1. Bank Service Price Measurement and Output Deflation in Canada Presented at the 2008 World Congress on National Accounts and Economic Performance Measures for Nations, May 17, 2008 S. Dubey and M. Ruddock, Statistics Canada

2. 2 Steps and Challenges in Building a Canadian Bank Services Producer Price Index (SPPI) 1.Measure and Price of Bank Output: SNA 1993, Financial Intermediation Services Indirectly Measured (FISIM), and the User-Cost of Money framework 2.Stakeholder Consultations and Fitness-for-Use: A Quality Assurance approach to index development and levels of dissaggregation 3.A review of the Canadian Industrial Structure of Commercial Banking 4.What remains: The measurement challenges of defining Bank Service/Output and Price in the User Cost Framework; Data Collection; and Index Calculation

3. 3 We began with the features of an Ideal Price Index 1.Price indices must be Well-Aligned with Output 2.Prices should reflect transaction prices 3.Prices must measure Constant Quality Transactions

4. 4 Which led to the question, What is Bank Output / Bank Services? Which led to the question, What is Bank Output / Bank Services? Banks provide the following services: –Monitoring and Information Processing; Liquidity and Payment Services; Safe-keeping; Asset Transformation; Risk Management (C. Wang, S. Basu, X. Freixas, J-C Rochet) These services are bundled into products, such as consumer loans, mortgages, business loans, time deposits, etc. Pricing these products is, perhaps, the closest we get to pricing bank services Changes in these services may constitute quality change –Credit scoring models and regulatory requirements such as Basel II also help monitor and manage risk; –Financial Engineering models/growth of derivatives increase asset transformation; –Telephone Banking and ABMs increase access to liquidity; –Internet Banking facilitates speed and ease of payments

5. 5 And the question How will a Bank Service SPPIs be used? 1. 1.Banking SPPI component of overall Producer Price Index 2. 2.Output (Price) Deflators for the Canadian System of National Accounts Implicit (interest) charges on deposits: banks and other deposit credit intermediaries. Deposits include Demand deposits, Notice deposits, Fixed term deposits, Sub-ordinated debt and Other interest-bearing liability Implicit (interest) charges on loans: banks and other deposit credit intermediaries. Loans include Mortgages (residential and non- residential), Personal loans, Other loans for business purposes, Loans to government and financial institutions, Securities and Other interest-earning assets Paid (service) charges: banks and other deposit credit intermediaries

6. 6 Commodity Output Share of Banking and Other Depository Credit Intermediation, 2004 Current Dollars

7. 7 Currently price indices produced at Statistics Canada do not meet these needs Price Indices:Price Indices: –No Bank Service SPPI exists –Implicit Services: No current price index for implicit services. The SNA uses other methods to derive constant price output. –Explicit Services: CPI began production of price indices for households using a model-price approach:CPI began production of price indices for households using a model-price approach: –profile typical consumers (# of transactions, minimum balance, etc), using bank service charges as posted by Industry Canada No producer price or non-household explicit fee index exist at presentNo producer price or non-household explicit fee index exist at present

8. 8 So next we looked at the User Cost of Money framework to price Bank Products (Loans and Deposits) p Aj = unit price of assets (loans) with characteristic j p Di = unit price of deposits (liabilities) with characteristic i r Aj * = interest received by bank from borrowers; s Aj = explicit service fee on loans; cj = expected capital gains on loans (assets); πj = expected provision for loan losses; and r Di = interest paid by banks to depositors; s Dj = explicit service fee on deposits; k = reserve requirement on deposits (now = 0 in Canada); r j and r i = reference rate (may be the opportunity cost to the financial institution, sometimes seen as a risk-free rate);

9. 9 The User Cost of Money and Bank Output q j A = loans (assets) with characteristic j = 1, 2, …, Jq j A = loans (assets) with characteristic j = 1, 2, …, J q i D = deposits with characteristic i = 1, 2, …, Iq i D = deposits with characteristic i = 1, 2, …, I Total Income or Output for Banks from Loans & Deposits: First two terms = income from implicit fees (FISIM);First two terms = income from implicit fees (FISIM); Third and Fourth terms = income from explicit fees;Third and Fourth terms = income from explicit fees; MEASUREMENT ISSUE #1: Bank interest paid on loans likely include expected capital gains and expected loan losses: r Aj = r Aj * + c j – π j. However, the Canadian SNA excludes capital gains/losses.MEASUREMENT ISSUE #1: Bank interest paid on loans likely include expected capital gains and expected loan losses: r Aj = r Aj * + c j – π j. However, the Canadian SNA excludes capital gains/losses.

10. 10 Aggregating Canadian Bank Output and Prices, by sector of the economy: Implicit Net Interest received from loans (relative to reference rate): q j A * (r Aj - r j ) q j A * (r Aj - r j ) Explicit fees charged on loans: q j A * s Aj Implicit Net Interest received on deposits (relative to reference rate): q i D * (r i - r Di ) Explicit fees charged on deposits: q i D * s Di Total Bank Output/Price = Net Value of Assets (mortgage & non-mortgage loans) Explicit Fees Implicit Fees II + + Net Value of Deposits

11. 11 Price Index Quality and Fitness-for-use requires its satisfied needs of users/stakeholders Prices Division at Statistics Canada began a consultation process in October, 2007Prices Division at Statistics Canada began a consultation process in October, 2007 –Participants: System of National Accounts; Bank of Canada; Department of Finance Canada; Industry Canada –Process included inter-agency meetings; presentations; and a consultation questionnaire –Questionnaire helped clarify what was meant by bank output, along with the most needed disaggregations of a Bank SPPI (frequency, geography, sector, product line, and income source) –Consensus: Most important use of the Bank SPPI comes from its use as a deflator in the System of National Accounts –Deflation Section, in turn, requires a separate deflator for implicit (interest) fees and explicit (service) fees

12. 12 Consultation Questions 1.What is your division/department/agencys principal anticipated uses of a bank services SPPI? (Please check all that apply) –Direct use as a Deflator of bank output –Direct use in Productivity Research –Direct use in International comparisons of Bank Service SPPIs –Direct use as a Business indicator/Price Trend of bank services –Indirect use in Productivity Research of Trends in Real (Deflated) Bank Output –Indirect use in International comparisons of Trends in Real (Deflated) Bank Output –Other (please specify) _____________________________________________ 2.Please rank the items in Q1 by priority.

13. 13 Consultation Questions (in progress) 3.In your view, how do you define Bank Services or Bank Output? Please check all that apply. Bank output consists primarily of: –Traditional products offered by banks, such as loans (mortgage and non- mortgage) and deposits –All products offered by banks, including loans, deposits, brokerage services, mutual funds services, investment advice, insurance, trust services, etc. –The income components of bank income, such as explicit (service) fees, implicit (interest) fees, returns on use of own funds, etc. –Other (please specify) _____________________________________________ 4.What Bank Service price indices are important to your group? Please check all that apply: –An overall Bank Service SPPI –Bank Service SPPIs broken down into products, such as loans, deposits, insurance, etc –Bank Service SPPIs broken down into income sources, such as explicit (service) fees, implicit (interest) fees, returns on use of own funds, etc. –Bank Service SPPIs broken down by both products and income sources –Other (please specify) _____________________________________________

14. 14 Consultation Questions (in progress) 5.What sector categories of Bank Service price indices are important to your group? Please check all that apply: –Bank Service SPPIs for the household sector –Bank Service SPPIs for the business sector –Bank Service SPPIs for non-residents/foreign sector –Bank Service SPPIs for the public sector –An overall Bank Service SPPI that aggregates all four sectors above –Other (please specify) ______________________________________ 6.What levels of geography and time frequency of Bank Service price indices are important to your group? Please check all that apply: AnnualQuarterlyMonthly Canada Total Provincial/Territorial Other (specify)

15. 15 Consultation: Questions for Discussion 7.In calculating a Bank Services price index, we use a risk-free reference rate of interest to compute the implicit (interest) fees portion of the index. What do you believe is the appropriate risk-free rate? Do you believe this is a single rate, or multiple rates? 8.In calculating a price index, it is important that a statistical organization collect information on price determining characteristics. For example, since auto insurance is provincially regulated, a good price index for auto insurance would take into account provincial differences. In your view, what are some of the important price determining characteristics that affect the price of bank services? 9.Quality change affects the nature of a product, and hence the way in which price index theory prices products. For example, a savings account held in a Canadian bank in 1980 allowed individuals to access their savings during bank hours; today, these savings can be access virtually any time through Automatic Bank Tellers and Internet Banking. Changes in features, such as accessibility, alter the quality of the bank service, and should be taken into account in determining price changes. Please list and discuss some of the quality change features you feel are important, and how they might be taken into account in pricing bank services. 10.Are you aware of existing methodologies used to measure bank service price indexes, or bank productivity? If so, are there lessons we should take from them? 11.Are there issues, other than the items above, you feel are relevant for the development of Bank Service price indexes? Please explain and discuss.

16. 16 Preliminary Findings: 1.Use of Bank Services SPPI: Range of uses requested covers all choices 2.Ranking Uses: Need for accurate output deflator the most important 3.Bank Output definition: SNA requires commodity level detail: aggregate product lines (mortgage loans, non-mortgage loans, deposits) by type of fee (explicit/implicit)SNA requires commodity level detail: aggregate product lines (mortgage loans, non-mortgage loans, deposits) by type of fee (explicit/implicit) External productivity researchers interested in detailed product line, but recognize data collection limitations.External productivity researchers interested in detailed product line, but recognize data collection limitations. 4.Price index detail: SNA requires SPPIs by sector (household, business, etc) and by explicit/implicit fees breakdown for loans and deposits.SNA requires SPPIs by sector (household, business, etc) and by explicit/implicit fees breakdown for loans and deposits. If limited in choice, BoC prefers aggregate financial services SPPI to sub- component SPPIsIf limited in choice, BoC prefers aggregate financial services SPPI to sub- component SPPIs Department of Finance, which sets the five-year regulatory regime for financial institutions, also interested in global output of Canadian banks, not just booked in CanadaDepartment of Finance, which sets the five-year regulatory regime for financial institutions, also interested in global output of Canadian banks, not just booked in Canada

17. 17 Preliminary Findings: 4.Sector Breakdown: All sectors (household, business, non-resident, public, NPISH) 5.Geography: Annual national the most important, but need exists for quarterly national indices and annual provincial indices. 6.Reference rate selection: Should rate reflect government securities or bankers acceptances?Should rate reflect government securities or bankers acceptances? Should rate be a single rate or multiple rate (e.g. yield curve or term structure)Should rate be a single rate or multiple rate (e.g. yield curve or term structure) Note: Wrong choice can result in negative prices, as pointed out by Canadian SNA; Bank of Japan; and Indias Ministry of IndustryNote: Wrong choice can result in negative prices, as pointed out by Canadian SNA; Bank of Japan; and Indias Ministry of Industry Note: Booked in Canada concept essential, yet creates data problems : System of National Account measures Gross Domestic Product, which requires Booked in Canada data.System of National Account measures Gross Domestic Product, which requires Booked in Canada data. Under Basel II, banks operating internationally disclose data on global operations.Under Basel II, banks operating internationally disclose data on global operations.

18. 18 Primary use of Bank SPPIs as deflators in our SNA requires the following disaggregations For Explicit (Service) Charges: Banking and other depository credit intermediation services - explicit chargesBanking and other depository credit intermediation services - explicit charges For Implicit (Interest) Charges: Banking and other depository credit intermediation services - implicit changes on depositsBanking and other depository credit intermediation services - implicit changes on deposits Banking and other depository credit intermediation services - implicit changes on mortgagesBanking and other depository credit intermediation services - implicit changes on mortgages Banking and other depository credit intermediation services - implicit changes on other loansBanking and other depository credit intermediation services - implicit changes on other loans

19. 19 Concentration of Commercial Banking in Canada will impact SPPI development for Bank Services In 2007, there were 71 chartered banks: 22 domestic + 49 foreign bank subsidiaries/branchesIn 2007, there were 71 chartered banks: 22 domestic + 49 foreign bank subsidiaries/branches Six largest domestic banks control about 85 of industry assets; and rank between 40 and 119 of the worlds top 150 banksSix largest domestic banks control about 85 of industry assets; and rank between 40 and 119 of the worlds top 150 banks Income from service charges is growing relative to interest income; as is off-balance sheet activitiesIncome from service charges is growing relative to interest income; as is off-balance sheet activities Concentration results in a sector already heavily burdened by Statistics Canada surveysConcentration results in a sector already heavily burdened by Statistics Canada surveys IMPLICATIONS & CHALLENGES: Cut-off sampling of a very small first-stage sample of banks may be sufficient to build a good index; but loss of a single respondent has important data quality consequencesCut-off sampling of a very small first-stage sample of banks may be sufficient to build a good index; but loss of a single respondent has important data quality consequences All 6 fall under the regulatory reporting requirements of Basel II, but reported data do not match the Booked-in-Canada requirements of an SPPI or output deflatorAll 6 fall under the regulatory reporting requirements of Basel II, but reported data do not match the Booked-in-Canada requirements of an SPPI or output deflator

20. 20 Canadian Chartered Banks own over 70% of financial service industry assets, amounting to $2.5 trillion in 2007

21. 21 Implicit charges as a Percent (%) of Bank & Credit Union Output fell from 70% in 1971 to 50% in 2003

22. 22 Unresolved Measurement Issues 1.Bank interest paid on loans likely include expected capital gains and expected loan losses. However, the Canadian SNA excludes capital gains/losses 2.Most countries with Banking SPPIs use Unit price to calculate price (interest) on deposits and loans. If a class of loans (deposits) is not homogenous, is a unit price correct? 3.Calculating separate indexes for explicit fees and implicit fees may increase the risk of negative prices in one category: Consider low-interest periods on credit card balance transfers, where low or zero interest income is offset by fees on the balance of transferred funds. Separating implicit and explicit fees could certainly make implicit fees face a negative price.Consider low-interest periods on credit card balance transfers, where low or zero interest income is offset by fees on the balance of transferred funds. Separating implicit and explicit fees could certainly make implicit fees face a negative price.

23. 23 Unresolved Measurement Issues 4.What is the correct choice of Reference Rate? Multiple reference rates have let to problems of negative pricing, and hence, negative output.Multiple reference rates have let to problems of negative pricing, and hence, negative output. Reference rate based on cost of funds (such as inter-bank lending rate) can also lead to negative prices.Reference rate based on cost of funds (such as inter-bank lending rate) can also lead to negative prices. Single risk-free reference rate using government securities is problematic:Single risk-free reference rate using government securities is problematic: Wang, Basu and others argue that reference rate should not be risk free.Wang, Basu and others argue that reference rate should not be risk free. How does a risk-free rate result in relative productivity comparisons between countries where banks have different appetites for risk?How does a risk-free rate result in relative productivity comparisons between countries where banks have different appetites for risk? T-Bill rates, for example, may lead to negative prices depending on the term structure of assets (Japan)T-Bill rates, for example, may lead to negative prices depending on the term structure of assets (Japan) Flight to safety feature of government securities during credit crisis begs the question of whether they are truly risk freeFlight to safety feature of government securities during credit crisis begs the question of whether they are truly risk free Single reference rate as midpoint between loan rate and deposit rate reduces problem of negative pricing, but is this theoretically valid? Is the risk-free rate the same for deposits (usually insured by deposit insurance) and loans?Single reference rate as midpoint between loan rate and deposit rate reduces problem of negative pricing, but is this theoretically valid? Is the risk-free rate the same for deposits (usually insured by deposit insurance) and loans?

24. 24 Unresolved Measurement Issues 5.How do you adjust for quality change? After 1993 ABMs per capita grew dramatically – as more households use this and other technology, has liquidity increased? Basel II and Financial Engineering impact on risk management. How do we adjust for these?After 1993 ABMs per capita grew dramatically – as more households use this and other technology, has liquidity increased? Basel II and Financial Engineering impact on risk management. How do we adjust for these? Currently, no other country does quality adjustment of Bank Service SPPIs.Currently, no other country does quality adjustment of Bank Service SPPIs. 6.Where do we place off-balance sheet items? If asset transformation is a bank service, should these be ignored? 7.If Payments systems generate a positive externality, then banks are not capturing the benefits from this external benefit, which might imply that bank output is underestimated. Do we need to look further at the non-market output of banks?

25. 25 Unresolved data collection issues: The International Experience of data collection for Bank Service SPPIs Index Start Date Start Index Publication Data Needs Points of Note United States (BLS) 2001 2003 as part of SPPI Sample data for account information Imposes respondent burden on chartered banks for sample data; still need to separate single index into explicit/implicit fees for deflation of output United Kingdom (ONS) 19992004 (February). Currently on hold. Part of Corporate Services Price Index (CSPI) UK facing difficulty with interest rate measure; currently revising SPPI Japan (Central Bank) 19851991 as part of Corporate Service Price Index (CSPI); not published separately Sample data and bank transactions data for multiple reference rates Requires transactions data not readily available to most statistical organizations Australia (ABS) 19981998-2003, loans, deposits and other bank services part of experimental Financial Services Index (FSI); FSI incorporated in CPI since 2005 Explicit Fees: Samples 7,000 acounts, 3 million transactions from banks; then uses model pricing Large respondent burden on chartered banks and calculation burden on the ABS; only produces price index for CPI

26. 26 Next Steps Develop and evaluate alternative strategies for data collection and index calculation. Your thoughts, advice, comments, and suggestions are all welcome!