I have been making the point (ad nauseum perhaps) that it is hard to reconcile the Reserve Bank senior management’s public anguishing about the threat house prices allegedly pose to the soundness of the New Zealand financial system with the results of their own 2014 stress tests, reported in the November 2014 Financial Stability Report. The latest FSR does not even mention the earlier stress tests, despite the new regulatory controls the Bank is planning.
But in the Herald this morning – not the Bank’s own statutorily-required accountability document – we find an official Reserve Bank spokeswoman quoted on the very topic. Mary Holm, the Herald’s personal finance columnist had had a question from a reader about what would happen if house prices dropped sharply. Surely, the reader suggests, banks would collapse? So Holm went to the Reserve Bank for comment:
What does the RB think about the possibility of a property plunge. “Whether property prices could drop by half from today’s values is purely speculative,” she says. “Nevertheless, a 50 per cent drop matches some of the more severely affected economies in the global financial crisis such as Ireland.”
So they’re not ruling it out. But would such a drop cause banks to “collapse”? “The short answer is no, we do not believe so,” she says.
“The Reserve Bank conducts regular bank stress tests in collaboration with the Australian Prudential Regulation Authority. The most recent one was last year, and the results of it are featured in the November 2014 Financial Stability Report, pages 9 to 11, on our website.
“This stress-test exercise featured two imagined adverse economic scenarios over five years, one of which involved a sharp slowdown in economic growth in China, which triggered a severe double-dip recession in New Zealand. Among the impacts were house prices declining by 40 per cent nationally, with a more pronounced fall in Auckland – similar to your reader’s worst case scenario.”
So how would our banks fare?
“The Reserve Bank was generally satisfied with how the banks managed their way through the impacts of these scenarios, and we are comfortable that the New Zealand financial system is currently sound and stable, and capable of withstanding a major adverse event.”
So our own Reserve Bank, required to run prudential regulation to promote the soundness and efficiency of the financial system, is quite comfortable that, based on the asset structure of the major banks last year, our banks and our financial system would come through just fine if (Auckland) house prices were to fall by 50 per cent.
Note carefully, I am not misreading them as suggesting that our banks would always be robust to any such collapse in asset prices. In other circumstances, with a different mix of loans on the books, the threat could be much much greater. But as things stood last year – and bank loan books haven’t changed much since then – the New Zealand financial system would be fine. Recall that it is not residential mortgage loans that typically threaten banking systems, but construction and commercial property exposures. The Reserve Bank spokeswoman mentioned the Irish case, but in Ireland it was reckless lending on a huge property development boom (commercial and residential) that played the central role in undermining the health of the Irish banking system, and in particular which brought down their most egregious lender , Anglo Irish Bank (read about it here). We don’t have any such large scale credit-financed property development boom in New Zealand.
Which brings us back to the question, what does Graeme Wheeler think he is doing with his proposed new restrictions on banks lending to small businesses in the rental property market? His spokeswoman just told us that the financial system was likely to be robust even if house prices fell 50 per cent, and his only statutory mandate is about the soundness and efficiency of the financial system. His proposed new controls will impair the efficiency of the financial system, and his own spokeswoman says (what his FSR opened by saying as well) that soundness is just fine. Dampening house prices temporarily just does not, and should not, figure as an objective in the Reserve Bank Act.
Just one other quick point on the Bank spokeswoman’s comments. Holm reports her as saying:
“In the extremely unlikely event of a bank failure, our Open Bank Resolution (OBR) policy would apply. The aim of OBR is to allow a distressed bank to be kept open for business while placing the cost of its failure primarily on the bank’s shareholders and creditors rather than the taxpayer.
The first sentence of that statement is just wrong, as I’m sure the Bank now recognises. Any decision to use OBR will not be a matter for the Reserve Bank, but for the Minister of Finance. The chances of OBR being used in respect of a major bank have always seemed to me quite small. It is a good tool to have available, and might be a credible option for the failure of a small New Zealand bank, but it has always only been one option to have in the toolkit (as the Bank reports here) , to present to the Minister of FInance at the point when a bank fails. For the major banks, it is good to be able to scare the Australian authorities that we just might use it, but in most plausible failure scenarios OBR is much less likely than a government bailout. And that is partly because New Zealand has not yet come to grips with deposit insurance. Deposit insurance is not an ideal policy by any means, but without it the chances that a Minister of Finance and his Prime Minister will agree to allowing widespread losses for retail investors seems vanishingly small. That is a general proposition, not specific to the current government, but having bailed out every creditor of AMI this particular government does have form.