Fed Holds Rate, Confirms Intent

The latest statement from the FED says the US economic momentum continues, if but slowly. Inflation and income remains on the low side. So they kept the fed funds rate at current levels, but signalled continued future rises. Balance sheet normalisation has yet to start, but says it will commence.

U.S. stocks closed higher, buoyed by strong earnings and the Feds decision.

Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending and business fixed investment have continued to expand. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.


Understanding Banking from the Ground Up

From The St. Louis Fed On The Economy Blog.

Weak U.S. family balance sheets have driven more Americans to the “fringe” of the American banking system. But is this necessarily a bad thing?

The Federal Reserve’s Board of Governors recently released a shocking report showing that, if confronted with an unanticipated $400 expense, nearly half (44 percent) of Americans would have to sell something, borrow or simply not pay at all.1

Other surveys have been equally concerning:

This balance sheet fragility, especially illiquidity, is fueling the demand among Americans—and clearly, as the above data suggest, among middle-class Americans—for “alternative” financial services, including those from payday lenders, auto title lenders, check cashers and the like.

But should we be too critical of their financial choices? Is patronizing an alternative provider necessarily a poor or irrational choice? And do we ban payday lenders and the like because of annual percentage rates that are often in excess of 300 percent?

A Conversation with Lisa Servon on Unbanking

I wrestled with these questions following a recent St. Louis Fed event titled “The Banking and Unbanking of America”—featuring Lisa Servon, author of The Unbanking of America: How the New Middle Class Survives—and I think the answer to these questions is no.

Servon wondered: If these services are so bad, why have check-cashing transactions grown 30 percent between 1990 and 2010 while payday lending transactions tripled between 2000 and 2010?

According to Servon, it turns out that banks (with a growing number of encouraging exceptions) haven’t been serving these customers well, including charging more and higher fees for account opening, maintenance and overdrafts. Meanwhile, struggling consumers are turning to alternative providers (as well as to community development credit unions) because they value:

  • Greater transparency (with actual costs clearly displayed like signs in a fast-food restaurant)
  • Better service (including convenient hours, locations and friendly, multilingual staff)

What I really liked is that Servon—an East Coast, Ivy League academic—didn’t just arrive at these conclusions by only reading reports and talking to experts. She actually became a teller at both a payday lender in Oakland, Calif., and a check casher in the South Bronx, N.Y.

Mapping Financial Choices

I also like that several of my Community Development colleagues here at the St. Louis Fed have embraced this community-driven understanding of financial decision-making as well through a “system dynamics” research study, which maps the actual factors that influence the financial choices consumers make.

Like Servon’s work, the forthcoming version of this study will focus less on the narrow “banked/unbanked” framework and more on the broader, CFSI-inspired idea of “financial health.”

Other Areas to Address

Beyond adopting the financial health framework, Servon also suggests rethinking the government/banking relationship and supporting smart regulation so financial innovation or risk taking can thrive with some protections.

Most importantly, in my view, she recommends addressing the macro problems—for example, flat or declining real wages, less full-time and stable employment, and weaker unions—that underlie the demand for the immediate cash that alternative providers offer so well, albeit not so cheaply.

But it’s also true that weak balance sheets—the micro—contribute to the macro problem: Strapped consumers just don’t spend as much. So, we really must address both.

Notes and References

1Report on the Economic Well-Being of U.S. Households in 2016.” Board of Governors of the Federal Reserve System, May 19, 2017.

2 Gutman, Aliza; Garon, Thea; Hogarth, Jeanne; and Schneider, Rachel. “Understanding and Improving Consumer Financial Health in America.” Center for Financial Services Innovation, March 24, 2015.

3The Precarious State of Family Balance Sheets.” The Pew Charitable Trusts, January 2015.

Author: By Ray Boshara, Senior Adviser and Director, Center for Household Financial Stability

Who Would Be Affected by More Banking Deserts?

From The St. Louis Fed On The Economy Blog.

Although technology has made it easy to bank from almost anywhere, personal and public benefits are still derived from bank branches. In areas without branches—commonly referred to as “banking deserts”—the costs and inconveniences of cashing checks, establishing deposit accounts, obtaining loans and maintaining banking relationships are exacerbated.

Banking Deserts a Growing Concern?

The closing of thousands of bank branches in the aftermath of the last recession has intensified societal concerns about access to financial services among low-income and minority populations, groups that are often affected disproportionately in such situations. The number of people stranded in areas devoid of bank services would probably expand in the future if branches continue to close.

From this perspective, available resources may be better spent trying to prevent more deserts than trying to repopulate existing deserts with new branches.

What Areas Are at Risk?

In the figure below, we isolated branches that were outside the 10-mile range of any others. That is, we found branches that would create new banking deserts if closed. Our analysis is based on demographic and economic data collected for the county subdivision in which each branch is located.

Banking Deserts

We identified 1,055 potential deserts in 2014, of which 204 were in urban areas and 851 in rural areas. The urban areas had a combined population of 2 million, while the rural areas had a combined population of 1.9 million.

These potential deserts have relatively low population densities of 26 people per square mile in urban areas and 12 people per square mile in rural areas. Comparative densities outside potential deserts are, respectively, 176 and 26 people per square mile. In other words, areas with dispersed populations are more at risk of becoming a banking desert.

Potential Effects of New Banking Deserts

Median incomes are $46,717 in potential urban deserts and $41,259 in potential rural deserts. This suggests that any desert expansion would affect lower-income people more than higher-income people.

Minorities constitute 9.8 percent of the population in potential urban deserts and 4.0 percent of the population in potential rural deserts. Both percentages are lower than those for existing deserts and nondeserts. This suggests that newly created deserts may not disadvantage minorities to a greater extent than existing deserts do.

Branches in potential deserts are small, with median deposits of $23 million in urban areas and $20 million in rural areas. They tend to be operated by small banks, with median total assets of $776 million in urban areas and $317 million in rural areas.

The small size of these branches and the banks that own them suggest that what stands between a community and its isolation within a new banking desert are not the decisions made by big banks with a national footprint but, rather, the decisions made by locally oriented community banks. Additionally, potential deserts are more likely to be located in Midwestern states.

The Market’s Expectations about FOMC Meetings

From The St. Louis Fed On The Economy Blog.

There are eight scheduled Federal Open Market Committee (FOMC) meetings each year. However, not all FOMC meetings are created equal. A prescheduled press conference follows four of the eight meetings (those held in March, June, September and December in 2017). This allows the chairperson to present the FOMC’s current economic projections and provide additional context for policy decisions.

Many believe that the FOMC prefers to make policy changes at meetings with a press conference because the opportunity for communication reduces uncertainty in the markets. A brief examination of the data suggests that markets hold this belief.

The Federal Funds Rate Target

The federal funds rate target is an important policy tool controlled by the FOMC, allowing it to influence short-term and long-term interest rates. As the FOMC continues the rate hike cycle it began in December 2015, future target rates are the subject of much speculation by market participants.

Using federal funds rate futures, projections of future target rates are computed each trading day. The figure below plots the market estimates of rate increases at future FOMC meetings following the Jan. 31-Feb. 1 meeting, which affirmed a target range of 0.5 to 0.75 percent.

rate hike probability

The orange line indicates the probability that the federal funds rate target is between 0.75 to 1.0 percent at the March meeting for each trading day between Jan. 31 to March 14, the date of the March meeting.

For example, on Feb. 1, the market gave a 28.8 percent chance that the target would be at 0.75 to 1.0 percent at the March meeting. Given that the next meeting as of Feb. 1 was the March meeting, the 28.8 percent was indeed the rate hike probability for the March meeting.

Similarly, the blue line plots the same probability for May. On Feb. 1, the market gave a 35.9 percent probability that the target would be at 0.75 to 1.0 percent after the May meeting.

However, the May meeting would be the second meeting after Feb. 1, so the interpretation of this 35.9 percent probability is slightly different. It represents the probability of a rate hike at either the March meeting or the May meeting.

Market Expectations of Rate Increases

Does the market expect the FOMC to change the federal funds rate target only at meetings accompanied by a press conference? We can answer this question by comparing changes in the market’s projection between two consecutive meetings.

Let’s first compare the market’s expectation between the press conference meeting in March and the nonconference meeting in May.

The March and May FOMC Meetings

As discussed earlier, the orange line indicates the rate hike probability for the March meeting, and the blue line indicates the rate hike probability for the March or May meeting. Hence, the difference between these two probabilities can be thought of as the probability of a rate hike only at the May meeting.

If the market expects that the federal funds rate target can only be changed at the conference meeting in March and remain the same at the nonconference meeting in May, then we should see that the orange line and the blue line follow each other closely until the date of the March meeting with a difference that is close to zero.

This is exactly what we observe. Right before the March meeting, both probabilities approached 100 percent, indicating that the market expected a rate hike at the March meeting followed by no change at the nonconference meeting in May.

The May and June FOMC Meetings

Similarly, we can compare the rate hike probabilities between the nonconference meeting in May and the press conference meeting in June, which are indicated by the red line and the purple line:

  • The red line represents the rate hike probability for the May meeting.
  • The purple line indicates the rate hike probability for the May meeting or the June meeting.

Hence, the difference between the lines indicates the probability of a rate hike at the June meeting only.

The red line suggests that the probability of a rate hike at the May meeting is essentially zero after the March meeting occurred. Given that the market assigned a rate hike probability of zero for the May meeting, the rate hike probability for the June meeting is essentially equal to the probability indicated by the purple line. It started around 50 percent right after the March meeting and gradually approached 100 percent right before the June meeting. This is additional evidence that market participants expect rate hikes to occur only at the conference meetings.

Effects of FOMC Press Conferences

The market seems to believe that important policy changes can only be done at meetings accompanied by a press conference. If that is the intention of the FOMC, then the role of these nonconference meetings becomes ambiguous. In addition, if economic conditions change enough that a policy response is required at a nonconference meeting, should the FOMC pursue the policy change or wait until the next meeting with a press conference? If this is not the intention of the FOMC, should the FOMC consider equalizing the meetings to correct the bias expected among market participants?

How Trump’s nominee for the Fed could turn central banking on its head

From The Conversation.

President Donald Trump on July 10 nominated Randal Quarles to be one of the seven governors of the Federal Reserve System, the central bank of the United States.

Before I get to Quarles and his qualifications, it’s important to understand the Fed and what it does. Its decisions are vital to every person on the planet who borrows or lends money (pretty much everybody) since it has enormous influence over global interest rates. Its board of governors also influences most other aspects of the global financial system, from regulating banks to how money is wired around the world.

Quarles, for his part, is clearly qualified for a job at the pinnacle of financial regulation. He has held numerous positions in the U.S. Treasury Department, including undersecretary for domestic finance under George W. Bush, and was the U.S. executive director at the International Monetary Fund (IMF). He has also worked on Wall Street for The Carlyle Group and founded his own investment company, The Cynosure Group. He also has a law degree from Yale.

The issue that I believe deserves careful scrutiny, however, does not involve his qualifications. Rather it’s a view of his that, if allowed to permeate the Fed, would represent a seismic shock to how the central bank operates and could potentially have severe consequences if – or when – we stumble into another financial crisis like the one we endured only a decade ago.

Trump Fed nominee Randal Quarles, left, talks with then-central bank Chair Alan Greenspan in 2002. Reuters/Hyungwon Kang

How the Fed controls the world

Currently, the Fed rules the financial world using a very simple model: A handful of very smart people sit together at least eight times a year and decide how to execute the country’s monetary policy.

The implications are enormous. In the words of the Fed itself, decisions made in these meetings:

“trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit and, ultimately, a range of economic variables, including employment, output and prices of goods and services.”

Janet Yellen currently chairs this group, called the Federal Open Market Committee (FOMC), and its decisions, like those of the Supreme Court, are final. There are few or no absolute rules, and there is no appeal.

Quarles, however, has described the discretionary decisions of this small group as “a crazy way to run a railroad.”

Instead, Quarles argues that the Fed should use a rules-based approach, with little or no discretion. Economic data would be plugged into a simple model, which would spit out the decision the Fed should take.

Since the model would be well-known and the relevant economic data (such as GDP, inflation rates, etc.) are already widely publicized, everyone from Wall Street to Main Street who cares about interest rates would be able to predict how the Fed is going to react under such a rules-based approach.

The Taylor rule

While Quarles has not specifically referred to which rule he would favor, a frequently cited one is called the “Taylor rule.”

It is named after Stanford economist John B. Taylor, who proposed it in 1993 as a new guiding principle for central bank decision-making. In recent years, the rule has gained much interest among people who watch and study the Fed.

The Taylor rule states that the Fed should establish short-term interest rates using a mathematical formula. It would use the current rate as a starting point and then factor in data tied to inflation and GDP, both based on the difference between the actual figures and the bank’s targets.

John Taylor created his eponymous rule to guide central bank decision-making. AP Photo/Ted S. Warren

Inflation is an important variable because price changes impact people’s standard of living, while GDP growth affects the number of jobs available in the economy.

Since it would rely on a few human inputs from the Fed, the Taylor rule is somewhat flexible, enough to accommodate different situations by allowing central bankers to specify the importance of inflation compared with GDP growth.

Some countries, like Germany, primarily focus on keeping inflation extremely low. Others, such as the U.S., try to balance both inflation and GDP growth roughly equally. Central banks in some developing countries like those in Africa often put stronger emphasis on boosting economic growth with less regard to inflation.

But that’s about as far it will stretch.

Why does this matter?

In general, the Taylor rule would lead central banks to increase interest rates when inflation is high or when unemployment is very low. Conversely, the rule indicates central banks should lower interest rates when inflation is too low (or there is deflation), when economic growth is poor or unemployment is climbing.

But therein lies the rub. Rules work well when things are “normal,” but when the unexpected happens, they become much less useful – even harmful.

If the Taylor rule were an effective and straightforward method of transforming complex choices into simple, easy-to-understand decisions, the question is, why doesn’t every central bank use this rule?

The answer is as simple as the Taylor rule itself. Sometimes a country faces an economic quandary, such as what the U.S. experienced during the oil price shocks of the late 1970s. Back then, inflation was too high and GDP growth was too low, leaving the country stuck in what is known as a period of stagflation.

In these circumstances, the Taylor rule breaks down. It tells central bankers there is nothing they can do to improve economic conditions. The rule signals that interest rates need to be raised to combat high inflation, yet at the same time that would weaken already-sluggish GDP growth.

Had the U.S. followed the Taylor rule back then, it would have done nothing. Instead, the Fed raised interest rates and broke the back of inflation expectations.

What’s crazier

Simply put, central bankers around the world – including those at the Fed – have not adopted rules-based monetary policy using the Taylor rule or another because in times of economic crisis, a simple precept usually fails to provide effective solutions.

The current ad-hoc approach provides maximum flexibility and allows central bankers to reach for untested methods that help them get the economy back on track.

Quarles may be right. It might be a crazy way to run a railroad. But then again, monetary policy – and the US$18.6 trillion U.S. economy – is a bit more complex than operating a train on a set of rails. The crazy thing might be to do it any other way.

Author: Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University

Fed Will Lift Rates, And Remove Funding Support

The Federal Reserve Board and the Federal Open Market Committee released the minutes of the Committee meeting held on June 13-14, 2017.

They are expecting the benchmark rate to continue to rise, as inflation normalises.

They also provided more colour around the normalisation of the balance sheet. This will have significant market impact.

All participants agreed to augment the Committee’s Policy Normalization Principles and Plans by providing the following additional details regarding the approach the FOMC intends to use to reduce the Federal Reserve’s holdings of Treasury and agency securities once normalization of the level of the federal funds rate is well under way.

The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

  • For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
  • For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at threemonth intervals over 12 months until it reaches $20 billion per month.
  • The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances. The Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.

The Committee affirms that changing the target range for the federal funds rate is its primary means of adjusting the stance of monetary policy. However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.

Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

US Banks Now Significantly More Capitalised

The US Federal Reserve Board has announced it has completed its review of the capital planning practices of the nation’s largest banks and reports that their ratios have more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 per-cent in the fourth quarter of 2016.

Each US bank is listed, so we can make comparisons, unlike the “behind closed door” arrangements in Australia, where regulatory disclosure is so poor.

CCAR, in its seventh year, evaluates the capital planning processes and capital adequacy of the largest U.S.-based bank holding companies, including the firms’ planned capital actions such as dividend payments and share buybacks. Strong capital levels act as a cushion to absorb losses and help ensure that banking organizations have the ability to lend to households and businesses even in times of stress.

“I’m pleased that the CCAR process has motivated all of the largest banks to achieve healthy capital levels and most to substantially improve their capital planning processes,” said Governor Jerome H. Powell.

Figure A provides the aggregate ratio of common equity capital to risk-weighted assets for the firms in CCAR from 2009 through the fourth quarter of 2016. This ratio has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 per-cent in the fourth quarter of 2016. That gain reflects a total increase of more than $750 billion in common equity capital from the beginning of 2009 among these firms, bringing their total common equity capital to over $1.2 trillion in the fourth quarter of 2016.

The decline in the common equity ratio in the first quarter of 2015 resulted from the incorporation of risk-weighted assets calculated under the standardized approach under the capital rules that the Board adopted in 2013, which had a one-time effect of reducing all risk-based capital ratios. However, the aggregate common equity capital ratio of the 34 firms increased by around 65 basis points between the first quarter of 2015 and the fourth quarter of 2015. Previously, risk-weighted assets were calculated under a prior version of the capital rules.

In the aggregate, the 34 firms participating in CCAR 2017 have estimated that their common equity will remain near current levels between the third quarter of 2017 and the second quarter of 2018, based on their planned capital actions and net income projections under their baseline scenario.

When considering a firm’s capital plan, the Federal Reserve considers both quantitative and qualitative factors. Quantitative factors include a firm’s projected capital ratios under a hypothetical scenario of severe economic and financial market stress. Qualitative factors include the strength of the firm’s capital planning process, which incorporate risk management, internal controls, and governance practices that support the process.

This year, 13 of the largest and most complex banks were subject to both the quantitative and qualitative assessments. The 21 other firms in CCAR were subject only to the quantitative assessment. The Federal Reserve may object to a capital plan based on quantitative or qualitative concerns, and if it does, a firm may not make any capital distribution unless authorized by the Federal Reserve.

The Federal Reserve did not object to the capital plans of Ally Financial, Inc.; American Express Company; BancWest Corporation; Bank of America Corporation; The Bank of New York Mellon Corporation; BB&T Corporation; BBVA Compass Bancshares, Inc.; BMO Financial Corp.; CIT Group Inc.; Citigroup, Inc.; Citizens Financial Group; Comerica Incorporated; Deutsche Bank Trust Corporation; Discover Financial Services; Fifth Third Bancorp; Goldman Sachs Group, Inc.; HSBC North America Holdings, Inc.; Huntington Bancshares, Inc.; JP Morgan Chase & Co.; Keycorp; M&T Bank Corporation; Morgan Stanley; MUFG Americas Holdings Corporation; Northern Trust Corp.; The PNC Financial Services Group, Inc.; Regions Financial Corporation; Santander Holdings USA, Inc.; State Street Corporation; SunTrust Banks, Inc.; TD Group US Holdings LLC; U.S. Bancorp; Wells Fargo & Company; and Zions Bancorporation.

The Federal Reserve did not object to the capital plan of Capital One Financial Corporation, but is requiring the firm to submit a new capital plan within six months that addresses identified weaknesses in its capital planning process.


US Banks Pass Federal Reserve’s Stress Test

From Moody’s

Last Thursday, the US Federal Reserve published the results of the 2017 Dodd-Frank Act stress test (DFAST) for 34 of the largest US bank holding companies (BHCs), all of which exceeded the 4.5% minimum required common equity Tier 1 (CET1) capital ratio under the Fed’s severely adverse stress scenario, a credit positive.

This is the third consecutive year that all tested BHCs exceeded the Fed’s minimum requirement, and the median margin above the minimum also increased. However, for the first time, this year’s test incorporated the supplementary leverage ratio (SLR) for advanced-approach banks, which was more constraining for some of the banks.

DFAST considers how well banks withstand a severely adverse economic scenario, which is characterized as a severe global recession. The 2017 test scenario used modestly more favorable interest rates than in 2016 with a greater increase in rates and no negative short-term rates. The test incorporated a 6.5% peak-to-trough decline in US real gross domestic product, an increase in the unemployment rate to 10%, a 50% decline in equity prices through year-end 2017, and a 25% drop in home prices and a 35% decline in commercial real estate prices by 2019.

All 34 BHCs were subjected to this scenario, including new participant CIT Group Inc. In addition, the stress tests for eight of the 34 BHCs with substantial trading or processing operations were required to incorporate the sudden default of their largest loss-generating counterparty. The eight BHCs subject to the counterparty default component were Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., The Goldman Sachs Group, JPMorgan Chase & Co. Morgan Stanley, State Street Corporation, and Wells Fargo & Company. Finally, six of these eight BHCs with significant trading operations were also required to include a global market shock (Bank of New York Mellon Corporation and State Street Corporation were excluded from this global market shock scenario.)

On 28 June, the Fed will release the results of the Comprehensive Capital Analysis and Review (CCAR), which evaluates the BHCs’ capital plans, including dividends and stock repurchases, incorporating their DFAST results. The capital-planning processes of the large complex banks will also be publicly evaluated. Prior to the CCAR release, BHCs can reduce their planned capital distributions, commonly known as taking a “mulligan.” Our analysis of pre-provision net revenue declines and loan losses under the severely adverse scenario highlights still significant tail risks for DFAST participants. Nonetheless, we expect banks’ capital distribution requests to be more aggressive than in prior years, which will limit or negate improvement in their capital ratios.


Exhibit 1 compares the minimum CET1 ratios of 34 participating BHCs under the Fed’s severely adverse scenario with their actual CET1 ratios reported at year-end 2016. The exhibit segments the BHCs into two groups: the 26 BHCs subject only to the severely adverse economic scenario (on the right), and the eight BHCs also subject to the additional global market shock and counterparty default components noted above (on the left). The minimum CET1 ratios of the eight large BHCs are all comfortably above the Fed’s 4.5% requirement despite being subjected to the additional stress components. The other 26 BHCs are also above the 4.5% requirement, although for many the margin is smaller than for the largest BHCs. The lowest minimum ratios were for Ally Financial Inc. at 6.6%, up from 6.1% in the 2016 test; and KeyCorp at 6.8%, up from 6.4% in 2016.

Even though all of the BHCs passed the 4.5% minimum threshold, many would still take sizeable capital hits under the Fed’s severely adverse scenario (Exhibit 2). The estimated declines in the BHCs’ CET1 ratios range from a high of 840 basis points (bp) for Morgan Stanley to a low of 210 bp for Santander Holdings USA, Inc.. Positively, the median of the 34 banks was narrower at 280 bp compared with 350 bp last year, indicating greater overall resilience to an economic shock. In its report, the Fed partly attributed this to lower losses from changes in the banks’ portfolio composition and risk characteristics.


The BHCs’ generally good results for stressed CET1 ratios in DFAST suggests that increased capital distributions are likely for the vast majority of institutions. However, CET1 is not the most constraining ratio for all banks. In particular, this year’s test for the first time incorporated the supplementary leverage ratio (SLR) for the advanced approach banks (Exhibit 3). Because the denominator of the SLR comprises average assets and off-balance sheet exposures, it tends to be much larger than the risk-weighted asset denominator of CET1, with the result that the banks’ margin above the 3% minimum SLR is smaller. Morgan Stanley had the lowest minimum SLR of 3.8%, which is likely to constrain its efforts to return more capital to shareholders. State Street and Goldman Sachs also had comparatively low minimum SLRs.

Housing and Financial Stability

An excellent speech by Fed Vice Chairman Stanley Fischer at the DNB-Riksbank Macroprudential Conference Series, Amsterdam, Netherlands

It is often said that real estate is at the center of almost every financial crisis. That is not quite accurate, for financial crises can, and do, occur without a real estate crisis. But it is true that there is a strong link between financial crises and difficulties in the real estate sector. In their research about financial crises, Carmen Reinhart and Ken Rogoff document that the six major historical episodes of banking crises in advanced economies since the 1970s were all associated with a housing bust. Plus, the drop in house prices in a bust is often bigger following credit-fueled housing booms, and recessions associated with housing busts are two to three times more severe than other recessions. And, perhaps most significantly, real estate was at the center of the most recent crisis.

In addition to its role in financial stability, or instability, housing is also a sector that draws on and faces heavy government intervention, even in economies that generally rely on market mechanisms. Coming out of the financial crisis, many jurisdictions are undergoing housing finance reforms, and enacting policies to prevent the next crisis. Today I would like to focus on where we now stand on the role of housing and real estate in financial crises, and what we should be doing about that situation. We shall discuss primarily the situation in the United States, and to a much lesser extent, that in other countries.

Housing and Government
Why are governments involved in housing markets? Housing is a basic human need, and politically important‑‑and rightly so. Using a once-popular term, housing is a merit good‑‑it can be produced by the private sector, but its benefit to society is deemed by many great enough that governments strive to make it widely available. As such, over the course of time, governments have supported homebuilding and in most countries have also encouraged homeownership.

Governments are involved in housing in a myriad of ways. One way is through incentives for homeownership. In many countries, including the United States, taxpayers can deduct interest paid on home mortgages, and various initiatives by state and local authorities support lower-income homebuyers. France and Germany created government-subsidized home-purchase savings accounts. And Canada allows early withdrawal from government-provided retirement pension funds for home purchases.

And‑‑as we all know‑‑governments are also involved in housing finance. They guarantee credit to consumers through housing agencies such as the U.S. Federal Housing Administration or the Canada Mortgage and Housing Corporation. The Canadian government also guarantees mortgages on banks’ books. And at various points in time, jurisdictions have explicitly or implicitly backstopped various intermediaries critical to the mortgage market.

Government intervention in the United States has also addressed the problem of the fundamental illiquidity of mortgages. Going back 100 years, before the Great Depression, the U.S. mortgage system relied on small institutions with local deposit bases and lending markets. In the face of widespread runs at the start of the Great Depression, banks holding large portfolios of illiquid home loans had to close, exacerbating the contraction. In response, the Congress established housing agencies as part of the New Deal to facilitate housing market liquidity by providing a way for banks to mutually insure and sell mortgages.

In time, the housing agencies, augmented by post-World War II efforts to increase homeownership, grew and became the familiar government-sponsored enterprises, or GSEs: Fannie, Freddie, and the Federal Home Loan Banks (FHLBs). The GSEs bought mortgages from both bank and nonbank mortgage originators, and in turn, the GSEs bundled these loans and securitized them; these mortgage-backed securities were then sold to investors. The resulting deep securitized market supported mortgage liquidity and led to broader homeownership.

Costs of Mortgage Credit
While the benefits to society from homeownership could suggest a case for government involvement in securitization and other measures to expand mortgage credit availability, these benefits are not without costs. A rapid increase in mortgage credit, especially when it is accompanied by a rise in house prices, can threaten the resilience of the financial system.

One particularly problematic policy is government guarantees of mortgage-related assets. Pre-crisis, U.S. agency mortgage-backed securities (MBS) were viewed by investors as having an implicit government guarantee, despite the GSEs’ representations to the contrary. Because of the perceived guarantee, investors did not fully internalize the consequence of defaults, and so risk was mispriced in the agency MBS market. This mispricing can be notable, and is attributable not only to the improved liquidity, but also to implicit government guarantees. Taken together, the government guarantee and resulting lower mortgage rates likely boosted both mortgage credit extended and the rise in house prices in the run-up to the crisis.

Another factor boosting credit availability and house price appreciation before the crisis was extensive securitization. In the United States, securitization through both public and private entities weakened the housing finance system by contributing to lax lending standards, rendering the mid-2000 house price bust more severe. Although the causes are somewhat obscure, it does seem that securitization weakened the link between the mortgage loan and the lender, resulting in risks that were not sufficiently calculated or internalized by institutions along the intermediation chain. For example, even without government involvement, in Spain, securitization grew rapidly in the early 2000s and accounted for about 45 percent of mortgage loans in 2007. Observers suggest that Spain’s broad securitization practices led to lax lending standards and financial instability.

Yet, as the Irish experience suggests, housing finance systems are vulnerable even if they do not rely on securitization. Although securitization in Ireland amounted to only about 10 percent of outstanding mortgages in 2007, lax lending standards and light regulatory oversight contributed to the housing boom and bust in Ireland.

Macroprudential Policies
To summarize, murky government guarantees, lax lending terms, and securitization were some of the key factors that made the housing crisis so severe. Since then, to damp the house price-credit cycle that can lead to a housing crisis, countries worldwide have worked to create or expand existing macroprudential policies that would, in principle, limit credit growth and the rate of house price appreciation.

Most macroprudential policies focus on borrowers. Loan-to-value (LTV) and debt-to-income (DTI) ratio limits aim to prevent borrowers from taking on excessive debt. The limits can also be adjusted in response to conditions in housing markets; for example, the Financial Policy Committee of the Bank of England has the authority to tighten LTV or DTI limits when threats to financial stability emerge from the U.K. housing market. Stricter LTV or DTI limits find some measure of success. One study conducted across 119 countries from 2000 to 2013 suggests that lower LTV limits lead to slower credit growth. In addition, evidence from a range of studies suggests that decreases in the LTV ratio lead to a slowing of the rate of house price appreciation. However, some other research suggests that the effectiveness of LTV limits is not significant or somewhat temporary.

Other macroprudential policies focus on lenders. First and foremost, tightening bank capital regulation enhances loss-absorbing capacity, strengthening financial system resilience. In addition, bank capital requirements for mortgages that increase when house prices rise may be used to lean against mortgage credit growth and house price appreciation. These policies are intended to make bank mortgage lending more expensive, leading borrowers to reduce their demand for credit, which tends to push house prices down. Estimates of the effects of such changes vary widely: After consideration of a range of estimates from the literature, an increase of 50 percentage points in the risk weights on mortgages would result in a house price decrease from as low as 0.6 percent to as high as 4.0 percent. These policies are more effective if borrowers are fairly sensitive to a rise in interest rates and if migration of intermediation outside the banking sector to nonbanks is limited.

Of course, regulatory reforms and in some countries, macroprudential policies‑‑are still being implemented, and analysis is currently under way to monitor the effects. So far, research suggests that macroprudential tightening is associated with slower bank credit growth, slower housing credit growth, and less house price appreciation. Borrower, lender, and securitization-focused macroprudential policies are likely all useful in strengthening financial stability.

Loan Modification in a Crisis
Even though macroprudential policies reduce the incidence and severity of housing related crises, they may still occur. When house prices drop, households with mortgages may find themselves underwater, with the amount of their loan in excess of their home’s current price. As Atif Mian and Amir Sufi have pointed out, this deterioration in household balance sheets can lead to a substantial drop in consumption and employment. Extensive mortgage foreclosures–that is, undertaking the legal process to evict borrowers and repossess the house and then selling the house–as a response to household distress can exacerbate the downturn by imposing substantial dead-weight costs and, as properties are sold, causing house prices to fall further.

Modifying loans rather than foreclosing on them, including measures such as reducing the principal balance of a loan or changing the loan terms, can allow borrowers to stay in their homes. In addition, it can substantially reduce the dead-weight costs of foreclosure.

Yet in some countries, institutional or legal frictions impeded desired mortgage modifications during the recent crisis. And in many cases, governments stepped in to solve the problem. For example, U.S. mortgage loans that had been securitized into private-label MBS relied on the servicers of the loans to perform the modification. However, operational and legal procedures for servicers to do so were limited, and, as a result, foreclosure, rather than modification, was commonly used in the early stages of the crisis. In 2008, new U.S. government policies were introduced to address the lack of modifications. These policies helped in three ways. First, they standardized protocols for modification, which provided servicers of private-label securities some sense of common practice. Second, they provided financial incentives to servicers for modifying loans. Third, they established key criteria for judging whether modifications were sustainable or not, particularly limits on mortgage payments as a percentage of household income. This last policy was to ensure that borrowers could actually repay the modified loans, which prompted lenders to agree more readily to the modification policies in the first place.

Ireland and Spain also aimed to restructure nonperforming loans. Again, government involvement was necessary to push these initiatives forward. In Ireland, mortgage arrears continued to accumulate until the introduction of the Mortgage Arrears Resolution Targets scheme in 2013, and in Spain, about 10 percent of mortgages were restructured by 2014, following government initiatives to protect vulnerable households. Public initiatives promoting socially desirable mortgage modifications in times of crises tend to be accompanied by explicit public fund support even though government guarantees may be absent in normal times.

What Has Been Done? What Needs to Be Done?
With the recent crisis fresh in mind, a number of countries have taken steps to strengthen the resilience of their housing finance systems. Many of the most egregious practices that emerged during the lending boom in the United States‑‑such as no- or low-documentation loans or negatively amortizing mortgages‑‑have been severely limited. Other jurisdictions are taking actions as well. Canadian authorities withdrew government insurance backing on non-amortizing lines of credit secured by homes. The United States and the European Union required issuers of securities to retain some of the credit risk in them to better align incentives among participants (although in the United States, MBS issued by Fannie and Freddie are currently exempt from this requirement). And post-crisis, many countries are more actively pursuing macroprudential policies, particularly those targeted at the housing sector. New Zealand, Norway, and Denmark instituted tighter LTV limits or guidelines for areas that had overheating housing markets. Globally, the introduction of new capital and liquidity regulations has increased the resilience of the banking system.

But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.

What should be done as we move ahead?

First, macroprudential policies can help reduce the incidence and severity of housing crises. While some policies focus on the cost of mortgage credit, others attempt directly to restrict households’ ability to borrow. Each policy has its own merits and working out their respective advantages is important.

Second, government involvement can promote the social benefits of homeownership, but those benefits come at a cost, both directly, for example through the beneficial tax treatment of homeownership, and indirectly through government assumption of risk. To that extent, government support, where present, should be explicit rather than implicit, and the costs should be balanced against the benefits, including greater liquidity in housing finance engendered through a uniform, guaranteed instrument.

Third, a capital regime that takes the possibility of severe stress seriously is important to calm markets and restart the normal process of intermediation should a crisis materialize. A well-capitalized banking system is a necessary condition for stability in bank-based financial systems as well as those with large nonbank sectors. This necessity points to the importance of having resilient banking systems and also stress testing the system against scenarios with sharp declines in house prices.

Fourth, rules and expectations for mortgage modifications and foreclosure should be clear and workable. Past experience suggests that both lenders and borrowers benefit substantially from avoiding costly foreclosures. Housing-sector reforms should consider polices that promote efficient modifications in systemic crises.

In the United States, as around the world, much has been done. The core of the financial system is much stronger, the worst lending practices have been curtailed, much progress has been made in processes to reduce unnecessary foreclosures, and the actions associated with the Housing and Economic Recovery Act of 2008 created some improvement over the previous ambiguity surrounding the status of government support for Fannie and Freddie.

But there is more to be done, and much improvement to be preserved and built on, for the world as we know it cannot afford another pair of crises of the magnitude of the Great Recession and the Global Financial Crisis.


Fed Heading for Faster-than-Expected Normalisation

The Federal Reserve hiked its benchmark rate hike this week. Judging by their associated comments, Fitch Ratings says this reinforces the view that U.S. interest rates will normalise faster than financial markets expect.

The Fed on Wednesday raised the fed funds target rate for the third time in seven months, to 1.00%-1.25%. The Fed also announced that it expects to start phasing out full balance sheet reinvestment in 2017 and provided details on the modalities of doing so.

The rate increase and accompanying comments bolster our view that the fed funds rate is likely to normalise at 3.5% by 2020, and U.S. 10-year bond yields will rise back above 4%. These developments would mark a significant shift in the global interest rate environment.

Fitch believes the Fed is increasingly comfortable with its normalisation process and less data-dependent following recent inflation readings that have been slightly lower than consensus expectations (although they remain close to target). The interest rate hike showed the Fed was prepared to look through weak first quarter consumption and GDP and underlines Fed concerns about unemployment falling too far below its equilibrium rate. .

Our fed funds rate forecasts also reflect scepticism regarding the idea that the equilibrium (or “natural”) U.S. real interest rate has fallen close to zero. We think the fall in actual real rates is explained by the slowdown in potential GDP growth driven by demographics and weaker productivity growth, and by an elongated credit and monetary policy cycle. As this extended credit cycle comes to an end, Fitch believes the Fed will set rates according to its view of the U.S.’s long-term potential growth rate and its inflation target. This suggests the equilibrium nominal fed funds rate would be 3.5%-4% if real rates normalise in line with our estimate of U.S. potential growth at slightly below 2%.

The impact on bond yields will also be determined by how far the term premium rises from the current historically low level partly caused by the Fed’s Quantitative Easing (QE) programme. The Fed’s approach to balance sheet normalisation sees reinvestment only to the extent that maturities exceed pre-set caps. The caps will initially be set at low levels but will rise to maximum levels of USD30bn per month for Treasuries and USD20bn per month for agency debt and mortgage-backed securities. A return to a positive term premium of 50bp-100bp as the QE programme is unwound would see long-term U.S. bond yields normalise at 4%-5% given our estimates of the equilibrium Fed Funds rate.