First-time buyers: how do they finance their purchases and what’s changed? – Bank Underground

Some interesting research out of the UK examining the impact of a variety of factors associated with first time house purchases.

Our results support claim that average FTBs are increasingly higher up the income distribution for their age. And slower than average income growth for younger workers have worked against FTBs. But our results challenge the view that average FTB ages have got much higher. And while FTBs on average are borrowing more in nominal terms, they aren’t spending more of their income on mortgage repayments than before: cheaper credit has roughly cancelled out the effect of bigger mortgages.

— Read on bankunderground.co.uk/2020/09/16/first-time-buyers-how-do-they-finance-their-purchases-and-whats-changed/

The dark art of measuring residential mortgage risk

Residential mortgages are one of the seemingly more plain vanilla forms of bank lending. Notwithstanding, comparing capital requirements applied to this category of lending across different types of banks can be surprisingly complicated and is much misunderstood. I have touched on different aspects of this challenge in a number of mortgage risk weight “fact check” posts (see here and here), focussing for the most part on the comparison of “standardised” capital requirements compared to those applied to banks operating under the “internal rating based” (IRB) approach.

A discussion paper (“A more flexible and resilient capital framework for ADIs”, 8 December 2020) released by the Australian Prudential Regulation Authority (APRA) offers a good summary (see p27 “Box 2”) of the differences in capital requirements not captured by simplistic comparisons of risk weights. However, one of the surprises in the discussion paper was that APRA chose not to address one of these differences by aligning the credit conversion factors applied to off-balance sheet (non-revolving) residential mortgage exposures.

Understanding why APRA chose to maintain a different treatment of CCFs across the two approaches offers some insights into differences in the way that the two approaches recognise and measure the underlying risks.

Before proceeding we need to include a short primer on “off-balance exposures” and “CCFs”. Feel free to skip ahead if you already understand these concepts.

  • Off-balance sheet exposures are the difference between the maximum amount a bank has agreed to lend and the actual amount borrowed at any point in time.
  • The CCF is the bank’s estimate of how much of these undrawn limits will in fact have been called on (converted to an on balance sheet exposure) in the event a borrower defaults.
  • In the case of “non-revolving” residential mortgages, these off-balance sheet exposures typically arise because borrowers have got ahead of (“pre-paid”) their contractual loan repayments.

APRA noted that the credit conversion factor (CCF) currently applied to off-balance sheet exposures was much higher for IRB banks than for standardised, thereby partially offsetting the lower risk weights applied under the IRB approach. It had been expected that APRA would address this inconsistency by applying a 100% CCF under both approaches.

Contrary to this expectation, APRA has proposed to revise the CCFs applying to (non-revolving) off-balance sheet residential mortgage exposures as follows:

Current

Standardised 0-50%

IRB 100%

Proposed

40%

100% (unchanged)

The interesting nuance here is that APRA is not saying that standardised banks are likely to experience a lower percentage drawdown of credit limits in the event a borrower defaults. In the “Response to Submissions” that accompanied the Discussion Paper, APRA noted that “Borrowers do not typically enter default until they have fully drawn down on their available limit, including any prepayments ahead of their scheduled balance.

However, APRA also noted that loans with material levels of prepayment are also likely to be lower risk based on the demonstrated greater capacity to service and repay the loan.

Under the IRB approach, the greater capacity to repay the loan is generally recognised through a lower PD estimate which the IRB formula translates into lower risk weights reflecting the lower risk. In the absence of some equivalent risk recognition mechanism in the standardised approach, APRA is proposing to use a concessional CCF treatment to reflect the lower risk of loans with material levels of prepayment. It notes that the concessional CCF treatment will also contribute to ensuring the difference in residential mortgage capital requirements between the standardised and IRB approaches remains appropriate.

Summing up:

  • Looked at in isolation, 100% is arguably the “right” value for the CCF to apply to off-balance sheet exposures for a non-revolving residential mortgage irrespective of whether it is being measured under the standardised or IRB approach
  • But a “concessional” CCF is a mechanism (fudge?) that allows the standardised approach to reflect the lower risk associated with loans with material levels of prepayment

Tony – From the Outside

Low Risk Residential Mortgage Risk Weights

I have posted a number of times on the question of residential mortgage risk weights, either on the general topic of the comparison of the risk weights applied to the standardised and IRB ADIs (see here) or the reasons why risk weights for IRB ADIs can be so low (see here).

On the question of relative risk weights, I have argued that the real difference between the standardised and IRB risk weights is overstated when framed in terms of simplistic comparisons of nominal risk weights that you typically read in the news media discussion of this question. I stand by that general assessment but have conceded that I have paid insufficient attention to the disparity in risk weights at the higher quality end of the mortgage risk spectrum.

A Discussion Paper released by APRA offers a useful discussion of this low risk weight question as part of a broader set of proposals intended to improve the transparency, flexibility and resilience of the Australian capital adequacy framework.

In section 4.2.1 of the paper, APRA notes the concern raised by standardised ADIs…

A specific concern raised by standardised ADIs in prior rounds of consultation has been the difference in capital requirements for lending at low LVRs. Stakeholders have noted that the lowest risk weight under the standardised approach would be 20 per cent under the proposed framework, but this appears to be significantly lower for the IRB approach. In response to this feedback, APRA has undertaken further analysis at a more detailed level, noting the difference in capital requirements that need to be taken into account when comparing capital outcomes under the standardised and IRB approaches (see Box 2 above).

But APRA’s assessment is that the difference is not material when you look beyond the simplistic comparison of risk weights and consider the overall difference in capital requirements

APRA does not consider that there is a material capital difference between the standardised and IRB approaches at the lower LVR level. For loans with an LVR less than 60 per cent, APRA has estimated that the pricing differential that could be reasonably attributed to differences in the capital requirements between the two approaches would be lower than the differential at the average portfolio outcome.

In explaining the reasons for this conclusion, APRA addresses some misconceptions about the IRB approach to low LVR lending compared to the standardised approach

In understanding the reasons for this outcome, it is important to understand the differences in how the standardised and IRB approaches operate. In particular, there are misconceptions around the capital requirement that would apply to low LVR lending under the IRB approach. For example, it would not be appropriate to solely equate the lowest risk weight reported by IRB ADIs in market disclosures with low LVR loans. The IRB approach considers a more complex range of variable interactions compared to the standardised approach. Under the standardised approach, a low risk weight is assigned to a loan with a low LVR at origination.

One of the key points APRA makes is that IRB ADIs do not get to originate loans at the ultra low risk weights that have been the focus of much of the concern raised by standardised ADIs.

In particular, IRB estimates are more dynamic through the life of the loan, for example, they are more responsive to a change in borrower circumstances or movements in the credit cycle. Standardised risk weights generally do not change over the life of a loan. For an IRB ADI, the lowest risk weight is generally applied to loans that have significantly prepaid ahead of schedule. A low LVR loan on the standardised approach is not necessarily assigned the lowest risk weight under the IRB approach at origination.

APRA states that it is not appropriate to introduce “dynamic”factors into the standardised risk weight framework.

APRA is not proposing to include dynamic factors in determining risk weights under the standardised approach for the following reasons:

– the standardised approach is intended to be simple and aligned with Basel III. For the standardised approach, APRA considers it more appropriate to focus on origination rather than behavioural variables as this has more influence on the quality of the portfolio and leads to less procyclical capital requirements; and

– the average difference between standardised and IRB capital outcomes is much narrower at the point of origination, which is the key point for competition. While the difference between standardised and IRB capital outcomes could widen over the life of the loan, APRA has ensured that the difference in average portfolio outcomes remains appropriate

But that it does intend to introduce a 5 per cent risk weight floor into the IRB approach to act as a backstop.

That said, APRA is proposing to implement a 5 per cent risk-weight floor for residential mortgage exposures under the IRB approach, to act as a simple backstop in ensuring capital outcomes do not widen at the lower risk segment of the portfolio. This is consistent with the approach taken by other jurisdictions and will limit the difference in capital outcomes between the standardised and IRB approaches for lower risk exposures. This risk-weight floor is in addition to other factors that will reduce the difference in capital outcomes between standardised and IRB ADIs, such as the higher CCB for IRB ADIs and lower CCF estimates for standardised ADIs.

As always, it remains possible that I am missing something. The explanation offered by APRA however gives me confidence that my broad argument about the overstatement of the difference has been broadly correct. Equally importantly, the changes to residential mortgage risk weights proposed in the Discussion Paper will further reduce the gap that does exist.

Tony – From the Outside

Financing the Danish home

There is a surprising (to me at least) variety of ways that countries address the common problem of financing the purchase of residential property. To date, I have mostly approached the question from the perspective of trying to understand differences in mortgage risk weights across different banks in Australia (see here). The topic also has implications for cross border comparisons of capital adequacy ratios (see here and here).

Marc Rubinstein wrote a great piece looking at the mysteries of the the 30-year fixed-rate fully prepayable mortgage that finances the majority of home purchases in America. Marc noted in passing that Denmark is the only other country that offers a comparable form of mortgage financing. That is broadly true but I think the Danish mortgage financing system has some distinct and intriguing features of its own. A paper published by the New York Fed in 2018 comparing the US and Danish mortgage systems has been especially useful in gaining some deeper insights into the different ways that countries solve the residential property finance challenge.

This extract from the New York Fed paper gives you a flavour of the history and main features of the Danish system

In Denmark, mortgage lending has long been dominated by specialized mortgage banks. Denmark’s first mortgage bank was established in 1797, and Nykredit, the country’s largest mortgage bank today, traces its origins to 1851 (Møller and Nielsen 1997). Originally, these firms were set up as mutual mortgage credit associations with a local focus. But several waves of mergers—some encouraged or even prescribed by their then-regulator—led to the formation of the handful of large mortgage banks that today dominate mortgage lending in Denmark.


Because the original mortgage credit associations were founded by borrowers, lending terms were to a large extent designed to reflect borrowers’ objectives and interests. At the same time, the associations needed to build trust among the investors in covered bonds, and this led to a business model aimed at balancing borrower and investor interests (Møller and Nielsen 1997).

Key aspects of this business model included:

# Mortgage lenders could not call for early redemption of a loan unless the borrower became delinquent.

# Investors could not call the covered bonds.

# Homeowners had a right to prepay the mortgage loan at par on any payment day without penalty.

# Homeowners were personally liable for the mortgage debt.

# Homeowners were jointly and severally liable for the covered bonds issued by the mortgage credit association.

# Mortgage margins could be increased for the entire stock of mortgage loans—for example, if needed in order to increase capitalization or cover loan losses.

# Strict lending guidelines were instituted that were regulated by law (maximum LTV ratio, maximum maturity, and so forth).

With the exception of joint and several liability, these principles still apply to mortgage banks today.

Berg J, Baekmand Nielsen M, and Vickery J, “Peas in a Pod? Comparing the U.S. and Danish Mortgage Financing Systems”, Federal Reserve Bank of New York Economic Policy Review 24, no. 3, December 2018

The paper summarises the comparison between the two systems as follows

The U.S. and Danish mortgage finance models both rely heavily on capital markets to fund residential mortgages, transferring interest rate and prepayment risk, but not credit risk, to investors. But in Denmark, homeowners can buy back their mortgages or transfer them in a property sale, avoiding the “lock-in” effects present in the U.S. system, and easier refinancing reduces defaults and speeds the transmission of lower interest rates in a downturn. Denmark’s tighter underwriting standards and strong creditor protections help limit credit losses, while its higher capital requirements make lenders more stable.

Worth reading.

Tony – From the Outside

The case for low mortgage risk weights

I have touched on residential mortgage risk weights a couple of times in this blog, most recently in a post on the Dutch proposal to increase residential mortgage RW. This post explores the question of why residential mortgage RW under the Internal Rating Based (IRB) approach can be so low. More importantly, can we trust these very low risk weights (and the banks generating them) or is this yet more evidence that the IRB approach is an unreliable foundation for measuring bank capital requirements? It also touches on some of the issues we encounter in cross border comparisons of capital strength.

It has to be said at this point that IRB modelling is not an area where I claim deep expertise and I would welcome comments and input from people who do have this subject matter expertise. However, it is an important issue given the role that residential mortgage lending plays both in the economy as a whole. If nothing else, the post will at least help me get my thoughts on these questions into some kind of order and potentially invite comments that set me straight if I have got anything wrong. Notwithstanding the importance of the issue, this post is pretty technical so likely only of interest if you want to dig into the detailed mechanics of the IRB approach.

Recapping on the Dutch proposal to increase mortgage risk weights

First a recap on what the Dutch bank supervisor proposes to do. Residential mortgage RW in the Netherlands are amongst the lowest observed in Europe

DNB:Financial Stability Report Autumn 2019


The Dutch banks can of course cite reasons why this is justified but, in order to improve the resilience of the banking system, the Dutch banking supervisor proposes to introduce a floor set at 12% on how low the RW can be. The 12% floor applies to loans with a dynamic Loan to Value (LTV) of 55% or lower. The RW floor increases progressively as the LTV increases reaching a maximum of 45% for loans with a LTV of 100% or more. DNB expects the application of the measure to increase the average risk weights of Dutch IRB banks by 3-4 percentage points (from 11% to 14%-15%).

What drives the low end of the IRB Mortgage RW?

None of the discussion set out below is in any way intended to challenge bank supervisors seeking to apply limits to the low mortgage risk weights we observe being generated by the internal models developed by IRB banks. That is a whole separate discussion but the move to higher RW on these exposures broadly makes sense to me, not only for reasons of systemic resilience, but also with regard to the way that it reduces the disparity between IRB RW and those the standardised banks are required to operate against. It is however useful to understand what is driving the model outcomes before citing them as evidence of banks gaming the system.

This extract from Westpac’s September 2019 Pillar 3 Report shows a weighted average RW of 24% with individual segments ranging from 6% to 137%. The CBA Pillar 3 shows a similar pattern (RW range from 4.4% to 173.5%). I won’t get too much into the technical detail here but the effective IRB RW is higher when you factor in Regulatory Expected Loss. The impact on the RW in the table below is roughly 16% on average (I divide REL by .08 to translate it to an RWA equivalent and then divide by RWA) but this effect only becomes material for the 26% and higher RW bands).

Source: Westpac Pillar 3 Report – Sep 2019

I am very happy to stand corrected on the facts but my understanding is that the 6% and 14% RW bands in the table above capture “seasoned” portions of the loan portfolio where the Loan to Valuation (LVR) ratio has declined substantially from the circa 80% plus typically observed in newly originated loans. The declining LVR is of course a natural outcome for Principal and Interest loans which is the kind traditional prudent banking prefers.

What at face value looks like an incredibly thin capital requirement starts to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and, perhaps more importantly, have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.

Australian owner occupied borrowers have an incentive to repay as fast as possible because their interest is not tax deductible (making the mortgage repayment one of the best applications of surplus cash) and they typically borrow on a floating rate basis. The natural amortisation of loan principal is also likely to have been accelerated by the progressive decline in interest rates in recent years which has seen a large share of borrowers apply the interest saving to higher principal repayments.

Comparing Dutch and Australian Mortgage Risk Weights

Looking at the Dutch RW provides some perspective on the mortgage RW of the Australian IRB banks and the initiatives APRA has implemented to increase them. I will only scratch the surface of this topic but it is interesting none the less to compare the 14-15% average RW the Dutch IRB banks will be required to hold with the 25% average RW that Australian IRB banks must hold.

The Dutch banks cite a favourable legal system that supports low LGD by allowing them to quickly realise their security on defaulted loans. That is a sound argument when you are comparing to a jurisdiction where it can take up to 3 years for a bank to gain access to the security underpinning a defaulted loan. That said, the Australian banks can make a similar argument so that does not look like a definitive factor in favour of lower Dutch RW.

The Australian LTV is based on the amortised value of the loan compared to the value of the property at the time the loan was originated. The Dutch LTV as I understand it seem to includes the updated value of the property as the loan ages. Again I don’t see anything in the Dutch system that renders their residential mortgage lending fundamentally less risky than the Australian residential mortgage.

The other positive factor cited by the Dutch banks is the tax deductibility of mortgage interest which applies even where the property is owner occupied. In Australia, interest on loans for owner occupied property is not tax deductible. The Dutch banks argue that the tax deduction on interest enhances the capacity of the borrower to service a loan but my guess is that this advantage is highly likely to be translated into higher borrowing capacity and hence higher property prices so it is not clear that there is a net improvement in the capacity to repay the loan.

I obviously only have a very rudimentary understanding of Dutch tax rules but my understanding is that tax deductibility of interest expense in some European jurisdictions is quid pro quo for including the implied value of rental on the property in the owner’s taxable income. If that is the case then it looks like tax deductibility of interest is a zero sum game from the lending bank perspective. Qualified by the caveats above, I will provisionally take the side of the Australian mortgage in this comparison. It seems equally likely to me that the the absence of a tax deduction creates an incentive for Australian borrowers to repay their loan as quickly as possible and hence for a greater proportion of loans outstanding to move into the low LVR bands that insulate the bank from the risk of loss. There does not seem to be the same incentive in the Dutch system, especially where the loans are fixed rate.

Summing up

The purpose of this post was mostly to help me think through the questions posed in the introduction. If you are still reading at this point then I fear you (like I) take bank capital questions way too seriously.

There are two main points I have attempted to explore and stake out a position on:

  • What at face value looks like an incredibly thin capital requirement for some parts of the residential mortgage portfolio start to make more sense when you consider the fact that the borrowers in these segments have demonstrated their capacity to service their loans and have built up a substantial pool of their own equity in the property that will absorb very substantial declines in property prices before the bank is likely to face a loss.
  • Cross border comparisons of capital are complicated but mortgages are a big part of the Australian bank risk profile and I still feel like they stack up relatively well in comparison to other jurisdictions that cite structural reasons why theirs are low risk.

If you have some evidence that contradicts what I have outlined above then by all means please let me know what I am missing.

Tony

Mortgage Risk Weights – revisited

I post on a range of topics in banking but residential mortgage risk weights is one that seems to generate the most attention. I first posted on the topic back in Sep 2018 and have revisited the topic a few times (Dec 2018, June 2019#1, June 2019#2, and Nov 2019) .

The posts have tended to generate a reasonable number of views but limited direct engagement with the arguments I have advanced. Persistence pays off however because the last post did get some specific and very useful feedback on the points I had raised to argue that the difference in capital requirements between IRB and Standardised Banks was not as big as it was claimed to be.

My posts were a response to the discussion of this topic I observed in the financial press which just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. I identified 5 problems with the simplistic comparison cited in the popular press and by some regulators:

  • Problem 1 – Capital adequacy ratios differ
  • Problem 2 – You have to include capital deductions
  • Problem 3 – The standardised risk weights for residential mortgages seems set to change
  • Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
  • Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book

With the benefit of hindsight and the feedback I have received, I would concede that I have probably paid insufficient attention to the disparity between risk weights (RW) at the higher quality end of the mortgage risk spectrum. IRB banks can be seen to writing a substantial share of their loan book at very low RWs (circa 6%) whereas the best case scenario for standardised banks is a 20% RW. The IRB banks are constrained by the requirement that their average RW should be at least 25% and I thought that this RW Floor was sufficient to just focus on the comparison of average RW. I also thought that the revisions to the standardised approach that introduced the 20% RW might make more of a difference. Now I am not so sure. I need to do a bit more work to resolve the question so for the moment I just want to go on record with this being an issue that needs more thought than I have given it to date.

Regarding the other 4 issues that I identified in my first post, I stand by them for the most part. That does not mean I am right of course but I will briefly recap on my arguments, some of the push back that I have received and areas where we may have to just agree to disagree.

Target capital adequacy ratios differ materially. The big IRB banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong Benchmark and will typically have a bit of a buffer over that threshold. Smaller banks like Bendigo and Suncorp appear to operate with much lower CET1 targets (8.5 to 9.0%). This does not completely offset the nominal RW difference (25 versus 39%) but it is material (circa 20% difference) in my opinion so it seem fair to me that the discussion include this fact. I have to say that not all of my correspondents accepted this argument so it seems that we will have to agree to disagree.

You have to include capital deductions. In particular, the IRB banks are required to hold CET1 capital for the shortfall between their loan loss provision and a regulatory capital value called “Regulatory Expected Loss”. There did not appear to be a great awareness of this requirement and a tendency to dismiss it but my understanding is that it can increase the effective capital requirement by 10-12% which corresponds to an effective IRB RW closer to 28% than 25%.

The risk of a mortgage depends on the overall portfolio not the individual loan. My point here has been that small banks will typically be less diversified than big banks and so that justifies a difference in the capital requirements. I have come to recognise that the difference in portfolio risk may be accentuated to the extent that capital requirements applied to standardised banks impede their ability to capture a fair share of the higher quality end of the residential mortgage book. So I think my core point stands but there is more work to do here to fully understand this aspect of the residential mortgage capital requirements. In particular, I would love get more insight into how APRA thought about this issue when it was calibrating the IRB and standardised capital requirements. If they have spelled out their position somewhere, I have not been able to locate it.

You have to include the capital required for Interest Rate Risk in the Banking Book (IRRBB). I did not attempt to quantify how significant this was but simply argued that it was a requirement that IRB banks faced that standardised banks did not and hence it did reduce the benefit of lower RW. The push back I received was that the IRRBB capital requirement was solely a function of IRB banks “punting” their capital and hence completely unrelated to their residential mortgage loans. I doubt that I will resolve this question here and I do concede that the way in which banks choose to invest their capital has an impact on the size of the IRRBB capital requirement. That said, a bank has to hold capital to underwrite the risk in its residential mortgage book and, all other thinks being equal, an IRB bank has to hold more capital for the IRRBB requirement flowing from the capital that it invests on behalf of the residential mortgage book. So it still seems intuitively reasonable to me to make the connection. Other people clearly disagree so we may have to agree to disagree on this aspect.

Summing up, I had never intended to say that there was no difference in capital requirements. My point was simply that the difference is not as big as is claimed and I was yet to see any analysis that considered all of the issues relevant to properly understand what the net difference in capital requirements is. The issue of how to achieve a more level playing field between IRB and Standardised Banks is of course about much more than differences in capital requirements but it is an important question and one that should be based on a firmer set of facts that a simplistic comparison of the 39% standardised versus 25% IRB RW that is regularly thrown around in the discussion of this question.

I hope I have given a fair representation here of the counter arguments people have raised against my original thesis but apologies in advance if I have not. My understanding of the issues has definitely been improved by the challenges posted on the blog so thanks to everyone who took the time to engage.

Tony

Mortgage risk weight fact check

I have posted a couple of times on the merits of the argument that differences in mortgage risk weights are a substantial impediment to the ability of small banks employing the standardised approach to compete against larger banks who are authorised to use the Internal Ratings Based approach.

There was some substance to the argument under Basel II but the cumulative impact of a range of changes to the IRB requirements applying to residential mortgages has substantially narrowed the difference in formal capital requirements.

APRA has commented on this issue previously but that did not seem to have much impact on the extent to which the assertion gets repeated. For anyone still reluctant to let the facts stand in the way of a good story, Wayne Byres has restated APRA’s view on the issue in a speech to the Customer Owned Banking Association’s 2019 conference.

That brings me to the final point I want to make, about mortgage risk weights. Much is made of the headline difference in risk weights between the IRB and standardised approaches. At first glance, they do indeed look different. But as we pointed out in our most recent discussion paper, the comparison is much more complex than a superficial comparison implies: there are differences in capital targets, the treatment of loan commitments, the application of capital for interest rate risk in the balance sheet, and adjustments to expected losses – all of which have the effect of adding to IRB bank capital requirements and mean that the headline gap is greatly narrowed in practice.

When looked at holistically, we think any gap is small. Perhaps most tellingly, we now hear from candidates for IRB status that they are concerned the proposals being developed will not provide them with any capital benefit whatsoever. Whether that is the case or not, we are very conscious of this issue in designing the new proposals, and we have explicitly stated that we intend that any differences will remain negligible.

APRA Chair Wayne Byres – Speech to COBA 2019, the Customer Owned Banking Convention – 11 November 2019

Hopefully that settles the question. There is no question that all banks should be able to compete, as far as possible, on a level playing field but complaints about vast differences in the capital requirements applying to residential mortgages are a distraction not a solution.

Let me know what I am missing …

Tony

“The rate of return on everything”

This is the focus of a paper titled “The Rate of Return on Everything, 1870-2015 that seeks to address some fundamental questions that underpin, not only economic theory, but also investment strategy.

To quote the abstract:

This paper answers fundamental questions that have preoccupied modern economic thought since the 18th century. What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including—for the first time—total returns to the largest, but oft ignored, component of household wealth, housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from1870 to 2015, and our new evidence reveals many new insights and puzzles.ets.

“The Rate of Return on Everything” Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M. Taylor – December 2017

The paper is roughly 50 pages long (excluding appendices) but the 5 page introduction summarises the four main findings which I have further summarised below:

  1. Risky Returns: The study finds that “… residential real estate and equities have shown very similar and high real total gains, on average about 7% per year. Housing outperformed equity before WW2. Since WW2, equities have outperformed housing on average, but only at the cost of much higher volatility and higher synchronicity with the business cycle”.
  2. Safe Returns: The study finds that “Safe returns have been low on average, falling in the 1%–3% range for most countries and peacetime periods“. However, “the real safe asset return has been very volatile over the long-run, more so than one might expect, and oftentimes even more volatile than real risky returns.” This offers a long-run perspective on the current low level of the safe returns with the authors observing that “… it may be fair to characterize the real safe rate as normally fluctuating around the levels that we see today, so that today’s level is not so unusual. Which begs the question “… why was the safe rate so high in the mid-1980s rather than why has it declined ever since.”
  3. The Risk Premium: The study finds that the risk premium has been very volatile over the long run. The risk premium has tended to revert to about 4%-5% but there have been periods in which it has been higher. The study finds that the increases in the risk premium “… were mostly a phenomenon of collapsing safe rates rather than dramatic spikes in risky rates. In fact, the risky rate has often been smoother and more stable than safe rates, averaging about 6%–8% across all eras” . This for me was one of the more interesting pieces of data to emerge from the study and has implications for the question of what should be happening to target return on equity in a low interest rate environment such as we are currently experiencing. In the Authors’ words “Whether due to shifts in risk aversion or other phenomena, the fact that safe rates seem to absorb almost all of these adjustments seems like a puzzle in need of further exploration and explanation
  4. On Returns Minus Growth: This is the question that Thomas Piketty explored in his book “Capital in the Twenty-First Century”. Piketty argued that, if the return to capital exceeded the rate of economic growth, rentiers would accumulate wealth at a faster rate and thus worsen wealth inequality. The study finds that, “for more countries and more years, the rate of return on risk assets does in fact materially exceed the rate of growth in GDP… In fact, the only exceptions to that rule happen in very special periods: the years in or right around wartime. In peacetime, r has always been much greater than g. In the pre-WW2 period, this gap was on average 5% per annum (excluding WW1). As of today, this gap is still quite large, in the range of 3%–4%, and it narrowed to 2% during the 1970s oil crises before widening in the years leading up to the Global Financial Crisis.

So why does this matter?

There is a lot to think about in this paper depending on your particular areas of interest.

The finding that the long run return on residential housing is on par with equity but lower volatility is intriguing though I must confess that I want to have a closer look at the data and methodology before I take the conclusion as a fact. In particular, I think it is worth paying close attention to the way that the study deals with taxation. Fortunately, the paper offers a great deal of detail on the way that residential property is taxed (Appendix M in the December 2017 version of the paper) in different countries which is useful in its own right. I have been looking for a source that collates this information for some time and this is the best I have seen so far.

For me at least, the data on how the Equity Risk Premium (ERP) expands and contracts to offset changes in the return unsafe assets was especially interesting. This observation about the relationship is not new of itself but it was useful to find more data in support of it. I have been thinking a lot about Cost of Equity in a low interest rate environment and this seems to support the thesis that the target Return on Equity (ROE) should not necessarily be based on simply adding a fixed measure of the ERP (say 4%-5%) to whatever the current long run risk free rate is. It is at least worth having the question in mind when considering the question of whether Australian bank ROE is excessive at this point of the cycle.

If you are interested in the issues covered above then it is also worth having a look at an RBA Research Discussion Paper titled “A History of Australian Equities” by Thomas Matthews that was published this month.

From The Outside

Mortgage risk weights fact check revisited – again

The somewhat arcane topic of mortgage risk weights is back in the news. It gets popular attention to the extent they impact the ability of small banks subject to standardised risk weights to compete with bigger banks which are endorsed to use the more risk sensitive version based on the Internal Ratings Based (IRB) approach. APRA released a Discussion Paper (DP) in February 2018 titled “Revisions to the capital framework for authorised deposit-taking institutions”. There are reports that APRA is close to finalising these revisions and that this will address the competitive disadvantage that small banks suffer under the current regulation.

This sounds like a pretty simple good news story – a victory for borrowers and the smaller banks – and my response to the discussion paper when it was released was that there was a lot to like in what APRA proposed to do. I suspect however that it is a bit more complicated than the story you read in the press.

The difference in capital requirements is overstated

Let’s start with the claimed extent of the competitive disadvantage under current rules. The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” described the challenge with APRA’s current regulatory capital requirements as follows:

“For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).”

You could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair.

Just comparing risk weights is less than half the story

I am very much in favour of a level playing field and, as stated above, I am mostly in favour of the changes to mortgage risk weights APRA outlined in its discussion paper but I also like fact based debates.

While the risk weights for big banks are certainly lower on average than those required of small banks, the difference in capital requirements is not as large as the comparison of risk weights suggests. To understand why the simple comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements.

The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

  1. The risk weights applied to its assets
  2. The target capital ratio applied to those risk weighted assets
  3. Any capital deductions required when calculating the capital ratio

I have looked at this question a couple of times (most recently here) and identified a number of problems with the story that the higher risk weights applied to residential mortgages originated by small bank places them at a severe competitive disadvantage:

Target capital ratios – The target capital adequacy ratios applied to their higher standardised risk weighted assets are in some cases lower than the IRB banks and higher in others (i.e. risk weights alone do not determine how much capital a bank is required to hold).

Portfolio risk – The risk of a mortgage depends on the portfolio not the individual loan. The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. All other things being equal, small banks will typically be less diversified and hence riskier than a big bank.

Capital deductions – You also have to include capital deductions and the big banks are required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (i.e. an effective RW closer to 28% for the IRB banks).

IRRBB capital requirement – IRB banks must hold capital for Interest Rate Risk in the Banking Book (IRRBB) while the small standardised banks do not face an explicit requirement for this risk. I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

How much does reducing the risk weight differential impact competition in the residential mortgage market?

None of the above is meant to suggest that the small banks operating under the standardised approach don’t have a case for getting a lower risk weight for their higher quality lower risk loans. If the news reports are right then it seems that this is being addressed and that the gap will be narrower. However, it is important to remember that:

  • The capital requirement that the IRB banks are required to maintain is materially higher than a simplistic application of the 25% average risk weight (i.e. the IRB bank advantage is not as large as it is claimed to be).
  • The standardised risk weight does not seem to be the binding constraint so reducing it may not help the small banks much if the market looks through the change in regulatory risk measurement and concludes that nothing has changed in substance.

One way to change the portfolio quality status quo is for small banks to increase their share of low LVR loans with a 20% RW. Residential mortgages do not, for the most part, get originated at LVR of sub 50% but there is an opportunity for small banks to try to refinance seasoned loans where the dynamic LVR has declined. This brings us to the argument that IRB banks are taking the “cream” of the high quality low risk lending opportunities.

The “cream skimming” argument

A report commissioned by COBA argued that:

“While average risk weights for the major banks initially rose following the imposition of average risk weight on IRB banks by APRA, two of the major banks have since dramatically reduced their risk weights on residential mortgages with the lowest risk of default. The average risk weights on such loans is now currently on average less than 6 per cent across the major banks.”

“Despite the imposition of an average risk weight on residential home loans, it appears some of the major banks have decided to engage in cream skimming by targeting home loans with the lowest risk of default. Cream skimming occurs when the competitive pressure focuses on the high-demand customers (the cream) and not on low- demand ones (the skimmed milk) (Laffont & Tirole, 1990, p. 1042). Cream skimming has adverse consequences as it skews the level of risk in house lending away from the major banks and towards other ADIs who have to deal with an adversely selected and far riskier group of home loan applicants.”

“Reconciling Prudential Regulation with Competition” prepared by Pegasus Economics May 2019 (page 43)

It is entirely possible that I am missing something here but, from a pure capital requirement perspective, it is not clear that IRB banks have a material advantage in writing these low risk loans relative to the small bank competition. The overall IRB portfolio must still meet the 25% risk weight floor so any loans with 6% risk weights must be offset by risk weights (and hence riskier loans) that are materially higher than the 25% average requirement. I suspect that the focus on higher quality low risk borrowers by the IRB banks was more a response to the constraints on capacity to lend than something that was driven by the low risk weights themselves.

Under the proposed revised requirements, small banks in fact will probably have the advantage in writing sub 50% LVR loans given that they can do this at a 20% risk weight without the 25% floor on their average risk weights and without the additional capital requirements the IRB banks face.

I recognise there are not many loans originated at this LVR band but there is an opportunity in refinancing seasoned loans where the combined impact of principal reduction and increased property value reduces the LVR. In practice the capacity of small banks to do this profitably will be constrained by their relative expense and funding cost disadvantage. That looks to me to be a bigger issue impacting the ability of small banks to compete but that lies outside the domain of regulatory capital requirements.

Maybe this potential arbitrage does not matter in practice but APRA could quite reasonably impose a similar minimum average RW on Standardised Banks if the level playing field argument works both ways. This should be at least 25% but arguably higher once you factor in the fact that the small banks do not face the other capital requirements that IRB banks do. Even if APRA did not do this, I would expect the market to start looking more closely at the target CET1 for any small bank that accumulated a material share of these lower risk weight loans.

Implications

Nothing in this post is meant to suggest that increasing the risk sensitivity of the standardised risk weights is a bad idea. It seems doubtful however that this change alone will see small banks aggressively under cutting large bank competition. It is possible that small bank shareholders may benefit from improved returns on equity but even that depends on the extent to which the wholesale markets do not simply look through the change and require smaller banks to maintain the status quo capital commitment to residential mortgage lending.

What am I missing …

Mortgage risk weights – fact check

It is frequently asserted that the major Australian banks have been “gifted” a substantially lower mortgage risk weight than the smaller banks. To be precise, the assertion is that the major banks are only required to hold capital based on a 25% risk weight versus 39% for smaller banks.

If you are not familiar with the arcane detail of bank capital adequacy, then you could be forgiven for concluding that this differential (small banks apparently required to hold 56% more capital for the same risk) is outrageous and unfair. While the risk weights for big banks are certainly lower on average than those required of small banks, I believe the difference in capital requirements is not as large as the simple comparison of risk weights suggests.

Bank capital requirements involve more than risk weights

To understand why this comparison of risk weights is misleading, it will be helpful to start with a quick primer on bank capital requirements. The topic can be hugely complex but, reduced to its essence, there are three elements that drive the amount of capital a bank holds:

  1. The risk weights applied to its assets
  2. The target capital ratio applied to those risk weighted assets
  3. Any capital deductions required when calculating the capital ratio

Problem 1 – Capital adequacy ratios differ

The comparison of capital requirements based on risk weights implicitly assumes that the regulator applies the same capital ratio requirement to all banks, but this is not the case. Big banks are targeting CET1 ratios based on the 10.5% Unquestionably Strong benchmark set by APRA while there is a greater range of practice amongst the smaller banks. Bendigo and Suncorp appear to be targeting a CET1 ratio in the range of 8.5 to 9.0% while the smaller of the small banks appear to be targeting CET1 ratios materially higher (say 15% or more).

If we confine the comparison to the alleged disadvantage suffered by Bendigo and Suncorp, then the higher risk weights they are required to apply to residential mortgages is substantially offset by the lower CET1 target ratios that they target (the 56% difference in capital required shrinks to something in the order of 30% if you adjust for the difference in target CET1 ratios).

Broadening the comparison to the smaller banks gets even more interesting. At face value the much higher CET1 ratios they appear to target suggest that they are doubly penalised in the required capital comparison but you have to ask why are they targeting such high CET1 ratios. One possible explanation is that the small less diversified mortgage exposures are in fact more risky than the more diversified exposures maintained by their larger competitors.

Problem 2 – You have to include capital deductions

This is quite technical I recognise but, in addition to the capital tied to the risk weight, the big banks are also required to hold capital for a capital deduction linked to the difference between their loan loss provisions and a regulatory capital value called “Regulatory Expected Loss”. This capital deduction increases the effective risk weight. The exact amount varies from bank to bank but I believe it increases the effective capital requirement by 10-12% (I.e. an effective RW closer to 28%). My understanding is that small banks are not required to make the same capital deduction.

Problem 3 – The Standardised risk weights for residential mortgages seem set to change

A complete discussion of the RW difference should also take account of the fact that APRA has proposed to introduce lower RW Categories for the smaller banks such their average RW may be lower than 39% in the future. I don’t know what the average RW for small banks would be under these new RW but that is a question you could put to the banks who use the 39% figure without acknowledging this fact.

Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan

The statement that a loan is the same risk irrespective of whether it is written by a big bank or small bank sounds intuitively logical but is not correct. The risk of a loan can only be understood when it is considered as part of the portfolio the bank holds. Small banks will typically be less diversified than a big bank.

Problem 5 – What about the capital required for Interest Rate Risk in the Banking Book (IRRBB)?

I don’t have sufficient data to assess how significant this is, but intuitively I would expect that the capital that the major banks are required to hold for IRRBB will further narrow the effective difference between the risk weights applied to residential mortgages.

Summing up

My aim in this post was not to defend the big banks but rather to try to contribute some of the knowledge I have acquired working in this area to what I think is an important but misunderstood question. In the interests of full disclosure, I have worked for one of the large Australian banks and may continue to do work for them in the future.

On a pure risk basis, it seems to me that the loan portfolio of a large bank will tend to be more diversified, and hence lower risk, than that of a smaller bank. It is not a “gift” for risk weights to reflect this.

There is a legitimate debate to be had regarding whether small banks should be given (gifted?) an advantage that helps them compete against the big banks. That debate however should start with a proper understanding of the facts about how much advantage the large banks really have and the extent to which their lower risk weights reflect lower risk.

If you disagree tell me what I am missing …