Category: Essentials of Economics: Ch 11

Posted on

Mortgage rationing

Throughout the credit crunch and since then, one of the major problems in the global economy has been a lack of lending by banks. A key cause of the credit crunch and many of the debt problems countries and people face today is because of people living off borrowed money. In the past, credit was so easy to obtain – people could receive a mortgage for more than 100% of the value of their property. However, when more and more people began to struggle to make their monthly mortgage repayments, the banking crisis began and since then mortgage lenders have become increasingly wary about who they lend to and how much.

The Bank of England has said that in the coming months it will become even harder to obtain mortgages, as banks become increasingly wary about who becomes their customer and potential home buyers put off even applying for a mortgage. Although mortgage approvals are at a 2-year high, they still remain significantly below their pre-crisis level. Indeed, the Bank of England said:

“Lenders expected the proportion of total loan applications being approved to fall over the coming quarter with some lenders commenting that they had revised down expectations for households’ disposable incomes and hence the affordability of taking out new secured loans.”

As part of this new rationing of mortgages, lenders are requiring applicants to put down larger and larger deposits and so for first time buyers, getting on to the property ladder is becoming more and more of a dream. The property market has been suffering from this mortgage rationing as house sales are down below their pre-crisis level. The housing market is crucial to any economy, as so many other sectors and hence jobs depend on it. If mortgages remain scarce and the required deposit so high, the UK housing market is likely to remain stagnant and this will certainly prove damaging for the prospects of the UK economy in 2012.

Articles

Mortgage approvals hit new two-year high The Telegraph, Angela Monaghan (4/1/12)
Mortgage approvals up but overall lending weak Reuters (4/11/12)
Mortgage rationing becomes worse, Bank of England says BBC News (5/1/12)
Mortgage demand fell in Q4 2011, say lenders Mortgage Strategy, Tessa Norman (5/11/12)
Mortgage lending still stagnant, Bank figures show BBC News (4/11/12)
BoE: Lending to be tighter in Q1 2012 Mortgage Introducer, Yuan Phoon (5/11/12)

Data

Lending to Individuals Bank of England

Questions

  1. Why are mortgages being rationed?
  2. Why is the housing market so important for the UK economy?
  3. Which other sectors of the economy employ people whose jobs are dependent on a buoyant housing market?
  4. Why has the Bank of England said that in the coming months it will become harder to get a mortgage?
  5. Why would increased mortgage lending be a much needed stimulus for the UK economy?
  6. Using an aggregate demand and aggregate supply diagram, show how rationing of mortgages and other loans will affect the UK economy.
Posted on

Taking the gambling out of high street banking (update)

Original post (19/9/11)
The Independent Commission on Banking (ICB), led by Sir John Vickers, has just delivered its report. Central to its remit was to investigate ways of making retail banking safer and avoid another bailout by the government, as was necessary in 2007/8.

The report recommended the ‘ringfencing’ of retail banking from the more risky investment banking, often dubbed ‘casino banking’. In other words, if the investment arm of a universal bank made a loss, or even faced collapse, this would not affect the retail arm. The ringfenced operations would include banking services to households and small businesses. Wholesale and investment banking would be outside the ringfence. As far as retail banking services to big business are concerned, these could be inside the ringfence, but details would need to be worked out about precisely which banking services to big business would be inside and which would be outside the ringfence.

The ICB was keen to stress that the ringfence should be high and that the retail arm should be both operationally and legally separate from the wholesale/investment arm. The ringfenced part of the bank should have a capital adequacy ratio of up to 20% (above the Basel III recommendations), with at least 10% of liabilities in the form of equity. Capital could only be moved from the ringfenced arm to the investment arm of the bank if this did not breach the 10% ratio.

The ICB report also recommends measures to increase competition in banking, including making it easier to switch accounts, greater transparency about the terms of accounts and a referral of the banking industry for a competition investigation in 2015. The cost to the banking industry of the measures, if fully implemented, is estimated to be between £4m and £7m.

Because of the requirement in the report for banks to build up their capital and the danger that a too rapid process here would jeopardise the expansion of lending necessary to underpin the recovery, banks would be given until 2019 to complete the recommendations. Moves towards this, however, would need to start soon.

Update (19/12/11)
In December 2011, the government announced that it would accept most of the ICB report, including separating retail and investment banking. It would not, however, demand such stringent capital requirements as those recommended in the report.

The following articles examine the details of the proposals and their likely effectiveness. The later articles examine the government’s response.

Original articles (some with videos)

Audio podcasts

ICB report and press conference

Later articles and webcasts

Questions

  1. Explain the difference between a capital adequacy ratio and a liquidity ratio. Will the Vickers proposals help to increase the liquidity of the retail banking arm of universal banks?
  2. Does it matter if equity capital in excess of the 10% requirement for retail banking is transferred to a bank’s investment arm?
  3. What risks are there for a bank in retail banking?
  4. What are the advantages and disadvantages of bringing in the measures gradually over an 8-year period?
  5. Does it matter that the capital adequacy requirements are higher than under the internationally accepted standards in Basel III?
  6. Assume that there is another global financial crisis. Will the proposals in the report mean that the UK taxpayer will not have to provide a bailout?
Posted on

Will new ECB repo operations support the eurozone bond market?

The European Central Bank does not provide direct support to eurozone countries by buying new bonds. However, it can give indirect support by helping banks buy such bonds. In a move announced on 8 December, the ECB will increase the maximum term of its ‘longer-term refinancing operations’ (LTROs) from the current 13 months to three years. In other words, it will effectively provide three-year loans to banks by purchasing banks’ assets on a ‘repurchase (repo)’ basis, whereby banks agree to buy back the assets at the end of the three-year term.

The hope is that banks will use these loans (at an annual rate of 1%) to purchase new bonds from countries such as Italy and Spain. If banks are more willing to buy them, this should help reduce the interest rate at which governments are forced to borrow. Banks would benefit from the ‘carry trade’, whereby they borrow at a low interest rate (from the ECB) and lend at a higher rate to governments by buying their bonds.

To encourage banks to take advantage of these new longer-term repos,the ECB announced that the assets it was prepared to purchase would include securitised assets with a rating of single A (the highest rating is AAA). In other words, it would accept assets with a ‘second-best rating’.

But although the scheme would allow banks to make a clear gain from a carry trade, banks may be reluctant to use such loans to increase their holdings of sovereign debt of countries with large debt to GDP ratios, given concerns in the market about the riskiness of such assets.

Articles and podcast
ECB repo extension a fillip for sovereigns Financial News, Matt Turner (15/12/11)
Doubts over ECB move to boost bond sales Financial Times, Tracy Alloway (15/12/11)
ECB Chief Plays Down Hopes for Bigger Bond Purchases Wall Street Journal, Tom Fairless And Margit Feher (15/12/11)
Eurozone crisis ‘misdiagnosed’ BBC Today Programme, George Magnus (16/12/11) (second part of podcast)
Banks snap up €500bn in loans from European Central Bank Guardian. Larry Elliott (22/12/11)
Analysis: ECB cash to give indirect boost via banks Reuters, Natsuko Waki and Steve Slater (22/12/11)
Demand for ECB loans rises to €489bn Financial Times, Tracy Alloway and Ralph Atkins (21/12/11)
ECB’s rescue of eurozone banks is temporary BBC News, Robert Peston (21/12/11)

ECB Press release
ECB announces measures to support bank lending and money market activity ECB (8/12/11)

Questions

  1. Explain how repos work. What is the difference between repos and reverse repos?
  2. What is meant by the term ‘carry trade’?
  3. Why may banks be unwilling to gain from the carry trade possibilities of the ECB’s new 3-year LTROs by using them to fund the purchase of new sovereign bonds? What risks are entailed by their doing so?
  4. How do these new long-term repo operations differ from quantitative easing? Explain whether or not the effect is likely to be similar
  5. What are the arguments for and against the ECB engaging in a round of substantial quantitative easing?
Posted on

Is £7.7 trillion enough to make us spend?

In Gloomy prospects for UK consumer spending in 2012? we talked about how consumer spending can be affected by the financial position of households. Figures from United Kingdom National Accounts – Blue Book 2011 (see Tables 6.1.9 and 10.10) give the latest complete set of balance sheets for the UK household sector. The figures are for 2010 and in this blog we provide a brief overview of what these figures reveal.

In effect, there are two main balance sheets of interest for households (and non-profit institutions serving households (NPISHs), i.e. charities and voluntary organisations). The first details their net financial wealth and the second their physical wealth, also known as their non-financial wealth. We begin with net financial wealth. This is found by subtracting financial liabilities (debt) from financial assets. The household sector in 2010 had financial liabilities of £1.54 trillion equivalent to 1.6 times its disposable income for the year or 1.1 times the nation’s Gross Domestic Product. Of these liabilities, £1.2 trillion was mortgage debt, i.e. loans secured against property. On the other hand, the sector had financial assets of £4.3 trillion equivalent to 4.4 times its disposable income in 2010 or 3 times GDP. Of these financial assets, the value in pension funds and life assurance was £2.27 trillion.

The net financial wealth of households and NPISHs in 2010 was £2.8 trillion, 2.9 times the sector’s disposable income for the year or 1.9 times GDP. To this we need to add physical wealth of £4.9 trillion, a massive 5 times the sector’s disposable income or 3.3 times the nation’s GDP. The majority of this is residential buildings the value of which were put at £4 billion for 2010. This demonstrates the significance of housing to the UK household sector balance sheet.

If we now add physical wealth to net financial wealth, we find that in 2010 the household and NPISH sector had a net worth of £7.7 trillion. To put this in context, it is equivalent to 7.8 times the disposable income it earned in 2010 and 5.3 times the UK’s Gross Domestic Product. While these are enormous figures it is worth noting that in 2007 the sector’s net worth was £7.4 trillion, equivalent to 8.5 times annual disposable income.

A trawl through the figures clearly shows the impact of the financial crisis on the sector’s net worth. From £7.4 trillion in 2007, net worth fell in 2008 to £6.6 trillion or 7.2 times annual disposable income. However, 2009 and 2010 did see the households’ net worth increase again – including relative to its disposable income. This has been the result of its net financial wealth increasing. Net financial wealth in 2010 was 9.8 per cent higher than in 2007. However, the depressed housing market has continued to adversely impact on the sector’s net worth. Physical wealth in 2010 was 0.7 per cent lower than in 2007.

Of course, while these empirical observations are undoubtedly interesting, the key question for debate is how these patterns affect household behaviour. Of particular importance, is how changes in both the household sector’s total net worth and the components making up the total will translate into changes in consumer spending. Economists are increasingly recognising that in understanding consumer spending patterns we need to gain a deeper understanding of the impact of the balance sheets on consumer spending. It is quite likely that many retailers when forming their plans for the year ahead will be analysing the potential impact of household finances on spending behaviour. Developing strategies to respond to the state of the household balance sheets may be crucial to their success.

Data

United Kingdom National Accounts – Blue Book 2011 (datasets) Office for National Statistics (see Tables 6.1.9 and 10.10)

Articles

Debt levels head towards £30,000 for every adult Mirror, Tricia Phillips (2/12/11)
40% risk getting further in debt this Christmas Independent, Simon Read (3/12/11)
Uk’s debts ‘biggest in the world’ BBC News, Robert Peston (21/11/11) (This article looks at debt across all sectors, including corporate and government debt too)
Drowning in debt: Warning over 4,000% interest rates as 3.5m people say they will be forced to take out ‘payday’ loans in the next 6 months Daily Mail, Emily Allen (7/12/11)
UK households wealthier than Germany’s says UBS Telegraph, Jamie Dunkley (9/12/11)

Questions

  1. In the context of the household balance sheets, explain the difference between the concepts of stocks and flows.
  2. Illustrate with examples your understanding of what is meant by secured and unsecured debt. What factors are likely to affect the growth from one period to another in the stocks of secured and unsecured debt outstanding?
  3. Draw up a list of possible factors that could affect the value of the household sector’s net financial wealth. Now repeat the exercise for non-financial wealth.
  4. Draw up a list of ways in which you think changes to the values of items on the household balance sheets could affect consumer spending. After drawing up this list consider their significance in 2012.
  5. What sort of items would be included in the balance sheets of firms and of government?
Posted on

Gloomy prospects for UK consumer spending in 2012?

A key determinant of our economy’s rate of growth over the year ahead is likely to be the behaviour of households and, in particular, the rate of growth in consumer (or household) spending. In other words, your appetite for spending will help to determine how quickly the economy grows. The importance of household spending for the economy is straightforward to understand given that it accounts for roughly two-thirds of the total demand for firms’ goods and services, i.e. two-thirds of aggregate demand. In its November 2011 Economic and Fiscal Outlook the Office for Budget Responsibility presents it forecasts for economic growth and household spending. The following table summarises these forecasts.

OBR Forecasts (annual real percentage change)

2011 2012 2013 2014 2015 2016
GDP 0.9 0.7 2.1 2.7 3.0 3.0
Consumption –1.1 0.2 1.2 2.2 2.7 2.9
Disposable income –2.3 –0.3 0.9 2.0 2.5 2.5

Source: Economic and Fiscal Outlook (Table 3.6) (Office for Budget Responsibility)

The OBR are forecasting that household spending will fall in real terms in 2011 by 1.1 per cent and grow by only 0.2 per cent in 2012. This is not good news for retailers nor, of course, for the economy. The drag on consumer spending growth is largely attributed to expected falls in real disposable (after-tax) incomes in both 2011 and 2012. In 2011, the household sector’s real income is forecast to decline by 2.3 per cent and then by a further 0.3 per cent in 2012.

The OBR’s figures on spending growth critically depend on the ability of households to absorb the negative shock to their real income. Empirical evidence tends to show that household spending growth is less variable than that in income and that households try and smooth, if they can, their spending. This means that the marginal propensity of households to consume out of changes to their income is below 1 in the short-run. In fact, the shorter the period of time over which we analyse income and consumption changes the smaller the consumption responses become. This is consistent with the idea that households are consumption-smoothers disliking excessively volatile spending patterns. In other words, the size of our monthly shop will usually vary less than any changes in our real income.

Of course, consumption-smoothing cannot be taken for granted. Households need the means to be able to smooth their spending given volatile and, in the current context, declining real incomes. Some economic theorists point to the importance of the financial system in enabling households to smooth their spending. In effect, households move their resources across time so that their current spending is not constrained solely by the income available to them in the current time period. This could mean in the face of falling real income perhaps borrowing against future incomes (moving forward in time expected incomes) or drawing down past savings.

The ability of households to move future incomes forward to the present has probably been impaired by the financial crisis. Banks are inevitably less cautious in their lending and therefore households are unable to borrow as much and so consume large amounts of future income today. In other words, households are credit-constrained. Furthermore, it is likely that households are somewhat uneasy about borrowing in the current climate, certainly any substantial amounts. Uncertainty tends to increase the stock of net worth a household would like to hold. A household’s net worth is the value of its stock of physical assets (largely housing wealth) and financial assets (savings) less its financial liabilities (debt). If households feel the need for a larger buffer stock of wealth to act as a sort of security blanket, they will not rush to acquire more debt (even if they could) or to draw down their savings.

The impairment of the financial system and the need for a buffer stock are two impediments to households smoothing their spending. They tend to make consumption more sensitive to income changes and so with falling incomes make it more likely that consumption will fall too. There are other related concerns too about the ability and willingness of consumers to smooth spending. Uncertainty arising from the volatility of the financial markets imposes liquidity constraints because households become less sure about the value of those savings products linked to the performance of equity markets. Consequently, they become less certain about the money (liquidity) that could be raised by cashing-in such products and so are more cautious about spending. Similarly, the falls in house prices have reduced the ability of households to extract housing equity to support spending. Indeed, with fewer transactions in the housing market the household sector is extracting less housing equity because it has been quite common, at least in the past, for households to over-borrow when moving and use the excess money borrowed to fund spending.

In short, there are many reasons to be cautious about the prospects for household spending. The expected decline in real income again in 2012 will ‘hit’ consumer spending. The question is how big this ‘hit’ will be and crucially on the extent to which households will be able to absorb it and keep spending.

Articles
Household spending frozen says ONS report BBC News (29/11/11)
Families £13 a week worse off Telegraph (10/12/11)
Household spending power shrinks for 22nd month in a row Mirror, Clifton Manning (29/11/11)
Britons inject record £9 bn of housing equity in Q2 BBC News (30/11/11)
UK retail growth weakest since May, says BRC BBC News (6/12/11)

Data
Housing equity withdrawal (HEW) statistical releases Bank of England

Questions

  1. What do you understand by a consumption function? What variables would you include in such a function?
  2. Using the figures in the table in the text above, calculate ‘rough’ estimates of the income elasticity of consumption for each year. Why are these estimates only ‘rough’ approximations of the income elasticity of consumer spending?
  3. Draw up a list of factors that are likely to affect the strength of consumer spending in 2012. Explain how similar or different these factors are likely to have been to those that may affect spending during periods of strong economic growth.
  4. Explain what you understand by the term consumption-smoothing. Explore how households can smooth their spending and the factors that are likely to both help and prevent them from doing so.
  5. What do you understand by the net worth of housholds? Try drawing up a list of factors that could affect the net worth of households and then analyse how they might affect consumer spending.