Misconceived and deeply flawed

Later this week submissions close on the Reserve Bank Governor’s attempt to get the some sort of debt to income restriction added to the list of possible direct controls on banks upon which the government has bestowed its favour.  (I write it in that slightly awkward way because, by law, the Governor does not need the Minister’s permission at all –  Parliament, somewhat recklessly, appears to have given all those powers to the Governor personally, but a few years ago the Governor committed to only using restrictive tools that the government had approved of.)

This would be the latest in the series of direct interventions by which the Reserve Bank has been undermining the effectiveness and efficiency of the housing finance market.  For now, the (outgoing) Governor says he wouldn’t apply a debt to income restriction even if he had the Minister’s imprimatur.  But all it will need will be another rebound in the property market and Wheeler would no doubt be keen.  Whether his permanent successor next year shares that enthusiasm is, I would hope, something the Board and the (next) Minister turn their minds to in considering possible candidates for Governor.

I probably will put in a submission, but if so it will overlap in many areas with the paper just published by my former colleague (now Tailrisk Economics) Ian Harrison.    Ian spent many years in the prudential supervisory wing of the Reserve Bank and led the work on risk modelling that has underpinned the Bank’s positions on capital, risk weights etc.  He has previously written and published his critical analysis on the Reserve Bank’s decision to treat residential mortgage loans owed by investors as riskier than the same loan on the same security when owed by owner-occupiers.  It was published under the somewhat provocative title House of Cards – and I wrote about it here.

His new paper on the proposal to have a debt to income instrument available doesn’t have a provocative title.   But it is no less forceful in its conclusions.  Here is the bulk of Ian’s press release

A report by Tailrisk Economics on the Reserve Bank’s justifications for possibly imposing debt to income (DTI) limits on housing lending, shows that that they are deeply flawed.

The main problem is that the DTI is a crude tool that does not adequately assess borrowers’ debt servicing capacities, and which will perversely target better quality loans.

“The Reserve Bank has presented no substantive evidence that higher DTI loans are ‘excessively’ risky, or that a DTI ratio of 5 is a sensible cut-off,” said Ian Harrison, Principal of Tailrisk Economics, “but there is significant evidence that DTIs do not predict loan defaults, or reduce the likelihood or severity of crises”. The European Systemic Risk Board found, in a recent assessment of GFC performance, that DTI levels did not have any “relevant effect either on the prediction of the crisis or on the depth of the crisis” .

The application of the DTI limit to investor loans, which are the primary focus of the policy, is particularly misconceived, because DTI limits are only intended to apply to owner occupier borrowers. The DTI measure assumes that when investor purchases a new property their living expenses increase. “This simply does not make sense”, Harrison commented.

The effect of the policy could be to impose an effective LVR limit as low as 30 percent on professional investors.  No other country has imposed DTI restrictions on investor loans.

“Higher future interest rates do not pose a material systemic risk, providing the conduct of monetary policy is competent”  Harrison added. “Further, the Bank’s assessment that the restrictions would have a net welfare benefit, is very optimistic. Our assessment is that they will have  a welfare cost, like most misconceived quantitative interventions.”

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.

One of the Reserve Bank’s bugbears is that while the current lending practices may look broadly okay at current interest rates, those same loans will look rather less sound if interest rates rise considerably.  Of course, banks already take into account the resilience of each borrower, including their ability to cope with unexpected changes in servicing costs.    I wrote about this in my post on the most recent FSR.

… there was something a little odd in the box the Bank included on “Vulnerability of owner-occupiers to higher mortgage rates“, clearly softening us up for the consultation paper on debt to income ratios.  They argue that

New Zealand is particularly vulnerable to a sharp rise in mortgage rates as the banking system funds a large proportion of its mortgage credit from offshore wholesale markets. The cost of this funding can increase sharply if there is an unexpected increase in global interest rates or a change in investor risk appetite, and banks are likely to pass on the higher funding costs to customers through higher mortgage rates.

But mostly this is just untrue.  The Reserve Bank sets the OCR in New Zealand based on overall inflation pressures in New Zealand.  If funding spreads rise –  as they did in 2008/09 –  and domestic inflation pressures don’t the Reserve Bank can easily offset most or all of the potential impact on retail interest rates by lowering the OCR.    That is what happened in 2008/09.

Of course, retail interest rates can rise, quite materially.  As the Bank points out, new floating mortgages rose from “around 7 per cent to over 10 per cent between early 2004 and 2007”.  Of course, as we used to stress at the time, fixed mortgage rates rose nowhere near that much.  But, more importantly, interest rates here didn’t rise because foreign rates were rising, but because the economy was cyclically strong, unemployment was low and falling, and wage and price inflation were increasing.  Wages rose roughly 20 per cent in that period.

It is fine and good for the Reserve Bank to do these sorts of stress-testing exercises, looking at what happens if interest rates rise to 7 per cent, or 9 per cent.  But in any realistic assessment, those sorts of substantial increases are only remotely likely if the economy is doing really cyclically well.  If jobs are readily available and wages are rising, not many people will be under that much stress even if interest rates rise quite a lot.  And those that are should quite readily be able to sell their house and move on.  It might be painful for them, but it simply isn’t a financial stability event.

Ian makes many of the same points, including

Financial  stability  will  only  be  threatened  if  there  is  a  large  number  of  borrowers   who  can  not  service  their  loans,  and  if  there  is  a  material  fall  in  house  prices.      If   house  prices  hold  up  through  the  interest  rate  cycle  then  borrowers  who  come   under  servicing  pressure  will  generally  be  able  to  resolve  their  problem  by  selling  the   house.  A  systemic  problem  only  starts  to  arises  if  the  interest  rate  increases  cause  a   large  fall  in  house  prices.    However,  if  this  did  occur  then  RBNZ  could  readily  respond   by  reducing  the  OCR.  It  is  almost  inconceivable  that  a  large  house  price  shock  would   not  feed  through  into  broader  economic  activity,  and  into  the  inflation  rate,  which   would  naturally  require  a  monetary  policy  response.    Mortgage  interest  rate  would   fall  and  the  pressure  on  borrowers’  servicing  capacity  would  be  relieved.

He also rightly highlights how unusual it is to propose including investor loans in a debt to income limit.  The Reserve Bank likes to highlight the debt to income limits adopted by the United Kingdom and Ireland, but simply hasn’t engaged with the fact that neither country includes investor loans in its limits.   Of the Bank of England Ian notes

The  Bank  of   England  has  the  legal  capacity  to  apply  DTI  limits  to  investor  lending,  but  has  not  done  so,   because  the  retail  DTI  limits  do  not  readily  translate  to  investor  lending.  Instead  the  Bank   requires  banks  to  meet  minimum  qualitative  standards  in  their  affordability  assessments.  In   addition,  banks  are  required  to  apply  a  2  percentage  point  stress  test  to  the  interest  cost   assessment,  and  the  test  rate  must  be  at  least  5.5  percent.  Where  buy-­‐to-­‐let  borrowers  rely   on  other  income  to  support  the  loan,  account  must  be  taken  of  taxation  and  living  costs.  This   is  basically  the  methodology  that  New  Zealand  banks  apply  to  retail  investment  lending.   There  are  no  further  quantitative  restrictions  such  as  times  interest  cover.  This  is  left  to   individual  bank’s  assessments.

In its assessment of submissions, the Reserve Bank should really be expected to provide rather more justification for the inclusion of investment loans than it has done to date.

Ian concludes his press release this way

“There are simpler, and less distortionary, ways of targeting ‘excessive’ house price rises, which appears to be the Bank’s primary motivation for DTI restrictions,” Harrison said. “Banks could be required to apply a prescribed higher test interest rate to affordibilty assessments.  This would provide the Reserve Bank with an interest rate policy tool that can be directed to imbalances in the housing market.”

His is a pragmatic response.   Mine is perhaps more hardnosed –  and perhaps less “realistic”.  It is no business of the Reserve Bank to be targeting house prices, targeting whether investors or owner-occupiers are buying, or even targeting levels of household debt.  Apart from anything else, they have no robust model of the housing market, or of the incidence of financial crises, and without those all they appear to have is gubernatorial whim, or the shifting winds of political preferences.  That is no basis for sound public policy.     The Bank –  and its political masters –  needs to be reminded of its mandate in this area: to promote the soundness and the efficiency of the financial system.  Direct controls that apply to one set of lenders and not others, to one set of loans and not others, to one class of borrowers but not others, are quite simply inferior on both limbs of that mandate to reliance on indirect instrument, such as capital standards, stress tests, and a deeply informed understanding of how banks are measuring, monitoring and managing risk.   To their credit, banks in countries like ours appear to have done a good job in recent decades of managing housing loan books.  It is a shame that the same cannot be said of the central and local government politicians and officials who have regulated urban land markets to the point where a house purchase is an increasingly impossible dream for too many of our fellow citizens.    How did we allow such disastrous outcomes?

Anyway, for anyone interested in the DTI proposal I’d commend Ian’s paper.  I don’t agree with everything in it, but is a detailed review of many of the relevant issues, and of the “evidence” the Reserve Bank seeks to rely on.  I hope that, for example, the Treasury will pay careful attention when they formulate their advice on the Reserve Bank inevitable (regardless of this “consultative process”) bid for approval to add debt to income limits to their toolkit of direct controls.


LVRs, interest rates and so on

I was recording an interview earlier this afternoon, in which the focus of the questioning was the Real Estate Institute’s call for some easing in the Reserve Bank’s LVR restrictions.

Of course, 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.

That doesn’t mean I think it is remotely likely that the Reserve Bank will be easing the restrictions any time soon –  apart from anything else, it would leave their consultation paper on debt to income ratio restrictions looking a little silly.   Of course, it would be good if the Reserve Bank did lay out some specific criteria for lifting these ostensibly temporary restrictions, but with the toxic brew of rapid population growth and continuing land use restrictions in place, if I saw the world as they seem to, I wouldn’t be in a hurry to lift the restrictions either.

In any case, it isn’t that clear quite how large a role the LVR restrictions are playing in the reduction in sales volumes.   They must be playing a part, but so too will higher interest rates, and the apparent increase in banks’ own lending standards, and pressure through the parents from APRA (on the lending standards across the whole of Australian banking groups).  Which, of course, is also why it isn’t clear quite how much difference any easing back in the New Zealand LVR controls might make.  Some presumably, but even the Reserve Bank has never claimed that LVR controls would have a very large impact on house prices, or housing market activity, for very long.   And while I noticed an article this morning about negative equity, it is worth bearing in mind that, on the REINZ index (not using median prices), house prices have risen 65 per cent in the last five years, and are currently 0.6 per cent off their peak.

But what of interest rates?  A year ago, the OCR was 2.25 per cent, and today it is 1.75 per cent.  Thus, the Reserve Bank talks of having eased monetary policy.   Here are mortgage rates though.

mortgage ratesI don’t suppose anyone is taking out four or five year fixed rate mortgages, but across the entire curve, interest rates are higher not lower.   Or we could go back another year or so, to just prior to when the Reserve Bank began cutting the OCR.   The OCR has been cut by 175 basis points since then.   Even at the shortish end of the mortgage curve, rates are down only 50-70 basis points.

Having been reflecting this morning on Graeme Wheeler’s performance over his term, I had a look back at where interest rates were when Wheeler took office in September 2012.

mortgage rates sept 12Barely lower, even though core inflation –  on their own favoured measure – is as low today as it was then (and has been consistently low throughout his term).

I wondered if there were offsetting factors but:

  • Two year ahead inflation expectations are about 25 basis points lower than they were then (largely offsetting any reductions in nominal mortgage rates, to leave real rates little changed)
  • the TWI measure of the exchange rate is a bit higher than it was then,
  • the ANZ commodity price index, in inflation-adjusted world price terms, is hardly changed from what it was then.

Of course, the unemployment rate has fallen since September 2012, but there hasn’t been any sign of a pick-up in the best indicator of labour scarcity –  real wage inflation.

So, overall, it is a bit of a puzzle how the Governor expected to get core inflation back to fluctuating around the target midpoint without actually easing monetary conditions.  I don’t happen to agree with him on this one, but he keeps talking about how the huge migration inflows have reduced net inflation pressures (supply effects outweighing the demand effects).  If he really believes that it is even more puzzling that monetary conditions haven’t been eased.

I’m not sure how he’d respond.  But perhaps he could explain that too in the forthcoming speech.


Reserve Bank DTIs and the cost of crises

I was late getting round to reading the whole of the Reserve Bank’s consultation document, that backs its bid to persuade the Minister of Finance to agree to authorise them (at some future time) to impose debt to income limits on banks’ mortgage lending.   I’d heard from some people who’d read it that it wasn’t very good, but even so I was surprised how weak the document making the Bank’s case is.  This post isn’t a substantive response to the body of the document, which will probably come in a few posts over the month or so until submissions close.  Today I wanted to focus on just one assumption they make.

The Minister of Finance insisted that the Reserve Bank include a cost-benefit analysis in the consultation document, and one that was a bit more than the usual Reserve Bank effort (an unweighted list of unquantified pros and cons).    It is hard to do so when they aren’t wanting to impose the control right now, but they made a valiant effort.   The value in these things is not in the precise bottom line number (inevitably wrong), but in forcing regulators to spell out their assumptions.

In their cost-benefit analysis, the Reserve Bank assumes that a DTI type instrument can reduce –  by a third –  the risk of a financial crisis.    And they assume that (a) financial crises are really expensive (lost GDP) and (b) that in addition to reducing the probability of a financial crises, a DTI instrument can reduce –  by a quarter –  the severity (again, lost GDP) of such a crisis.      If all three assumptions aren’t correct –  if, say, a DTI instrument could reduce the probability but not the cost, or vice versa, or if a plausible crisis wasn’t as costly as the Bank assumed –  the expected net benefits shown in the paper would simply evaporate.

So how costly are financial crises (especially one concentrated in developments around housing) in moderately well-governed market economies which (a) have their own monetary policy, and (b) haven’t run up against hard fiscal constraints?    The Reserve Bank assumes a cumulative loss of 20 per cent (of a single year’s GDP) –  and they describe that as “conservative”, meaning towards the lower end of a plausible range.

The honest answer is that we don’t really know.   The relevant historical sample (of such crises) is exceptionally small.     And even when a financial crisis happens, it is hard to disentangle the contribution of the financial crisis itself from adjustments that would have happened anyway.

Of course, there is the United States in the last decade –  the case that grabbed everyone’s attention at the time.   Plenty of writers since have described it as ‘the worst financial crisis since the Great Depression” –  in some respects (narrow financial system stresses) one could mount an argument that the recent episode was worse.    The Reserve Bank constantly like to invoke Ireland, but while that case study might be useful for some purposes, it isn’t for this one.   Ireland gave up its own monetary policy when it joined the euro, and so had little or no scope for any stabilising macro policy when the crisis hit.

So lets have a look at how things unfolded in the United States.     They had a nasty recession but they weren’t alone in that.  So one benchmark might be to look at how the US relative to, say, other moderately well-governed floating exchange rate countries, and especially ones that had lots of housing debt and house price inflation but didn’t have a domestic financial crisis.   Australia, New Zealand, Canada, and Norway seemed like a nice subset of such countries.

This chart uses IMF WEO annual data. It shows real GDP per capita for the US normalised to 100 in 2007, the last year before the recession (and before the financial crisis itself intensified).   And it shows the average for the four rising house price non-financial crisis countries on the same basis.

US vs NZ Can etc

Sure enough, the US recession was deeper than that in the average of these other four floating exchange rate countries which –  despite the debt and run-up in house prices –  avoided both housing busts and financial crises.      But the cumulative gap between the two lines (ie adding up the differences across the nine years) is just under 10 per cent, which isn’t even quite half of the “conservative” assumption the Reserve Bank is using.

Of course, even among these four countries there are some quite different experiences: Australia didn’t have a real GDP recession at all, and Norway still hasn’t regained the level of per capita income they had in 2007.  That is why it helps to average across a range of non-crisis countries.

Is it a fair test?   If anything, I think the simple difference between the two lines errs towards overstating the costs of the US financial crisis.  After all, the US ran into the effective lower bound on nominal interest rates.  Standard Taylor-rule prescriptions would have had the Fed cut interest rates a lot more than the 500 basis points they did cut by (a nice chart I have in front of me from the Boston Fed illustrates that in the previous six easing cycles the Fed had cut by an average of more like 800 basis points).    And the US went into the crisis with much less fiscal leeway than our fairly unindebted comparative sample.   And, as it happens, each of the four comparators benefited from average terms of trade in the years since 2007 that were higher than those in the previous half decade or so.    By contrast, the terms of trade for the US have been weaker than they were in the pre-crisis years.

Of course, if I compared Iceland with the four non-crisis countries, I could come out with a number that exceeds the Reserve Bank’s 20 per cent loss estimate.   But the Icelandic crisis (a) wasn’t concentrated on housing, (b) was an order of magnitude more severe (in its own financial system) than the US one, and (c) the Icelandic government ran into severe policy constraints, including exhausting their capacity to borrow.    It is an important case study, but it isn’t the sort of crisis we should be thinking about in contemplating the possible use of DTI controls here.   Arguably, even the US experience is only somewhat enlightening given that an oversupply of houses was a significant element in the US experience.   An oversupply of houses might be fine thing here one day, but it seems unlikely to be an issue here or in other Anglo countries while tight land-use restrictions are in place.  But that is an issue –  not touched on in the Reserve Bank paper – for another day.

If a reasonable “cost of crisis” were, say, a third lower than then Reserve Bank assumes then, on their assumptions about everything else, there are no net benefits from a DTI instrument.

Thoughts prompted by the FSR

I had only a limited number of specific comments to make on the details of the Reserve Bank’s Financial Stability Report released yesterday.  But it is the last such report for the outgoing Governor Graeme Wheeler, and that itself prompts a few other thoughts.

The Bank continues to tout the line that monetary policy in much of the world is “very accommodative” –  relative to what benchmark is never clear –  and yesterday they claimed that

“a sustained period of very accommodative monetary policy has supported the long-awaited recovery in global economic activity”

That seems questionable on multiple counts.  First, the recovery or growth phase has been underway since at least 2009/10.  There have been setbacks and what felt a little like “growth pauses”, and the overall experience has been pretty underwhelming.  But there also isn’t really much sign of that changing for the better.

And since what the Bank calls “very accommodative monetary policy” has been concentrated in the advanced economies, one obvious place to look for upbeat news might be investment spending.  Lower interest rates, all else equal, make investment today more attractive than otherwise.   But here is the IMF data –  and the IMF is the Bank’s standard reference point for comment on the wider world – for investment as a share of GDP in advanced economies.

investment imf

The latest actual data –  for 2016 –  are still below the cyclical lows in the early 2000s.  And if investment isn’t picking up strongly, neither is the IMF picking a slump in savings rates to support an acceleration of demand.

Across the advanced world, there just isn’t much consistent sign of anything very different in the next few years than we’ve had in the past few.  That suggests interest rates are low for a good –  if not fully-explained –  reason, rather than just that monetary policy is “very accommodative”.

At one level, the terminology doesn’t matter very much, but coming from a central bank offering insights on financial stability, it doesn’t suggest that they really have a good sense of what is going on.   They might be in good company on that score, but it isn’t exactly reasssuring.  If you don’t have a good “model”, the prognostications might not be of much value.

I also found it rather surprising that there was almost nothing in the Financial Stability Report  – the major statutory document on financial stability issues, including the Bank’s conduct of its various regulatory responsibilities – on the recently-released report on New Zealand under the IMF’s financial sector assessment programme (FSAP).   It was a major independent report, which seems to have also involved a substantial commitment of resources by the New Zealand authorities (including the Reserve Bank), in some areas it reached conclusions quite different from current policy, and yet it is barely mentioned in the Bank’s own review.  It isn’t because they didn’t have time –  the papers were released to the public three weeks ago, and the Bank will have had them well before that.  Perhaps it isn’t yet time for a definitive responses to all the points, and some of the issues the FSAP reports raise are really for the government rather than the Bank to decide, but…the silence was deafening.   Perhaps the Bank thought the IMF report really wasn’t much use at all, and was simply being polite?   (I would have some sympathy for such a view, and will before long have my own post on some aspects of the report.)

And there was something a little odd in the box the Bank included on “Vulnerability of owner-occupiers to higher mortgage rates“, clearly softening us up for the consultation paper on debt to income ratios.  They argue that

New Zealand is particularly vulnerable to a sharp rise in mortgage rates as the banking system funds a large proportion of its mortgage credit from offshore wholesale markets. The cost of this funding can increase sharply if there is an unexpected increase in global interest rates or a change in investor risk appetite, and banks are likely to pass on the higher funding costs to customers through higher mortgage rates.


But mostly this is just untrue.  The Reserve Bank sets the OCR in New Zealand based on overall inflation pressures in New Zealand.  If funding spreads rise –  as they did in 2008/09 –  and domestic inflation pressures don’t the Reserve Bank can easily offset most or all of the potential impact on retail interest rates by lowering the OCR.    That is what happened in 2008/09.

Of course, retail interest rates can rise, quite materially.  As the Bank points out, new floating mortgages rose from “around 7 per cent to over 10 per cent between early 2004 and 2007”.  Of course, as we used to stress at the time, fixed mortgage rates rose nowhere near that much.  But, more importantly, interest rates here didn’t rise because foreign rates were rising, but because the economy was cyclically strong, unemployment was low and falling, and wage and price inflation were increasing.  Wages rose roughly 20 per cent in that period.

It is fine and good for the Reserve Bank to do these sorts of stress-testing exercises, looking at what happens if interest rates rise to 7 per cent, or 9 per cent.  But in any realistic assessment, those sorts of substantial increases are only remotely likely if the economy is doing really cyclically well.  If jobs are readily available and wages are rising, not many people will be under that much stress even if interest rates rise quite a lot.  And those that are should quite readily be able to sell their house and move on.  It might be painful for them, but it simply isn’t a financial stability event.

There was some good news in the report.  Previous stress tests conducted by the Reserve Bank with the major banks have used very severe adverse macroeconomic shocks (in some respects –  notably the critical unemployment assumptions –  beyond anything ever seen in a modern floating exchange rate country).  Banks came through those tests largely unscathed.  So this time, the Bank did something a bit different.

The most recent regulator-led exercise was a ‘reverse’ stress test completed in late 2016. This test required the largest four New Zealand banks to determine the most plausible scenario that would lead to a breach of a minimum capital requirement. The results highlight that severe risks would need to materialise before this would occur, beyond the sustained macroeconomic downturn assumed in a typical stress test.

It was another way of reaching the same conclusion the previous tests pointed to: our major banks appear to be strong, and well-managed.   The Reserve Bank is quite explicit that the regulatory regime is not a “zero-failure” one –  in a market economy, firms will fail sometimes, and that includes banks  – but with the sorts of loans the banks had on their books late last year, the latest stress test suggests (again) that it would take something almost inconceivable for one of them to fail.

Which does leave one wondering, again, quite what all the fuss has been about in the last few years, with successive rounds of LVR controls, and the forthcoming consultative document in which the Bank tries to persuade us (and more importantly the Minister of Finance) that it should be able to impose debt-to-income limits too.      When it discusses the world economy, the Bank is quite fond of invoking concerns about “policy uncertainty”, but what certainty and stability has it provided in the markets/institutions it regulates in recent years?  And to what end has all the uncertainty been?

The Bank likes to claim that its successive interventions have ‘improved the resilience of the banking system”.  In fact, they offer us no evidence on that score.   No doubt, as their data show, the number and value of high LVR loans on the books of banks have both fallen.   But high LVR loans require banks to hold higher amounts of capital, and loans that are just below some regulatory threshold, supplemented perhaps by other forms of credit (eg family support), may be only very slightly (if at all) less risky than the loans the banks would have made in an unconstrained world.     The Bank’s claim would be more convincing if (a) they directly addressed the clear and simple point that lower risk lending also lowers the amount of capital banks have to hold (so that the risks might be lower, but so are the buffers if things do turn bad), and (b) if they ever addressed the question of what banks do instead of the high LVR housing lending they are now largely barred from.  Banks’ own risk-appetite probably hasn’t changed, and neither (probably) have the return expectations of their shareholders, so have they pursued other types of risk.   FSR after FSR the Bank never engages with this fairly straightforward point.  It also never engages with the question of how direct controls, frequently revisited, better advance the efficiency of the financial system than indirect mechanisms (primarily the capital requirements for banks, which don’t interpose government regulators directly between banks and their customers).

Perhaps there are good and convincing responses to these sorts of points.  The Wheeler Bank has never even attempted to provide them.

I’m also uneasy about the Bank’s treatment of the housing market.  They have a long list of various factors that play a part at various times in influencing house prices.  I’m pleased that they quite openly state the obvious point –  well, it should be obvious if we didn’t have business think tanks and government-funded researchers arguing that opposite –  that when housing and urban land supply is less than fully elastic, strong net migration inflows can and do boost house prices.

But, for an organisation that has chosen to intervene repeatedly, and which weighs in every six months with an assessment of the risks around the stock of housing lending, they don’t seem to have anything very authoritative to offer.      They have never once noted that land use restrictions –  not just here, but in a variety of similar countries –  could make urban land prices permanently higher.    Without major changes to those laws, other interventions –  taxes, LVR restrictions, government housebuilding programmes, and even immigration restrictions –  will typically only make a modest difference for a relatively short period of time.   And there are no natural market forces that will undo those restrictions –  they aren’t like a temporary credit bubble.     When bank lending standards deteriorate rapidly, there is good reason for people who have lent to banks (and for the regulators) to worry.  When governments enable pernicious land use restrictions, there are plenty of reasons for many to worry – notably the young, who might struggle to ever get a place of their own – but it isn’t much of an issue for financial stability regulators (in that climate, higher gross credit is mostly just an endogenous response).  And yet, for all their interventions, the Reserve Bank has never been able to give us an authoritative story (“model”) on what role the various possible explanatory factors are playing now, and have played over the last 25 years.

I can imagine that the Reserve Bank is uneasy about wading into what can be a rather political debate. I can understand that.  But if you are a government agency actively intervening in a market –  itself a highly “political” choice, favouring some groups of potential buyers over others – you have an obligation to show us your robust supporting analysis.  The Reserve Bank simply hasn’t done so thus far.  Perhaps the robust cost-benefit analysis in the forthcoming consultative document will be different?

And, years on, there is still no robust analysis or research suggesting that the Reserve Bank has thought hard about what the important differences might be between countries where banks’ domestic loan books got into serious trouble and those where they did not?  In 2008/09 for example, New Zealand, Australia, Canada and the UK saw quite different things than the United States and Ireland did (and even those two latter experiences were themselves quite different). It seems like a pretty elementary line of inquiry –  and we do, as taxpayers, pay for a lot of researchers at the Reserve Bank –  but there has been just nothing.  In the meantime, people who are regulated out of credit markets pay the price.

If the Bank doesn’t know the answers to these sorts of questions, perhaps they need to be rather more agnostic about the outlook and the case for their own direct policy interventions in the market.  Focus on stress tests and capital requirements, and eschew direct interventions which have little economic foundation, and are arguably ultra vires anyway.

These are now mostly challenges for the new Governor.  Both Graeme Wheeler and his deputy (and Head of Financial Stability) Grant Spencer are leaving shortly –  Wheeler in September, and Spencer next March.  I hope the new guard takes more seriously some of these issues.  If they do, writing FSRs will be harder, but there would be a great deal more value in the resulting documents even if, in many cases, the resulting analysis leaves as many questions as answers.  That might simply reflect the limits of what we know about the world (and housing markets, housing finance, and banking risk).

Earlier in the year, the Minister of Finance intervened and instructed the Board of the Reserve Bank to stop their search for candidates for a new permanent Governor, and instead to recommend a candidate to be a temporary (acting) Governor.   Doing so avoided trespassing on conventions which restrain governments from making major permanent appointments which would take effect around the time of general elections.  Deputy Governor, Grant Spencer, was –  with what still looks like little secure legal basis –  appointed acting Governor for six months, allowing whichever government takes office after the election to make the appointment of a permanent new Governor.

You might have thought –  I did –  that such a temporary appointment was designed to leave the new government free, and also not to tie the hands of the new Governor.  An acting Governor would make the decisions that really had to be made, keep a steady hand on the tiller, and otherwise leave substantive decisions until a permanent appointee was in place next year.

But it seems that Graeme Wheeler, and the Reserve Bank’s Board –  the latter perhaps still smarting at having to end their earlier search process – didn’t quite see it that way.

With Spencer stepping up to acting Governor, and then retiring when that term ends, there was going to be a vacancy in his substantive roles.  There were two of those.  One was the fulltime day job as Head of Financial Stability (a role in which three departmental heads report to him, covering financial markets and financial stability/supervision.  And the second was the statutory position of Deputy Chief Executive.

A month or so ago, there was a press release from the Reserve Bank filling both positions.    The other current Deputy Governor, Geoff Bascand, was to transfer from his current role (oversight of the operations and admin sides of the Bank) to become Head of Financial Stability, and he was also promoted to become Deputy Chief Executive.  In addition, a search process would get underway straightaway to fill Bascand’s role (adverts have subsequently appeared, and applications have already closed).

Frankly it all seems rather odd.  For a start, even though Bascand has no background in banking, financial markets, or the regulation of those activities, there was no sign that any sort of competitive or contestible process was undertaken before he was appointed Head of Financial Stability.

But it also looks like an attempt to box in the new Governor, whoever he or she may be.  Sure, it is common for a chief executive to inherit a senior management team –  although often enough that is a prompt for a (often disruptive) restructuring etc to allow the new person to shape his or her own team.  Moreover, the qualities one might want in other members of the top team surely depend, at least in part, on the skills, experience, and other qualities of the person at the top.    A more obvious (and common elsewhere) solution would have been to have appointed an acting Head of Financial Stability and then let the new Governor make his or her own choice about the sort of structure and people they want in the roles.  For example, it might be fine to have a macroeconomist as Head of Financial Stability  –  key point of contact with senior people in the financial sector and other regulatory agencies –  if the new Governor has a strong banking background.  If not, it might be a lot more problematic, especially given how large and prominent the Reserve Bank’s regulatory role now is.   (Of course, if Bascand himself becomes Governor, that issue solves itself.)

These points are more important than usual given that talk of statutory reform of Reserve Bank decisionmaking is in the air.  Labour and the Greens are committed to change, and the government has had Iain Rennie looking at the issue.  Again, depending how those matters are resolved (including those around the Bank’s financial regulatory powers), it could easily influence the sort of person one wants in key senior management roles.   (That includes the Assistant Governor position they are filling now.  For all Graeme Wheeler’s talk of the key role of the Governing Committee in making key policy decisions in the Bank, the advert for that position, had hardly any mention of monetary policy and, from memory, none at all of financial regulation.  In many respects that makes a lot of sense –  while the Governor in law actually makes those decisions –  but perhaps not if the Act was to be changed to make a holder of this position a statutory decisionmaker on major areas of public policy.)

And then, of course, there is question of whether all of this was even lawful.   In the Reserve Bank Act,  the role of deputy chief executive is filled by the Board on the recommendation of the Governor.  But there is no vacancy in the role of deputy chief executive while Graeme Wheeler is Governor.  And, even though the press release was worded as coming from both Wheeler and Spencer, the Act does not talk of an acting Governor being able to recommend a deputy chief executive appointment.  Perhaps it is a small issue, but details matter, and the law matters.

All else equal, I happen to think that Geoff Bascand would normally be a sensible appointment for deputy chief executive.    I’m less convinced he is right for the role of Head of Financial Stability, and generally think he would be better-suited (despite his fling with LUCI) for the role of Head of Economics (a role which should have become much more important as the Governor has had to focus increasingly on the Bank’s various regulatory roles).

There is a public sector culture of generalist managers.  I’m not sure it serves particularly well.  Of course, Grant Spencer also had a background in macroeconomics but had also served as the Bank’s Head of Financial Markets, and then had almost 10 years in various relatively senior roles at ANZ in New Zealand and Australia.   It wasn’t doing credit –  perhaps the essence of banking –  but it was much more of an exposure than Bascand has had (and the Head of Financial Stability job is itself much bigger than it was when Spencer was first appointed to it).  Sure, Bascand has sat around the internal committees on regulatory issues for the last three or four years, but it really isn’t that much depth of involvement.  And I say this even though, when I also sat on those committees, Bascand’s was often more willing to challenge and questions the interventionist inclinations of staff than many of his colleagues were.  I welcomed that.

Perhaps he is the single best person in the country (or abroad) for the role.  And there is something to be said, in high-performing organisations, for promoting from within.  But the appointment has an uncomfortable feel about it, including the dimensions of Wheeler either trying to box in his successors, or give Bascand another leg up in the succession stakes.

And there is also the uncomfortable fact that, for someone soon to be charged with oversight and regulation of much of our financial system –  regulating in the interests of the wider economy, not that of the banks –  Bascand doesn’t exactly have a spotless track record.   Defensive behaviour and an attempt to close down issues, rather than open them up, seems to be his style.  There was his attempt to tar the whistleblower –  me –  last year when I alerted the Bank to what turned out to be a leak of an OCR decision and a systematic weakness in their processes.  There was the seeming inability to distinguish between his (and others) role as trustee and as Bank employee –  particular worrying to the Bank I’d have thought if a financial sector employee had a similar cavalier attitude.  There was the attempt to close down, without substantive inquiry, significant complaints from a member of the Reserve Bank superannuation fund, only to find later that a breach of the law had occurred (and various other –  still ongoing – issues identified), for which breach trustees later had to apologise to members.  And, meetings with fellow regulators might be interesting, given that there is an outstanding complaint with the Financial Markets Authority –  regulatory body responsible for superannuation schemes –  around the decisions and processes adopted by the superannuation scheme trustees under Geoff’s chairmanship.

I know we don’t have depositor protection as one of the statutory elements in New Zealand’s banking regulation, but whether as a depositor or citizen I’m not sure this sort of track record would fill me with confidence in Bascand’s ability to lead financial regulatory functions, with the drive and willingness to leave no stone unturned that, in some circumstances would surely be required.  Bankers will often be keen to close things down quickly, and paper over problems.  The last thing we need is officials who will be content, or perhaps even complicit, in letting that happen.    At very least, this was a decision the new Governor should have been left to make.


On Graeme Wheeler

Morning Report had invited me on this morning to talk about Graeme Wheeler, the change of governor, prospects for a permanent successor etc.  The death of Steve Sumner apparently changed their schedule so that interview didn’t happen, but I’d already jotted down some notes as to what I might say, so I thought I’d use them here.  Wheeler, of course, still has seven months in office, and we’ll see his next Monetary Policy Statement tomorrow.

When Graeme Wheeler was first appointed as Governor, there was generally a fairly positive reaction.  I shared that view.  Until quite late in the process, I’d assumed that Grant Spencer was the favourite for the role –  after all, successful organisations tend to promote from within, and a capable insider should always have an advantage, being constantly visible to the Board.  And so when Graeme was appointed, my initial reaction was “well, he must have been a very strong candidate to have beaten the capable internal deputy”.    And it was well known at the time that Bill English and John Key had been keen to have Wheeler back in New Zealand –  there had been well-sourced talk that the Minister had wanted him as Secretary to the Treasury, something apparently stymied by SSC bureaucracy.

With hindsight, one can only conclude that the Bank’s Board –  the key players in the appointment of the Governor –  just didn’t do a very good job in evaluating the candidates. Perhaps that shouldn’t be surprising –  mostly behind the scenes people themselves, they don’t have much experience in appointing someone to a position with as much visibilty and probably more untrammelled power than most Cabinet ministers.  There are suggestions that Board members were rather too easily swayed by big names Wheeler had produced as referees, and by his international connections (coming just a few years after the international financial crisis) rather than looking hard at the qualities required to do the Reserve Bank Governor job well.    Since many of the Board members then are still on the Board now, one can only hope they’ve learned from their experience.

I think Wheeler has done a poor job as Governor, both in the specific decisions he has made, and in the processes and procedures and style he has adopted.   For most of the time, he seems to have been aided and abetted –  or at least sheltered –  by the Board, who are actually paid as the public’s agents, not as associates and defenders of the Governor.

And it is not as if times have been unusually hard for him.  We haven’t had a recession in New Zealand and there has been no major flare-up of international financial stresses during his term (so far).  The terms of trade moved around a bit, but not much more so than usual.  There was no domestic financial crisis, no major domestic fiscal stresses, no change of government, and the major natural disasters of the last decade (the Canterbury earthquakes) had all happened by the time the Governor took office.   Sure, what is going on globally is a little hard to fully make sense of, but whereas most other advanced country central banks had by 2012 largely reached the limits of conventional monetary policy (interest rates very close to zero) that has not yet been a constraint here.

The Reserve Bank’s primary function –  according to the Act –  is monetary policy.  Graeme came into office with a new PTA that he was comfortable with –  in particular, with an explicit focus for the first time, on the 2 per cent midpoint of the inflation target range.  And yet over his 4.5 years in office, annual headline inflation has averaged not 2 per cent but 0.8 per cent.  Falling oil prices played a part in that, but CPI ex petrol has averaged not 2 per cent, but 1.1 per cent.  The Governor’s preferred measure of core inflation –  the sectoral factor model measure –  has averaged not 2 per cent, but 1.35 per cent.  All sorts of one-off factors that the Governor can’t be really be held accountable for influence inflation rates –  thus cuts in ACC levies have held down headline inflation in the last couple of years, while large increases in tobacco taxes have artificially boosted headline inflation throughout the Governor’s term.

There are a lot of comfortable commentators inclined to treat these inflation outcomes as a matter of indifference –  so what they imply, after all low inflation is better than high inflation.    But persistently low inflation over several years –  and especially when it doesn’t arise from surprisingly good productivity outcomes – almost invariably comes at a cost –  lost output, and lost employment.  And that has almost certainly been the case over the last few years.   Throughout the Governor’s term, the unemployment rate has been reasonably materially above estimates of the non-inflationary or “natural” level –  these days thought to be around 4 per cent.  The Governor’s choices affected the lives and options of real people –  and years lost out of employment simply can’t be got back.

My standard here isn’t one of perfection.  Central banks, engaged in active discretionary monetary policy of the sort now common around the world, will inevitably make mistakes.  Central banks try to operate on the basis of forecasts, and yet no one  –  least of all them  – knows the future.  So in evaluating the Governor, we need to look at the specific circumstances, and at the willingness to acknowledge and learn from mistakes.  Here, Graeme Wheeler doesn’t score well.

Before he came to office, the Reserve Bank had already once misjudged the need for a tightening cycle to commence, and had had to reverse itself.  At the time –  2010/11 –  they had some company internationally, and there was a fairly widespread expectation that interest rates would need to return to “normal” fairly soon.  That wasn’t the case by the end of 2013, when the Governor was not just talking about tentatively beginning a tightening cycle, but confidently asserting that interest rates would need to rise by 200 basis points.   He –  and his machinery of advisers –  simply got that one wrong.  Fortunately, they never raised the OCR by 200 basis points, but it was 18 months before they even started to reverse themselves –  and even now, to my knowledge, they have never acknowledged having made a mistake.  In so doing, they’ve unnecessarily exaggerated both interest rate and exchange rate variability, all the while leaving unemployment unnecessarily high.   Good managers and leaders recognise that human beings make mistakes, but they expect those who make them to acknowledge and learn from them.  Graeme Wheeler failed that test.

The other big part of the Reserve Bank’s policy responsibilities is the regulation of key elements of the financial system, to promote the soundness and efficiency of the system.  Graeme made that a much more prominent part of the Bank’s role with his enthusiasm for successive waves of LVR controls.   The Reserve Bank has no policy responsibility for the housing market, or for house prices, only for the soundness and the efficiency of the financial system.    And yet I see a leading commentator criticising the Governor for not doing the impossible:

Wheeler should have earlier called out the Prime Minister and Finance Minister on their tardiness in developing policy responses to counter the house price bubble. But he was late to the party.

Notably, the bank was also tardy in its own policy responses, thus earning itself a rebuke from then Prime Minister John Key, who rather cynically tried to take the focus off a Government that was running immigration hot for its own ends.

A more adept governor should have been able to persuade the politicians that slowing the boom was a job for both the politicians and the central bank. And that it was necessary for NZ’s long-run stability.

Quite how Graeme Wheeler was supposed to have changed the mind of the government on reforming supply – when no one else, in New Zealand or in many Western countries, has succeeded in doing that –  is a bit of mystery.  I have pretty high expectations of a Reserve Bank Governor, but that seems like a Mission Impossible task.  It is not that reform couldn’t be done, but against a Prime Minister determined to present high and rising house prices as a mark of success, a central bank Governor, with no detailed background in the area, no real research to back him, and no particular mandate wasn’t likely to succeed.  After all, our housing supply and land use laws have created problems, interacting with immigration policy, for 25 years, and Alan Bollard and Don Brash had made no inroads either.

As for the Bank being “tardy”, hardly.  When Graeme Wheeler took office, no one in the Reserve Bank had been keen on direct LVR controls –  they were a clear fourth preference, when assessed against the Bank’s responsibility for financial system soundness and efficiency.    But Graeme rushed such restrictions into place, at times surprising even his own senior managers, with no tolerance for any debate or dissent (there was no substantive discussion of the merits of the measures at the key relevant internal committee).  If you think LVR limits were a good thing, the last thing you can accuse Graeme of was being tardy.  I think they were ill-conceived, sold on a false promise (about how temporary they would be), are still poorly-researched, and have spawned one new set of controls (and odd exemptions) after another.  And, unsurprisingly, the real housing market issues –  mostly about land supply, not finance –  haven’t been dealt with.  Wheeler liked to fancy himself as a shrewd political player, and yet if there is a valid criticism of him in this particular area it is as much that he eased the pressure on politicians by rushing to do something/anything, at time when there was a growing sense that “something must be done”.  The appropriate response to “something must be done” is not “so anyone should do anything”.    And it remains concerning that despite Wheeler’s penchant for increased use of direct controls –  harking back to earlier decades –  there has been little or no serious analytical or research engagement with the issues around the efficiency of the financial system, and the way in which direct controls can undermine efficiency, and in the process favour insiders over outsiders, the well-connected and well-resourced over the more marginal, and so on.  The experience of the US over 2008/09 –  where Wheeler lived at the time –  always seemed to loom large, and never once has the Bank answered my challenge to consider the similarities and differences between the US and New Zealand, or to look at the experiences of countries (many of them including New Zealand) that didn’t have domestic financial crises in 2008/09 despite large house price booms.

Effective communication is a big part of what the central bank governor should be expected to do, and the more so in New Zealand where (a) all the statutory power rests with the Governor personally, and (b) where the Bank has such wide-ranging powers, and is not just responsible for monetary policy.  And yet during the Wheeler years, the Bank hasn’t done well on that score either.    The number of on-the-record speeches the Governor has made has dwindled, and those he does give don’t typically compare favourably –  in terms of quality, depth and insight –  with those of his peers in other countries.   There have been specific communications stuff-ups (speeches inconsistent with subsequent action etc), although I’m reluctant to be too harsh on those –  most central banks end up with some of those problems in one form or another, at some time or another.  But it is also a matter of accountability:   Wheeler has been very reluctant to grant serious media interviews (none at all to the main TV current affairs programmes, and only belatedly the occasional soft-soap interview to the Herald) in a way that is quite extraordinary for someone personally wielding so much power.  A Cabinet minister wouldn’t get away with it.  And in his press conferences, the Governor has often come across as embattled, defensive and weary.    Despite his past senior roles, he had no background in the public limelight, and clearly wasn’t comfortable with it.  But that was a significant part of what made him, at least with hindsight, the wrong person for the job.

Neither in my time at the Bank –  around half his term, involved in most of key policy committees –  nor subsequently have I seen any sign in the Governor of wanting to foster a climate of debate and explorations of ideas and alternative options.  I mentioned the LVR controls already, but they weren’t the only example.  In my own experience, one small example lodged in my brain.  One day a few years ago Graeme was down in a meeting in the Economics Department and there was a bit of a low key discussion about alternative policy approaches etc: the death glare I received for even mentioning, hypothetically, nominal income targeting was a pretty clear message, not just seen by me, that what the Governor wanted was support for his position, and answers to his detailed questions, not alternative perspectives or debate, no matter how non-urgent the issues were.  People respond to incentives.  In a area so rife with uncertainty as monetary policy, it is very dangerous approach.  The same goes for the ability to deal with external criticism –  a capable and intellectually confident Governor would recognise the value in alternative perspectives and relish the prospect of engaging with the alternative ideas.  Doing so is part of how people come to have confidence in the Governor.  But there has been none of that with Wheeler –  if anything he seemed to become unreasonably rattled by disagreement (his active effort to tar the messenger who drew to his attention the OCR leak last year was a sad example of that –  made worse by the cover he received for it from his Board).

I could go on, but won’t at length.  The Governor has been highly obstructive in his approach to the Official Information Act –  we still don’t have access to papers relating to the 2012 PTA for example –  and has done nothing to advance transparency around the Bank’s medium-term spending plans.  Nothing appears to have been done to prepare for the likelihood that the near-zero bound will become an issue here in the next recession.  The refusal of the Governor to engage with serious evidence of past misconduct around staff superannuation policy is a blight.  And despite the large team of researchers and analysts the Governor commands, there has been little good policy-relevant research published in the last few years, particularly in the areas of financial system regulation and macro and financial stability.  Sadly, the Reserve Bank has been living off reputational capital for some considerable time now, and one of the challenges for a new Governor should be turning that around and lifting the quality of the Bank’s outputs and its senior people.

As I’ve noted before, I give the Governor a small amount of credit for his recognition that the single decisionmaker model is past its use-by date, and should be reformed.  A committee of his own apppointees –  his two deputy governors and one assistant governor, all answerable to him – is not the right answer, but at least he was willing to start addressing the issue, unlike his predecessor.  Responsibility for the Reserve Bank governance model rests mostly with the Minister of Finance and the Treasury, but the Governor sought to get approval for legislative changes and failed.  That reflects poorly on him  –  our current model is so out of step with how countries do things and how government agencies are structured –  and is partly a reflection of his own fixation on a technocratic model, and partly of the loss of trust he incurred with the Minister and the Treasury (including around the financial regulation powers).  The Bank should have been able, by a flow of good research and analysis, to have helped shape a public debate on the appropriate future governance model.  But it failed to do that –  and now still refuses to release any of the background papers from that long-completed work programme undertaken at taxpayers’ expense (and this time, extraordinarily, they have managed to get Ombudsman cover for their refusal).

Quite who will be the next Governor is anyone’s guess.  If I had to put money on it, I’d assume it would come down to a choice between Geoff Bascand and Adrian Orr –  both of whom have their own weaknesses –  but there are other possible candidates both here and (New Zealanders) abroad.  Even though the Bank’s Board have all been appointed by the current government and have the key role in determining who will be the next Governor, quite a bit could still turn on the outcome of the election and what changes, if any, they might want to make to the Act.  In my view, whoever wins the election should focus quite quickly on sketching out a plan for governance reforms, and should look to appoint a person who will be able to carry those through and help the Bank adapt, and perform well, under a new model, under which the Governor personally would have a vital role, but a much less dominant personal role in determining monetary and bank regulatory policy.

Doing so now isn’t a reflection on Graeme Wheeler –  as perhaps it might have been seen as a year or two ago –  just a recognition that times, and the institution and its challenges, have changed,  While so much power rests with the Governor personally, it is important to appoint someone with some reasonable credibility in the subject areas the Bank is responsible for –  an effective deputy can do much of the day-to-day management of what isn’t a very large or complex organisations –  but if the new government, of whatever stripe, is seriously willing to move to a committee-based model (the more conventional approach) then the requirements for a Governor would be rather different.   Change management skills would be a key component, as part of revitalising the Bank and shaping a position for a strong chief executive who can support the decisionmakers –  rather than being both the principal decisionmaker, and the one who controls all the flow of paper, him or herself.  It might be a little more akin to the important role a Secretary to the Treasury plays in leading his organisation as advisers to the Minister of Finance.

Stress tests and credit availability

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

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

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

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


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

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

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

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

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

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

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

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

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

Debt to income limits: some questions

One of the jobs of the new Minister of Finance will be to decide whether or not to accept the Governor of the Reserve Bank’s request to add some sort of debt-to-income limit tool to the list of direct regulatory interventions that the government gives the Reserve Bank political cover to use.  It does this under the Memorandum of Understanding on (so-called) macroprudential tools.  I phrase things in that slightly awkward way because Parliament has delegated so much power to the Reserve Bank –  probably without fully realising the import of several legislative changes over the years –  that one unelected official, the Governor, does not actually need approval of the Minister of Finance, or of Parliament, to impose such intrusive direct controls.

To give some credit to the outgoing Minister of Finance, the Memorandum of Understanding framework, while legally non-binding, does more or less ensure that the current Governor would not use such a regulatory intervention without at least the political cover provided by allowing the inclusion of a debt-to-income limit on the list of approved tools.  Longer-term, reform of the governance and regulatory powers of the Bank should include making decisions on the application of such controls formally a matter for the Minister of Finance, on the recommendation of the Reserve Bank.

The Reserve Bank has been at pains to claim that their successive waves of LVR controls have improved the resilience of the banking system.  That claim is less well-founded than they would like people to believe.  For example, shifting a large group of borrowers from say 81 per cent LVR mortgages to, say, 79 per cent LVR mortgages won’t make any material difference to the expected losses a bank might face in a severe downturn, but might actually modestly reduce the ability of a bank to withstand those losses (since loans with less than an 80 per cent LVR typically have lower risk weights).   This risk is one my former colleague Ian Harrison has drawn attention to.  In addition, the Bank has never presented any sort of analysis, not even impressionistic in nature, of what banks are doing instead of making high LVR housing mortgages.  If their risk appetites haven’t changed, and the capital invested in the business hasn’t changed, the risks are likely to be developing somewhere else, perhaps somewhere rather less visible, on banks’ books.  There are also ongoing questions about the evidence base behind the regulatory discrimination against those borrowing to buy a house for residental rental purposes.  Before giving his imprimatur to the possibility of further Reserve Bank regulatory interventions, the new Minister of Finance might reasonably ask some harder questions about what has already been done.  He might also ask some questions about when the drift towards ever more direct intervention –  initially sold as quite temporary back in 2013 –  might end.

Before approving the addition of any sort of debt to income limit tool to the approved list, it would also be worth the Minister insisting that the Bank’s background papers get public scrutiny.  No doubt Treasury gets to see them and Treasury has had some serious questions in the past about proposed Bank interventions.  But since the Governor says there is no urgency about using a debt to income tool, there can be no good grounds for not putting the background material out for wider scrutiny now, before the Minister makes his decision, not sometime –  if ever –  afterwards, when (with luck) the OIA finally gets the papers out of the Bank.

In particular, it would be good to see a careful assessment of the empirical evidence the Bank is using in support of its case for a DTI limit, on both soundness and efficiency dimensions (both important in the Reserve Bank Act).  Along those lines, there was an interesting post out earlier this week on the blog of Richard Green a professor (in housing, real estater economics etc) at the University of Southern California.

In that post, he reports some interesting empirical work on a sample of 281000 fixed-rate mortgages purchased by Freddie Mac, one of the US quasi-government “agencies”, in 2004.  He runs a regression model across two-thirds of these mortgages, using a range of variables to model the probability of subsequent default, including through the largest shakeout in the US housing market in many decades.  His DTI term is not actually the ratio of debt to income, but the ratio of debt service to income, but clearly the two will be highly correlated, especially for these relatively high quality mortgages (ones that met US agency standards –  “qualifying”), looking at all the mortgages across the same period of time.

The equation results are in Green’s post.

Note that while DTI is significant, it is not particularly important as a predictor of default.  To place this in context, note that a cash-out refinance is 5.2 percentage points more likely to default than a purchase money loan, while a 10 percentage point change in DTI will produce a 1.3 percent increase the probability of default.

To be clear, increasing the total service burden from, say, 40 per cent of income to 50 per cent of income –  a huge increase – produced a 1.3 per cent increase in the (always quite low) probability of default.

One reason he notes is measurement

First, while DTI is a predictor of mortgage default, it is a fairly weak predictor.  The reason is that it tends to be measured badly, for a variety of reasons.  For instance, suppose someone applying for a loan has salary income and non-salary income.  If the salary income is sufficient to obtain a mortgage, both the borrower and the lender have incentives not to report the more difficult to document non-salary income.  The borrower’s income will thus be understated, the DTI will be overstated, and the variable’s measurement contaminated.

More generally, and in the US context

The Consumer Financial Protection Board has deemed mortgages with DTIs above 43 percent to not be “qualified.”  This means lenders making these loans do not have a safe-harbor for proving that the loans meet an ability to repay standard.  Fannie and Freddie are for now exempt from this rule, but they have generally not been willing to originate loans with DTIs in excess of 45 percent.  This basically means that no matter the loan-applicant’s score arising from a regression model predicting default, if her DTI is above 45 percent, she will not get a loan.

This is not only analytically incoherent, it means that high quality borrowers are failing to get loans, and that the mix of loans being originated is worse in quality than it otherwise would be.  That’s because a well-specified regression will do a better job sorting borrowers more likely to default than a heuristic such as a DTI limit.

He tests this by applying his model to the one third of the sample of loans held back in the initial estimation.

To make the point, I run the following comparison using my holdout sample: the default rate observed if we use the DTI cut-off rule vs a rule that ranks borrowers based on default likelihood.  If we used the DTI rule, we would have made loans to 91185 borrowers within the holdout sample, and observed a default rate of 14.0 percent.  If we use the regression based rule…… we get an observed default rate of 10.0 percent.  One could obviously loosen up on the regression rule, give more borrowers access to credit, and still have better loan performance.  

And extending the point

Let’s do one more exercise, and impose the DTI rule on top of the regression rule I used above.  The number of borrowers getting loans drops to 73133 (or about 20 percent), while the default rate drops by .7 percent relative to the model alone.  That means an awful lot of borrowers are rejected in exchange for a modest improvement in default.  If one used the model alone to reduce the number of approved loans by 20 percent, one would improve default performance by 1.4 percent relative to the 10 percent baseline.  In short, whether the goal is access to credit, or loan performance (or, ideally, both), regression based underwriting just works far better than DTI overlays.  

The current focus in the US isn’t on responding to a house price boom, but on access to finance (in a market still dominated by the government).  But the sorts of questions posed by these sorts of results are just as relevant here as they might be in a US context.  Perhaps here too, high debt to income borrowers might generally be better quality borrowers?     How confident can the Reserve Bank be that an actual debt to income limit –  as distinct from a pure hypothetical –  will actually improve the resilience of banks –  not just on the housing book, but overall?  And even if there is some improvement in resilience, at what cost –  recall the statutory efficiency mandate –  in terms of access to credit would that gain come at?

Perhaps there are good answers to all these sorts of questions.  Perhaps the Reserve Bank has access to other careful studies that produce different, and robust, results.  But these are the sorts of questions the new Minister of Finance, and the public, should be asking in response to the Governor’s request for political imprimatur for adding another tool to his kit of potential interventions.     And, more broadly, how confident can we be of any sustained gains from such interventions, as compared to the sure increases in resilience that would result from either higher risk weights on housing loans more generally, or higher overall capital requirements for banks (and non-banks regulated by the Reserve Bank)?