Big banking systems and house prices

On Saturday afternoon I found myself in an email exchange with a couple of people about how the composition of bank lending had changed since 1984.  I wasn’t quite sure where the table I was responding to had come from, but when I eventually got to the business section of Saturday’s Herald I found the answer.  Brian Gaynor had devoted his column to a discussion of the changing significance of banks in recent decades, portentously headed  “Banks’ long shadow over New Zealand economy”.   I found myself agreeing with almost none of his interpretation.

My alternative story has two key strands:

  • the institutions we label “banks’ have become more important in the financial system as the incredible morass of restrictions built up since the days of Walter Nash were removed, first (too) slowly, and then in a great rush over 1984/85.  That has allowed the financial system to become much more efficient.  Financial intermediation is now undertaken mostly by those best placed to do it, rather than increasingly by those either subsidized by the government to do it, or just outside the network of controls and so still free to do it.
  • total credit to GDP (and especially the housing component) has risen mostly because of regulatory restrictions on building and, in particular, on urban land use. Higher housing credit is mostly an endogenous response to this policy-created scarcity.

There are all sorts of caveats to the story.  In some respects, banks are much more heavily and directly regulated now than they have ever been (and that burden is only getting heavier with LVR controls which threaten a new wave of disintermediation).  The “too big to fail” problem probably skews things a little too far towards banks (but adequately price deposit insurance and banks will still remain dominant), and at times banks get over-enthusiastic about increasing lending to particular sector and sub-sectors.  But, fundamentally, the rising importance of banks (relative to other intermediaries) has been a good thing not a bad one, and if one might reasonably be ambivalent or even concerned about the rise in household credit, that has been an almost inevitable consequence of artificial shortages created by central and local government.  Given the determination of our leaders to mess up urban land supply, in a country with a fast rising population, it would have happened in one form or another, and it is better that it has been done by efficient intermediaries.  Concerns should be addressed to central and local government politicians who keep the housing supply market dysfunctional, not to bankers.

At this remove, it is probably hard for many to appreciate quite what the New Zealand financial system was like in the heavily regulated decades.  Old New Zealand Official Yearbooks will give a good flavour, and the Reserve Bank published in 1983 a 2nd edition of its Monetary Policy and the New Zealand Financial System, which has lots of detail (the 3rd edition is a quite different book –  a weird confusion, which I take responsibility for).

In addition to the Reserve Bank  –  which lent, not just to its staff, but also to the major agricultural marketing bodies –  we had:

  • trading banks (each established by statute, with no new entrants for many decades)
  • private savings banks (savings banks subsidiaries of the trading banks, introduced in the early days of deregulation in the 1960s)
  • trustee savings banks (a different one in each region, some large and strong, some tiny)
  • the Post Office Savings Bank
  • the Housing Corporation (government mortgage finance)
  • the Rural Banking and Finance Corporation (govt rural finance)
  • the short-term official money market
  • finance companies
  • the PSIS
  • building societies (terminating and permanent)
  • life insurance and pension funds (large and fast-growing supported by a tax regime, and fairly large lenders)
  • the Development Finance Corporation
  • stock and station agents

And that was just the institutional entities –  almost all with different statutory and regulatory powers and restrictions.  And there was a very large non-institutional market in finance –  notably, the role of solicitors’ nominee companies in mortgage finance.

Trading banks had never been dominant providers of finance in New Zealand –  since they had not historically provided mortgage finance, whether to farmers or for households –  but even in their role as providers of, typically, short-term finance to business, they had been withering (under the burden of regulatory restrictions) for decades. As the Reserve Bank noted in its 1983 book, “trading bank loans and investments have fallen from being around 50 per cent of GNP in 1930 to around 25 per cent of GNP in 1981”.    As far as I can tell –  it was my impression back then, when writing an honours thesis on the disintermediation process, and it is my impression now –  that the only people who benefited from this state of affairs were the people running the entities subject to a lighter burden of regulation.  My schooling was mercifully free of so-called “financial literacy” education, but the one message I recall being drummed in repeatedly (reinforcing the one from my father) was that it was very difficult to get a mortgage, and one had to spend years building a track record that might allow one to go, on bended knee, to a lender, seeking as a special favour access to such credit.  But if you were on a lower income, the state would provide.  Alternatively, coming from a well-off family, or getting a job in an organization with concessional staff mortgages, was the way to go.  (Reserve Bank concessional loans were very good, although in the end I had one for only 2 months.)

Gaynor quotes statistics showing that trading bank housing lending was 14 per cent of total lending in 1984 and is 52 per cent now.  But look who did housing lending back then.  This chart is drawn from the 1984 New Zealand Official Yearbook, and shows the flow of new mortgages (on properties less than 2 hectares, so largely excluding farm mortgages) in the year to 31 March 1983.

mortgages 1983

Trading banks barely figure at all (and this includes their private savings bank loans, and loans to staff).  Most mortgages by then were being made through the Housing Corporation, within families, or through solicitors’ nominee companies.  Neither of the latter two offered much diversification, a key way of making available affordable finance.  Call me a relic of the 1980s if you like, but I count it as huge step forward that large and efficient private sector entities are now the main vehicle for residential mortgage finance.

I mostly want to focus on housing lending, but Gaynor also notes in support of his case

The first point to note is the huge fall in lending to the manufacturing sector, from 24.5 per cent of total bank lending 30 years ago to only 2.8 per cent at present. This reflects the deregulation and demise of manufacturing, which was also the result of policy initiatives by Sir Roger Douglas and the fourth Labour Government.

Yes, the relative importance of the manufacturing sector in the economy has shrunk –  perhaps more than it would have in a better-performing economy  –  but by my calculations drawn from Gaynor’s table, trading bank lending to manufacturing ($1.6 bn) was around 3.5 per cent of GDP in 1984 and at $11.4 bn is around 5 per cent of GDP now.  Across all the financial intermediaries that existed in 1984, the share would have been higher, but the overall picture is a quite different one from that Gaynor paints.

But what about housing lending?   Gaynor asserts that

The clear conclusion from this is that anyone who bought a house in the early 1980s has been extremely fortunate because aggressive bank lending has been a major contributor to the sustained rise in house prices over the past few decades.

Since 1980/81 was the trough of a very deep fall in real house prices, there is no doubt that it was an ideal time to have bought.  And there is also no doubt that there has been an aggressive (and almost entirely desirable) process of re-intermediation.  Some entities that weren’t trading banks became trading banks (or ‘registered banks’ as we now know them) – think of Heartland, SBS, ASB, PSIS –  or were directly purchased by banks (think of the United or Countrywide building societies, or Trustbank or Postbank), and in other cases banks just won market share away from other participants in the market (no need for a solicitor’s second or third flat (short-term interest only) mortgage when you could get a 80 per cent table first mortgage at the local bank branch).

But is there any evidence that “aggressive lending” by the financial sector (now mostly ‘banks’) has been a “major contributor” to the huge rise in real house prices in recent decades?    I think the evidence is against that claim.  Why?

First, “aggressive lending” usually ends badly.  It did for the banks when they lent on the massive commercial property and equity boom post-1984.   It did for the finance companies with aggressive property development lending in the years up to 2007.  It did for the banks with dairy lending (both in 2008/09 with a surge in NPLs and perhaps again now –  going even by the Reserve Bank’s own stress test).  Housing lending, by contrast, has not ended badly, even though the push by banks into housing lending has been going on now for more than 25 years, through several economic cycles and one very nasty recession.  It is easy to say “just wait”, but history is strongly against that proposition.  Inappropriately aggressive lending goes wrong much faster than that.

Second, while the lending terms of banks have become easier than they were 25 years ago –  when banks were just finding their way in this new market for them, and nominal interest rates were still extraordinarily high – they are not noticeably looser (at least in asset-based terms) than the terms applied by other housing lenders in earlier decades. 80 or 90 per cent 30 year mortgages from the Housing Corporation weren’t uncommon (or inappropriate for a young couple with decades of servicing capacity ahead).  Banks, including the Reserve Bank, had long lent those sort of proportions to their own staff.  And, on the other hand, we have not had any material amount of mortgage business written with LVRs above 100 per cent, or with terms of 100 years or beyond (things seen in various European markets at times).  Overall, credit conditions are probably easier than they were, but not in way that is self-evidently inappropriate or overly risky for either borrowers or lenders.  The Reserve Bank’s housing stress test backs that conclusion  – taking account of the joint risk of losses in asset values, and losses in servinig capacity (if unemployment were to rise sharply).

Third, there is a simpler explanation for high house and urban land prices.  Regulatory land use restrictions combined with population pressures (including policy-driven immigration ones) are a more persuasive story, including in explaining why house prices in Auckland have increased so much more than those elsewhere.  In New Zealand we have only one fairly large city, but think of the situation in the United States: there is a fairly unified financial system (albeit with some state level differentiation in restrictions) and yet we find huge increases in house prices in places like San Francisco (with tight land use and building restrictions) and very modest real increases in large and growing places such as Houston, Atlanta, Nashville and so on.  High house prices, and high house price to income ratios, are not an inevitable feature of a liberalized financial system.  They aren’t an inevitable feature of tight land use restrictions either, but the correlation across cities is pretty good.

demogrpahia 2016And if finance were primarily responsible, finance would also have brought forth lots of new supply.  That is way markets work –  it is part of the reason why credit-driven booms don’t last that long.  Instead, prices have been bid up largely as a result of regulatory constraints: there are not consistently excess profits lying around that developers can readily take advantage of.

Of course, higher house prices typically mean that buyers of houses need more credit than they otherwise did.  If house prices suddenly double because some regulatory change makes land scarcer, then with incomes unchanged either people can wait (much) longer to buy, saving a larger deposit, or they can borrow more to complete the purchase.  If the people who wanted to buy, but are reluctant to take on more debt, do hold back, someone else will buy the property.  And that person will need finance –  either debt or equity.  If banks are reluctant to lend on houses, then houses will tend to be owned by people who are least dependent on debt: those with large amounts of established wealth already.  All else equal, since few people get into the owner-occupied housing market without debt, that would be a recipe for even larger falls in owner-occupation rates than we have already seen.

Much of the overall increase in housing debt in New Zealand (and other similar countries) in recent decades has been the endogenous response to the higher house prices, rather than some independent factor driving up prices.  And these forces take a long time to play out.

In the chart below I’ve done a very simple exercise.  I’ve assumed that at the start of the exercise, housing debt is 50 per cent of income, house prices and incomes are flat, and people repay mortgages evenly over 25 years.  Only a minority of houses is traded each year, but each year the new purchasers take on new debt just enough to balance the repayments across the entire mortgage book.

And then a shock happens –  call it tighter land use regulation –  the impact of which is instantly recognized, and house prices double as a result.  Following that shock, house purchasers also double the amount of debt they take on with each purchase, while the (now rising) stock of debt continues to be repaid in equal installments over 25 years.

In this scenario remember, house prices rose only in year 1.  There is no subsequent increase in house prices or incomes.  But this is what happens to the debt to income ratio:

debt to income scenario

In this particular scenario, 100 years after the initial doubling in house prices, the debt to income ratio is still rising, solely as a result of the initial shock, converging (ever so slowly by then) to the new steady-state level of 1.  One could play around with the parameters, but a permanently higher level of real house prices will, in almost any of them, produce a permanently higher level of gross housing debt, and it will take many years to get to that new level.  The flipside, which I could also show, is the deposit balances of the other parts of the household sectors – the young who have to save for a higher deposit (even for a constant LVR) and the older cohorts who extract more money from the housing market when they downsize or exit the market.  Higher house prices do not, of themselves, require banks to raise more funding offshore.

This is deliberately highly-stylized, but it is designed to illustrate just two main points: higher debt ratios can be primarily a symptom of higher house prices (rather than any sort of cause) and the adjustment upwards in debt levels following an upward house price movement can take many years to work through.    And there is one more important point: this a process that mostly reallocates deposits and credit among participants in the housing market: it needn’t materially affect the availability of credit, or economic opportunities, in the rest of the economy.

None of which is to suggest that higher house prices, as a result of some combination of regulatory measures (eg land use restrictions and high non-citizen immigration), are matters of indifference.    They have appalling distributional consequences, and prevent the housing supply market working remotely efficiently.   But the banks aren’t the people to blame: that blame should be sheeted home, constantly, to the politicians responsible for the regulatory distortions.   We get bigger banks as a result –  more gross credit has to be distributed from one group in society to another –  but if we are going to mess up the housing and land supply markets, bigger banks are almost an inevitable, perhaps even second-best desirable, outcome. The alternative would be whole new waves of disintermediation, and a housing stock ending up (even more) increasingly owned by those not dependent on debt.

The preferable path would be one in which land use restrictions were substantially removed, and house and urban land prices once again reflected market economic factors rather than regulatory impositions.  That would be a path towards smaller banks –  but just as in my chart above, the adjustment would take many years.

14 thoughts on “Big banking systems and house prices

  1. Do not forget that geographical restrictions(we built our largest city on the smallest strip in NZ) and as a result costly infrastructure requirements and the lack of infrastructure funding and spending all add up to more and more expensive houses.


  2. Simple enough to understand.
    However its not just land use restrictions that cause higher house prices.

    Bob Jones used to make the point that new buildings won’t be built until the value of the older buildings rises towards the replacement cost. i.e. we won’t build new until it’s worth the return.

    So, when we look at housing the older houses chase the new cost. and what ramps that up. Well a builder friend tells me that the H& S Laws have added around $25k to a new 3 beddy house. Before that the councils have added all the nice to haves and essentials to the cost and of course we have to pay for all the disastrous results of leaky homes, all in the cost of the new ones.
    Then of course we have size. Todays homes are about double the size of those built in the 1970-80’s. Why well most subdivders insist on covenants around the build to”protect” the future home owners asset value. Try busting one of those.

    So no matter how much we increase a builders productivity houses will get more expensive to make unless we remove all that stuff.


  3. I see today has exposed the real reason our dollar remains consistently high and the forth traded currency in the world.
    Apparently we launder like a Fisher and Paykel at high speed.

    Time to shut this down and give Kiwi’s a fair go.
    sorry off topic.But does affect our interest rates etc.


    • I haven’t foillowed this stuff closely, but my impression was that it involved NZ legal entities, rather than NZD exposures.

      On your earlier comment, yes fair points – altho of course there are still plenty of small existing houses, just not new ones.


    • It has to do with Foreign Trusts set up under NZ trust law. In NZ, Foreign Trusts do not pay any NZ tax on assets and income from a foreign source and are therefore not required to register with IRD. They do have to get taxed and are liable to obtain a IRD number only if they hold any trading assets that derive an income in NZ. As we do not have a public directory for trusts that’s where there is a transparency issue.

      Under the foreigner purchasing new rules brought in on 1/10/2015 on foreign buying of NZ property, if a Foreign Trust buys a NZ property they need to register a IRD number.

      Andrew Little really need to get a better understanding before he jumps onto IRD because it is not a IRD issue. The Foreign Trusts in reference to using NZ as a Tax haven usually do not have to declare to IRD because those trusts do not usually hold NZ income producing assets nor do any funds come into NZ. They usually only hold foreign assets and foreign funds. Notice how Grant Robertson does not even have a clue what to say??? The lack of expertise in Labours lineup is glaringly inept in anything to do with Finance or taxation!!!!


  4. Seems to me the ability to leverage existing property wealth is a thorny issue: perhaps restrictive land policies and falling interest rates – combined with financial liberalisation/innovation – has enabled past equity gains to be pledged as collateral placing this owner/investor cohort in a currently superior buying position relative to the chasing pack? And somewhat paradoxically, increased housing supply might accentuate risks assuming prices fall? “Auckland, Tauranga, and Hamilton property prices drop 10% yoy” – not sure such a headline would be easily digested before the sports news……and how would those offshore lenders (real rather than stylized) react? ‘Just wait’ and see I suppose…


    • We did see a 8% drop headline over Christmas. Nothing much occurred other than to wait till those 80,000 foreign students in Auckland alone, started looking for accomodation space in February. It really does give landlords a bit of a smile.


  5. There are certainly distributional implications – those who have get further ahead.

    Re falling house prices, recall that they fall quite a lot in nominal terms during the 08/09 recession and it never sparked concern about NZ banks’ creditworthiness, and the standard crisis warning lights were flashing much more brightly then than now, In the end, it is loss of servicing capacity that destroys residential mortgage books, not falling asset prices in isolation, so I’d be much more uneasy if the unemployment rate was extraordinarily low (again, as it was in late 07)


    • …agreed. I guess price appreciation from the 07/08 period is still somewhat of a puzzle: population growth and land planning are no doubt important drivers but low rates with a return of credit supply also seems to be part of the explanation: the latter, one of those ‘unintended consequences’ (of an uncertain duration) perhaps.


      • The level of savings deposits in NZ banks have hit a record $157 billion in December 2015. The banks have to on-lend this massive increase in savings otherwise their profitability would be impacted. This is the unintended consequence of holding interest rates too high. NZ dollar again is on the rise suggesting that interest rates are still too high. Bank stability risks are rising not due to increasing property lending but due to too much savings in banks which then leads to indiscriminate lending in the more risky sectors eg Dairy farming.


    • Since 1929 banks have been much more restraint in terms of mortgagee sales. They do not react in negative equity situations.knowing that as long as people are able to pay their mortgages they have a saleable asset on their books. No point tipping everyone into mortgagee sales because you end up with people in tents and too many bank owned houses that can’t sell.


  6. Thx for clarifying his article. I read it before reading yours, but with the expectations of inaccuracies and misleading comments after I saw you were commenting on it.

    Comments like the increase in profitability, no doubt correct, but as soon as they are mentioned without a context such as RoE or RoA, I assume the writer has a bias to their comments.

    But there may be a few things you can easily comments on: –
    – the share of M3 going from 47.5% to 97%,
    – I note he comments on the recognition that deregulation was going to be a profitable thing, and was recognised by Aus parent banks. But no comment on others that recognised it, but got it wrong, BNZ, DFC, even AMP started but eventually bailed. His implied choice was binary, either recognise it and make money, or don’t recognise it and sell out.
    – I also noticed the manufacturing lending decreasing as a percentage, but increasing by a factor approaching 10, so good to see your GDP related figure.
    – “mainly funded by the banks borrowing heavily offshore”, is this true? I don’t know what the overseas borrowing levels used to be, $0 wouldn’t surprise me. But I believe domestic funding is now something like 75-80%, although it may have been higher ten years ago.
    – “aggressive lending”, I do wonder if lenders are now lending more aggressively. Do they now lend on greater multiples of income or as a greater percentage of the value than they used to? I suspect so. But this is probably just the way the banks have tried to keep some of the housing stock ownership dependent on debt.


    • Just on your specifics:
      – yes, the process of re-intermediation does mean that institutions we label ‘banks’ are now the main players in the credit/money process. That isn’t a bad thing, and is partly about labels eg ASB was a trustee savings bank in 1984 and so not counted as a trading bank (which Gaynor focuses on), and many building societies have since been taken over by banks.
      – agree, and of course deregulation was going on in Aus at much the same time. I don’t recall much about the ANZ structure, but I suspect tax and dividend imputation issues will have been at least as important.
      – back in the 80s the govt was the largest single borrower from abroad (plus some big corporate borrowings – think of Fletcher Challenge), and for the last 20 years banks have been most important. Two points tho: the net international investment position as a % of GDP has not changed materially for 25 years, so the country has not been getting more indebted, even as house prices have soared. And the point of my little scenario exercise was partly to make the point that higher house prices of themselves do not result in banks needing to borrow more offshore. More physical investment relative to savings (a large current account deficit) certainly does, but higher asset prices in an of themselves do not – they just result in higher debts for buyers and larger deposits for sellers.
      – I covered your final point in my post: I don’t think first home buyer LVRs are materially higher than they ever were (90% LVR loans from Housing Corp weren’t that unusual, and the RB used to lend to staff on those sorts of terms). Loan to income ratios have increased materially (as house price to income ratios have), and some would worry greatly about this as a decline in lending standards. I think it is more likely to be a slightly reluctant adjustment by banks concerned that if they stuck to the old sorts of levels there would be no FHB borrowers left – ie again partly an endogenous response. How would one distinguish this hypothesis from a story about aggressive banks pushing the limits as much as they could in a hunger to write new business? Well, one could look at the consequences – we have had a nasty housing/credit bust, and the literature suggests busts happen within 5 years of so of the credit boom – or we could look at the new entrants (who are attracted by huge profits and easy credit standards): the last main new player in retail banking was Kiwibank, 14 years ago, promoted by the govt and without high rate of return requirements.


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