Reflections on the banking royal commission

Chief Economist's View

Revelations from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry have shown banks’ conduct to be worse than most had been expecting. As the Royal Commission grinds on, attention will shift towards the potential recommendations that Commissioner Hayne and his team will put forward to the government. Given the pernicious bank behaviour, community expectations will pressure the Commission to be stringent in their recommendations. In this week’s Brief, we review the potential outcomes from the Royal Commission’s enquiries into consumer lending, which constituted round one of the Commission (round 2 being a review of financial advice and round 3 being the banks’ practices with regard to small and medium businesses).

Over the course of the first round of enquiries, a pattern of lax lending standards applied by banks to mortgage applications emerged. The National Consumer Credit Protection Act of 2009 requires banks to make reasonable enquiries into and to verify a mortgage applicant’s financial status. The Royal Commission’s enquires showed that banks often paid only lip service to their obligation to diligently review a mortgage applicant’s financial health.

The outcome of this lax approach is that loans have been extended to applicants that are in vulnerable financial positions; particularly with respect to the sizes of their loans. We expect one of the Royal Commission’s recommendations will be to tightening bank lending standards. The stringency of any resulting recommendations will influence the extent to which banks will need to restrict loans, and hence, the extent to which housing credit growth will be curtailed.

A sharp slowdown in housing credit growth can impact the economy through a number of channels. Slower housing credit growth will slow demand in the housing market. A slower demand for housing will place further downward pressure on house prices and the demand for residential dwelling construction. A sharper decline in house prices will lower the household sectors net wealth, which typically leads to downward pressure on consumer spending. Reducing the demand for residential dwelling construction will reduce demand for employment in the industry and in the economy more generally.

In our basecase forecasts, we are anticipating a decline in housing credit growth from its current annual rate of 5-6% to an annual rate of 2-4%, consistent with a decline in Australia-wide house prices of around 5% (peak to trough). Given movements in house prices to date, we estimate that we are about ¼ of the way through the current correction in the Australian housing market. Depending on the recommendations of the Royal Commission, and the willingness of the government to enact the recommendations, a slide in housing credit growth to below zero could result in a significant deepening of the housing market correction. One type of recommendation that could spark such a slowdown in housing credit growth, would the imposition of loan-to-income ratio (LTI) caps, similar to those imposed in the UK and Ireland. Currently, the Bank of England limits loans with LTI’s of more than 4.5x to 15% of a bank’s total home loans, while in Ireland, the limit is 20% for loans with an LTI more than 3.5x. In Australia, home loans with LTI’s in excess of 4x are currently estimated to be around 35-40% of banks’ residential mortgage loan book.

What would be the impact of a further slowing in the housing credit growth? Results of simulations using QIC’s proprietary version of the NiGEM macroeconomic model show that a fall in credit growth from our baseline of 2/4% to -1/0% could cause a further fall in house prices of 10%; for a total fall in house prices of 15% peak to trough. The decline in house prices would hit stock prices of banks and AREITs, which would both fall by around 10%. The fall in bank equity value and profitability would lead banks to raise their lending rates by 50 basis points in an effort to defend rates of return on equity. With credit growth and house prices falling and mortgage rates rising, despite a likely cut in the cash rate by the Reserve Bank of Australia (RBA), dwelling investment would fall by 8%, on top of our current expectation of a fall 8%, making a total peak to trough decline in dwelling investment over the coming two years of 18%.

With reduced support from construction employment, the unemployment rate would remain sticky around 5.6%, rather than declining to 5.2% by the end of 2019, as in our basecase. Any pick up in wage growth would stall and consumer spending would drop to below an annual rate of 1.5% over the remainder of this year and 2019. The RBA would cut the cash rate by 25 basis points to 1.25%, with the possibility of a second rate cut in 2019, holding the lower rate until 2020. In response, the Australian dollar would fall to around US$0.67. The recovery in the Australian economy back to full employment would be set back into the next decade.

Table 1: Financial market movements, 17 - 24 May 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,727.8

0.3%

US

2.98%

-13.4 bps

US Dollar Index (DXY)

93.78

0.3%

Nikkei 225

22,437.0

-1.8%

Japan

0.05%

-1.4 bps

USD-JPY

109.26

-1.4%

FTSE 100

7,716.7

-0.9%

UK

1.40%

-16.2 bps

GBP-USD

1.338

-1.0%

DAX

12,855.1

-2.0%

Germany

0.47%

-16.8 bps

EUR-USD

1.172

-0.6%

S&P/ASX 200

6,037.1

-0.9%

Australia

2.81%

-11.7 bps

AUD-USD

0.758

0.9%

Source: Bloomberg

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