Stress tests and credit availability

It is 3 January, a public holiday, the heart of summer (notionally at least –  it is actually cool and wet in Wellington), and something of a low ebb in local news and analysis.  But bright and early this morning, I did a radio interview on the Reserve Bank’s stress tests of the major banks.

The request was apparently prompted by a Stuff article, itself prompted by a recent new Reserve Bank animated video explaining stress tests.    The article, rightly, pointed out that following a very severe recession and significant credit losses for banks it was likely that banks’ lending standards would be somewhat tighter than they would have been in the previous boom.  That might even affect some of those hoping to take advantage of lower asset prices.

The stress tests themselves aren’t new.  They were done in late 2015, and were written up in the Reserve Bank’s Financial Stability Report last May.   I wrote about those results at the time.  In that stress test the Reserve Bank, quite appropriately, looked at how banks would cope if they were faced with a very severe recession and a very sharp fall in asset prices.  Stress tests are useless unless they use very demanding shocks.   These were. In the stress test, the unemployment rate rose to around 13 per cent and stayed there for some time.  For housing loan books it is the combination of unemployment and falling house prices that creates the scope for large loan losses –  either strand alone isn’t enough.  In fact, the increase in the unemployment rate was larger than anything experienced in any advanced economy with its own monetary policy in the 70 years since the end of World War Two.  And house prices were assumed to fall by 40 per cent generally, and by 55 per cent in Auckland –  about as large as any falls anywhere.

The banks emerged from these very demanding stress tests intact.  It wasn’t even a close run thing.  Capital ratios dropped, but mostly because the risk weights applied to banks’ outstanding loans increased  (a 50 per cent initial LVR loan looks riskier after house prices fall by 40 per cent).  The actual loan losses weren’t large enough to offset bank’s other operational earnings, so that the actual dollar value of banking system capital was not reduced.  This is the Reserve Bank’s chart of losses.

box-c-fig-c1-fsr-may16

Total losses, over four years, were around 4 per cent of assets.  As the Bank observed

The cumulative hit to profits averaged around 4 percent of initial assets (figure C1), which is a similar outcome to phase 2 of the full regulator-led exercise conducted in late 2014. About 30 percent of total losses were related to mortgage lending, with half of this due to the Auckland property market. SME and rural lending accounted for most of the remainder of financial system losses. Loss rates for mortgage lending were around 2 percent, significantly lower than the 5 percent loss rate observed for most other sectors.

Faced with such very demanding economic circumstances, banks could be expected to become more cautious about lending.  That is what generally happens in economic downturns.    Banks –  like others in the economy –  find that things hadn’t turned out as they expected, and aren’t sure what will happen next, or how long the downturn will last for.  Central banks don’t know either.

In this sort of climate banks are typically keen to conserve capital –  it isn’t necessarily easy to raise more capital, and shareholders are a bit uneasy.  On the other hand, banks stay in business by lending and borrowing, and being known to be reasonably willing to extend credit.    As I noted in my earlier post, lower asset prices (houses and farms) tend to result in a lower stock of credit over time just through the normal process of turnover.  What was a million dollar house might now be a half million dollar house, and a new purchaser will typically need a lot less credit to facilitate the transaction than the previous million dollar purchaser would have.  That process takes time, but it is fairly inexorable.  Combine it with the lower turnover that is typical during recessions and there is likely to be a lot less new credit going out the door, even without credit standards tightening.  Business credit demand also tends to fall away sharply during recessions –  demand for new investment projects dries up, and that is particularly marked in sectors like commercial property (where empirical evidence suggests banks are particularly prone to taking losses).

But I’m sceptical of the notion that even in the sort of recession dealt with in the Reserve Bank’s stress tests credit conditions for home buyers would tighten much.  There are really three reasons for that.  The first  –  unique to current circumstances –  is that credit conditions for home buyers are already quite (inappropriately) tight as a result of the Reserve Bank’s successive waves of LVR controls.  That is a very different climate than existed in previous booms (here or abroad).  Those controls would typically be expected to be lifted in any downturn.  The second reason is that, as the Bank’s results above show, even in a scenario of this sort loan losses on the housing loan books are not large –  not trivial by any means, by not of the sort of scale that is likely to take banks by surprise if such a shakeout ever occurs.   Servicing capacity remains a vitally important factor and any young couple with a secure income would be unlikely to find it that difficult to secure a 70 or 80 per cent LVR loan to purchase a first home.  Banks, after all, will often be keen to replace extremely highly indebted borrowers (eg investment property borrowers with negative equity) with less indebted owner occupiers with decades of home ownership in front of them.

The third reason is history.  Take, for example, the banking crisis of the late 1980s and early 1990s, which was much more damaging that the stress test results in the recent Reserve Bank exercise.  Several major banks were severely adversely affected, and the BNZ would have failed were it not for the government bailout.  And yet through that period-  late 80s and early 90s –  banks’ housing credit stock grew quite rapidly.  Even though the unemployment rate was high and rising –  not to 13 per cent –  and interest rates were still quite high, banks recognised that housing loans were generally relatively lower risk exposures.  To be sure, the stock of housing credit was much lower then than it is now –  and there was still some reintermediation (from non-banks to banks) going on, so I wouldn’t expect a repeat, but it is a reason not to be too worried about the availability of credit to house purchasers with reasonable deposits even in the aftermath of a very nasty recession and a sharp fall in house prices.  Even good projects advanced by property developers would probably struggle to get credit  –  as happened after 2007/08 –  but existing suburban houses are likely to be a very different proposition than new commercial developments, or even new fringe residential subdivisions.   (One caveat to that might be if governments were to intervene, in response to a sharp fall in house prices, and impair the value or certainty of banks’ security interests in residential mortgages –  but that isn’t an element in the Reserve Bank stress test.)

As a reminder, the stress test scenarios are very demanding.  The Reserve Bank likes to suggest that the scenarios don’t fully account for the second round effects of tighter credit conditions after the initial shakeout, but the scenario is so severe –  more so, say, than the US experience in 2008/09 – that we can largely set that concern to one side.     Based on the lending standards our banks were adopting in 2015 –  when the stress tests were done –  our banks look to be able to withstand all but the very worst imaginable economic shocks, and to be able to emerge still providing finance to reasonable projects, perhaps especially mortgages on existing residential properties.  Indeed, credit conditions for potential mortgage borrowers might be little or no worse than they are now, given the direct interference in that market through the waves of LVR restrictions.

The Stuff article appeared to be driven by the idea that those hoping to take advantage of a future fall in house prices might be out of luck, as the credit might not be available to do so.    For the potential first home buyer considering waiting for a future shakeout that seems a misplaced concern (although it might not be for someone wanting to buy say 20 properties at once).

The bigger question, of course, is what might trigger a really sharp fall in New Zealand real and nominal house prices.  I don’t think there is any evidence that what has happened here is, primarily, some sort of speculative bubble.  Mostly it is a consequence of the land use restrictions, exacerbated by the rapid immigration-policy fuelled population growth.  As we saw in 2008/09, recessions and reversals in immigration numbers can prompt a temporary fall in nominal house prices.  But without far-reaching reforms in land use regulation, perhaps supported by permanent material changes in target immigration levels, it is difficult to be optimistic that the sustained halving in house prices, that might re-establish more reasonable levels of affordability, is in prospect.