Is The Reserve Bank On A Mission To Lose Its Independence?

The role of a central bank is to implement monetary policy. The role of a central bank is not to act as an arbiter of what credit allocation decisions are good and what credit allocation decisions are bad.

Matt Nolan has a very good overview of the issues around the level of discretion the Reserve Bank is claiming mandate for with respect to macro-prudential policy.

I’d point out that on top of the level of discretion the Reserve Bank is engaging in, the Basel III framework which includes provision for unexpected losses, is just as discretionary and distortionary when it comes to capital allocation decisions in the economy.

The idea that a bunch of officials can forecast market tops better than private industry is hilarious. If they could they’d be hired by hedge funds in the US straight out of graduate school and would never set foot in a central bank because the opportunity cost in terms of wealth accumulation would be too high.

Even though I’m still just an economics student, I follow the literature and blogosphere closely. I know that since the global financial crisis, a lot of the stuff the Reserve Bank talks about in its bulletins has been dealt to by private actors.

How so? Banks are only going to give large mortgages to large earners in stable careers. If you run a business or are self-employed, you are subject to credit rationing because banks have been burned so often. Although Rob Hosking is correct in saying that LVR restrictions will save some people from themselves, the unintended consequences of discretionary policy are where the real welfare losses lie.

At the heart of the housing affordability issue is that in 2008 a lot of banks prematurely pulled the plug on residential development funding that was plugging the supply and demand deficit in Auckland and other places around the country.

New Zealand is a poor country – someone on wages is unlikely to be able to save up enough capital to take a risk on a speculative property development so banks need to match up developers with loans. It’s risky – but it’s a societal benefit because without this activity, there would be no downwards pressure on house prices.

In the most cynical of analyses, I think the RBNZ could be pre-empting the possibility of a Labour / Greens / NZ First coalition government ripping up the already expanded memorandum of understanding and throwing in a whole lot of additional policy objectives for the RBNZ to achieve.

Are they on a mission to lose their independence? It sure seems that way. I’m not convinced that there is enough discussion about the trade-offs involved in making arbitrary decisions on what sort of lending is good and what sort of lending is bad.

In terms of efficiency, risk should be managed by those closest to the coalface. I think there has been a bit too much hysteria over the finance sector and not enough examination of how substantial changes in how they do business in light of their regulatory changes makes the Reserve Bank’s new clothes an awkward fit.

6 Charts You Need To See From The Latest Reserve Bank Bulletin

The Reserve Bank Bulletin is always an interesting read. The June issue delivers with “The last financial cycle and the case for macroprudential intervention” by Chris Hunt.

I like Reserve Bank publications for the awesome charts they produce. In this piece they try and apply the policies they’re suggesting to the 2001 – 2008 boom.

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Look at the massive reduction in private sector credit growth to business – how much of that is due to finance company failures and risk aversion on the part of bankers? It also seems like agricultural credit growth ground to a halt as we saw over-extended farmers like the Crafars have their loans called in.

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OK – so if you are on a floating rate mortgage, that you can only afford when interest rates are low, what happens to your debt servicing ability when interest rates rise? Bueller? Bueller?

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Finance companies competed aggressively in the property development sector, lending on more marginal and riskier housing projects which ultimately sowed the seeds of failures within the sector from 2006.

OK. So with massive population growth and supply side restrictions on housing, who shall fund the supply-side response? What constitutes a “marginal and riskier housing project” when New Zealand is not building enough houses each year even to keep up with population growth and reduced family formation?

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There are some big questions that don’t appear here – how do we compensate society if our macro-prudential intervention chokes an economic recovery before it even gets started? Do we include the costs of subdivisions not built or higher rents paid for apartments when marginal apartment building projects can’t get approved because of higher capital requirements in the financial sector?

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There is a trade-off between lending and meeting Basel III requirements. There hasn’t been nearly enough discussion of how Basel III by itself could kill any credit financed recovery (household risk preferences won’t pay for it!).

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OK so here the author is highlighting the gap between actual capital ratio and what any counter-cyclical buffer would have been to put a dampener on credit growth starting late 2005 – if the RBNZ had possessed such powers.

  1. Where would financial institutions raise additional capital from if their regulating central bank has just taken action to force them to raise additional capital or substantially reduce their loan book?
  2. Where would non-bank deposit takers be in this situation? How can the Reserve Bank stay ahead of alternative credit providers?

If there is one thing we can be grateful for when it comes to the Reserve Bank, it’s that you can read their bulletins regularly and develop a pretty good idea of where monetary policy and prudential regulation are headed.

They are transparent – so when I see criticism of “shadowy central bankers” it’s clear that someone hasn’t spent time on the recently redesigned Reserve Bank website.

All of this stuff affects you and your finances – particularly if you have a mortgage – so there’s no excuse not to read through this stuff when it’s available for free.

What You Ought To Know About Financial Stability And House Prices

The Reserve Bank of New Zealand has a financial stability mandate. If you go over to their recently redesigned website you’ll find a plethora of information about their oversight of banks, insurers and non-bank deposit takers (that’s finance companies and the like).

But what you ought to know about financial stability is that there is only so much that the Reserve Bank can do. Just because there is regulation and frameworks that have a goal of financial stability, does not mean that there actually is financial stability.

I believe that many people have no idea about what financial stability is, and how policies to achieve that sort of objective interact with their banking relationships and insurance relationships. Reading the latest Financial Stability Report would go right over the heads of many people that sort of information is produced to protect.

The other day I shared with you my thoughts on Basel III and how that has an impact on capital allocation in the economy. The higher capital and liquidity requirements mean there is a bias towards secured mortgage lending over business lending for example.

But here in New Zealand, the Reserve Bank is making judgments that I consider to be outside its purview. Here is a selection of quotes from that report’s introduction that concern me:

  1. New Zealand’s elevated exchange rate is also continuing to hinder a rebalancing of domestic activity towards the tradables sector, which would assist in reducing external vulnerabilities.

  2. Despite the higher capital buffers, rising house prices are creating risks for the New Zealand financial system, by increasing both the probability and potential impact on bank balance sheets of a significant house price adjustment. The greater willingness of banks to approve high loan-to-value ratio (LVR) mortgages has further increased the potential adverse impact of a fall in house prices.

  3. This [limits on high LVR lending] will strengthen the capacity of the banking system to weather a housing downturn, and should also lead the banks to review the riskiness of the loans they are currently writing.

  4. The Reserve Bank’s aim would be to apply the restrictions at times when high-LVR lending was judged to be posing a significant risk to financial system stability.

These are just some quotes that jumped out at me and set off alarm bells in my head. You should be concerned that the Reserve Bank thinks it can identify when price increases are in response to supply side contraints as opposed to “naughty” types of demand like speculation and residential property investment 😉

Why should you be concerned? Because there is no evidence that any central bank in the world has ever successfully identified the peak of a market cycle and adjusted its policy in such a way that a “crisis” was averted.

We need to think about what sort of buyer ends up in a high loan-to-value mortgage. Then we need to think about the reasons why house prices are so high relative to incomes. Then we need to read the NZ Initiative’s report on how all of the little rules and regulations around housing have halved the average number of houses built in this country to half of what needs to be built just to cover population growth.

We also need to think about changes in the rate of family formation and how that affects the number of houses and apartments that must be built. Deferred marriage and children means way more apartments are currently needed than are currently available. It also means that many couples are less able to save for a house because supply side restrictions jack up their rent and their income growth is not what they thought it would be when they left university or trades training.

All of these things matter when it comes to the price of houses – yet although I’m sure RBNZ officials are aware of them, they do not seem to realise how premature action on property lending could cut off the desperately needed supply side response before it even begins.

When BNZ Chief Economist Tony Alexander wrote a big wishlist of policy that could fix housing, I could not help but think about the most obvious reason there has been a slow supply side response to higher demand for housing in Auckland – his bank and other big banks pulled the plug on umpteen numbers of property developers and small time investors because of the GFC and the need to reduce risk.

The Reserve Bank does not want to acknowledge the role that the financial system plays in allocating capital. Mum & dad investors (the notional investor, as finance company judgments called them) are unlikely to invest in property developments. The only way for houses to be built in an industry that depends on credit is when the banks lend to builders and developers. That is not happening nearly as much as it should.

There are a lot of skilled people in construction sitting on the sidelines because the people that employ them can’t obtain funding even though there are clear supply side issues. It is a capital allocation failure that pursuit of financial stability at all costs will only make worse.

In fact, the concept of the “counter cyclical buffer” that would require banks to reduce lending and raise more capital if the RBNZ judges the economy to be in a “boom” does not come with any discussion of price rises as a price signal for more supply attached.

That should terrify you. There are hundreds of thousands more people in Auckland than anyone predicted over the past few decades. There is obviously a massive increase in demand from domestic migration to Auckland before taking overseas migration into account – Auckland is where most of the jobs are.

I am skeptical of the idea that more rules and regulations around financial stability will do anything to actually attain financial stability. Financial stability is a nebulous policy objective that runs the risk of thwarting any recovery in the economy. The near absence of funding for supply side responses to increased demand for housing is a function of risk reduction at the banks.

The collapse of many finance companies didn’t help things either. No matter what you think about them, and property developers, riddle me this – if finance companies had not provided billions of funding to developers that the banks didn’t want to touch, how much higher would house prices be now?

In the case of Auckland apartments, if all of those oft-disparaged “shoebox” apartments hadn’t been funded, can you imagine how much worse the housing situation in Auckland would be?

If you think the Reserve Bank is possessed of some special knowledge that enables it to call a “bubble” in the pursuit of financial stability, I have some finance company bonds with negligible risk premium to sell to you.

When Technocrats Strike (Bank Of International Settlements Basel III Edition)

Over at TVHE, Matt writes about the BIS arguing that structural adjustments and balance sheet restructuring should be imposed on the world without any democratic input. He makes it clear that there has to be some democratic input into these processes. I argue that the BIS has already won a cold war against risky lending with Basel III.

The Bank of International Settlements is a technocratic institution based in Basel, Switzerland. Alongside providing a lot of good stuff in the form of supervising global payments systems and coming up with some very good global settlement policy, it has also produced one of the most complicated pieces of technocrat policy since Bretton-Woods.

That would be Basel III – a series of capital and liquidity requirements for all banks around the world. Check your local bank’s Key Disclosure Statement – you’ll find a lot of footnotes stating how they’re transitioning towards Basel III compliance and some banks are even raising additional capital so that their Tier 1 capital ratio is higher than it needs to be “just in case”.

These capital and liquidity requirements are obviously a good idea in the aftermath of the global financial crisis. Investment banks like Lehman Brothers and Bear Stearns over-extended themselves on mortgage-backed securities and when they marked their positions to market, they essentially were worthless.

The US Treasury, using AIG Financial Products as a conduit, paid out the credit default swaps on all of these sub-prime CDOs at 100 cents on the dollar. This transferred hundreds of billions of dollars from US taxpayers to Wall Street banks.

In essence, Basel III is a technocratic series of rules and committee based supervision (seriously) that aims to avoid a repeat of 2008. The theory goes that if banks have to hold more capital and make fewer risky loans, then the financial system will be more stable and there’ll be no need for big bank bailouts.

The BIS has essentially changed the way every single bank abiding by or transitioning to Basel III does business. Why? Because different types of loans require different levels of reserves held against them in case of default. Different types of equity offer different levels of capital the bank can use in calculating its compliance with Basel III.

This means that, without any democratic input, the BIS and everyone participating in the Basel III process has already imposed massive structural adjustments on how capital is allocated in literally every single country! The technocrats have already changed how every single bank in the world prepares its financial statements and manages its balance sheet! If that isn’t a technocratic imposition without reference to democratic processes I don’t know what is.

Why are banks happy to lend on houses but not to small businesses? Because they need higher loss reserves for business lending. Ergo, you can borrow a $1 million for a house but borrowing $1 million for a development to increase housing supply is almost impossible unless you already have $1 million in net assets as security, rendering the whole point of participating in the bank lending market moot and the likelihood of any economic recovery relying on credit negligible.

What does this have to do with Basel III? Well, with quantitative easing injecting enormous amounts of liquidity into the financial system at the same time that higher capital requirements and liquidity constraints have been imposed on banks and financial institutions, it simply makes more sense to keep stuff on your balance sheet in assets that enable you to count them as Tier 1 capital under Basel III rules. That is why financial institutions have returned to profitability so quickly.

Thus, in the pursuit of financial stability, the Basel III process has also made it less likely that loans will be granted to the risky activities that will bring the Western economies back into growth mode. There is a trade-off between financial stability and credit being allocated towards risky activities like business startups and property development.

Remember, when private sector demand for credit is down, and banks need to raise enormous amounts of capital to meet Basel III requirements, how focused will they be on performing their role as a capital allocation utility i.e. the reason they’re given banking licenses? How focused can you be on business development in property lending when you made big mistakes in the last boom and now have a whole plethora of new rules around who you can lend money to?

It’s almost as if the technocrats did not believe that there were any tradeoffs in pursuing policy that, funnily enough, I think the average person in the street would wholeheartedly approve of. Regulation has consequences. We should be very concerned that the Reserve Bank wants to increase its level of “macro-prudential supervision” through loan-to-value restrictions.

WATCH: What’s Wrong Mr Bernanke? (Epic Rick Santelli Rant)

“Where does it say in the Constitution that stock prices have to go up?” – CNBC commentator Rick Santelli on an epic rant in the aftermath of Ben Bernanke’s FOMC comments on tapering and QE and how the Fed has no idea about what they’re doing.

When you add in Bill Gross saying on Bloomberg that the Federal Reserve is “walking around in a fog”, we have to laugh. His PIMCO Total Return fund took a bath yesterday as financial markets took a hit on the back of Bernanke’s comments. When Bill Gross “the king of bonds” basically said “WTF are you doing Mr Chairman!” you know that central banks playing central planner has opened a massive can of worms for the global financial markets.

On A Cross Of Bonds (An Interest Rate Is A Price)

The goal of quantitative easing was to keep interest rates low so households and firms would go out, borrow money and spend like there is no tomorrow.

Because consumption drives the debt fuelled economy, central bankers around the world were happy to crucify price signals in the form of interest rates that reflect risk and the time value of money on a cross of bonds.

One of the most basic concepts in economics is diminishing marginal returns. When you consume more of something, you get less and less satisfaction until some point where you’re getting negative utility from consuming more of it. I think that quantitative easing has hit diminishing returns and no there is nothing central banks can do in order to restore valid price signals in the form of interest rates.

Just like an exchange rate is a price, an interest rate is a price. It’s a price of how much it will cost for us to bring consumption forward to today. It’s an exchange rate across time. By keeping interest rates low, central banks were trying to change the way we thought about borrowing for more consumption today to be repaid with interest tomorrow. Even firms have been paying down debt and returning cash in dividends or buybacks.

But the household balance sheet restructuring of the past few years has changed something. Private sector demand for credit has declined. The velocity of money is low so that monetary base ain’t going anywhere than financial institutions balance sheets. Sure, we’ve got a resurgent housing boom, but there are big supply side backlogs that need to be cleared in New Zealand. Banks will lend to home buyers, but they won’t lend to builders or developers.

When you realise that banks get a decent proportion of their funding on the wholesale money markets, where the rates they’ve been paying have been artificially low since the GFC hit, and then realise that macro-prudential tools just introduced by the Reserve Bank and Basel III mean that banks need lower reserves for housing lending than they do for business lending, you’ll get some sort of idea of how stuffed we are when rates rise.

An interest rate is a price, and one of the reasons the financial markets are producing dramatic movements is that investors are trying to sort out whether the recovery is real or if it’s just the response of people whose preferences have been twisted far enough by central banks to make them willing to lend or willing to buy bonds that they wouldn’t have touched a decade ago.

An example of this is high yield corporate bonds in the US – also referred to as junk bonds. These low rated bonds that are very risky in terms of default potential have reached yields as low as 5% in the past few months. When there is a speculative reach for yield, anything with a yield will do as long as it has some sort of rating attached.

One of the problems with central bankers is that they live in a bubble. In their interactions with the financial community, the media, the corporate executives they meet at conferences and the people who sit next to them in private jet terminals and airport lounges around the world – quantitative easing is doing wonders for their household net worth.

But the problem of living in a bubble is that for pretty much anyone who does not own a substantial amount of assets, the economy sucks. Household wealth has gone down for most people, with tarnished credit ratings they can’t borrow even though they might have a good cheap business idea. That means that quantitative easing can only succeed if the banks pass on the implicit subsidy they’re getting from everyone else in the world.

Inflation has not emerged like some said it would. That’s because although the monetary base has expanded dramatically, velocity of money has declined – even plummeted in some economies. After Cyprus, people are aware that a bank deposit is an unsecured deposit and it’s not yours. This means that moving from cash into anything but a bank account pushes asset prices even higher.

How does this all end? Well, if interest rates rise suddenly, enormous capital losses are imposed on bondholders. The mantra of the global financial crisis has been “Thou shalt protect the bondholders” – same for the Wall Street bailout that used AIG as a conduit. How leveraged have hedge funds been in taking advantage of QE? How bad will the margin calls be? How will the prime brokerage desks handle a potential repeat of 1994?

I don’t know, and am smart enough to realise that at this point, the most honest thing economists can do is tell the truth. The central bank playing around in ways that were never conceptualised at the outset of monetarism has opened a whole new can of worms. Using the S&P500 as an indicator of economic performance does not lead to broad prosperity.

When the central bankers want to sacrifice everything on a cross of bonds, the demand for physical assets and financial assets that will benefit from inflation is clear. There’s a demand side story on top of the monthly bond purchases by central banks around the world. And if the fundamentals improve, who knows where asset prices could go?

Lowering The Cash Rate Is No Panacea

Last week the Reserve Bank of Australia lowered its cash rate to a record low.The Australian dollar tumbled, and there are rumours that George Soros bet US$1 billion against the Aussie in expectation of that. But just because the central bank lowered the cash rate does not mean that Australia will have softening demand from China offset by a domestic recovery.

At the onset of the global financial crisis, the Federal Reserve quickly slashed the fed funds rate and injected enormous amounts of liquidity into the financial system. Even the RBNZ received a few billion dollars in Fed largesse. Not long after, the Bank of England joined the party of quantitative easing. The UK even nationalised most of its banking sector.

Fast forward to today. The European Central bank has been doing its own form of quantitative easing and sovereign debt restructuring since 2010. While there is enormous liquidity in the financial system, private sector demand for credit is nowhere near pre-crisis levels. The Bank of Japan is doubling down on quantitative easing in the vain hope that higher inflation will somehow kickstart the Japanese economy.

If everyone is engaging in quantitative easing, the country that does not will quickly find its exports uncompetitive. The New Zealand dollar is currently at record highs – not because New Zealand is an economic miracle but because there is a global reach for yield. It just so happens that our interest rates – and dividend yields – are very attractive in a low interest rate environment.

This is because although quantitative easing has succeeded in keeping interest rates low, it has not flowed through into substantial investment and consumption spending. The United States recently surpassed the “socialist” Eurozone for youth unemployment and underemployment. Household incomes have stagnated since the 1970’s. Corporations are running massive surpluses and can even issue long-term debt to finance dividends to shareholders because that is cheaper than repatriating capital from offshore.

The tragedy of the Australian story is that they have squandered the boom. I shared with you a while back a McKinsey Global Institute report that clearly shows how their economy has had poor productivity growth, pursued resource projects barely economic even at sky high commodity prices and failed to ensure that the whole Australian balance sheet was ready for any inevitable downturn.

My opinion is that the Reserve Bank of Australia will keep cutting interest rates. There will be a change of government and the incoming Liberal government under Tony Abbott will not be able to implement any significant supply side reforms because they will be in a massive slump.

Lowering the cash rate is no panacea for an economy already plagued by malinvestment. Because Australia has a larger balance sheet than New Zealand, it will be interesting to see if they eventually copy the Federal Reserve and join in the quantitative easing party. Australia sure is important for us to watch – our economy depends more on theirs than many in New Zealand want to admit.