LVR restrictions

The successive waves of LVR controls that the Reserve Bank Governor has imposed on banks’ housing lending in recent years are back in the headlines, with comments from both the Prime Minister and the Leader of the Opposition (here and here).

As readers know, I’m no defender of LVR restrictions.  The other day I summarised my position this way

I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries –  appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks.   We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan book –  and those in other similar countries –  came through just fine.

The Bank’s statutory mandate is to promote the soundness and efficiency of the financial system.  On soundness, successive (very demanding) stress tests suggest that there is no credible threat to soundness, while the efficiency of the system is compromised at almost every turn by these controls.

At a more micro level, this comment (from my post yesterday) about the Bank’s debt to income limit proposals is just as relevant to the actual LVR controls they’ve put on in successive waves.

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

For all that, in partial defence of the LVR controls right now, many of those who are calling for the controls to be lifted or eased seem to be giving all the credit (or blame) for the current pause in housing market activity to the LVR controls.   That seems unlikely.  Other factors that are probably relevant include rising interest rates, self-chosen tightening in banks’ credit standards, pressure from Australian regulators on the Australian banking groups’ housing lending, a marked slowdown in Chinese capital outflows, and perhaps some election uncertainty (Labour is proposing various tax changes affecting housing).  I don’t know how much of the current slowdown is explained by each factor, but then neither do those focusing on the LVR controls.   Neither does the Reserve Bank.

And the backdrop remains one in which house price problems haven’t been caused mostly by credit conditions, but by the toxic brew of continuing tight land use restrictions (and associated infrastructure issues) and continuing rapid population growth.     Those two factors haven’t changed, so neither has the medium-term outlook for house and land prices.  Political parties talk about improving affordability, but neither main party leader will openly commit to a goal of falling house prices, and neither main party’s policies will make much sustained difference to the population pressures.   A brave person might bet on  some combination of (a) a recovering Australian economy easing population pressure, and (b) talk of abolishing limits around Auckland actually translating into action and much more readily useable land.  It’s a possibility, but so is the alternative –  continued cyclical swings around a persistently uptrend in the price of an artificially scarce asset.

And thus, in a sense, the Reserve Bank has a tiger by the tail.  House prices are primarily a reflection of serious structural and regulatory failures, and the problem won’t just be fixed by cutting off access to credit for some, or even by just buying a few months breathing space until a few more houses are built (before even more people need even more houses).   This isn’t a “bubble”, it is a regulatorily-induced severely distorted market.

So I strongly agree with the Prime Minister that, having repeatedly sold the LVR controls as temporary, the Reserve Bank Governor really needs to lay down clear and explicit markers that would see the controls be wound back and, eventually, removed completely.     And yet how can the Governor do that in any sensible way?   After all, the underlying problem wasn’t credit standards, or even overall credit growth.  It appeared to be simply that the Governor thought that he should “do something” to try and have some influence on house prices, even though he (a) had no good model of house prices in the first place, and (b) his tool didn’t address causes at all, and bore no relationship to those causes –  it was simply a rather arbitrary symptom-suppression tool.  And the Reserve Bank knew that all along –  they never claimed LVR controls would do much to house prices for long.

Because the interventions weren’t well-designed, any easing or removal of the controls will inevitably be rather arbitrary, with a considerable element of luck around how the removal would go.   What sort of criteria might they lay out?

  • a pause in house prices for a couple of years?  Well, perhaps, but as everyone knows no one is good at forecasting cyclical fluctuations in immigration.  Take off the LVR controls and, for unrelated reasons, house price pressures could still return very quickly,
  • housing credit growth down to, say, the rate of growth of nominal GDP for a couple of years.  But there isn’t much information in such a measure, as the stock of housing credit is mostly endogenous to house prices (high house prices require a higher stock of credit).

The latest set of restrictions seemed to be motivated as much by a distaste for investor buyers as by any sort of credit or systemic risk analysis, so it isn’t clear what indicators they could use to provide markers for winding back the investor-lending controls.  And since the Bank has never documented the specific concerns about banks’ lending standards that might have motivated the controls in the first place, it isn’t obvious that they could easily lay out markers in that area either.  Since the controls were never well-aligned with the underlying issues or risks, it seems likely that any easing won’t be able to be much better grounded –  almost inevitably it will be as much about “whim” and “taste” as anything robust.  Unless, that is, the incoming Governor simply decides they are the wrong tool for the job, and decides to (gradually) lift them as a matter of policy.   Doing so would put the responsibility for the house price debacle where it belongs: with politicians and bureaucrats who keep land artificially scarce, and at the same time keep driving up the population.

Some have also taken the Prime Minister’s comments as ruling out any chance of the Reserve Bank’s debt to income tool getting approval from the government.  I didn’t read it that way at all.

But he [English] explicitly ruled out giving the bank the added tool of DTIs, which it had requested earlier in the year.

“We don’t see the need for the further tools, Those are being examined. If there was a need for it then we’re open to it, but we don’t see the need at the moment. We won’t be looking at it before the election.”

As even the Governor isn’t seeking to use a DTI limit at present (only add it to the approved tool kit), and as submissions on the Bank’s proposal haven’t yet closed, of course the government won’t be looking at it before the election (little more than a month away).  It will take at least that long for the Reserve Bank to review submissions and go through its own internal processes.  In fact, at his press conference last week Graeme Wheeler was explicitly asked about the DTI proposal, and responded that it would be a matter for his (acting) successor and the new Minister of Finance to look at after the election.    Perhaps the Prime Minister isn’t keen, but his actual comments yesterday were much less clear cut on the DTI proposal than they might have looked.

In many ways, the thing that interested me most in yesterday’s comments was the way both the Prime Minister and the Leader of the Opposition seemed to treat decisions on direct interventions like LVR or DTI controls as naturally a matter for the Reserve Bank to decide.

The Prime Minister’s stance was described by as

However, he again reiterated that relaxing LVR restrictions was a matter for the Reserve Bank. “I’m not here to tell them what to do.” English said government was not going to make the decision for them and that he did not want to give the public the impression that politicians could decide to remove them. “The Reserve Bank decides that.”

The Leader of Opposition similarly

“But we’ve not proposed removing their ability to set those…use those tools,” Ardern said. “We’re not taking away their discretion and independence.”

Both of them accurately describe the law as it stands.  The Reserve Bank –  well, the Governor personally –  has the power to impose such controls.    But there isn’t any particularly good reason why the Reserve Bank Act should be written that way.

The case for central bank independence mostly relates to monetary policy.  In monetary policy, there is a pretty clearly specified objective set by the politicians, for which (at least in principle) the Governor can be held to account.  In our legislation, the Governor can only use indirect instruments (eg the OCR) to influence things –  he has not direct regulatory powers that he is able to use.

Banking regulation and supervision are quite different matters.  I think there is a clear-cut argument for keeping politicians out of banking supervision as it relates to any individual bank –  we don’t want politicians favouring one bank over another, and we want whatever rules are in place applied without fear and favour.  In the same way, we don’t want politicians making decisions that person x gets a welfare benefit and person y doesn’t.  But the rules of the welfare system itself are rightly a matter for Parliamant and for ministers.

There isn’t compelling reason why things should be different for banking controls (and, in fact, things aren’t different for non-bank controls, where the Governor does not have the same freedom).  As my former colleague Kirdan Lees pointed out on Morning Report this morning, when it comes to financial stability and efficiency, there are no well-articulated specific statutory goals the Reserve Bank Governor is charged with pursuing.  That gives the holder of that office a huge amount of policy discretion –  a lot more so than is typical for public sector agencies and their chief executives – and very little effective accountability.    So when Ms Ardern says that she doesn’t propose to take away the Bank’s discretion or independence, the appropriate response really should be “why not?”.

We need expert advisers in these areas, and we need expert people implementing the controls and ensuring that different banks are treated equitably, but policy is (or should be) a matter for politicians.  It is why we have elections.  We get to choose, and toss out, those who make the rules.  It is how the system is supposed to work –  just not, apparently, when it comes to the housing finance market.

I’ve welcomed the broad direction of the Labour Party’s proposal to shift to a committee-based decisionmaking model for monetary policy.   But, as I noted at the time of the release, their proposals were too timid, involved too much deference to the Governor (whoever he or she may be), and simply didn’t even address this financial stability and regulatory aspects of the Bank’s powers.      There is a useful place for experts but –  especially where the goals are vague, and the associated controls bear heavily on ordinary citizens –  it should be in advising and implementing, not in making policy.   Decisions to impose, or lift, LVR controls or DTI controls should –  if we must have them at all – be made by politicians whom we’ve elected, not by a single official who faces almost no effective accountability.



Doomed to repeat history…..or not

Last week marked 10 years since the pressures that were to culminate in the so-called “global financial crisis” burst into the headlines .

Local economist Shamubeel Eaqub marked the anniversary in his Sunday Star-Times column yesterday.  It grabbed my attention with the headlines Ten years on from the GFC” and “We appear dooomed to repeat history” .  

Frankly, it all seemed a bit overwrought.

It seems inevitable that there will be yet another crisis in the global financial system in the coming decade.

There have been few lessons from the GFC. There is more debt now than ever before and asset prices are super expensive. The next crisis will hopefully lead to much tighter regulation of the financial sector, that will force it to change from its current cancerous form, to one that does what it’s meant to.

The first half of the column is about the rest of the world.  But what really caught my attention was the second half, where he excoriates both the Reserve Bank and the government for their handling of the last decade or so.    This time, I’m defending both institutions.

There are some weird claims.

We were well into a recession when the GFC hit. So, when global money supplies dried up, it didn’t matter too much, because there was so little demand to borrow money in New Zealand anyway.

Here he can’t make his mind as to whether he wants to date the crisis to, say, August 2007 (10 years ago, when liquidity pressures started to flare up) or to the really intense phase from, say, September 2008 to early 2009.

Our recession dates from the March quarter of 2008 (while the US recession is dated from December 2007), but quite where he gets the idea that when funding markets froze it didn’t matter here, I do not know.  Banks had big balance sheets that needed to be continuously funded, whether or not they were still expecting any growth in those balance sheets. And they had a great deal of short-term foreign funding.  Frozen foreign funding markets, which made it difficult for banks to rollover any such funding for more than extremely short terms, made a huge impression on local banks.  For months I was in the thick of our (Treasury and Reserve Bank) efforts to use Crown guarantees to enable banks to re-enter term wholesale funding markets.  Banks were telling us that their boards wouldn’t allow them to maintain outstanding credit if they were simply reliant on temporary Reserve Bank liquidity as a form of life support.

Despite what he says I doubt Eaqub really believes the global liquidity crunch was irrelevant to New Zealand, because his next argument is that the Reserve Bank mishandled the crisis.

The GFC highlighted that our central bank is slow to recognise big international challenges. They were too slow to cut rates aggressively. They were not part of the large economies that clubbed together to co-ordinate rate cuts and share understanding of the crisis.

I have a little bit of sympathy here –  but only a little.  I well remember through late 2007 and the first half of 2008 our international economics people patting me on the head and telling me to go away whenever I suggested that perhaps events in the US might lead to something very bad (and I’m not claiming any great foresight into just how bad things would actually get).  And I still have a copy of an email from (incoming acting Governor) Grant Spencer in August 2007 suggesting that it was very unlikely the international events would come to much and that contingency planning wasn’t worth investing in.

And, with hindsight, of course every central bank should have cut harder and earlier.  I recall going to an international central banking meeting in June 2007 when a very senior Fed official commented along the lines of “some in the market are talking about the prospect of rate cuts, but if anything we are thinking we might have to tighten again”.

As for international coordination, well the Reserve Bank was part of the BIS –  something initiated in Alan Bollard’s term.  Then again, we were tiny.   So it was hardly likely than when various central banks did coordinate a cut in October 2008 they would invite New Zealand to join in.  Of its own accord, the Reserve Bank of New Zealand cut by 100 basis points only two weeks later (having already cut a few weeks earlier).

But what did the Reserve Bank of New Zealand actually do, and how did it compare with other advanced country central banks?

The OECD has data on (a proxy for) policy rates for 19 OECD countries/regions with their own currencies, and a few other major emerging markets.   Here is the change in the policy rates between August 2007 (when the liquidity pressures first became very evident) and August 2008, just before the Lehmans/AIG/ agencies dramatic intensification of the crisis.

policy rate to aug 08

The Reserve Bank had cut only once by this time.  But most of these countries had done nothing to ease monetary policy.  It wasn’t enough, but it wasn’t exactly at the back of the field, especially when one recalls that at the time core inflation was outside the top of the target range, and oil prices had recently been hitting new record highs.

That was the record to the brink of the intense phase of the crisis.  Here is the same chart showing the total interest rate adjustment between August 2007 and August 2009 –  a few months after the crisis phase had ended.

policy rate to aug 09

Only Iceland (having had its own crisis, and increased interest rates, in the midst of this all) and Turkey cut policy rates more than our Reserve Bank did.   In many cases, the other central banks might like to have cut by more but they got to around the zero bound.  Nonetheless, the Reserve Bank cut very aggressively, to the credit of the then Governor.  It was hardly as if by then the Reserve Bank was sitting to one side oblivious.

Obviously I’m not going to defend the Reserve Bank when, as Eaqub does, he criticises them for the mistaken 2010 and 2014 tightening cycles.  And the overall Reserve Bank record over several decades isn’t that good (as I touched on in a post on Friday), but their monetary policy performance during the crisis itself doesn’t look out of the international mainstream.   Neither, for that matter, did their handling of domestic liquidity issues during that period.

Eaqub also takes the government to task

The government bizarrely embarked on two terms of fiscal contraction. This contraction was at a time of historically low cost of money, and a long list of worthy infrastructure projects in housing and transport.

Projects that would have created long term economic growth and made our future economy much more productive, tax revenue higher, and debt position better.

Our fiscal policy is economically illiterate: choosing fiscal tightening at a time when the economy needed spending and that spending made financially made sense.

To which I’d make several points in response:

  • our interest rates, while historically low, remain very high relative to those in other countries,
  • in fact, our real interest rates remain materially higher than our rate of productivity growth (ie no productivity growth in the last four or five years),
  • we had a very large fiscal stimulus in place at the time the 2008/09 recession hit, and
  • we had another material fiscal stimulus resulting from the Canterbury earthquakes.

Actually, I’d agree with Eaqub that the economy needed more spending (per capita) over most of the last decade –  the best indicator of that is the lingering high unemployment rate – but monetary policy is the natural, and typical, tool for cyclical management.

And, in any case, here is what has happened to gross government debt as a share of GDP over the last 20 years.

gross govt debt

Not a trivial increase in the government’s debt.   Not necessarily an inappropriate response either, given the combination of shocks, but it is a bit hard to see why it counts as “economically illiterate”.  Much appears to rest on Eaqub’s confidence that there are lots of thing governments could have spent money on that would have returned more than the cost of government capital.  In some respects I’d like to share his confidence.  But I don’t.   Not far from here, for example, one of the bigger infrastructure projects is being built –  Transmission Gully –  for which the expected returns are very poor.

Eaqub isn’t just concerned about how the Reserve Bank handled the crisis period.

Our central bank needs to own up to regulate our banks much better: they have allowed mortgage borrowing to reach new and more dangerous highs.

I’d certainly agree they could do better –  taking off LVR controls for a start.  But bank capital requirements, and liquidity requirements, are materially more onerous than they were a decade ago.  And our banking system came through the last global crisis largely unscathed –  a serious liquidity scare, but no material or system-threatening credit losses.  Their own stress tests suggest the system is resilient today.  If Eaqub disagrees, that is fine but surely there is some onus on him to advance some arguments or evidence as to why our system is now in such a perilous position.

Macro-based crisis prediction models seem to have gone rather out of fashion since the last crisis.  In a way, that isn’t so surprising as those models didn’t do very well.     Countries with big increases in credit (as a share of GDP), big increases in asset prices, and big increases in the real exchange rate were supposed to be particularly vulnerable.  Countries like New Zealand.   The intuitive logic behind those models remained sound, but many countries had those sorts of experiences and had banks that proved able to make decent credit decisions.  And we know that historically loan losses on housing mortgage books have rarely been a key part in any subsequent crisis.     Thus, the domestic loan books of countries like New Zealand, Australia, Canada, the UK, Norway and Sweden all came through the last boom, and subsequent recession, pretty much unscathed.

One of the key indicators that used to worry people (it was the centrepiece of BIS concerns) was the ratio of credit to GDP.  Here is private sector credit as a per cent of GDP, annually, back to when the Reserve Bank data start in 1988.

psc to gdp

Private sector credit to GDP was trending up over the two decades leading up to the 2008/09 recession.   There was a particularly sharp increase from around 2002 to 2008 –  I recall once getting someone to dig out the numbers suggesting that over this period credit to GDP had increased more in New Zealand than it had increased in the late 1980s in Japan.  It wasn’t just housing credit.  Dairy debt was increasing even more rapidly, and business credit was also growing strongly.   There was good reason for analysts and central bankers to be a bit concerned during that period.  But what actually happened?  Loan losses picked up, especially in dairy, but despite this huge increase in credit –  to levels not seen as a share of GDP since the 1920s and 30s – there was nothing that represented a systemic threat.

And what has happened since?  Private sector credit to GDP has barely changed from the 2008 peak.  In other words, overall credit to the private sector has increased at around the same rate as nominal GDP itself.  It doesn’t look very concerning on the face of it.  Of course, total credit in the economy has increased as a share of GDP, but that reflects the growth in government debt (see earlier chart), and Eaqub apparently thinks that debt stock should have been increased even more rapidly.

It is certainly true that household debt, taken in isolation, has increased a little relative to household income.  But even there (a) the increase has been mild compared to the run-up in the years prior to 2008, and (b) higher house prices –  driven by the interaction of population pressure and regulatory land scarcity – typically require more gross credit (if “young” people are to purchase houses from “old” people).

If anything, what is striking is how little new net indebtedness there has been in the New Zealand economy in recent years.  Despite unexpectedly rapid population growth and despite big earthquake shocks, our net indebtedness to the rest of the world has been shrinking (as a share of GDP) not increasing.  Again, big increases in the adverse NIIP position has often been associated with the build up of risks that culminated in a crisis –  see Spain, Ireland, Greece, and to some extent even the US.   I can’t readily think of cases where crisis risk has been associated with flat or falling net indebtedness to the rest of the world.

There is plenty wrong with the performance of the New Zealand economy, issues that warrant debate and intense scrutiny leading up to next month’s election.  In his previous week’s column, Eaqub foreshadowed the possibility of a domestic recession here in the next year or two: that seems a real possibility and our policymakers don’t seem remotely well-positioned to cope with such a downturn.     But there seems little basis for “GFC redux” concerns, especially here:

  • for a start, we didn’t have a domestic financial crisis last time round, even at the culmination of two decades of rapid credit expansion,
  • private sector credit as a share of GDP has been roughly flat for a decade,
  • our net indebtedness to the rest of the world has been flat or falling for a decade,
  • there is little sign of much domestic financial innovation such that risks are ending up in strange and unrecognised places, and
  • whereas misplaced and over-optimistic investment plans are often at the heart of brutal economic and financial adjustments, investment here has been pretty subdued (especially once one looks at capital stock growth per capita).

In other words, we have almost none of the makings of any sort of financial crisis, “GFC” like, or otherwise.

House prices are a disgrace. We seem to have no politicians willing to call for, or commit to, seeking lower house prices.  But markets distorted by flawed regulation can stay out of line with more structural fundamentals for decades.  If house prices are distorted that way, it means a need for lots of gross credit.  But it tells you nothing about the risks of financial crisis, or the ability of banks to manage and price the associated risks.

Bank capital: some thoughts

Six months or so ago the Reserve Bank announced that it would be conducting a review of capital requirements for banks.  At the start of last month, they released an Issues Paper, inviting submissions by today (rather a short period of time, for an issue which has major implications for banks’ financing structures and, potentially, costs).   I’m not going to make a formal submission, but thought I might outline a few thoughts on some of the issues that are raised in (or omitted from) the paper.

I’d also note that it is a curious time to be undertaking the review.  Background work and supporting analysis is always welcome, but here is how the Reserve Bank summarises things.

Detailed consultation documents on policy proposals and options for each of the three components will be released later in 2017, with a view to concluding the review by the first quarter of 2018.

But the Reserve Bank is now well into a lame-duck phase.  Graeme Wheeler –  currently the sole formal decisionmaker at the Bank –  leaves office on 26 September, and then we have an acting Governor (lawfully or not) for six months.  Spencer’s temporary appointment expires (and he leaves the Bank) on 26 March 2018, which is presumably when a new permanent Governor will be expected to take office.   The incentives look all wrong for getting good decisions made, for which the decisionmakers will be able to be held accountable.     Big decisions in this area –  and the Bank is raising the possibility of big increases in capital requirements –  are something the new Governor should be fully coomfortable with (and, especially if an outsider is appointed, that shouldn’t just mean some pro forma tick granted in his or her first days in office.)    We have constitutional conventions limiting what governments can do immediately prior to elections.  It isn’t obvious why something similar shouldn’t govern the way unelected decisionmakers behave in lame-duck, or explicitly caretaker, periods.  Some decisions simply have to be made and can’t wait.   These sorts of ones aren’t in that category.

(In passing, and still on capital, I’d also note that there is something that seems not quite right about the Reserve Bank’s refusal to comment on why a couple of Kiwibank instruments have not been allowed to count as capital.   The capital rules should be clear and transparent.  The terms of the relevant instruments are also presumably not secret.  Perhaps Kiwibank has been told why their instruments missed out, but it seems unsatisfactory that everyone else is left guessing, or reliant on things like the deductions and speculations of an academic who was once a regulatory policy adviser (eg here and here).    I have no particular reason to question the Reserve Bank’s substantive decision, but these are matters of more than just private interest.  It is an old line, but no less true, that in matters where government agencies are exercising discretion sunlight is the best disinfectant.)

High levels of bank capital appeal to government officials.   To the extent that more of a bank’s assets are funded by shareholders rather than depositors then, all else equal, the less chance of a bank failing.  And if avoiding bank failure itself isn’t a public policy interest –  after all the Reserve Bank regularly reminds us that the supervisory regime isn’t supposed to produce zero failures –  minimising the cost of government bailouts is.   There might be various ways to do that –  the Open Bank Resolution model is designed to be one, but high levels of capital are another.

High levels of capital should also appeal to depositors and other creditors.  Your chances of getting your money back in full are increased the more the bank’s assets are funded by shareholdes, who bear the losses until their capital is exhausted.   Of course, that argument is weakened if you think that the government will bail out anyway, but that is just another reason for governments to err towards high levels of capital.

Capital typically costs more than deposits (or wholesale debt funding).  That isn’t surprising –  the shareholders are taking on more risk.  But, of course, the larger the share of equity funding then the lower the level of risk per unit of equity.  In principle, higher capital requirements lower the cost of capital.  Very low capital levels should tend to raise the cost of debt (debt-holders recognise an increased chance that they will be the ones who bear any losses).  Modigliani and Miller posited that, on certain assumptions, the value of a firm was unaffected by its financing structure –  to the extent that is true, higher capital requirements don’t affect the economics of (in this case) banking.

It won’t hold in some circumstances.  For example, if creditors are all sure a government will bail them out, a bank is much more profitable the lower the capital it can get away with.  In the presence of that sort of perceived or actual bailout risk, there is little doubt that increasing capital requirements is a real cost to the banks.  But it is almost certainly worth doing: it helps ensure that the risks are borne by the people responsible for the decisions of the bank (shareholders, and their representatives –  directors and management).

Taxes also complicate things.  If the tax system has an entrenched bias in favour of debt, then increased capital requirements will also represent a real cost to the banking system.  Many –  most –  tax systems do have such a bias.  For domestic shareholders, and to a first approximation, neither our tax system nor that of Australia have that bias.  That is because of the system of dividend imputation, which is designed to avoid the double-taxation of business profits (returns to equity).    Unfortunately, there is no mutual recognition of trans-Tasman imputation credits, and most of our banking system is made up of Australian banks with (mostly) Australian shareholders.   For most, but not all, of our banks increasing capital requirements is likely to represent some increase in effective cost.  And the resulting revenue gains are mostly likely to be collected by the Australian Tax Office.

An open question –  and one not really touched on in the Bank’s issues paper –  is to what extent our bank regulators should take account of these features of the tax system.  For most companies, capital structure is a choice shareholders and management make, weighing all the costs, benefits, opportunities and distortions themselves.  But in banking, for better or worse, regulators decide how much capital banks have to raise to support any given set of assets.   One could argue that tax is simply someone else’s problem:  if higher required capital ratios increased costs, the Australian banks could simply redouble their lobbying efforts in Canberra to get mutual recognition of imputation credits, and if that didn’t work, there would simply be a competitiveness advantage to New Zealand banks.   Perhaps that solution looks good on paper, but I think it is less compelling than it might seem. First, banks can and do lobby here too.  The Reserve Bank might get to set capital ratios at present, but that law could be changed.  And second, we benefit from having foreign banks, with risks spread across more than one economy.

Even if all the tax issues could be eliminated here –  and they won’t be in time for this review, if ever –  there is still the possibility that the market will trade on the basis that additional capital requirements will increase overall funding costs for banks, even if there is little rational long-term reason for them to do so.   One reason that problem could exist is because the tax biases are pervasive globally, and it is therefore a reasonable rule of thumb for investors to treat higher capital requirements as an expected cost.

Over the years, I’ve tended to have a bias towards higher capital requirements.  I’ve read and imbibed Admati’s book (for example).  As recently as late last year I wrote here

My own, provisional, view is that for banks operating in New Zealand somewhat higher capital requirements would probably be beneficial, and that there would be few or no welfare costs involved in imposing such a standard.  My focus is not on avoiding the possible wider economic costs of banking crises (which I think are typically modest –  if there are major issues, they are about the misallocation of capital in booms), but on minimising the expected fiscal cost of government bailouts.  As I’ve explained previously, I do not think the OBR tool is a credible or time-consistent policy.

But I have been rethinking that position to some extent.   The Reserve Bank talks in its Issues Paper of the possibility of an “optimal” capital ratio (from the academic literature) of perhaps 14 per cent (with estimates that range even higher), well above the minimum ratios that are in place today.

But if there are additional costs from raising capital requirements –  which seems likely, at least to an extent –  we need some pretty hard-headed assessments of the real gains that might accrue to society as a whole to warrant those increased costs.  And those gains are hard to find:

  • for over 100 years our banking system has been impressively stable.  If that was in jeopardy in the late 1980s, that was in unrepeatable circumstances in which a huge range of controls had been removed in short order (and when there were no effective minimum capital requirements at all).
  • repeated stress tests, whether by the Reserve Bank, APRA, or the IMF all struggle to generate credible extreme scenarios in which the health of an indvidual bank, let alone the system, could be seriously impaired.  In most of those scenarios, the existing stock of capital hasn’t been impaired at all, let alone being at risk of being exhausted.
  • we have a banking system where most of the main players are owned by major larger overseas banking groups with a strong interest in the survival of the domestic operation, and the ability to provide any required capital support (the New Zealand regulated entities aren’t widely-held listed companies).

I’m still not sure what to make of the role of the OBR mechanism.  As I noted earlier, I’ve never been convinced that it is a credible or time-consistent option, but our officials appear to, and even ministers talk up the option.  If they really believe that they (and their successors) will be willing and able to impose material losses on bank creditors and depositors in the event of a future failure, there can’t be any strong case for higher capital requirements (indeed, arguably a very credible OBR eliminates the basis for capital requirements at all).  Even if officials and ministers aren’t 100 per cent sure about OBR, any material probability of it being able to be used in future crises needs to be weighed into the calculations when a proper cost-benefit assessment of proposals for higher capital requirements is being done.  At present, there is little or sustained discussion of the OBR issues in the Issues Paper.  I look forward to the inclusion of OBR considerations in a proper cost-benefit analysis if the Bank does end up proposing to raise capital ratios.

My other reason for unease is that in the Issues Paper the Reserve Bank does not engage at all with, for example, the past stress test results.  There is nothing in the paper to suggest that current capital ratios don’t more than adequately cover risks.  Instead, they fall back on generalised results from an offshore literature, and arguments about why New Zealand capital ratios should be higher than those abroad.  Those simply fail to convince.

Here is the gist of their argument

One of the principles of the capital review is that the regulatory capital ratios of New Zealand banks should be seen as conservative relative to those of their international peers, to reflect New Zealand’s current reliance on bank-intermediated funding, New Zealand’s exposure to international shocks, the concentration of our banking sector, the concentration of banks’ portfolios, and a regulatory approach that puts less weight on active supervision and relatively more weight on high level safety buffers such as regulatory capital.

I’m not sure what weight should rest on that “be seen as” in the second line.  I presume not that much, as these seem to be presented as arguments that would warrant genuinely higher capital ratios than in other countries, not just something about appearances.  But in substance they don’t amount to much:

  • “New Zealand’s current reliance on bank-intermediated funding”.  I’m not quite sure what point they are trying to make here.  Does the Reserve Bank regard bank-based intermediation as a bad thing?  If so why?  I presume the logic of the point is something about it being more important than in most places to avoid bank failures, but that simply isn’t made clear, or justifed with data.  Payments systems –  a big focus of Bank concern around the point of a bank failure –  tend to be based through the banking system everywhere.  It is not even as if our corporate bond market –  while modestly-sized –  is unusually small by international standards.   (Incidentally, it is also worth noting that there appears to be nothing in the Issues Paper about non-banks, some of whom the Reserve Bank also regulates.  Making bank-based intermediation relatively more expensive –  which higher capital requirements could do –  would tend to lead to disintermediation.)
  • “New Zealand’s exposure to international shocks”.   Again, it isn’t obvious what this point amounts to.  Presumably the sorts of shocks New Zealand is exposed to are reflected in the scenarios used in the stress tests the Bank and others have run?  And it isn’t obvious that New Zealand’s economy is more exposed to international shocks than many other advanced economies –  there was nothing very unusual for example about our experience of the crisis of 2008/09.   I suspect that lurking behind these words is some reference to the old bugbear, the relatively high level of net international indebtedness –  a point the Bank and the IMF often like to make.   But this simply isn’t an additional threat to the soundness of the financial system.  Rollover risks can be real, but they aren’t primarily dealt with by capital requirements (but by liquidity requirements) and as we saw in 2008/09 the Reserve Bank can easily temporarily replace offshore liquidity.  Funding cost shocks also aren’t a systemic threat because, with a floating exchange rate, the Reserve Bank is able to offset the effects through lowering the OCR and allowing the exchange rate to fall.  The difference between a fixed exchange rate country and a floating exchange rate one, in which the bank system’s assets are all in local currency, seems to be glossed over too easily.
  • “the concentration of our banking sector”    Is this really much different from the situation in most smaller advanced economies (or even than Australia and Canada)?
  • “the concentration of banks’ portfolios”.  This seems a very questionable point.  Banks’ exposure in New Zealand are largely to labour income (the largest component of GDP, and the most stable) –  that is really what a housing loan portfolio is about – and to the export receipts of one of our largest export industries.  That is very different from, say, being heavily exposed to property development loans, to financing corporate takeovers, or other flavours of the day.   The effective diversification is very substantial, including the fact that in any scenario in which labour income is severely impaired (large increases in unemployment) it is all but certain the exchange rate will be falling (boosting dairy returns).  The two biggest components of the banks’ books themselves thus provide additional diversification.
  • “a regulatory approach that puts less weight on active supervision and relatively more weight on high level safety buffers such as regulatory capital.”     Is the Reserve Bank really saying they believe that on-site supervision would produce better financial stability outcomes?  I’m sceptical, but if they are saying that, surely the case would be strong to change the regulatory philosophy.  It would, almost certainly, be cheaper than a large increase in capital requirements.  At very least, if they want to rely on this argument, it would need to be carefully evaluated in any cost-benefit analysis.

It all leaves me a bit uneasy as to whether there is really the strong case for higher capital ratios that the Bank might like us to believe.  They’ll need to provide much more robust analysis if they really choose to pursue such an option.

And a final thought.  The Bank devotes some space in their Issues Paper to considering the role of convertible capital instruments  –  issued as debt but converting to equity under certain (more or less well-defined) adverse event circumstances.  In doing so, they provide vital loss-absorbing capacity, providing a buffer for depositors and other non-equity creditors.  There are some practical problems with these instruments –  the Bank touches on many of them –  and they probably shouldn’t be marketed to retail investors (at least without very explicit warnings) lest the pressures mount for holders of these instruments also be to bailed out in a crisis.     Nonetheless, in the presence of the tax issues discussed earlier, convertible instruments look like a generally attractive option for supporting the robustness of banks in a cost-efficient way.

Given that I was interested in this paragraph  on convertible instruments from the Bank.

In New Zealand there has been no conversion at all of Basel-compliant AT1 and Tier 2 instruments, because banks have not been in financial difficulty, so there is even less certainty about the practical effects of conversion in New Zealand’s particular legal and institutional environments. In the Reserve Bank’s view these instruments should be regarded as essentially untested in the New Zealand environment.

Of course, the same can be said for OBR, and indeed for almost all the crisis-management provisions of New Zealand bank supervisory legislation.

The Bank does draw attention to the risk of bailouts of holders of convertible capital (co-co) instruments.  On the other hand, they can work when banks fail.  Earlier this week, Banco Popular in Spain “failed”.  It was taken over, for 1 euro, by Banco Santander, which will inject a lot of new equity into Popular.   Popular had co-co instruments on issue.  Here is what happened to the price of those bonds.

popular co-co

Banks can fail, banks should fail from time to time (as businesses in other sectors should), and when they do it should be clearly established who is likely to lose money.  This looks like a good example, where the shareholders and the holders of the co-cos will have lost everything they had invested in these instruments.

To revert briefly to our own Reserve Bank’s review, perhaps there is a case for higher capital ratios.  But, if they want to pursue that option, it isn’t likely to be cost-free, and any such proposal will need to be backed by a robust and detailed cost-benefit analysis. For now, it isn’t clear that the reasons they have suggested why capital ratios here should be higher than those in other advanced countries really stand up to scrutiny.


The Financial Stability Report: falling short again

The Reserve Bank yesterday released its six-monthly Financial Stability Report.   With (fortunately) no new direct controls to announce, the latest FSR didn’t get a great deal of coverage, and I won’t be writing about it at great length either.  But there were a few points that I thought it was worth making.

First, I thought it was a little surprising that the Bank did not have a bit more discussion of euro (and EU) break-up risk.  It has been a slow-burn process (materially slower than pessimists like me had expected) but none of the underlying stresses seem to be going away.  This weekend alone we have the Italian referendum, which could see the fall of the mainstream Italian government, and the rerun of the Austrian presidential election.  In the first half of next year, there are elections in France and the Netherlands, and in both countries anti-euro parties are polling very strongly.  The Reserve Bank does note problems in the banking systems of various European countries, but these are symptoms of some of the underlying problems not the source of the main risk.  As with all tail-risks, it is impossible to get the timing right, but to me these euro/EU risks remain by far the largest visible disruptive threat to the world economy and world markets over the next decade (China, by contrast, is more closed to the world, and has a strong (grossly over-strong) central government).  Perhaps the Reserve Bank feels uncomfortable writing about these euro/EU risks –  it might make for awkward conversations for the Governor the next time he goes to BIS meetings –  but these reports are for New Zealand citizens, not for the international fraternity of central bankers.  If it is too awkward to reflect on real and substantial risks, one has to ask how much value there is in FSRs more generally.  Conventional, and anodyne, references to Brexit and/or the US election don’t really cut it.

Second, it was a bit disappointing that even in a financial system piece like the FSR, the Bank still couldn’t help itself, and insists on running the line that

“New Zealand’s economy is strong relative to other advanced economies, growing 2.8 per cent in the year to 2016”.

And our population grew by 2.1 per cent in that year.  Per capita GDP growth is weak, and has been over the last few years taken together. I illustrated a while ago that relative to other advanced countries, growth in real GDP per capita since 2013 has been around the median.  And there has been no labour productivity growth here at all.

At one level when the Bank writes misleading things like this it doesn’t matter very much.  But at another level it does. Society has delegated an enormous amount of power to the Governor, including the resources to produce major reports like the FSR. We should expect them to avoid rose-tinted political perspectives.  If they don’t on small issues like this, how can we have much confidence in their willingness to accurately represent things in conditions of much greater stress or risk?

In the FSR the Bank puts quite a bit of weight on the increased use banks have been making of offshore wholesale funding.  I was a bit puzzled by this increased use, since there has been no sign of the current account deficit widening notably (and bank offshore borrowing tends to grow most notably when the current account deficit is large –  it was the main channel through which the larger deficits were financed).  I was interested in this chart, drawing on data from the Reserve Bank website.  It shows annual growth in Private Sector Credit to resident, and a broad measure of the money supply (M3, from residents), both adjusted for repo transactions.

psc and m3.png

The deposit side of the financial system balance sheet is growing at around the same rate as the credit side, hardly suggestive of any particular problems.  If anything, it looks as though banks’ increased reliance on foreign wholesale funding markets isn’t reflecting some deteriorating domestic macroeconomic imbalances, so much as the specification of the Reserve Bank’s core funding requirement (CFR) which, somewhat arbitrarily, distinguishes between some types of domestic deposits and others.  I don’t have a strong view on how the CFR is set up, and I believe some funding restrictions are necessary –  to internalise what would otherwise be a willingness of banks to simply rely on the central bank in times of stress.  But no such rule is perfect, and it would be good if the Bank were a bit more explicit about where the pressure for more (more expensive) foreign wholesale funding seems to be coming from.

One of my longstanding criticisms of FSRs over the years (including when I sat on the editorial committee reviewing them internally) is the weak treatment of the efficiency side of the Bank’s statutory responsibilities.  The Bank is required to use its statutory bank regulation powers to “promote the maintenance of a sound and efficient financial system”.  There is an almost inevitable tension between those two strands –  something I believe that Parliament recognised in phrasing things the way it did –  and the Act also requires the Bank to write FSRs in ways that allow the conduct of policy to be evaluated against the statutory criteria.

In yesterday’s FSR there is one paragraph (and one table) on the efficiency side of the Bank’s responsibility, under the somewhat ambiguous heading “Some indicators suggest New Zealand’s banking system is operating efficiently”.  Am I meant to take from that that other indicators, not reported, suggest otherwise?  I’m also a bit genuinely puzzled why the Reserve Bank considers that a low ratio of NPLs is an indicator of system efficiency.  In credit booms there are typically very few NPLs –  they come after the boom has bust.  In very risk averse systems there are typically very few NPLs.  In isolation, it simply doesn’t look like an efficiency indicator.      And the Bank simply does not address the inevitable adverse efficiency implictions of its increasing reliance on direct controls on specific classes of lending by specific types of institutions.   There has never been a proper cost-benefit analysis on the repeated waves of new controls.  Perhaps it is hard to do one formally, but the FSR should be an opportunity for some more considered analysis exploring some of these issues. As it is, it risks veering towards being a propaganda sheet for the Governor’s chosen policies.  Perhaps it is hard for it to be otherwise, especially under the current governance model –  the Governor signing off on a report on his own policy –  which simply highlights against the desirability of structural governance reform.

The FSR reports no reason to doubt the ability of the insurance sector to cope with the recent severe earthquake.  Perhaps the event was too recent to allow them to deal with the issue in any greater depth, but for the next FSR it might be worth posing the question as to what might threaten the ability of New Zealand insurers to keep getting reinsurance in large volumes for earthquake risk.    The NOAA database suggests that of the 33 earthquakes of 6.5 magnitude or greater to have hit New Zealand since 1840, 10 –  or almost a third –  have hit in the last 10 years (and the very destructive February 2011 aftershock was less than 6.5).    Is there a risk that a continuation of that sort of higher quake frequency could serously impair the ability to insure earthquake risk in New Zealand?  As we know that the Reserve Bank solvency standards for insurers were not set to cope with a repetition of the Christchurch quakes, what sort of tail risk concerns might this raise –   not just for the insurers, at least for the wider (currently) insured population?

The Reserve Bank has underway a review of the capital requirements for banks. on which they expect to consult next year.  As they note at present

The Reserve Bank will also look at international norms when considering calibration of New Zealand’s capital requirements. In raw international comparisons, the current capital ratio of New Zealand banks is relatively low. But a simple comparison is potentially misleading as the risk weights that New Zealand banks must apply to certain asset classes are set conservatively. This means New Zealand banks’ capital ratios appear lower than foreign banks’ ratios for the same underlying portfolios.

After adjusting for the conservative approach New Zealand takes, the Reserve Bank’s preliminary assessment is that New Zealand banks’ riskweighted capital ratios have been near or above international norms.

Looking ahead  (emphasis added)

As part of the review, the Reserve Bank will consider the appropriate amount and quality of capital New Zealand banks should be required to maintain. This will involve a survey of recent academic and central bank studies on optimal capital ratios. Care will be taken when interpreting these studies as they tend to be sensitive to assumptions about the effect of capital on banks’ funding costs and the scale of GDP losses that are directly attributable to banking crises.  It is also unclear how the inclusion of different types of capital affects the results of these studies.

I found those comments encouraging.  While I would hope that the Bank always interprets literature carefully, there are particular issues in this area.

Thus, those arguing for much higher bank capital ratios often suggest (for example) that all or most of the underperformance in economies since 2008 can be ascribed to the banking crises. If one assumes that, it is worth society spending almost any amount of money to avoid a repeat.  A more plausible story is that the banking crises themselves explain only a rather small amount of a structural global slowdown in productivity growth (that was already underway well before the crisis).  On other hand, those opposed to higher capital requirements often argue that having to fund a larger proportion of loans from equity would materially increase the cost of funding.  That approach tends to ignore both the potential for the Reserve Bank to cut the OCR, to offset any incipient rise in interest rates, and –  more importantly –  ignores the extent to which a higher reliance on equity reduces the riskiness of the institutions, and should reduce the required rate of return on equity.  Tax systems can complicate that story, but the New Zealand (and Australian) tax systems, with dividend imputation, tend to treat debt and equity more or less equally.

My own, provisional, view is that for banks operating in New Zealand somewhat higher capital requirements would probably be beneficial, and that there would be few or no welfare costs involved in imposing such a standard.  My focus is not on avoiding the possible wider economic costs of banking crises (which I think are typically modest –  if there are major issues, they are about the misallocation of capital in booms), but on minimising the expected fiscal cost of government bailouts.  As I’ve explained previously, I do not think the OBR tool is a credible or time-consistent policy.

Many of these have been relatively small points, at least for now.

I am more uneasy about two aspects of the report, one of which is missing completely.

There is simply no discussion at all –  and has been none in past reports –  of what the implications of drifting ever closer to the near-zero lower bound on nominal interest rates might be for financial system resilience in a further severe recession.  One of the great merits of a floating exchange rate system has been the flexibility it provides to national central banks to adjust policy interest rates, more or less without limit, as domestic conditions require. But the limits are now becoming increasingly visible.  It is remiss of the Bank – both in its MPS, its FSR, and its more corporate documents such as its Statement of Intent, or governors’ speeches – not to even begin to address these issues openly.  Simply ignoring them doesn’t make them go away, and there will no acceptable excuse if we find ourselves in the same position many other advanced countries found themselves in after 2008, having been given a decade’s sharp-focus notice of the potential problem.

And my final source of unease is around the Reserve Bank’s analysis of the housing market.  The Bank puts a great deal of importance on developments in the housing market, and the market for housing credit.  It is has imposed successive rafts of direct controls, of the sort never seen before in post-liberalisation New Zealand, all on the basis of little or no research.  And in the latest FSR, there is no fresh analysis, just the looming threat of debt to income restrictions –  if the market takes off again –  so long as the Governor can persuade the Minister of Finance to give him political cover (and of course he will, or otherwise the Opposition will attack the Minister for standing in the way of the Reserve Bank).

I’ve noted in the past that we’ve seen no analysis from the Bank on, for examples, countries that have had large increases in house prices and where there has been no subsequent financial crisis, or even collapse in house prices.  New Zealand, Australia, the United Kingdom and Canada in the 2000s are just some of the examples that spring to mind.  And although the Bank keeps talking about the problems in housing supply, they show no sign of having really thought deeply, or researched, the role of land market restrictions.  The New Zealand housing market is unlikely to be sorted out by simply building enough houses to keep the occupancy rate stable – or even a few more.  There is a much more structural issue around restrictions on land use (accentuated by the heavy regulatory costs imposed on building new houses).  I’m not aware of countries with floating exchange rates and tight land use restrictions where urban house and land prices have sustainably come down again.  Perhaps the Bank is, but if so surely the onus is on them to disseminate the research, rather than continuing to hand-wave and treat all house price increases as more or less equally risky.  When house prices are bid up on the back of congressional and executive pressure on lenders to lower lending standards, on pain of potentially losing favour with the regulators, that is a very different issue than when the combination of population pressures and land use restrictions drive prices up. But the Reserve Bank has never articulated that sort of distinction.

It is more than three years now since the Reserve Bank set off down the path of increasing direct controls (with no end in sight, let alone the prospect of removing the controls).  I went through the list of their Analytical Notes, Discussion Papers,  and  Bulletins over the last three years or so, and was struck by how little housing-market research they have published.  For an organisation with so much discretionary power, and a substantial publicly-funded research capability, it really isn’t good enough.

I could repeat a variety of points from previous commentaries –  including questions about what other risks banks are assuming if they are prevented from taking on as many high LVR housing loans as they would like –  but will leave it at that for now.



LVR controls, regulatory philosophy (and the OIA)

I’ve had a bit of a relapse in my recovery and seem set to spend much of this week doing little more than lying on the sofa reading something not too taxing.  There are plenty of things I’d like to comment on substantively, but for now it won’t happen.

The Reserve Bank released its (latest –  third in three years) final LVR decision on Monday.  To no one’s surprise, after a sham consultation, they confirmed the Governor’s original plans, albeit with some curious refinements to the exemptions –  curious, that is, if one thinks that decisions on such things should be based on considerations – the statutory ones – around the soundness and efficiency of the financial system.

And although the lawgiver has now descended from the mountain and issued his unilateral decrees, which have the force of law, there is still no sign of a regulatory impact assessment.  There is talk in the summary of submissions that one is forthcoming, but really……when the regulatory impact assessment is published only some time after all the decisions have been made, it reveals quite how little weight the Governor seems to put on good processes.  And it is not as if the initial consultation document was sufficiently extensive and robust to cover the ground –  recall the “cost-benefit” analysis that consisted of a questionable list of pros and cons with no attempts to quantify any of them.

One of the other things I had hoped to comment on in more depth was a speech given last week by Toby Fiennes, the Reserve Bank’s Head of Prudential Supervision. on the Bank’s regulatory philosophy and supervisory practices.    It included this nice chart, outlining various aspects of financial institutions’ operations and how much, in the Bank’s judgement, they mattered to the “RBNZ and society” (as if these were the same thing) and how much they mattered to the institutions themselves.

Figure 1: Selected interests of the RBNZ, society and financial institutions


Fiennes went on to note that the blue areas aren’t of much interest to the Bank (and don’t therefore attract much regulatory interest), while the red area are typically quite heavily and directly regulated.

But in this context, it was the comments on the green areas that caught my eye

Some things – like risk management and underwriting standards (in green) – are of strong interest to both the Reserve Bank and firms. Here we tend to use market and self-discipline. Examples of some of our supervisory practices in this area are:

  • Disclosure of credit risks;
  • Mandatory credit ratings;
  • Governance requirements; and
  • Publicly disclosed attestations by the board that key risks are being managed.

Now I know that the Bank’s prudential supervisors have never been keen on LVR restrictions, and that they are devised in a different department, but……..all controls are imposed under the same legislation –  indeed the same part of the legislation –  and by the same Governor.  And when housing loans are the biggest single component of banks’ credit exposure –  and banks have most to lose if things go wrong – and yet when the Bank has imposed three sets of direct controls on housing LVRs in three years, imposing its own judgements on underwriting standards, you might have hoped that practice and “philosophy” might have been better reconciled, or the gaps smoothed over in a speech by the Head of Prudential Supervision.

As regular readers know, I’ve been pushing to get submissions on Reserve Bank regulatory proposals routinely published.  Such publication is common practice in other areas of government, including submissions to parliamentary select committees.  If you make a submission seeking to influence public policy, that submission should generally be public as matter of course –  it should be one of the hallmarks of an open society.

Some progress has been made with the Reserve Bank.  If someone asks, they will now typically release submissions made by anyone who isn’t a regulated institution.  I asked for all the submissions on the latest LVR “proposal” to be released, and  –  as expected –  the Bank has released all those not made by banks (the regulated institutions in this proposal).  Anyone interested can find those submissions here. I have three remaining areas of concern.

The first is that release of submissions should be a routine part of the process for all consultations, not just when someone makes the effort (remembers) to ask.  The second is that on this occasion they have withheld the names of four private submitters.  As I noted, if you want to influence lawmaking, you should be prepared to have your name disclosed.  How can citizens have confidence in the integrity of lawmaking processes if they don’t know who the Bank is receiving submissions from, and what interests they may represent?  (Of course, since one of the anonymous submitters appears to have views very similar to my own, we can safely assume that that person’s views will have had no influence on the Bank.)

And the third concern is that the Reserve Bank is still consistently keeping secret the views of regulated entities (the banks in this case).  When the regulated lobby the regulator it is particularly important that citizens are able to see what arguments are being made, to ensure that the process remains robust and that the regulators are not being “captured” by their closeness to the regulated –  bearing in mind that the Bank is supposed to be regulating in the public interest, not that of banks.   As I’ve noted before, the Bank justifies withholding bank submissions on the grounds of section 105 of the Reserve Bank Act –  which they argue compels them to withhold such material.  In fact, that section of the Act gives no hint of a distinction between material received from banks and that from other parties,  If section 105 applies to submissions on proposed regulatory changes, the Bank is obliged to keep secret all submissions, not just those from banks.  As I’ve noted before, there is a good case for a small amendment to the Reserve Bank Act to make it clear that the section 105 protections do not apply to submissions on regulatory proposals and hence that banks should expect their submissions to the Reserve Bank on regulatory initiatives to be published, in just the same way that bank submissions to parliamentary select committees will generally be published.

I have appealed to the Ombudsman the Bank’s decision to withhold the bank submissions, in effect seeking greater legal clarity on what the section 105 restrictions actually apply to.  In the meantime, of course, if the banks have nothing to hide –  and I don’t imagine they really do –  they could chose to publish their submissions.  According to the Summary of Submissions “a few respondents urged tighter LVR restrictions on investors than proposed”, so perhaps the ANZ really did follow up on their CEO’s newspaper op-ed and advocate more far-reaching restrictions.  If so, citizens should have the right to know (customers might be interested to, but that is their affair).

Norway and the kitchen sink

In their weekly commentary yesterday, the ANZ economics team offered some thoughts on monetary policy and inflation targeting as conducted in New Zealand.   Among their comments was a reaction to my post the other day about Norway’s success in keeping inflation (and inflation expectations) up.

We noted some comparing the inflation performance of New Zealand and Norway last week, with the latter managing to achieve its inflation target. The argument was that other central banks had achieved it through looser monetary policy so the RBNZ could too. It certainly may be possible to get inflation up by throwing the kitchen sink at it. But household debt in Norway has risen to nearly 230% of disposable income (and is one of the highest in the OECD); that’s an accident waiting to happen. Is the economic cost of CPI inflation being 0.4% versus an arbitrary magical 2% that dire an outcome when one considers the possible side effects of this ‘kitchen sink’ style approach?

As a reminder, here are the policy rates for Norway and New Zealand.

policy int rates nz and norway

I don’t want to put too much weight on Norway, but:

Norway’s approach doesn’t look like ‘the kitchen sink” to me.  It looks like what many/most other central banks have done.   As inflation pressures around the world proved much weaker than most had expected, Norway had more leeway than most (their policy interest rate still hasn’t got to zero, let alone the extreme lows of Switzerland (-0.75 per cent) or Sweden (-0.5 per cent).  They used that leeway, and it seems to have delivered results (inflation fluctuating around target).   By contrast, our Reserve Bank has been constantly reluctant to cut –  having only realized quite late in the piece that they really shouldn’t have been tightening.  As I noted the other day, had the Reserve Bank done nothing more than hold the OCR at 2.5 per cent for the whole time since Graeme Wheeler took office, it is likely that today New Zealand’s inflation rate would be nearer target, and there would be less reason to worry about inflation expectations.  Had they set the OCR at its current level –  2 per cent –  even a year ago, things would look less problematic on the inflation front than they are now.  I don’t accept the characterization that even cutting the OCR to 1 per cent now would be an over the top reaction.  After all, even at that level our nominal policy interest rate would still be materially higher than those in most of the rest of the advanced world (with the important exception of Australia, but then Australia has a higher inflation target than most countries do and so –  all else equal –  should really have slightly higher nominal interest rates).  And many of the advanced economies would have been grateful to have had any additional policy leeway they could have found.  They didn’t have it.  We do.

Am I wholly comfortable with the idea of policy rates at 1 per cent or less, here or in other countries?  No, I’m not.  There is a variety of factors that help explain why policy rates, and long bond rates, are so low –  notably changing demographics and deteriorating productivity growth, both of which weaken the demand for investment –  but I don’t think anyone fully has the answer.  And if you ask whether, over the next 30 years I expect real interest rates to be higher than they are now, I’d answer yes to that.  But that just isn’t (or shouldn’t be) the basis for setting policy rates now –  apart from anything else, we just don’t know much of this stuff with any confidence/certainty.

When central banks set policy rates they should be, more or less, responding to market forces (savings supply, investment demand) –  attempting to mimic what the market would do if governments had not given central banks the right to issue our money.  In the immediate wake of the 2008/09 recession, it was plausible to argue that central banks were holding short-term interest rates down.  Implied future long-term interest rates (freely traded in the market) didn’t come down much at all.  These days that argument no longer holds. In fact, yesterday 10 year government bond rates in New Zealand were actually below 90 day bank bill rates.

yield gap

If anything, on this measure, monetary policy has been tightening not loosening (not inconsistent with my earlier chart showing that the real OCR remains above where it was for most of the post-recession period, even as inflation continues to undershoot).  The last time this measure got above zero was in early 2015, just before the succession of OCR cuts began.

But ANZ appears to believe that the best argument against following Norway in doing what it takes to get inflation back to around target is that Norway’s household debt is among the very highest in the OECD.  In both my posts on Norway, I have pointed out that Norway has had very large house price increases and high household debt.  The Norwegian government has responded to any associated financial stability concerns, by accepting the central bank’s recommendation to impose a “countercyclical capital buffer” on banks –  a relatively non-distortionary measure that requires banks to temporarily hold a larger margin of capital, just in case.

But the Norwegian story is much less alarming than ANZ makes out.   First, while house prices in Norway are very high, here is house price inflation in Norway for the last decade or so.

norway house price inflation

Not great, but much lower than what we’ve been experiencing recently in New Zealand.

And what about household debt?  I presume the ANZ economics team have read Chris Hunt’s Reserve Bank Bulletin article explaining some of the many pitfalls in comparing household debt to disposable income ratios (this piece looking across Nordic countries is also useful)?

That partly reflects challenges in comparing the level of debt across countries.  There are several types of issues.  For example, many countries include the debt associated with unincorporated business activities (small business owners, owner operated farms and some lending associated with rental property) in household sector accounts, since getting good breakdowns can be difficult.  In New Zealand, farm lending and non–mortgage lending to small businesses is not part of household debt, while mortgage lending that finances small business should also be excluded. However, much of New Zealand’s rental property is held by small investors, and lending that finances (the business) of renting out residential property generally is included in the New Zealand measure of household debt.

The other important difference is the way that institutional differences, such as those in the tax system can affect the gross assets and liabilities on a household’s balance sheet across countries, even if the net wealth is the same for two households.  In the Netherlands, for example, interest deductibility for mortgages on owner occupied houses encourages borrowers to have interest only mortgages on the liability side of their balance sheet and, for example, tax-preferred insurance policies on the other side.  At some point, the asset is used to extinguish the liability, but for households with the same amount of wealth and income, both financial assets and financial liabilities will be higher in the Dutch system than they would in the New Zealand system.

In Norway, for example, interest on mortgages is tax-deductible, which is not the case (for owner-occupied houses) in New Zealand.  A country with a stronger tradition of occupation pension schemes, for example, will –  all else equal –  tend to see higher outstanding levels of household debt, and higher levels of pension assets on the other side of a household’s balance sheet.  And a country in which the government levies high rates of tax on individuals and returns the proceeds in high levels of public services (consumed by households) will, all else equal, have a much higher ratio of household debt to disposable income –  for no greater threat to financial stability –  than a country with a lower average tax rate and a lower flow of public services to households.  Last year, on OECD numbers, Norway’s government receipts were 55 per cent of GDP, while New Zealand’s were 42 per cent.    It makes a real difference: if we look instead at the ratio of household debt to GDP, Norway (currently 95 per cent) is actually slightly below New Zealand (currently 99 per cent).

In short, comparisons across time in individual countries are generally meaningful (since the institutional and tax features typically change only slowly), but comparisons across countries at any one period in time are fraught.  The Reserve Bank article rightly focuses on the former.

The Reserve Bank publishes household debt data back to 1990.  In 1990, household debt in New Zealand was 28 per cent of GDP.  That ratio is now 99 per cent of GDP.    Here is a long-term time series chart I found for Norway


Household debt to GDP in Norway was already around 70 per cent in 1990, and hasn’t been as low as 28 per cent any time in the 40 year history of this series.  If one looks just at, say, the years since 2007, Norway has had more of an increase than New Zealand has, but over a longer-run of time household debt here has increased by (materially) more than what they’ve experienced in Norway.

Of course, perhaps ANZ would like to now reverse the argument and suggest that we need to be even more cautious since we’ve run up much more debt (in change terms) than Norway.  But then they’d have to confront the stress tests (in New Zealand) and the judgements of the respective supervisors that both countries’ banking systems are sound.  Recall those New Zealand stress test results –  and the ANZ is the largest bank in New Zealand –  in which a 55 per cent fall in Auckland house prices and an increase in unemployment to 13 per cent wasn’t enough to severely impair the position of New Zealand banks.  If ANZ thinks that conclusion misrepresented their risks, a phone call to the Reserve Bank’s supervisors might be in order.

Arguing against doing what it takes to get inflation back to fluctuating around 2 per cent on the basis of household debt numbers just isn’t very compelling. And as I’ve noted before, most of the increase in household debt is in any case a reluctant endogenous response to higher house prices, themselves the outcome of land use restrictions colliding with immigration-driven population pressures.

And that is before considering the other side effects of the current (“reluctant cutter”) policy approach the ANZ seems to be endorsing.  We’ll get another read on the unemployment rate tomorrow, but for now the unemployment rate of 5.2 per cent is well above any estimate of the NAIRU (including Treasury’s of around 4 per cent).  The unemployment rate has been above the NAIRU for seven years now, and almost by definition that gap is one that monetary policy could have done something about had the Reserve Bank chosen to.  There are well-documented long-term adverse implications for the individuals concerned if they are out of employment for long.  That is a rather more concrete cost –  seven years –  than the sort of ill-defined, but quite well protected against, risk around the level of household debt that ANZ worries about.  The Swedes ran policy for several years worrying about household debt risks, before they finally realized that Lars Svensson was right after all and began to cut rates aggressively.

There are distributional implications too. The “reluctant cutter” approach has left our (real and nominal) exchange rate higher than it needed to be –  consistent with meeting the inflation target. In the longer-term countries get and stay rich by finding products they can sell successfully to the rest of the world –  that is, after all, where most of the potential consumers are.  As a reminder, here is our export performance.

exports to gdp by govt

Another 100 basis points off the OCR wouldn’t transform this picture –  the long-term challenges are more about structural policy –  but in the last few years the trend has been in the wrong direction, and a misjudged stance of monetary policy has reinforced that.

There are some other things in the ANZ commentary that I agree with. I strongly endorse their call for a monthly CPI (a properly done one), and I was pleased to see their skepticism as to whether the large scale immigration programme is producing per capita income gains for New Zealanders. I might return to some of the questions about the best design of the monetary policy regime another day.

In the meantime,  for all of the ANZ’s economics team unease about the risks of housing debt, there is no sign of ANZ having published its submission on the Reserve Bank’s proposed new LVR controls.  So we still have no way of knowing whether their CEO was serious is his call for the LVR limits to be set even tighter than what the Reserve Bank is proposing.

The Reserve Bank wants most property investors around the country to have 40 percent deposits in future. We think they should go harder and ask for 60 percent.

I don’t suppose he was, but it would be interesting to see the economic arguments and evidence for such a proposal.

Tricontinental: revisiting the financial disasters of the 1980s

Browsing a few weeks ago in a secondhand bookshop in an obscure Northland village, I stumbled on Tricontinental: The Rise and Fall of a Merchant Bank, a  fascinating 1995 book documenting the utter disaster that Australia’s largest “merchant bank” –  by then wholly-owned by the State Bank of Victoria –  became in the late 1980s.  That failure was followed by a Royal Commission, helping to ensure that events around it –  including the failures of management, auditors, owners, politicians and regulators –  are better-documented (or more accessibly documented) than in most bank failures.

In both New Zealand and Australia, the mid-1980s was a period of great exuberance in banks and financial markets.  Controls that had been in place for decades were removed in pretty short-order (the changes were more far-reaching in New Zealand than in Australia, but Australia’s changes were large enough).  Exchange controls were removed, exchange rates were floated, interest rate controls were removed, new entrants to the financial system were allowed, and in both countries there were reforming (notionally) left-wing governments.  Brighter futures for all were in prospect.

Stock markets soared and those who were energetic and lucky quickly made themselves huge fortunes –  most of which had gone again only a few years later.  Debt paved the way, financing takeovers, often-questionable real investment projects (the Australasian commercial property glut followed) and (in Australia in particular) massive reshuffles of media holdings as the regulatory ground shifted.  Total credit –  and especially total business credit –  saw almost explosive growth.  Names like Bond, Holmes a Court, Brierley, Judge, Hawkins, Skase and so on dominated the business media.  There was even ridiculous talk of New Zealand firms having a comparative advantage in takeovers. The media were often enthralled by what was going on  –  it made for great stories –  and it was probably hard for politicians to resist either.  After all, a lot of political capital had been staked on those reforms, and associating with success tends to be much more attractive to politicians than the alternative.  On this side of the Tasman, the defining images of the period are probably (a) newly-listed goat farms, and (b) the way shares in the Fay/Richwhite entity rose and fell with the successes (and subsequent failure) of the New Zealand entry in the 1986/87 America’s Cup in Perth.

Much of what went on in those years ended very badly.  Many of the key business figures afterwards spent time in prison.  Many major corporates failed –  not in itself a bad thing –  and many banks did too.  On this side of the Tasman, the well-publicized disasters were the (predominantly government-owned) DFC and BNZ, and the less visible NZI Bank. In Australia, Westpac came under extreme stress, and the State Banks of Victoria and South Australia were the most visible calamities.  The State Bank of Victoria enabled Tricontinental –  and in turn Tricontinental did the lending that was enough to end its parent’s 150 year independent existence.

Tricontinental didn’t start (in 1969) as a government-owned entity.  Indeed, the name reflected the early spread shareholding –  stakes held by banks on three continents, dating from the pre-deregulation days when the best way for foreign banks to get into the Australian market had been through the merchant banking sector, which in turn was beyond the scope of many of the regulatory restrictions (eg on how short a term deposit could be) on banks.  It wasn’t wildly different here –  there had been huge disintermediation to the non-bank sector in the couple of decades prior to our deregulation.

But in the post-1984 ownership reshuffles, Tricontinental –  always a fairly aggressive, but fairly small, player –  became a wholly-owned subsidiary of the (Victorian government owned) State Bank of Victoria.  And in the same period, there was the rapid rise of Ian Johns, first as Tricontinental’s lending manager and then as CEO.  Johns was pretty young, had never (that I could see from the book) been through a serious economic downturn, but had the drive and aggression that enabled him to forge relationships and build a rapidly-growing lending business –  typically with emerging “entrepreneurs”, and generally not with the “big end of town”.  And if funding such a fast-growing lending book might have been a bit of an issue –  even in those heady days –  even that concern largely dissipated once Tricontinental came wholly under the wing of SBV –  one of the establishment institutions of Victoria, historically the financial centre of Australia.  SBV didn’t really even want to own Tricontinental in the long-term –  they thought they were dressing it up for a sale.  But in the meantime, there were next to no market disciplines, little or no regulatory discipline, and near non-existent self-discipline (including from the Board, the SBV Board, or SBV’s owners the Victorian government).

Reading the book, it was both staggering  and sadly familiar just how badly wrong things went.  Since 2008 I’ve read numerous books on the failures of individual institutions –  in Iceland, Ireland, the UK, the US, the Netherlands, past and present, as well as more general treatments of banking crises in these countries and Japan, Finland, Sweden, Norway.  There aren’t many new things under the sun, and Tricontinental wasn’t one of them.    In a way, it was a product of its time, but that doesn’t take away the responsibility of individuals and institutions.

Credit growth doesn’t just happen.  It needs people who want to borrow and people who are willing to lend.  In post-liberalization Australia (and New Zealand) there was no shortage of people with superficially plausible schemes who were willing borrow whatever anyone would lend.  Sadly, there were all too many people willing to lend –  attracted by some mix of the high fees, high credit spreads (Tricontinental apparently charged both), the mood the times, expectations of shareholders’ (everyone else is booking high profits, why not you?) –  and few people willing to say no.  Of course, those who had tried to say no might well have been shoved aside –  “get with the new world” –  but as far as one can tell from the book, hardly anyone ever tried to say no in Tricontinential/SBV.  The CEO drove the lending business, there was little robust internal credit analysis, the emphasis was on fast turnaround of proposals, and while Board approval was required for all major loans, often this was sought by couriering out papers to individual Board members’ and requiring consent within 24 hours  (and Board members weren’t just the glittering “great and good”; many look like the sort of people who would easily pass “fit and proper” tests).   Loans were collateralised, but the quality of security was typically poor (and often much worse than the not-overly-curious Board realized).  Internal guidelines –  eg on concentrated exposures –  were routinely ignored, and redefined to suit, and recordkeeping and reporting systems were grossly inadequate.  Auditors rarely asked hard questions –  and had they done so would no doubt have jeopardized their mandate –  and no one anywhere seems to have wanted to explore the possibility that things could go very badly wrong.  The Reserve Bank of Australia had few formal regulatory powers –  state banks were established under specific state legislation, and merchant banks weren’t generally supervised –  but hardly pushed to the limits its informal powers of persuasion or access.

After the 1987 sharemarket crash it all came a cropper.  Not on day one –  it took several years for the full scale of the disaster to become apparent (not that different from the situation here, where DFC only finally failed two years after the crash) –  but the fate was largely sealed then.  Share prices didn’t keep rising indefinitely.  Castles built in the air had their (lack of) foundations exposed.  And the value of collateral quickly dissipated.   Billions of dollars in loan losses were eventually recorded, destroying the parent, and (apparently) contributing in no small measure to the fall on the then Victorian Labor government.

As I noted, there was a Royal Commission inquiry into the failure –  itself embroiled in political controversy and legal challenges.  The authors of the book suggest that the Royal Commission bent over backwards to excuse many people, but no one seems to emerge that well from the episode.  It wasn’t, as the Commission reports, mostly about criminality or corruption (although Johns did go on to serve time in prison on not-closely-related offences), but was caused mostly: ordinary human failings, such as the careless taking of risks while chasing high rewards (in a decade noted for its commercial greed), complacent belief in the reliability of others, lack of attention to detail, and arrogant self-confidence in decision-making –  all of which resulted in poor management and unsound business judgements.

They criticized Johns “arrogant self-confidence, lack of business acumen, naivety when dealing with well-known entrepreneurs, lack of candour at times amounting to deviousness, and unwillingness to admit error”, the CEO of SBV (who sat on the Tricontinental Board) (“he appears to have been weak when he should have been strong”),  the Board chair, the Reserve Bank, and the rest of the SBV and Tricontinental directors.

Listed entities, with market disciplines, fail from time to time.  In wild booms all too many get caught up to some extent in the excesses.  And not all bank failures should be considered bad things.  But it is difficult to escape the conclusion that government-owned banks are that much more prone to running into serious financial strife than others, perhaps particularly when they are run at arms-length in a more deregulated environment (it was hard for any bank to fail in 1960s New Zealand or Australia).  We saw it in New Zealand and Australia in the 1980s, and with the German landesbanks.  Perceptions of too-big-to-fail around state-sponsored entities like the US agencies go in the same direction. And it is why I have never been comfortable with Kiwibank –  and am only more uncomfortable if the planned reshuffling of ownership within the New Zealand state sector goes ahead.  Market discipline doesn’t work perfectly –  perfect isn’t a meaningful standard in human affairs –  but it seems considerably better than the alternative, lack of market discipline.  And, regulators being human, when market discipline is weak, regulators often aren’t much help anyway –  they breath the same air, and are exposed to same hopes and dreams as the rest of us.

For anyone interested in Australasian financial history, the Tricontinental book is fascinating. I went looking to see what happened afterwards to some of the key characters –  Johns after all was still quite young in the early 1990s – but Google failed me.  There just doesn’t seem to be much around. But the interest is probably mostly in reliving the atmosphere of the times, when so much damage was wrought so quickly on both sides of the Tasman.

It is also, though, a reminder, of how poorly served New Zealand is in financial history.  There is no comparable book about the DFC failure (although Christie Smith at the RBNZ did an interesting recent draft paper on it), nothing comparable on the BNZ failure, and there are no serious works of economic or financial history on the extraordinarily costly and disruptive banking and corporate period after 1984.  There are small individual contributions (and I learned a lot from some memoirs by Len Bayliss on his experiences as a BNZ director during the period), but no single work of reference to send people to.  There must be huge paper archives still around –  both those of the institutions concerned and those of the Treasury and the Reserve Bank –  and many of the players are still alive.  A book of the Tricontinental sort written 2o years ago could have been no more than a first draft of history.  At this distance, it is surely the opportunity for some more serious reflective historical analysis that would, among other things, secure the record for future reference.

Reflecting on these sorts of institutional failures, it got me wondering again about the sorts of climates in which the risks build up that culminate in bank failures. Alan Greenspan’s phrase “irrational exuberance” springs to mind.  There was plenty of exuberance in post-1984 New Zealand and Australia, with asset prices and credit rising extremely rapidly to match. Whole new paradigms for assessing, or ignoring, risk were championed.  And in the respective domestic economies, times felt good too –  in one headline indicator, New Zealand’s unemployment rate, in the midst of widespread economic restructuring, was around 4 per cent.  Those look like the sorts of climates that characterized most of the advanced country crises of recent decades –  Ireland recently, or Japan or the Nordics in the 1990s being the clearest examples.  By contrast, today’s New Zealand –  limping along with modest real per capita GDP growth, subdued confidence,  lingering unemployment, few new or significant credit providers just doesn’t seem to fit the bill (no matter much the combination of population pressures and land use restrictions) drive house prices up.  (I wrote a piece last year on the lack of parallels between now and 1987.)

It is good to know there is diversity of views at ANZ

The Australian head of ANZ’s New Zealand business, David Hisco, was out last night with an article in the Herald headed Housing and New Zealand dollar overcooked.

Hisco is gung-ho on LVR limits.  Here are two of his list of “things that should be done”.

Heavily increase LVR limits for property investors. The Reserve Bank wants most property investors around the country to have 40 percent deposits in future. We think they should go harder and ask for 60 percent. Almost half of house sales in Auckland are to property investors. Taking them out of the market will be unpopular amongst investors but it may end up doing them a favour. Of course this would mean less business for us banks but right now the solution calls for everyone to adjust.

Voluntary tightening of lending criteria by banks. Since the GFC banks have been more conservative than ever on lending. But the current situation will see ANZ implement even tougher criteria for investment loans as house price inflation spreads from Auckland to other regions.

I have no problem at all if the management and Board of ANZ Bank want to adopt tighter lending standards.  They run a private business, in a competitive market, and must make their own choices about what risks are worth it, for their shareholders, to run.  Bureaucrats and politicians are fond of second-guessing those choices, and we all know that banks have made mistakes in the past –  as businesses in all sectors do –  but there is rarely much basis offered by the bureaucrats and politicians for thinking their assessments of what risks private lenders should run are better than those of the bankers.  Actually, Australasian bankers have had a pretty good record over many decades –  and when things did go wrong in the late 1980s, it had as much to do with bureaucrats and politicians as with bankers: repress an industry for decades by regulatory fiat, and inevitably it will take everyone a while to learn how to lend (and borrow) well in a much different environment.

It is the first of those paragraphs above that I have a problem with.  If Mr Hisco really thinks it would be imprudent –  they couldn’t make a positive expected risk-adjusted return from doing so –  to lend to anyone wanting to buy a potential rental property with an LVR over 40 per cent, he probably has the delegated authority to make that change himself.   Today.  He is paid a great deal of money by ANZ, and his board –  and superiors in Australia –  presumably think highly of his ability to manage the bank, including its credit risks   It simply doesn’t need a bunch of bureaucrats telling him to do his job.

But his paragraph seems stronger on the rhetorical flourishes than on the analysis.  After all, where have nationwide nominal house prices ever fallen by 60 per cent?  And even if they did fall 60 per cent –  or even more –  in Auckland to perhaps bring price to income ratios down to a more sensible 3 (rather than the current 10), such falls seem exceptionally unlikely in much of the rest of the country, where real house prices have barely changed in almost a decade.  Can bankers really not make money lending to landlords in Oamaru or Invercargill at LVRs of even 50 per cent?  If so, they must be a lot less good at their jobs than they would typically have us believe?  If so, one might reasonably hope for the emergence of new entrants to the new mortgage lending market – preferably non-bank lenders beyond the reach of the Reserve Bank’s controls.   One can always worry about extreme hypotheticals, but if one did no bank would ever lend money to anyone for anything –  which would rather defeat the point of setting up in business as a bank.

But I don’t suppose we will actually see ANZ move to ban all mortgages for residential investors with LVRs in excess of 40 per cent.  Instead, Hisco wants the Reserve Bank to do it for him.    That would enable him to tell his Board that he simply had no choice, and provide cover when profits fell below shareholder expectations.  That should be no way to run a business in a market economy –  although sadly too often it is.  It is good illustration of the distinction between pro-business and pro-market policies: the former too often involve politicians, bureaucrats and big business people in each other’s pockets, providing cover for actions that work against the interests of citizens.  We already see this  happening to some extent with the Reserve Bank and the banks: the Reserve Bank adamantly refuses to release submissions made by banks on its regulatory proposals.

If Hisco followed his own analysis and banned all investor mortages with LVRs above 40 per cent, no doubt ANZ would lose a lot of market share.  If Hisco was fundamentally right, and in another year or two house prices nationwide did fall 60 per cent, he’d be vindicated as presumably ANZ’s loan losses would be much lower than those of other banks who didn’t follow his lead (unless of course he’d taken the capital that would have funded investor mortgages and used it on something that proved even riskier, if currently less visible).  It is all very well to invoke the old Chuck Prince (ex Citi CEO) line about “while the music goes on one has to stay on the dance floor”.  But top executives are paid to be a bit ahead of the game in how they position their own businesses.  Of course, they aren’t always rewarded –  as often in life –  for being too far ahead, but nothing stops Hisco making his case to the Board and shareholders for pulling lending standards in even more than the Reserve Bank requires them to. If the shareholders decline, and in good conscience he cannot bring himself to undertake such lending, he could consider other career options.

As it happens, his own economics team doesn’t seem to agree with him.  Of course, they aren’t the people setting credit standards for the ANZ, but it was interesting to see their note on Tuesday shortly after the Reserve Bank had released its new proposals. It concluded.

To us, the case for requiring investors to have a 40% deposit is not overly
strong. This is particularly considering the RBNZ’s own stress tests and the fact that most investor lending was already done at sub-70 LVRs anyway.

There must be some interesting conversations going on at the ANZ.  It would be very interesting to see the ANZ submission on the Reserve Bank’s proposals, and if the Reserve Bank won’t release it, there is nothing to stop ANZ itself doing so.  I’ll be surprised if they do, and even more surprised if the submission recommends limiting all investors throughout the country to LVRs not in excess of 40 per cent.

Hisco seems to have some form as regards bold calls.  Digging around, I stumbled on this piece from October 2014, less than two years ago.  It was full of all sorts of calls for interventionist active government, but not a mention of LVR limits or bank lending standards.   Back then –  21 months ago, and not that much has changed since then –  it was all about supply.

The housing affordability issue is a housing supply issue, pure and simple. In 1974 there were 34,400 new homes built. Last year there were 15,000 – less than half. It’s no wonder houses doubled in price in under a decade in Auckland.

The solution is simple – urgently build more houses. To do that in places like Auckland we need to build more suburbs and allow intensification in existing areas.

In his latest piece, he hasn’t totally abandoned the supply arguments, but has rather markedly backtracked.  It doesn’t appear in his five point list of things we should do now, and there is just this

The Leader of the Opposition says we need to build more homes faster. That makes sense, too, if we have the resources and approvals to do it.

And yes I did notice his comments about immigration.   This is what he says about that item in his five point plan

Review immigration policies. Immigration has been great for New Zealand. We are a harmonious, diverse and inclusive society. But Auckland’s housing, roads, public transport and schools are struggling to cope. Let’s have an honest and sensible debate about immigration using facts rather than prejudice to see if we should push the pause button.

Debating using “facts rather than prejudice” seems a good idea in most areas of life, but his approach doesn’t really seem to offer much.    There is little evidence (“facts”) to suggest that immigration has been “great for New Zealand”, but on-off immigration policies seem about as undesirable as unpredictable regulation in any other area of life.



This is what good policy formulation looks like now?

I’ve now read the Reserve Bank’s consultation document on the latest iteration of their ever-extending, but highly unpredictable, LVR restrictions, and also the issue of the Bulletin they released yesterday Financial stability risks from housing market cycles.  Neither document seemed remotely convincing: just a series of the same old material, now twice-over lightly, that mostly doesn’t stand up to much scrutiny.  It was particularly striking that in the Governor’s mad rush to put yet more controls on banks and yet more potential borrowers, he never stops to reflect on any lessons from the fact that this is the third iteration (the Third Coming, as Gareth Vaughan puts it) of these controls in less than three years.  Does this not raise any questions in the Governor’s mind –  or those holding him to account –  about the Bank’s ability to set these sorts of controls effectively and provide a stable climate for private businesses and households?

But I’ve been tied up with other stuff today, and even on the Governor’s rushed timetable there are still a few days left to think harder about the Bank’s analysis.  (It is noteworthy that, despite the Bank’s commitment only a few months ago to longer consultative period, there is no attempt in the consultative documents to make a case for why action is so urgent that the new –  welcome –  standard is just tossed out the window.  Various critics suggest the Governor has bowed to political pressure, but I don’t believe that is the explanation).

So today I wanted to focus mostly, and quite briefly, on this table from the Bank’s consultative document.  As the Bank itself puts it, this table summarises the discussion “through the lens of a cost-benefit analysis”.

It looks like no cost-benefit analysis I’ve ever seen. I could commend to the Governor and his staff The Treasury’s guide to undertaking cost-benefit analysis.   Agencies simply cannot get away with calling a short list of possible costs and benefits, painted with the broadest possible brush and with not a number in sight, a cost-benefit “analysis”.  How could anyone look at a table like this and conclude with any confidence that what the Governor is proposing is in the national interest?  Perhaps he is right, but this table simply doesn’t show it.

Everyone knows there is a great deal of uncertainty about many of the possible costs and benefits, but one of the key arguments for disciplined  numerical cost-benefit analysis is that it forces agencies to write down numbers, make the case for those numbers, and illustrate the sensitivity of the resulting bottom line to a reasonable range of alternative assumptions.  Everyone knows bureaucrats and ministers game the system to help produce the outcomes they want, but the discipline of writing down the numbers is part of enabling others to scrutinize what is being proposed.  As a reminder, this is a consultative document –  a proposal for scrutiny and external comment –  and the Governor is legally required to have regard to submissions that are made. The law isn’t supposed to allow the Governor to simply rule by decree.

It is also striking that nowhere in the document, or anywhere in the cost-benefit so-called “analysis” is there any sense of the distributional implications of the proposed policy.  Who gains and who loses is often as important as the aggregate assessment of national costs and benefits? It isn’t clear that the Bank has given that any thought whatever.  That shouldn’t be good enough: Treasury, the Board, and  relevant parliamentary select committees should be questioning the Bank about the inadequacy of what it has rushed out yesterday.

What should be doubly disconcerting is that the Bank also shows no sign of having thought, in a disciplined way, about the distinction between private and social costs and benefits.  For example, take the very first “benefit”.    Loan losses are not a loss for the country as a whole, they are simply a redistribution of wealth among people within the economy.  Banks might be glad to have lower loan losses at some future date, but then banks –  private businesses accountable to their shareholders –  are able to adjust their lending practices themselves. Indeed recent evidence –  banks reining in, or cutting altogether, lending to offshore borrowers –  illustrates that they do just that.  What is that gives the Governor confidence that he is better able to make those judgements than the private businesses he is regulating?  We simply aren’t told –  even though this is his third attempt to get it right.

And why is a temporary reduction in house price inflation –  the second “benefit” –  a national gain.  Again, it redistributes gains/losses among players in the economy –  providing slightly cheaper entry levels in the near-term for those not directly affected by the controls, at the expense of those who are directly affected.   How do we value this alleged “gain”, especially if the fundamental distortions in the housing market –  yet more regulations –  aren’t changed.

I could go on.  There is, for example, no attempt to justify the proposition that it matters less if potential landlords are squeezed out of the market than if potential owner-occupiers are squeezed out.  And from a financial system efficiency perspective one could reasonably argue that an upsurge of non-bank lenders would  actually be a net gain, given that the controls are being put on at all.  But in any case, there is not a single number in sight.

These are highly intrusive controls, being imposed in a sweeping manner, and there simply isn’t much to underpin them.  Perhaps it won’t matter much to the Bank.  After all, the Prime Minister, the Labour Party Finance spokesperson, and even the former leader of the ACT Party seem to be in favour.   But citizens deserve much better quality policy formulation than what we have here.

I noted yesterday that it wasn’t clear quite why, even if one granted the need for some controls, we needed to effectively prohibit purchases of rental properties in places like Wanganui and Gisborne with LVRs above 60 per cent.  I half-hoped the consultative document might shed some light, but no.  Simply nothing.

As a reminder, real house prices in New Zealand as a whole are almost unchanged from the levels in 1987 –  and since those in Auckland are so much higher, those in the rest of the country  as a whole must be lower.

qv house prices since 2007 peak

We didn’t have a domestic financial crisis after 2007.  And I’m quite sure that anyone borrowing in those cities to the right of the chart, and anyone lending to them, is very conscious that house prices can go down as well as up.  The case for this regulatory imposition just isn’t made.

As ever, if the Bank is determined to rush ahead and do something more (perhaps on the  maxim that “something must be done by someone, and the Bank is ‘someone'”), the much less distortionary, and less knowledge-intensive, approach would be to increase capital requirements, either more generally or specifically on housing lending.  Doing so would provide bigger buffers, at minimal cost to banks and borrowers (since the financing structure shouldn’t materially affect the overall cost of capital).  The Governor talks complacently about longer-term reviews of capital requirements, but higher capital requirements could be imposed now.  I doubt there is a good economic case for doing so, but it is much less bad case than what we’ve been presented with in this latest consultative document.


Stress tests really should reassure us…for now

Last year, in the course of the Reserve Bank’s faux consultations on its proposed investor finance LVR restrictions, I devoted several posts to the results of the Reserve Bank’s stress-testing exercise.  Those tests –  2014 ones –  appeared to show that, even if faced with a very severe adverse shock to (in particular) house prices and unemployment, the New Zealand banking and financial system would come through substantially unscathed.  “Substantially unscathed” here meant some significant loan losses, not typically enough to wipe out even a full year’s profit, and a decline in capital ratios –  the latter simply because in the models as house prices fell the assigned risk weight on each still-performing loan would rise (eg a loan that might have had a 60 per cent LVR at origination becomes a 90 per cent  LVR loan if house prices fall by a third).   But there was nothing that suggested a threat to the soundness of any of the banks, or the banking system as a whole.   That result should not have been too surprising.  Bank shareholders have considerable amounts of  their own money at stake and credit allocation in New Zealand is not distorted by large scale government interventions (unlike pre-crisis US, or Ireland).  Housing loan books typically don’t see huge losses even in really severe crises –  and there hasn’t been a mad rush of highly risky corporate or property development lending in recent years.  But if the  banks came through such tough stress tests in relatively good shape, what possible basis could there be for yet more rounds of direct regulatory controls, which inevitably impair to some extent the efficiency of the financial system?

The Reserve Bank was never really satisfactorily able to respond to this point, even when some media and MPs started asking the questions.  The Governor went ahead and regulated anyway.

And now he seems to want to do so again.

This year, the Reserve Bank has been back with some more stress test results.  I wrote about their 2014 dairy stress test results here.  That scenario, and the results, didn’t look sufficiently severe, and there are already signs of worse outcomes than those indicated by the stress tests.

And then in last month’s FSR, we had the results of another set of stress tests on banks’ entire loan portfolios.

In late 2015, the four largest banks in New Zealand participated in a common scenario ICAAP test. This test was a hybrid between an internal test (conducted regularly with each institution choosing their own scenarios) and a regulator-led stress test (occurring every 2-3 years with common scenarios and assumptions). Due to the use of a common scenario across banks, the results of the test provided insights for the financial system as a whole. However, the test featured less standardisation of methodology than a full regulator-led exercise. For example, there was no ‘phase 2’ where loss rates were standardised.

Like the 2014 regulator-led stress tests, the scenario used in this exercise was severe

As with previous regulator-led tests, the stress scenario was a severe macroeconomic downturn. Over a three-year period, real GDP fell by 6 percent, unemployment rose to 13 percent, and dairy incomes remained at low levels. Residential property prices fell by 40 percent (with a more severe fall of 55 percent assumed for Auckland); and both commercial and rural property values fell by 40 percent. Finally, the 90-day interest rate fell by about 3 percentage points due to monetary policy easing,

These are very demanding scenarios.  In particular, for the unemployment rate to rise to 13 per cent, it would have to increase by more than 7 percentage points from the current quite-elevated level.  Even in the severe recession in the early 1990s, associated both with a financial crisis, disinflation and considerable fiscal consolidation, and a period of substantial structural change, New Zealand’s unemployment rate did not get above about 11 per cent.  No other floating exchange rate country has experienced an increase in its unemployment rate of that magnitude in modern times –  not even, for example, the US following 2007.

To be clear, I’m not objecting to the scenario.  Stress tests are really only useful if they use quite severe scenarios –  anyone can pass easy tests –  but this scenario looks to have quite a few buffers built in.  Similarly, a 55 per cent fall in Auckland house prices would be one of the larger falls ever seen anywhere –  again, not totally implausible, especially as New Zealand is prone to population shocks –  but about as large as the biggest falls ever experienced in an advanced country major city.   On the other hand, the last sentence of that scenario is worth noting: the ability to cut policy interest rates provides a substantial buffer (to economies and banking systems) in difficult times.  But with the OCR at 2.25 per cent, it would now be quite a stretch –  to the outer limits of conventional monetary policy –  for the 90 day bill rate to fall by three percentage points.  The Bank may need to take explicit account of that limitation in future stress tests.

In this stress test, the overall losses were quite substantial

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

Nonetheless, underlying operating margins were largely maintained, so that

underlying earnings during the scenario were of a similar magnitude to reported credit losses, so that return on assets averaged around zero.

In a very severe adverse scenario, banks did not make losses.  They simply did not make any profits.

But risk-weighted capital ratios still fell.

Although projected credit losses were largely absorbed with underlying profitability, capital ratios were expected to decline throughout the scenario. This reflected an increase in the average risk weight from around 50 to 70 percent, due to negative ratings migrations (rising probability of borrower defaults) and falling collateral values (rising losses given default).

In fact, although risk-weighted capital ratios fell during the scenario, simple leverage ratios, of total capital to total assets, (while not reported) are likely to have increased.  The dollar value of capital did not fall (no overall losses) while in estimating how the Reserve Bank’s severe shock would affect them and their businesses, banks generated results which implied a decline in credit exposures by 11 per cent. The Reserve Bank does not like leverage ratios, but most other regulators and analysts see a useful place for them –  the OECD, for example, used to regularly urge New Zealand to adopt them.

And here, for completeness, is that Reserve Bank’s chart of how the capital ratios behaved.

C2: Capital ratios relative to respective minimum requirements (% of risk-weighted assets)

Figure C2 Capital ratios relative to respective minimum requirements (% of riskweighted assets)

The regulatory minimum is zero on this chart, so banks were well away from that, even after this severe adverse shock –  and, of course, regulatory minima have been increased since before the 2008/09 downturn.  The grey area is the so-called “conservation buffer” and as the Reserve Bank notes

the average bank reported falling into the upper end of the capital conservation buffer in the final year of the test, which would trigger restrictions on dividend payments to shareholders (figure C2).

Since none of the big banks in New Zealand is listed, the temporary limitation on the ability to pay a dividend is unlikely to be too troubling.    Banks don’t want to be in the conservation buffer, and will seek to get out of it again.  But carry the scenario forward a year or two and on the basis of normal earnings they would probably get back there fairly quickly.  What each bank might actually do might, of course, depend on the health of its parent –  if the parents were experiencing a similar adverse scenario in Australia, the market and management pressures on the New Zealand subsidiary to quickly restore capital buffers would be materially greater.

Despite all this essentially “good news” story –  savage recession, huge unemployment, severe falls in leveraged asset prices, and yet the banking system is still in pretty good shape –  the Reserve Bank has never really been happy with the story.   That is implicit in the FSR and, from what I hear, also the story they tell people who come to visit them.

I think there is a variety of reasons for that, including innate regulator/central banker caution.  Some of that attitude is a good thing, provided it is conditioned by a good understanding of how systemic banking crises in other places/times have actually developed.  Here it doesn’t seem to be.

They also seem uneasy because their scenarios do not consciously take account of any second-round effects of the reduction in credit exposures the banks would effect as part of the response to the extreme adverse scenario.   As noted above, banks estimated that their credit exposures would fall by 11 per cent.  The Reserve Bank has long worried that such a reduction in the stock of credit would act as an additional factor amplifying the economic downturn and the fall in asset prices, such that the initial macro scenario they set out for the banks was no longer sufficiently demanding.

In principle, it is a fair point.  In practice, I think it is misplaced for two main reasons.

The first is that in developing their severe economic scenario they will have benchmarked it against other really nasty downturns in other times/places.  But any additional impact of forced bank deleveraging –  over and above the initial shock that triggered the downturn –  will already be included in the GDP/unemployment and asset price numbers we see.  The 1991 downturn in New Zealand included any additional impact from the BNZ and DFC failures, the post 2007 US recession included any deleveraging impacts from all the financial institution failure and additional lender caution, and so on.  It would be double-counting to take as extreme a scenario as the Reserve Bank is using, and then add a whole new downturn on top of that, as banks pulled in their lending horns.

The second reason is that it doesn’t look as though the Reserve Bank has given anything like adequate weight to the way in which the size of a mortgage book is driven primarily by house prices and housing turnover.    In the FSR discussion, they do note that the reduction in credit exposures “could reflect a reduction in customer demand” –  there is less investment etc in recessions for example – this seems a very weak statement of what would be likely to occur with bank mortgage books in particular.

A while ago, I ran a chart illustrating the way in which a simple initial shock to house prices goes on raising household debt to income ratios for years afterwards, even if there is no subsequent further increase in house prices.  That occurs just because the housing stock turns over relatively slowly, and so after prices move to a new high level it takes years for all purchases to have taken place at the new higher price (and associated higher need for credit).

This was that chart.  Price double in year 1, are unchanged thereafter, and borrower LVRs are the same after the initial shock as they were before.

scenario debt to income

In fact, in housing booms typically involve borrowers and lenders becoming less risk-averse and housing turnover increasing.

scenarios 2

You can see the difference higher initial LVRs and slower repayments make –  it still takes years for debt to income ratios to reach a new steady-state level, and the process will happen more or less automatically, unless banks actively stand in the way. Turnover and prices drive mortgage books.  When both increase, banks’ credit exposure will increase without them really trying.

But the same process can happen in reverse.

Recall that in the Reserve Bank’s scenario house prices fall by 40 per cent (and 55 per cent in Auckland.)  I’m assuming that the 40 per cent applies to the rest of the country, so lets say nationwide house prices fall by 45 per cent.  Each new house being purchased, even if the initial LVRs stay the same, now takes 45 per cent smaller mortgages than was required before house prices fell.

But in downturns, it isn’t only prices that fall.  In fact, turnover often falls first.  Sellers are reluctant to sell below purchase price, and many people are just genuinely uncertain. Economic downturns leave potential buyers more cautious too.  The drops in turnover can be very substantial.   Even in New Zealand, house sales per capita over 2008 to 2011 were only around half the rate seen at the peak of the boom in 2003.  Housing mortgage  approvals data only start at the end of 2003, but the same sort of fall is evident in approvals –  and this is a recession much less severe than the one in the Reserve Bank’s stress test scenario, and in which house prices fell by only around 10 to 15 per cent.

So what happens to the volume of housing credit outstanding if we assume:

  • house prices nationwide fall by 45 per cent, and stay at that low level thereafter
  • housing turnover (and new mortgages) fall by 50 per cent and stay at that low level for five years, before reverting to normal.

In the base scenario (the first chart above), we assumed prices double in year 1.    That produced a stock of debt which rose substantially in the first few years, and then kept rising slowly thereafter for many years.  Lets assume the severe adverse shock happens in year 10.  This is what happens to the stock of housing mortgage debt in the two scenarios.

scenarios 3

The differences are really large, without the banks even trying.   The housing market does it for them.  Within five years of the severe adverse shock, the stock of household mortgage debt is 10 per cent lower than it was just before the shock hit, and 20 per cent lower than it would be in the base scenario (where continuing turnover at the higher initial house prices carried household debt continually higher).  Even when turnover returns to normal, the stock of credit keeps dropping, just because new purchases are at the new much lower prices.

These scenarios are only illustrative, but they illustrate a key point: turnover and house prices drive the size of mortgage books, independently of any active choices banks make.  It seems quite plausible that bank balance sheets would shrink quite materially in the years following a shock like the stress test scenario, without the banks having to do very much active at all. Between lower turnover and low prices on both the housing and dairy books on the one hand and lower investment demand on account of the weaker economy on the other, there would be big savings in required capital simply from these customer choices.

Of course, in severe downturns, borrowers tend to be more cautious about how much they are willing to borrow –  and so it is quite plausible that borrower LVRs would shrink in the course of a shakeout like this, even without action by the banks.  That would further reduce the stock of debt.

And, of course, in a savage downturn of this sort one would have to expect banks to alter their lending standards –  pull in their horns.  This is something the Reserve Bank has never seemed comfortable with.   Way back in April 2008, just as the 2008/09 recession was beginning to become apparent, the then Governor was saying openly

Banks should avoid overreacting to the economic downturn, Reserve Bank Governor Alan Bollard told the Marlborough Chamber of Commerce today. “The New Zealand economy remains fundamentally sound and creditworthy,” he said.

“Banks, businesses and households alike need to recognise the new external environment and adopt a cautious approach – but don’t go into hibernation, the underlying economy remains robust,” he said.

In fact, the only sensible reaction of both banks and businesses, going into what proved to be a severe recession, from which in some respects the economy has still not fully recovered, was to pull in their horns.  That was especially so as the economy had quite severely overheated during the previous boom, and in some areas –  property development and dairy in particular –  credit standards had deterioriated very sharply during the boom.  The recession would prove that some of the critical assumptions –  by borrowers and lenders –  made during the boom were misplaced.  In the middle of the downturn no one knows what the correct “new normal” actually is, and considerably greater caution –  by lenders and borrowers –  was quite appropriate.  The only prudent step was to stop and reassess.

So it would be in a downturn –  a savage downturn –  of the sort in the stress test scenario.  Central bankers might win political brownie points by urging banks to keep lending.  But it isn’t obvious that it would be good business –  no Governor knows the future, any more than bankers and borrowers do.  Things no doubt do return to some sort of normal eventually, but as we’ve seen –  even in non-crisis in New Zealand –  quite when and how is a very open question.   And as I noted earlier, all those severe downturns that the Reserve Bank used to benchmark its stress test scenarios already included any pulling in of horns by banks (and borrowers).

This has become rather too long a post, so I will stop here.  Bank supervisors should never on their laurels.  Bank, and borrower, behavior can change quite quickly and the quality of loan books can deteriorate quite alarmingly quickly  –  and often does in the few years just before crises.  But on the stress tests the Reserve Bank has presented, and the supporting analysis the Bank has provided, there is little sign of anything other than a reasonably cautious prudent banking system, with robust capital buffers to cope with even seriously adverse shocks.  If the Reserve Bank wants to keep on imposing more and more controls, the onus really should be on it to show us what is wrong with its own published analysis and stress test results.