Banks & Interest Rates Archives - Page 33 of 63

July 28, 2015

China: Deja vu all over again

The Shanghai Composite today found support at 3500 today after plunging more than 8% on Monday. The large divergence on 13-week Twiggs Money Flow continues to warn of selling pressure.

Shanghai Composite Index

* Target calculation: 4000 – ( 5000 – 4000 ) = 3000

Japan’s Lost Decade

From Wikipedia:

The Japanese asset price bubble….. was an economic bubble in Japan from 1986 to 1991 in which real estate and stock market prices were greatly inflated. The bubble was characterized by rapid acceleration of asset prices and overheated economic activity, as well as an uncontrolled money supply and credit expansion. More specifically, over-confidence and speculation regarding asset and stock prices had been closely associated with excessive monetary easing policy at the time.

By August 1990, the Nikkei stock index had plummeted to half its peak by the time of the fifth monetary tightening by the Bank of Japan (BOJ)…..the economy’s decline continued for more than a decade. This decline resulted in a huge accumulation of non-performing assets loans (NPL), causing difficulties for many financial institutions. The bursting of the Japanese asset price bubble contributed to what many call the Lost Decade.

“…uncontrolled money supply and credit expansion….overheated stock market and real estate bubble.” Sound familiar? It should. We are witnessing a re-run but this time in China. Wait, there’s more…..

…..At the end of August 1987, the BOJ signaled the possibility of tightening the monetary policy, but decided to delay the decision in view of economic uncertainty related to Black Monday (October 19, 1987) in the US.

…..BOJ reluctance to tighten the monetary policy was in spite of the fact that the economy went into expansion in the second half of 1987. The Japanese economy had just recovered from the “endaka recession” ….. closely linked to the Plaza Accord of September 1985, which led to the strong appreciation of the Japanese yen.

…..in order to overcome the “endaka” recession and stimulate the local economy, an aggressive fiscal policy was adopted, mainly through expansion of public investment. Simultaneously, the BOJ declared that curbing the yen’s appreciation was a “national priority”……

Global stock market crash leads to prolonged monetary easing…… aggressive expansion of public investment to stimulate the domestic economy…..central bank efforts to curb appreciation of the currency. We all know how this ends. We’ve seen the movie before.

It’s like deja-vu, all over again. ~ Yogi Berra

July 20, 2015

APRA confirms further capital adequacy measures

From Robin Christie:

The Australian Prudential Regulation Authority (APRA) has confirmed that the country’s largest banks will face increased capital adequacy requirements for residential mortgage exposures – and hasn’t ruled out further rises.

The regulator made it clear yesterday that the new rules would be an interim measure based on the Financial System Inquiry’s (FSI) recommendations – and that it was keenly awaiting guidance from the Basel Committee on Banking Supervision before making any further changes.

The new measures, which come into effect on 1 July 2016, mandate that authorised deposit-taking institutions (ADIs) that are accredited to use the internal ratings-based (IRB) approach to credit risk must increase their average risk weight on Australian residential mortgage exposures to at least 25 per cent. According to APRA, the current average risk weight figure sits at around 16 per cent….

This is a welcome first step. Increases in bank capital will improve economic stability. Even at 25 percent, however, a capital ratio of 10% would mean that banks are holding 2.5 percent capital against residential mortgages. Further increases over time will be necessary.

July 15, 2015

China’s stock market falling off a cliff: Why, and why care? | Alicia García-Herrero at Bruegel.org

Great insight from Alicia García-Herrero:

….The need for Chinese corporations and banks to avail themselves of fresh equity cannot be underestimated. On the one hand, corporate debt has grown sixfold from 2005 levels. On the other hand, Chinese banks are not only heavily exposed to these corporates, being still their main source of financing, but also to local governments whose huge borrowing from banks is starting to be restructured. To make a long story short, China’s governments needed a bull stock market to transfer part of the cost of cleaning up its corporates’ and banks’ balance sheets from the state to private investors, including foreigners. The PBoC danced to the Government’s tune, easing monetary policy since November last year. This was done through several interest rate cuts and by lowering the liquidity ratio requirements. The problem with all of this liquidity is that it only fueled additional leveraging, including for gambling on the stock market…..

The sudden collapse of the Chinese stock market had two triggers. First, the was a wave of profit taking after the Shanghai benchmark index broke through 5 000 in early June and doubts emerged about further easing from the PBoC. At that very same moment, China’s securities regulator announced measures to cool down the market, which amounted to banning brokerage firms from providing unregulated margin funding to investors. This was more of a shock to the system than one might imagine, as margin financing in China is much larger than in other stock markets.

Japan had zombie banks, looks like China could end up with a zombie stock market.

July 14, 2015

Bank share prices tipped to decline

Chris Joye at the AFR warns that increased capital requirements could cause an 18.5 percent fall in bank stocks:

….APRA warns that because the report makes several assumptions that are unrealistically favourable to the majors, and the majors’ CET1 ratios have fallen behind global peers since June 2014, it believes they “are likely to need to increase their capital ratios by at least 200 basis points … to be comfortably positioned in the fourth quartile”.

In dollar terms, UBS’ No. 1 ranked analyst Jonathon Mott estimates that this represents a CET1 shortfall of about $24 billion today, accounting for the extra equity the majors have started sourcing since June 2014 (the short-fall would otherwise have been $30 billion). That’s consistent with the lower bound of estimates I previously canvassed here.

Yet this number may be a low-ball for two reasons. First, APRA has yet to respond to the FSI’s recommendation of introducing a minimum average residential mortgage “risk-weighting” of between 25 per cent and 30 per cent. Second, the majors are likely to be slugged with higher risk-weights on their non-residential assets as a consequence of the new Basel 4 rules.

UBS’ research implies that the combined impact of this will be another $16 billion in CET1 on top of the $24 billion shortfall, which gives a total CET1 capital deficiency of $40 billion.

The Australian Financial Review’s Chanticleer column says the majors will only be given 12 months to boost CET1 in response to APRA’s looming decision on residential mortgage risk-weights, which the regulator says it will make “shortly”.

Bank share prices tipped to decline

From a shareholders’ perspective, higher equity means lower leverage and associated returns. Whether that translates into a fall in the majors’ valuations is an open question and depends on whether reduced returns on equity are offset by repricing of deposits and loans and cheaper overall funding costs. As I have explained before, there are arguments for and against. My base-case is that we see a 200 basis point dilution in returns on equity from current world-beating marks that results in a circa 18.5 per cent reduction in major bank valuations.

I would expect APRA to soften the blow by phasing in increased capital ratios and risk-weighting of residential mortgages over time. The impact this will have on valuations depends on several factors. Lower perceived risk could lead to lower cost of funding as well as higher earnings multiples. Also, a BIS study has shown that banks with stronger balance sheets are likely to experience stronger growth — which would again raise the earnings multiple. But I agree with Joye that we are likely to witness some softening of major bank stocks.

July 13, 2015

APRA considers two per cent capital adequacy increase

by Robin Christie | 14 Jul 2015

The Australian Prudential Regulation Authority (APRA) has stated that the major banks would need to increase their capital adequacy ratios by at least two per cent to meet Financial System Inquiry (FSI) recommendations.

APRA has been comparing the capital position of the Australian major banks against a group of international counterparts, and the results of this study, released today, have led to the two per cent figure being mooted.

The study was implemented as a direct response to the FSI final report’s first recommendation, that APRA should “set capital standards such that Australian authorised deposit-taking institution [ADI] capital ratios are unquestionably strong”. This would mean making sure that Australian ADIs sit in the top quartile of internationally-active banks in capital adequacy terms.

….the statement adds that APRA is committed to ensuring that any capital adequacy requirement improvements occur “in an orderly manner”. This process would take into account Australian ADIs’ ability to manage the impact of any changes “without undue disruption to their business plans”.

While APRA hasn’t made a decision on whether it will go as far as mandating a two per cent increase in capital adequacy ratios…. it has stated that Australian ADIs should be well placed to accommodate its directives over the next few years – “provided they take sensible opportunities to accumulate capital”.

Bear in mind that capital adequacy ratios are measured against risk-weighted assets, where asset values are adjusted for the perceived risk of default. Australian banks have historically used risk weightings as low as 15% for residential mortgages compared to 50% in the US. That means that a bank with a capital ratio of 10% would only hold 1.5% capital against residential mortgages. And a 2% increase, to a capital ratio of 12%, would only increase capital cover to 1.8%. Revision of risk weightings is more important than an increase in the capital ratio, especially given Australia’s precarious property market.

July 9, 2015October 5, 2017

Dollar calm while prospect of rate rise fades

The Dollar Index penetrated its descending trendline, indicating the recent correction is over, but the latest red candle warns of uncertainty. Reversal below 95 would warn of another test of primary support at 93. A weaker Dollar would boost demand for gold and lift the US economy, enhancing the competitiveness of exporters and local manufacturers facing competition in domestic markets.

Dollar Index

10-Year Treasury yields retreated below support at 2.25% as turmoil in Europe (Greece) and China reduce the prospect of rate rises. Expect support at 2.10% and the rising trendline. Breach of support is unlikely, but a Fed retreat on rate hikes would warn of serious upheaval in financial markets.

10-Year Treasury Yields

July 8, 2015

RBA strategy: Fight fire with gasoline

This is just plain wrong.

Bulk Commodity Prices

The Australian economy is sitting atop an enormous housing bubble caused by credit expansion from 1995 to 2007. To counter the end of the mining boom, the RBA lowered interest rates to stimulate the economy. While this may be necessary to relieve pressure on borrowers, what we don’t need is another credit expansion. That would simply make the economy more unstable and increase the risk of a crash. Banks are moving to curb lending to speculators, with lower LVRs, but not fast enough in my view. We can’t afford a credit contraction, but the RBA needs to impose sufficient discipline to keep credit growth at/below the inflation rate — so that it gradually declines in real terms as the economy grows.

June 25, 2015October 5, 2017

Are US stocks really over-valued?

Stock Market Capitalization

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

June 9, 2015

RIP ZIRP | PIMCO

From Marc Seidner:

At this point, the evidence is close to overwhelming that the Federal Reserve will embark on a tightening cycle this year. The base case for markets should be a move in September. While the pace of tightening should be very shallow and the ultimate destination for interest rates considerably lower than historical experience, investors should not underestimate the potential volatility emanating from the first interest rate increase in nine years and the first move off of the zero bound in six years….

Liquidity Mismatch Helps Predict Bank Failure and Distress

Liquidity mismatch compares the saleability (liquidity) of a bank’s assets to the stability of its funding. Assets such as cash and Treasury bonds are highly saleable and one can expect a ready market even in times of crisis. Residential mortgages are less liquid, but still saleable at a discount, while development and construction loans may prove unsaleable at any price when the market is under stress.

In terms of funding, long-term deposits offer stability but are far more expensive than short-term wholesale sources and call deposits. The latter, however, are highly unstable and were instrumental in the collapse of Northern Rock (UK) and Washington Mutual (US) during the global financial crisis (GFC).

The challenge facing bank regulators is to monitor liquidity mismatch to ensure bank health. The more illiquid and speculative the assets are, the more stable (illiquid) the bank’s funding sources must be to avoid a liquidity crisis during a market down-turn.

Liquidity mismatch =
(Liquidity-weighted liabilities – Liquidity-weighted assets) / Total assets

This paper by J.B. Cooke, Christoffer Koch and Anthony Murphy at the Dallas Fed (Liquidity Mismatch Helps Predict Bank Failure and Distress) suggests that large banks suffer from higher levels of liquidity mismatch and that liquidity mismatch is as important as capital ratios in determining bank health:

Precrisis Rise in Mismatch
Liquidity mismatch rose significantly between 2002 and 2007. The median level of mismatch climbed about 6 percentage points. Most of this rise was driven by changes in liquidity-weighted assets rather than liquidity-weighted liabilities. Banks pursued higher returns on riskier, less-liquid assets. To a lesser extent, banks relied less on stable core deposits and more on “unstable” wholesale funding. The rise in liquidity mismatch before the financial crisis is noteworthy because equity capital (as a percentage of assets)—the ultimate buffer against losses—changed little. The rise in mismatch was faster and more persistent at the largest banks, representing the top 25 percent of institutions (Chart 2). Among those banks, the median mismatch rose about 8.5 percentage points between 2002 and 2007, while at the 25 percent representing the smallest banks, the increase was only 3 percentage points.

Early-Warning Sign?
Bank regulators look for early-warning signs of distress. Is liquidity mismatch one? Comparing the fourth quarter 2007 mismatch levels of commercial banks that failed or became distressed in 2008 or 2009 with those that did not may provide an indication. The average levels of liquidity mismatch for the two groups were significantly different. Failed or distressed banks generally had much higher levels of liquidity mismatch, as shown by the final entry in the liquidity mismatch row of Table 1.

While the timing of the changes in liquidity mismatch (as seen in Chart 2) and the difference in levels of mismatch at any one time (as seen in Table 1) suggest that liquidity mismatch is important, they do not necessarily imply that a rise in liquidity mismatch helps predict future bank failure or distress. Higher levels of liquidity mismatch may be correlated with lower levels of equity capital and higher proportions of brokered deposits and construction and land development loans as well as with nonperforming assets or lower returns on assets—all well-known predictors of failure or distress.

Modeling Failure and Distress
Statistical models were used to disentangle the effects of changes in liquidity mismatch from the effects of changes in equity capital and the other predictors of bank failure and distress between 2006 and 2011.9 This period was chosen because it followed a time when there were very few failures or cases of distress, the early 2000s. Failure or distress up to two years ahead was considered. For example, fourth quarter 2007 data were used to predict failure or distress any time in 2008.10 The results suggest that recent failure and distress rates are explained or predicted by many of the same factors as in 1985–92, when large numbers of commercial banks and savings and loans failed. These factors include too little equity capital, a high ratio of nonperforming assets and a high share of construction and land development lending……

Liquidity Mismatch Matters
Liquidity mismatch rose significantly before the financial crisis, especially at large banks, our research shows. The rise in mismatch contributed to the rise in bank failures and cases of distress. Liquidity mismatch helps predict bank failure or distress one year ahead, even accounting for equity capital and the other indicators at which regulators look.

Cooke is an economic analyst, Koch is a research economist and Murphy is an economic policy advisor and senior economist in the Research Department of the Federal Reserve Bank of Dallas.

Hat tip to Barry Ritholz.