposures are adjusted (risk-weighted) so that more capital is required to meet the minimum requirement if the bank has riskier exposures.

The high-level policy options raised in this Issues Paper have the potential to result in reasonably significant changes to the New Zealand capital framework. It is expected, however, that any changes are likely to occur within a Basel-like framework.

The Reserve Bank invites submissions on this Issues Paper by 5pm on 9 June 2017

APRA Looking At Capital Ratios For Mortgages

Wayne Byres speech “Fortis Fortuna Adiuvat: Fortune Favours the strong”, as Chairman of APRA, at the AFR Banking & Wealth Summit, makes two significant points.

First, there are elevated risks in the residential lending sector (even after the recent tactical announcements on interest only loans). Banks remain  highly leveraged businesses.

Second, despite the delays from Basel, APRA will consult this year on potential changes to the capital ratios, reflecting the Australian Banks’ focus on mortgage lending and the need to be “unquestionably strong”.

A further indication that mortgage costs will continue to rise!

In the past few days, there has been a great deal of attention given to our recent announcement on additional measures to strengthen one particular part of the financial system: the residential mortgage lending market. These measures build on the steps we have taken over the past two years to bolster loan underwriting practices and moderate investor lending, in an environment that we considered to be one of heightened risk.

Those measures had a positive impact (Chart 1), but at the same time the risk environment certainly hasn’t moderated:

  • house prices remain high;
  • household income growth remains subdued;
  • the already high ratio of household debt to income has got higher;
  • the already low official cash rate has got lower (although not all of this reduction has flowed to borrowers, particularly investors; and
  • competitive pressures haven’t diminished.

It’s important to be clear that our goal in implementing the additional measures we announced on Friday is not to determine house prices. Housing prices are not within the control, nor the mandate, of the prudential regulator. Nor, as the Reserve Bank Governor said last night, can prudential measures address underlying supply-demand issues within the housing market. Rather, our role in the current environment is to promote a higher-than-normal degree of prudence – definitely by lenders and, ideally, also borrowers – in both credit decisions and balance sheet strength. On this occasion, we have focussed on interest-only lending to complement our earlier measures. Although there are perfectly legitimate reasons why individual borrowers might prefer an interest-only loan, in aggregate the level of interest-only lending creates additional vulnerabilities and we came to the view some additional moderation in this area was warranted.

We chose not to lower the investor lending growth benchmark at this point in time, given the need to accommodate the increasing supply of housing in the construction pipeline. However, limitations on the volume of new interest-only lending will impact investors more acutely than owner-occupiers, given that around two-thirds of lending to investors is on an interest-only basis. Furthermore, although the 12-month annual growth rate for investor lending is currently below the 10 per cent benchmark, the run rate in more recent months has been closer to (if not a little above) 10 per cent on an annualised basis. Therefore, even with the benchmark unchanged, lenders are still likely to have to tighten their lending practices and slow lending from that in recent months to ensure they remain comfortably below the desired level.

This latest step is a tactical response to current market conditions – we can and will do more (or less) as conditions evolve. We also developing a more strategic response that recognises that, in the Australian banking system, housing lending risks and capital adequacy are far from independent issues.

The banking system certainly has higher capital adequacy ratios than it used to. But overall leverage has not materially declined. The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6½ per cent at the end of 2016. Notwithstanding the extra capital that new regulation has required, banking remains a highly leveraged business.

Unquestionably strong

One way to think about our objective in establishing ‘unquestionably strong’ capital requirements is that we should be able to assert, with credibility, that the banking system can withstand reasonably foreseeable adversity and continue to provide its core function of financial intermediation for the Australian community.

Unfortunately, there is no universal measure of financial strength that provides a clear cut answer to that test. So we need to be able to look at this question through multiple lenses. In thinking about the concept of ‘unquestionably strong’, there are three basic ways to do that:

  • relative measures: the FSI adopted a relative approach in suggesting that unquestionably strong regulatory capital ratios would be positioned in the top quartile of international peers. We have said on a number of occasions that we do not intend to tie ourselves mechanically to some particular percentile, but top quartile positioning is a useful sense check which we can certainly use to guide our policy-making.
  • alternative measures: regulators do not have exclusive domain over measures of financial strength. There are a range of alternative measures, such as those used by rating agencies, which can be used to benchmark Australian banks. Again, we do not intend to tie ourselves too closely to these measures, but it would be difficult to argue the banking system is unquestionably strong if alternative measures of capital strength, particularly those that are influential in investment decision-making, were to suggest something to the contrary.
  • absolute measures: relative and alternative measures are useful guides, but the real test for a bank to claim it is unquestionably strong is whether it can comfortably survive extreme but plausible adversity. So stress testing, which doesn’t rely on relativities with other banks, or competing measures of strength, provides another useful guide for us.
    Using multiple measures will provide useful insights on the banking system’s strength, but unfortunately will be unlikely to give us a single ‘right’ answer. At best it will provide a range for possible calibration which would reasonably meet our objective that, whichever lens you look through, we can credibly claim to have capital standards that produce an unquestionably strong banking system. We will still need to exercise judgement, taking account of other dimensions of risk within the system – both quantitative (such as liquidity and funding) and qualitative (such as risk management and risk culture within banks, and the strengths of the statutory framework and crisis management powers on which the stability of the system is built). Inevitably, some will argue the calibration should be higher, and others think it too high, but at the very least our logic and rationale should be transparent, and we can readily explain how our decisions are consistent with the FSI’s intent.

As things stand today, our plan is to issue an information paper around the middle of the year, which will set out how we view the banking system through the various lenses that I have just mentioned, the extent of further strengthening required, and the timeframe over which that can be achieved in an orderly manner.

Beyond establishing the aggregate level of capital, we will need to follow that up with consultation on how the regulatory framework should allocate that capital across the different types of risk exposure. Some of those changes will flow from the inevitable direction of the work in Basel that I referred to earlier: this will include, for example, greater limitations on the use of internal credit risk models, and the inevitable removal of operational risk models. These changes will primarily impact the larger banks.

But, coming back to my starting point, probably the biggest issue we will need to resolve in ensuring capital is appropriately allocated is whether and how we adjust the risk weights for housing-related exposures. Our announcement last week reflected a tactical response to current conditions in the housing market. We will continue to refine these sorts of measures as long as they are needed. But a longer term and more strategic response will involve a review, during the course of our work on ‘unquestionably strong’, of the relative and absolute capital requirements for housing exposures. That should not be taken to imply that there will be a dramatic increase in capital requirements for housing lending: APRA has always imposed capital requirements for housing exposures that are well above international minimum standards, so we do not start with glaring deficiencies. By anyone’s standard, however, we have a banking system that has a notable concentration in housing. It is therefore important we give that issue particular attention as we think about how to put the concept of ‘unquestionably strong’ into practice.


Bank Risk-taking Behaviour Rises As Monetary Policy Eases

A newly released IMF working paper ” Does Prolonged Monetary Policy Easing Increase Financial Vulnerability?” looks at how banks behave in an easing monetary policy environment. They found that the leverage ratio, as well as other measures of firm-level vulnerability, increases for banks and nonbanks as domestic monetary policy easing persists. Cross-border effects are also notable. Results are non-linear, with risk-taking behavior rising most quickly at the onset of monetary policy easing.

We think think this means that in a low interest rate environment, counter-cyclical buffers should be increased.  In Australia, in the current low rate environment, policy settings are still too generous.

While decisive and persistent monetary policy accommodation was necessary to support aggregate demand in advanced economies during and after the financial crisis, there is lingering concern about the side effects of low interest rates and central bank balance sheet expansion on risk-taking behavior in the financial sector. In this paper, we investigate the extent to which financial vulnerabilities build up at the firm level during extended periods of monetary policy easing at home and in the U.S.

Based on a data for roughly 1,000 bank and nonbank financial institutions—including insurance companies, investment banks and asset managers—in 22 countries over the past 15 years, we find significant evidence of increased risk-taking behavior. Domestic banks and nonbanks alike increase their leverage ratios in response to persistent monetary policy accommodation at home. In addition, prolonged Federal Reserve policy easing leads banks and nonbanks outside the U.S. to take on more risks, with an effect similar to equivalent domestic monetary policies.
These results are robust to alternative measures of financial vulnerability, controls, and specifications. Importantly, the relationship between persistent monetary policy easing and financial firm vulnerability appears to be non-linear, with risk-taking behavior rising most quickly at the onset of policy easing.

Our findings ideally will spur research in two directions. First, further work is needed to develop benchmarks for risk-taking behavior. While we document an increase in risks taken by financial institutions, we are unable to take a position on whether such increases in risk are worrisome or excessive. Some degree of change in risk-taking is an inherent part of the monetary policy transmission mechanisms. To some extent, if prudential policies and regulations inhibit financial institutions from taking more risk in response to monetary policy easing, the expansionary effect of monetary policy on the real economy may be diminished.

Second, our results should inform the ongoing debate on using monetary policy tightening for financial stability purposes (see IMF, 2015, for instance). Costs of doing so would arise from lower employment and output in the short to medium run, feeding back to higher defaults and funding costs, thus reducing financial stability. But benefits need further exploration. The emphasis so far has been on the link between policy rates and credit growth, and in turn between credit growth and financial stability (Svensson, 2015). However, this paper suggests that the link could also go through the leverage of financial sector firms.

But even without further work, our results have several policy implications. Countries should closely monitor financial sector risks during periods of monetary policy accommodation at home, and in the U.S. They should develop solid prudential and regulatory frameworks, so as to preserve room for monetary policy to manoeuver to achieve its inflation and output objectives. Such frameworks should apply to both banks and nonbanks.

Note: 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.

Think The Unthinkable – The Property Crash We Have To Have?

In past years we have been highlighting the misaligned policy settings which have allowed home prices to balloon, household debt to soar, interest rates to slide and investors to gain more than a third of the market, higher than UK or USA. As banks have continued to lend and inflate their balance sheets and bolster their profitability, despite some tightening of standards; households are massively exposed.

The high debt means households have less disposable income and banks choosing to lend for housing rather than for productive business investment; both growth killing. The current capital rules have also encouraged more home lending and despite some recent tweaks, are still very generous.

Here is a tracker of home price growth, working back from today’s prices. The problem is not just the Sydney and Melbourne markets.  Its just that Sydney and Melbourne came later to the party.

Wage growth is still slowing whilst debt continues to lift. This is a real problem.

Had the settings been adjusted several years ago, this was then a manageable problem, but I am not sure it is now.

If the RBA cuts the cash rate it will stimulate housing further, whilst if it lifts rates, then mortgage rates will rise (beyond the recent and continuing out of cycle uplifts) and move the ~22% of households in mortgage stress higher.  Some will default.  The international rate cycle is on the way up, not down.

If more homes come on the market they will continue to be snapped up by cashed up investors (often levering the capital in their existing property) and overseas buys, which account for perhaps 10% of transactions.

If first time buyers are offered incentives, be they stamp duty relief, money from parents, cash payments/grants or cannibalising their super, the net effect will be simply to drive prices higher, it being a zero sum game. We know there are more than 1 million households who “Want to Buy”. Plus more arriving thanks to migration.

Investors still want property, thanks to the tax breaks and years of sustained growth, despite crushed rental yields. If lending standards are tightened, and a lower speed limit put on investor lending, we will see more investors going to the smaller lenders and the non-bank sector.  Also, some who already bought will be unable to refinance as they would now fall out of revised tighter requirements – about 9% of buyers fall into this category.

Switching away from stamp duty to a property tax may make more people trade, but that will just change the demand/supply curve, and perhaps drive prices even higher (as an artificial barrier is removed).

In fact, even joined up thinking which collectively attempts to cool the market whilst encouraging first owners into the market, is unlikely to succeed. Given the current political environment, this is even more unlikely.

Beneath all this is the financialisation of property, where it is seen as an investment class, not a source of shelter. This was called out recently in a UN paper, and is a global problem.

So, it looks to me as though we need a circuit breaker to kick-in, and that circuit breaker has to be a property correction, or even a crash.

A correction would scare off many investors, drop home prices to allow new entrants to purchase, and whilst many households would see paper profits falling, it was always funny money anyway.  Banks would take a hit, but then they have the capital buffers in place, and the RBA backstop.

In parallel, we still will need tighter rules of lending – especially for investment purposes, and the removal of the tax breaks which underpin the sector.  I think we need lending growth to track wage growth.

From here if we are careful, we can perhaps manage the settings such that such an explosion in prices wont happen again in the future.

But I wonder if we NEED a property crash. We certainly seem unable to manage under the current conditions.



EU Defends Use of Banks’ Internal Capital Models

The European Central Bank (ECB) review of internal models TRIM, is a project to assess whether the internal models currently used by banks comply with regulatory requirements, and whether they are reliable and comparable. Banks sometimes use internal models to determine their Pillar 1 own funds requirements, i.e. the minimum amount of capital they must hold by law. TRIM was launched in late 2015 and is expected to be finalised in 2019. This underscores the ECB’s desire to safeguard internal model use for retail and SME portfolios from the potential imposition of a capital floor.

ECB Banking Supervision is making a large investment in TRIM in terms of its own staff as well as the cost of external resources. With regards to staff, close to 100 ECB and national supervisors will be involved.

The targeted review of internal models, or TRIM, is a project to assess whether the internal models currently used by banks comply with regulatory requirements, and whether they are reliable and comparable. Banks sometimes use internal models to determine their Pillar 1 own funds requirements, i.e. the minimum amount of capital they must hold by law.

One major objective of TRIM is to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (RWAs). This may occur because the current regulatory framework gives banks a certain freedom when modelling their risks.

TRIM also seeks to harmonise practices in relation to specific topics. As a result, the review should help to ensure that internal models are being used appropriately.

Thus, the objectives for TRIM coincide with two major goals of ECB Banking Supervision: to foster a sound and resilient banking system through proactive and tough supervision and to create a level playing field by harmonising supervisory practices across the euro area.

This signals the EU’s determination to restore market confidence in banks’ use of internal models to calculate capital requirements, Fitch Ratings says. It may indicate a desire by the ECB to safeguard internal model use for retail and SME portfolios from the potential imposition of a capital floor.

For the eurozone, whose lawmakers and regulators mostly support the use of internal models and the risk-weighting framework for banks, TRIM is important to their argument that internal models make sense for certain portfolios. The ECB hopes to iron out unwarranted variability between models and restore credibility to the use of internal models, at least for “high-default” portfolios where there is sufficient default data for good-quality modelling.

The ECB’s large investment in TRIM suggests that internal models will continue to play an important role in how eurozone banks compute their regulatory capital requirements. TRIM’s focus on retail and SME credit risk may reveal where the ECB’s focus is for discussions on international bank regulation. The EU may be prepared to lose the use of internal models for “low-default” portfolios, such as financial institutions and large corporates, where it is more of a challenge to model statistically robust estimates for unexpected losses.

TRIM seeks to reduce inconsistencies and unwarranted variability when banks use internal models to calculate their risk-weighted assets (RWAs), by harmonising bank and national supervisory practices relating to models. The ECB has issued a 150-page guide allowing banks to assess themselves against common standards and prepare for the scrutiny to come. TRIM is the biggest single investment made by the ECB in supervision since it started in November 2014. The ECB will lead more than 100 reviews in 2017, involving more than 600 people, at 68 eurozone banks, covering approved internal models for credit, market and counterparty credit risks.

TRIM will take place in 2017 and 2018 with a possible extension into the following year. The ECB will ask banks to put right any shortcomings based on the final version of the guide. We expect the ECB to take a harsher stance with tighter timelines for shortcomings due to the banks’ own practices, while allowing more time to adjust for changes from national standards applied by supervisors in the past. Banks are likely to start work this year on aligning their models with the ECB’s standards. This may lead to movements in RWAs from model changes in 2017-2018, before TRIM is completed in 2019.

Disclosure of RWA movements due to model changes would provide helpful insight to analysts, creditors and investors. These market participants will need to be convinced of the TRIM process if the ECB is to remove their scepticism of RWA calculations based on internal models, in our view.