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.
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.
croaking cassandra 
Michael, just to let you know that in this post – as one of your last ones before Xmas – you refer to an inserted chart, which is not included or visible, even when accessing your message through the web link.
Otherwise, you’re doing a great job which is very much appreciated!
Kind regards
Dieter
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Thanks for letting me know. Seems to be corrected now.
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Hi Michael. I spent some of this holiday season writing about the importance of the State to city building/housing. I took a first principles and historic perspective. Some of the history of State control by powerful central governments I am a little uncomfortable with. But I think it was worthwhile documenting the continuum of effective options to improve the housing situation.
It is a two-part article and here are the links.
View at Medium.com
View at Medium.com
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Thanks for the links Brendon. I must do some more reading in this area, but I’m not sure what to take from the roading percentage comparison between Akld and Manhattan. I wonder, for example, what the comparable number is for the whole of the New York MSA? And Manhattan – or even wider NY – are hardly affordable cities.
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The UN Habitat Report contains 30 cities -see the link in my article. I commented on Manhattan because it linked in with what Prof Angel’s Making Room thesis. The allocation of street space has implications for mobility, congestion, street life and affordability. Wrt affordability a key determinant is if enough public space for right of ways and trunk infrastructure is allocated ahead of development so that there is elasticity of supply from the adjacent privately owned land.
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Brendon, you can’t compare Brisbane with Auckland. They are definitely not similar cities. Brisbane has 2.3 million people that reside on 16,000skm, Auckland has 1.5 million people on 5,000skm. Brisbane is mainly a circular city, largely inland with a coast some distance away compared to Auckland which is a long city with water on 3 sides. When you use an analogy like travel distance. You must first establish a start point. Then you have to establish what suburbs, as half an hour from the central Auckland harbour can take you to Otara where prices are still around $500k.
Brisbane has a massive high rise central core that soaks up population. Aucklands central core around the harbour is only a tiny 550skm.
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Round cities have shorter travel distances compared with long cities with the same land mass. The problem with Auckland is the 57 sacred volcanos that has height sensitivity which means that once to get into Mt Eden which is the next street from Queen st, you are 3 to 4 level height constrained. Land values in the central suburbs has escalated following the normal land price increases experienced by every other growing city but the difference is that most other cities do not have 57 sacred mounts with significant heritage and cultural significance with height sensitivity and visual height limits.
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That magnitude of decline in house prices would surely have an impact on ‘confidence’, ‘uncertainty’, ‘expectations’ etc. – all of which are tricky to “stress” even though such difficult to measure factors contribute to banking stress. And its not really asset quality in the short run that matters: domestic deposits may not walk away but the offshore funding could run quite quickly especially if NZ asset prices are falling relative to the rest of the world….
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Thanks Michael. When the RBNZ does these stress tests with the banks, are they granted access to their loan books and the information on the incomes that service them?
In asking, I am not so much concerned about the stability of banks. Rather, I am hoping that the RBNZ has a good idea of the problems that say a 200 basis point rise would have on the ability of families to service their mortgages. Does anyone really know the answer to that question?
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Ryan, these days, families have a few more options available to them to service their mortgages and in terms of increasing rental returns. With tourist numbers headed towards 4 million this this year and a target of 7 million in subsequent years, Air BnB offers residential property whether it is single rooms or entire a entire house available to international and domestic travelers.
Also recently the garage is available for weekly renters as rooms get taken up by Air BnB travelers.
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The banks have an army of risk managers that ensures that loans are properly analysed and risk weighted. What you need to assess is the provisions for bad and doubtful debt and whether that is adequate. A loan becomes bad and doubtful only when the borrower is unable to meet their regular monthly payment instalments. Eg provisions for bad and doubtful debt would have increased when milk prices dropped by 50% recently from a high of $8 to $4. This would put most of the $60 billion in farm debt as potentially bad and doubtful. The banks would have increased their bad and doubtful debt provisions to cover the probability of default and a mortgagee sale. But with milk prices increasing, banks would have revised the bad and doubtful debt provisions downwards.
In a environment of falling interest rates banks make record profits as they easily manage the lag time between falling interest rates on deposits and falling rates for loans. But today’s banks profits is not next years bank stability as each years profits are paid out to shareholders.
In a period of stagnant and rising interest rates banks profits become a lot more difficult to manage as the lag time differential between the cost of savings deposits and the revenue from loans is not as easily justified to depositors and to borrowers. As interest rates rises savings deposits increases but lending slows down which therefore the lag time differential narrows between downward pressure on lending interest rates as the bank struggles to lend out increasing savings deposits.
Therefore it is in a period of rising interest rates that bank instability rises. The faster the OCR is increased banks instability rises exponentially. The RBNZ has a very bad trigger happy policy with interest rate rises usually in rapid 4 rate increases in a space of 12 months. Huge amounts of savings deposits start going into savings accounts which the bank has to lend out as fast as the deposits come in in order to maintain net positive asset position and to preserve net margins.
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People tend to focus on the lending risk as the primary issue. But forget that a banks financial position is made up of assets and liabilities. Lending to a bank is an asset on the books. Non performing loans impair assets but don’t forget that savings deposits are a liability, therefore as interest rate rises, savings deposits increase which equates to a increase in liabilities which also equally impair a banks net financial position.
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They give the scenario to the banks and ask the banks to do the loss calculations on their own detailed portfolios.
In this particular scenario, interest rates fall quite a long way – a big recession – but if I remember rightly there was another stress test a couple of years ago that looked at the impact of an interest rate shock. It is quite hard to specify such a shock in a very meaningful way, because it matters a great deal what causes the rise in interest rates (if it is a strong economy, then wages etc will be rising and asset prices are likely to be supported, so that overall loan losses won’t be overly large). If it is a global funding cost shock then (a) the exchange rate would be expected to fall, and (b) the OCR can generally be cut to offset the sharp rise in funding spreads.
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Thanks Michael. I take your point on the nature of the interest rate shock. I was thinking of a largely exogenous global funding shock – which we arguably ended up having with both Trump and the Fed signalling a more certain monetary path.
Three ideas I would like to run past you:
1. It would appear that the banks have a strong incentive to massage the results to make them appear stronger than they are (especially if they are less risk averse than the RBNZ).
2. Many RBNZ personnel go on to work for the banks. This suggests that many current RBNZ staff do not have a strong incentive to be tough with the banks… they are essentially tasked with policing their potential future employers.
3. With regards to your (a) and (b) – exactly. But both of these inflationary, no? That is, the bank would be choosing financial stability rather over taming inflation. In the coming year, I imagine the bank will have to decide whether it follows global interest rates back up. When evaluating that choice, it is not clear to me that they – or anyone – has a good grasp of what the impact will be on Auckland’s mortgagors if our mortgage rates increase.
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I guess I’d see the rise in global interest rates being sustained only if economies and inflation prove stronger than they’ve been. Over time, our rates won’t be higher just because US ones are unless we are sharing in some sort of more resource-pressuring recovery.
Re the stress tests, yes there are some incentive issues for banks. But each bank does the test independently of the others and there is often quite a wide range of results thrown up, which the RB in turn uses to pose questions of the banks that are coming up with low loss estimates. Personally, I suspect the incentive issues on banks might be more serious if there was a shock that took them closer to the edge (whereas the scenarios in recent years have not even come close to that – and that shouldn’t really surprise anyone, as historically it has been hard to lose lots of money on vanilla housing loans made under competitive market conditions).
Re the RB personnel, in principle it is a potential problem. In fact, I don’t think it has been one. From my memory there has only been quite a modest flow of people from the supervisory (and macro-financial) areas to the private banks (whereas a lot of macroeconomists have made the move). And of course at the upper levels of the organisation RB people have often come back from spending time in banks – eg Grant Spencer, the Dep Gov in this area, was in a senior ANZ role for almost 10 years, and Bernard HOdgetts, head of macrofinancial stability, was chief economist of ANZ earlier in his career. The one ex-RBer I can think of who ended up working in this sort of area in the private sector was one of the hardest line people around when inside the RB. It is a risk that constantly needs watching, but in recent years it has been in RB senior mgmt interests to, if anything, see the stress test results skewed to the pessimistic side (to support their interventions).
I don’t disagree with your final sentence. Partly it depends on the precise combination of circumstances – eg interest rates rise on the back of 4% GDP growth and continued strong immigration inflows, one might well see some distressed borrowers, but not much downward pressure on house/land prices, and hence quite small losses for the banks. But if it accompanied a return of the net outflow of NZers to Aus to more normal levels as activity/employment in Aus picked up it could be a different story. For what it is worth, I’d still be very surprised if the OCR was raised this year – although the wild card there is the likelihood of a new Governor after September.
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Many thanks for the insights into the bank, Michael. Good to know that the incentives are not as perverse as I was suggesting.
One thing you said piqued my interest, and I think this is the main point of difference in our perspectives:
> Over time, our rates won’t be higher just because US ones are
Suppose that in 18 months the federal funds rate and the OCR are the same: 1.75%, and all signals point to that zero differential remaining for the foreseeable future. Surely the bottom would drop out of the kiwi dollar, which would be a rather inflationary shock – all those imported commodities and goods we do not make are going up in price (and that is ignoring the inflationary effects on the demand side, which, admittedly, may be rather muted given the debt overhang in the farming sector anyway).
Under this scenario, I would have thought that the RBNZ would raise rates to avoid that incipient inflationary shock (at least in a situation in which they weren’t hamstrung by the potential effects on mortgagors). I have not worked at the bank, though and you have, hence I am interested in the thinking behind your statement quoted above.
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Depends quite a bit on what is happening in other countries. In the extreme, if the US is the only country raising rates (much), the USD is likely to continue to strengthen, weakening the NZD/USD rate. But the USD isn’t dominant in either our formal TWI or in actual economic effect on NZ. But if markets are right and global demand/inflation pressures are strengthening then yes all else equal the NZD TWI could weaken quite a bit without an OCR increase – and if we are really sharing in that strengthening then a rise in the OCR would be appropriate.
In the meantime though, NZ core inflation is still pretty low, and several of the factors that have boosted demand here are likely to be less strong than they’ve been. Having twice had to reverse tightening moves/cycles since 2010 I think the RB will be pretty cautious about tightening again. After all, the Governor often notes that the TWI needs to come down, and he might quite welcome a significant fall – it would, among other things, ease any pressure for further OCR cuts.
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With 115,000 international students and an increase of 10% per annum, it is clear to me that there would be upward pressure on the NZD as these students start coming in for their courses within the next few months. A simple maths will give a indicative of that potential NZD buying activity. Student Fees are around $1 billion plus on expenditure like rent, food, accessories and in some cases buying houses rather than renting, spending to the tune of $4 to $5 billion. Due to the restrictive nature of money transfers from China and India, any money transfer needs governmental approval which means transfers likely occur once a year. NZD starts moving upwards due to fundamental buying activity for at least a large portion of that $5 billion spendup during the year.
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The $5 billion spend up may occur during the year but the funding of that spendup will come in as students start to receive their spending money from ma and pa overseas from Feb, Mar, April. There would be upward pressure on the NZD from hereon right up to April.
With Kmart expanding its NZ stores in competition and the Warehouse taking 15% decline in profits, the collapse of Pumpkin Patch and Dick Smith, JB hi fi in struggle mode and the Nosh all struggling, the indication is continued low inflation. The RB will face downward pressure on the OCR.
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What is surprising is that the level of savings deposits that a bank carry is not stress tested. Each time the RBNZ gets trigger happy with rapid interest rate increases they actually start to initiate bank instability. As interest rates rises more money would go into bank savings deposits which is in effect increasing the level of liabilities on a banks books.
Savings Deposits are afterall liabilities on the banks books and the interest payable is a cost. The Reserve Bank by its very massive intervention in the OCR ususally with 4 or 5 rapid interest rate increases makes a bank vulnerable to Net asset impairment of their financial position.
Faced with rising interest costs and net asset impairment the bank is then forced in a position of making risky loans in order to rebalance its financial position.
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