ECB paper looks at short-term costs of higher capital ratios

By Central Banking Newsdesk | Official Record | 24 May 2019

Monetary policy should cushion blow caused by moving to higher capital requirements – researchers

European Central Bank

A new paper from the European Central Bank explores the costs and benefits of raising capital requirements.

In Bank capital in the short and in the long run, Caterina Mendicino et al use a macro-banking model to investigate the correct level for capital requirements.

High capital requirements can protect the banking system from collapse in the event of broad declines in asset prices, the authors note, but have potential costs. Raising capital requirements can impose “undue costs on the real economy during the transition to the higher level”.

Therefore, capital requirements must consider both the long-term costs and short-term benefits, the paper argues. The authors find that “25% of the long-run welfare gains are lost due to transitional costs”.

The paper argues that the correct level of capital requirements “crucially depends on the degree of fragility in the banking sector and on the conduct of monetary policy”, as well as the speed of implementation. If bank fragility is high, capital requirement increases are most beneficial, and a slower increase in capital requirements will cause less short-term loss.

The authors also argue monetary policy must become more accommodative during a transition to higher capital requirements, to cushion the blow to output and inflation.

BoE may impose capital floors on UK firms – PRA chief

By Daniel Hinge | News | 24 May 2019

Sam Woods says some leveraged loans are based on “heroic” risk assumptions

PRA chief Sam Woods

The Bank of England may need to intervene in firms’ modelling choices, as large UK mortgage lenders increase risk and cut their internally determined capital requirements, Sam Woods said today (May 24).

The Prudential Regulation Authority chief executive said firms had responded to a “price war” in the mortgage market by moving up the “risk curve” to compensate for squeezed interest margins.

At the same time, large firms using internal models have significantly trimmed the risk weights on mortgages, lowering their capital requirements. Because of this behaviour, internally modelled Pillar 1 capital requirements for mortgage lending have fallen a third since 2009, Woods said.

The PRA chief said BoE officials needed to approach this trend “with a very sceptical eye”. He added there was a need to “consider whether there is a case to impose more floors in firms’ models – particularly given the current stretch in some measures of house price valuation”.

The change in risk weights appears to have been driven by “real” factors, Woods acknowledged, namely the low modelled probability of default resulting from recent stability in markets, coupled with a fall in modelled loss given default due to rising house prices.

But he said it was important to mitigate such cyclical modelling of mortgage credit risk. The BoE’s stress tests contribute to this, by informing the setting of bank-specific Pillar 2 capital.

Woods said there were some advantages to relying on Pillar 2 to “take more of the strain”, since banks will be more willing to use these additional buffers in times of stress than breach the minimum Pillar 1 requirements. But it was important that policy-makers cross-checked their tests to make sure they were suitably robust, he said.

One way to do that was to compare the current average risk weight to other benchmarks, Woods said – in other words, what might risk weights be if calculated by other methods. “Such comparisons do not raise major worries, but nor do they suggest that risk weights should be any lower.”

In the longer term, the output floors contained within the revised Basel III standard should prevent banks from letting capital requirements slide too far, and the move away from “point-in-time” modelling approaches should also help, Woods said. Output floors are due to be introduced by January 2022.

“But despite this, we should be very cautious about any significant further moves down in Pillar 1 risk weights for UK mortgages,” he stressed.

Complex products

A related area that regulators are increasingly scrutinising is leveraged lending, or loans to highly indebted companies. Similarly to mortgages, firms have used such loans to add risk. The risk metrics behind the loans often contain “heroic assumptions”, Woods warned.

Margin loans are another area creating problems. These are secured against the equity holdings of the borrower, and can create problems in times of stress as the value of the collateral falls in line with the creditworthiness of the borrower, Woods said. The BoE’s analysis shows the risk from margin lending “is not well captured” in the capital framework.

“In this sense, just as the leveraged lending issue is akin to the UK mortgage risking-up issue, these margin loans have an echo of the problems we’ve been tackling on capitalisation of equity-release mortgages – complexity creates a weakness in the system,” Woods said.

The PRA chief said these examples highlighted the need to be “absolutely vigilant” to avoid letting the progress made in the past 10 years “slip through our hands”.

Sarb announces ‘CBDC feasibility project’

By Central Banking Newsdesk | News | 24 May 2019

Central bank pursues partners to test digital currency

The South African Reserve Bank has invited bids from private companies to develop the infrastructure necessary for a central bank digital currency, or CBDC.

The Sarb published the tender notice on May 14. It said the CBDC should be electronic legal tender, effectively performing the same function as cash. The notice specifies that the trial digital currency must only be issued by the Sarb, should have a one-to-one parity with the rand, and should be accepted by all sizes of business and the government.

The Sarb said that its CBDC feasibility project will be divided into two stages. The first will involve internal testing within the central bank’s ‘innovation lab’. In this phase, the central bank will “assess technical feasibility, identify opportunity for further innovation, and determine the potential impact on policy and legal constructs”, it said.

In the second stage, the Sarb will create a ‘sandbox’ with selected banks and mobile network providers, and potentially some payment service providers and niche technology providers.

The Sarb specified that the CBDC should not introduce any risk of destabilising the financial sector.

The tender notice specifies that customers must be able to own and use the CBDC without a bank account, and have a way to exchange the CBDC into cash and commercial bank money. The trial currency must be immediately transferable from person to person without the traditional need for clearing and settlement. It should also be both traceable and auditable.

The Sarb has previously shown an interest in digital currencies. In 2016, the central bank’s currency management department mandated a team to investigate the case for a CBDC. The team has continued to work on developing an understanding of digital currencies, and recommended that the central bank start this project.

In January, the Sarb released a new consultation paper focusing on crypto assets within South Africa.

South African MPC narrowly votes to hold rates

By Central Banking Newsdesk | News | 24 May 2019

Sarb cuts projected growth rates and expects looser monetary policy

The South African Reserve Bank’s monetary policy committee voted by a narrow majority on May 23 to keep its policy rate at 6.75%.

The five-member committee voted three to two for the decision. Slower inflation and growth data did not warrant a change in stance, the MPC said in a statement.

“The committee assesses the stance of monetary policy to be broadly accommodative over the forecast period,” the Sarb said in the statement. “Current challenges facing the economy are primarily structural in nature and cannot be resolved by monetary policy alone.”

It said there is an “urgent” need to have a combination of prudent macroeconomic policies and structural reforms to boost potential growth.

The central bank has revised its projected rate path to predict a more accommodative monetary policy. The Sarb now estimates one rate cut of 25 basis points by the end of the first quarter in 2020. This is compared to one 25bp hike projected for 2019 in the March meeting.

The Sarb also revised its GDP growth forecast for 2019 to 1%, down from its 1.3% projection in March. Weak business confidence, electricity supply constraints and high debt levels in certain state-owned enterprises were likely to bring investment down, the central bank said.

Despite cutting its growth projections, the Sarb said it welcomed the recent downward trend in inflation and inflation expectations. Year-on-year inflation came in at 4.4%, down from 4.5% in March. The figure sits roughly in the middle the central bank’s target range of 3–6%.

Pressure for performance

The May 23 policy meeting was the first since president Cyril Ramaphosa’s African National Congress party won a reduced majority this month. The ANC won 57.5% of the popular vote. This was nonetheless its lowest level of electoral support since the country’s black majority won the right to vote in 1994.

President Ramaphosa succeeded Jacob Zuma, who was forced to step down after accusations of wide-ranging corruption. Observers of South Africa say the government is under severe pressure to revive the economy after years of sluggish growth and high unemployment, particularly among black citizens.

Year-on-year GDP has been trending towards from 3.6% in the first quarter in 2011 to 1.1% in the fourth quarter of 2018, according to the national statistics service Statistics South Africa.

In the same time period, unemployment has increased from 25% to 27.6%, peaking at 27.7% for most of 2017. The number of employed persons decreased by 237,000 to 16.3 million in the first quarter this year.

Central banks turn to factor investing for reserve management

By Victor Mendez-Barreira | News | 24 May 2019

Lack of capabilities may hamper effective use of factor analysis, officials say

Central banks are starting to use “factor investing” techniques to manage reserves, but need to improve their in-house capabilities to do so effectively, according to officials at Central Banking’s National Asset-Liability Management conference in Mexico City on May 23.

Factor investing measures quantifiable factors accounting for differences in portfolio returns, unlike more traditional asset management techniques, which target assets instead.

“We are studying factor [analysis] as a performance attribution tool,” said an official from the foreign reserves department of a major South American central bank. “It  allows us to understand how much return comes from each specific factor: for instance, inflation, interest rates, growth. ”

The official says successful factor analysis “would deliver a better perspective, because at the moment we can only guess. We cannot tell for sure what the main drivers of our returns are”.

This trend is gaining momentum globally. “Factor-based investing is an area that we are watching closely,” said Ravi Menon, managing director of the Monetary Authority of Singapore, at Nalm Europe in London in March. “Institutional investors are starting to look beyond asset classes to view returns via a ‘factor lens’.”

“Looking through asset class labels to underlying risk factor exposures can enhance understanding of return sources,” said Menon. “Flipping them around, they also help to enhance understanding of risk drivers.”

Factor investing is mainly applied to macroeconomic factors and “style factors”. The first is used to assess risk across asset classes, and include economic growth, credit, or inflation.  

‘Style factors’ attempt to explain returns and risks within asset classes, and include variables such as momentum and value. Momentum concerns building strategies around existing market trends. For instance, it may involve adopting long positions in equities, futures or exchange-traded funds, recording rising prices and shorting assets in a downward trend.

Value trading, a form of analysis most famously used by US investor Warren Buffett, aims to assess assets’ fundamental value.

However, making investments based on these techniques requires robust analytical capabilities. “Our system is not ready from the econometrics and analysis stand point,” said the official from the major South American institution. “You need a dedicated group of people, with the skills needed to go through the data.”

A reserve manager from a North American central bank agrees that “studying how changing yields, rates, or inflation affect your portfolio is a labour-intensive activity”. It also requires the central bank to “adjust its models to account for the factor you are tracking”, the official notes.

Costa Rica cuts rates further following March reversal

By Central Banking Newsdesk | Official Record | 24 May 2019

Central bank concerned about downside inflation risks and slow economic activity

Central Bank of Costa Rica

The Costa Rican central bank continued an about turn on its monetary policy stance by lowering the policy rate further on May 22.

The bank reduced the rate by 25 basis points to 4.75%. The adjustment was made due to deflationary risks resulting from current low economic growth and high unemployment, it said in a statement.

The move to lower rates followed the central bank reversing its monetary policy stance in March – its first rate cut since January 2016. The most recent rate hike was in November last year.

In November, the bank said uncertainty over future public finances and exchange rate movements was creating upward pressure on inflation. It now appears to be more concerned about downside risks to inflation, despite a recent slight increase.

In April, headline inflation was 2.1%, which is up from an average of 1.5% for the first quarter of this year. Core inflation, however, was a little closer to the middle of the target range of 2–4%, at 2.4%. This was a rise of 0.2 percentage points from the first quarter average.

Unemployment reached 11.3% in the first quarter of this year, down from 12% in the fourth quarter of 2018. Year-on-year growth was 2.3%, down from 3.1% one year ago.

Bank of Jamaica expands global audience with latest reggae hit

By Daniel Hinge | News | 24 May 2019

Comms director says global success is pleasing but reaching local people is the ultimate goal

Tarrus Riley

The Bank of Jamaica (BoJ) has released another reggae video extolling the virtues of low and stable inflation, garnering a sizeable global audience in the process.

The video, which features Jamaican-American reggae singer Tarrus Riley, had already received 166,000 views this morning (May 24), a week since it was first published on Twitter.

“High inflation is a wicked thing, and we must abolish it like slavery,” sings Riley in the video. “We want inflation low so we can plan and prosper. But if it drop too low, we can’t grow.”

Echoing the central bank’s last reggae video, Riley says “low, stable and predictable inflation is to the economy like what the bassline is to reggae music”.

Tony Morrison, the Bank of Jamaica’s director of public relations, says the central bank is focused on speaking to the local population, but he adds the “huge international response” to the videos is a bonus. “It’s also pleasing that the campaign has had the positive side effect of bringing a lot of positive attention to the country,” he tells Central Banking.

The videos are some of the most watched of any central bank output. Norges Bank’s comedy music video about the cod on its banknotes has just over 283,000 views, while one of the Bank of Jamaica’s earlier videos is not far behind, on 241,000.

The Bank of Jamaica has caught the attention of communications teams at central banks worldwide, and won praise from the International Monetary Fund for its efforts. A recent IMF paper on how central banks could improve their communications cites the BoJ’s music videos approvingly.

Morrison says the central bank is cautious in judging the success of its programme, as reaching a global audience, many of whom are economic specialists, is not the same as speaking to the Jamaican public. But the early signs are positive.

“We are still in the early stages of our planned programme with a lot more work to do, but so far so good,” he says. “People are noticing and people are talking about it, and that’s the major intention at this point.”

Though he will not yet disclose any future plans for videos, Morrison emphasises a much broader communications effort is under way. There is a print campaign in newspapers, including in a publication pitched at primary-age children, as well as adverts on digital billboards, jingles and segments on local radio, and TV adverts.

“There are several more initiatives to come, including radio and TV shows, economics seminars on inflation, and several other ways of outreach, both traditional and otherwise, so fasten your seatbelt,” says Morrison.

Central banks must break with short-term political cycles – Díaz de León

By Victor Mendez-Barreira | News | 23 May 2019

Mexican governor stresses independence and long-term objectives can help tackle populism

Alejandro Díaz de León

Central banks should decouple from short-term political cycles and harness their independence to resist the rise of populist leaders, said Alejandro Díaz de León, governor of the Bank of Mexico.

In a speech today (May 23) at the Central Banking National Asset Liability-Management conference in Mexico City, Díaz de León analysed the role central banks in emerging countries can play to promote growth and stability.

“Idiosyncratic risks are becoming increasingly important in political as well as economic outlooks,” said the Mexican governor. “This is because societies are growing impatient, as widespread access to information increases expectations of social mobility, but governments fall behind the curve in developing the instruments to offer better opportunities.”  

Against this backdrop, short-term political narratives offering simple solutions are on the rise, added Díaz de León. However, “central bank independence and long-term horizons should be used to decouple from short-term political cycles, helping to develop the policies that deliver sustainable growth and stability.”

Global integration

The governor stressed how emerging markets became more integrated in global financial markets after the financial crisis. The process offers enhanced financial flows, but also increases their exposure to global risks.

As central banks in advanced economies implemented unconventional monetary policies such as negative rates and bond-purchase programmes, returns declined at home, boosting investors’ demand for the higher-yielding assets that emerging markets could offer.

“Total capital flows to emerging markets since 2008 up until May 2019 amount to $300 billion. And this is evenly distributed between fixed income and equity markets,” said Díaz de León.

This has contributed to a reduction in sovereign-debt spreads in Mexico, Colombia, Peru, Chile and Brazil, the governor said. But it has opened the door to greater volatility.

For instance, these flows have varied widely. While capital inflows reached very high levels from 2009–2010, volatile commodity prices and incipient US policy normalisation sharply reduced them in 2015. Additionally, this process has contributed to a sharp increase in non-resident holders of government bonds.

This increased integration has been accompanied by higher correlations between assets. Currencies, equities and sovereign bonds now move in more dramatic fashion when stress hits markets, Díaz de León said.

Latin America, and especially Mexico, are affected by the trade disputes started by the US president Donald Trump. This has negatively impacted investment and GDP growth forecasts. “Mexico was hit earlier by this process,” said the governor. “Trade tensions are challenging for open economies and, as trade conditions become blurry, it is challenging to deploy investment. This is particularly the case in manufacturing.”

Lower and more uncertain GDP growth forecasts have decreased inflation expectations in advanced economies, which in turn has triggered the adoption of more accommodative monetary policies.

“This looser policy in the US financial market has allowed emerging countries to record a favourable performance,” he said. “However, trade tensions have already caused some investors to fly to higher quality and safety assets.”

Challenges for the Mexican economy

As a result, Mexico has recorded lower external financial flows. This calls for a structural change in the external account and tighter fiscal and monetary policies, the governor said.

Another factor complicating the outlook is lower oil export revenues. For the first time, Mexico is recording lower oil production, in the context of weak international prices. This is due to the decay of major oil fields that the national oil company, Pemex, has failed to replace.

“Therefore the non-oil trade balance needed to offset that supported by a real exchange rate depreciation, which has required a tighter monetary policy to tackle inflation.”

This current account adjustment and the ongoing renewal of the North American Free Trade Agreement (Nafta), including Mexico, the US and Canada, impose tight financial conditions as growth remains subdued.

In order to improve the resilience of the Mexican economy, Díaz de León thinks it necessary to maintain solid economic fundamentals. A robust fiscal and monetary framework, a healthy financial system and a floating foreign exchange regime all contribute, he said.

The governor highlighted the importance of being an open economy, in spite of the challenges it now entails. “Benefits still outweigh risks when it comes to having an open financial market,” said the governor.

However, stronger economic growth will be needed. In order to attain that goal Mexico must be able to better deploy and attract investment, as well as increase productivity fostering competition.

Finally, an essential and still missing factor is developing a strong rule of law, Díaz de León said. Mexico must reduce insecurity, corruption and impunity if it is to reach a future marked by economic growth, price stability and a sound financial system.

Curaçao central bank deputy director arrested for forgery

By Elliot Gulliver-Needham | Official Record | 23 May 2019

Arrest is part of investigation into alleged money laundering

A deputy director of the Central Bank of Curaçao and Sint Maarten has been arrested on suspicion of making false statements on legal documents, local prosecutors announced.

The Curaçao Public Prosecution Service said that on May 13 its anti-corruption team had arrested René Lourents, the deputy director of corporate relations and facilities management. The central bank has 10 deputy directors, each covering different roles within the bank.

Curaçao is a former Dutch colony, and has a quasi-independent status. The Caribbean island state elects its own government and has its own currency – the Netherlands Antillean guilder – but accepts the Dutch monarch as head of state.

The prosecution service said on its Facebook page that the arrest is part of an investigation into alleged money laundering. The prosecutors claimed the alleged money laundering had taken place through a clothing company. In their statement, the prosecutors said Lourents will face trial soon.

Central Banking was unable to reach Lourents or any legal representative for comment. When contacted by Central Banking, the Central Bank of Curaçao and Sint Maarten said it would not comment on the matter. The central bank also said it was unable to provide contact details for Lourents or his lawyers or to issue a statement on his behalf.

Trump administration to delay $20 Tubman banknote

By Central Banking Newsdesk | News | 23 May 2019

Banknote featuring abolitionist Harriet Tubman pushed beyond Trump’s maximum term

Harriet Tubman, circa 1868

Treasury secretary Steven Mnuchin said the introduction of the planned $20 banknote featuring former slave and abolitionist Harriet Tubman will be delayed.

He said the banknote is now likely to come into circulation in 2028, and not the expected 2020. Speaking at a hearing of the House Financial Services Committee, Mnuchin said the “primary reason” for the delay was “counterfeiting issues”. He said he has received a classified briefing on what adjustments are needed.

Harriet Tubman was an American abolitionist during the civil war era. She helped free a number of enslaved people and supported the armed slave revolt in Harpers Ferry. In her later years, she was a political activist fighting for women’s suffrage.

The choice of image, originally announced during the administration of Barack Obama, is particularly symbolic, as Tubman would take the place of slave-owning president Andrew Jackson on the note. Under current plans, Jackson will still appear on the reverse of the note.

When asked if he was in favour of the image of Tubman being on the note, Mnuchin chose to avoid the question. “I have made no decision as it relates to that,” he said.

The ultimate decision on the redesign will most likely fall to one of Mnuchin’s successors at the Treasury, as the imagery is not likely to be an issue until 2026, he said. Even if Trump wins a second term in the White House, a new administration will take over in 2024.

Currency redesign process

In 2015, former Treasury secretary Jack Lew solicited feedback from the American people for nominations to replace the image of Alexander Hamilton, the first US Treasury secretary, with a famous woman. But Lew’s plans faced backlash, as a popular musical playing at the time featured Hamilton.

In 2016, the Treasury announced a full currency redesign that would more accurately represent the diversity of the US society. This included the $10 and $50 notes as well as the $20. Later in the year, Lew declared Tubman would be featured on the $20 note.

He followed the announcement by directing the bureau of engraving and printing to accelerate plans for the redesign to be ready for 2020, the 100-year anniversary of women getting the right to vote.

In the run-up to the 2016 presidential election, however, Donald Trump, who was then the Republican nominee, said the move to put Tubman on the banknote was “pure political correctness”. He suggested putting her on the $2 note, which is circulated in very low numbers.

Mnuchin said the $10 and $50 banknotes will be coming out with new features before 2028.