There Needs To Be More Discussion On Basel III Instead Of House Prices

Housing is topical. Housing is easy for a journalist with a BA in Media Studies to understand. Housing articles drive traffic for online ad impressions and listing revenue. But are high LVR restrictions really the answer to perceived problems with house prices?

Basel III capital and liquidity requirements are not topical, but when it comes to financial stability they are pretty much the global tool that is so much better than market specific intervention despite the fact that imposing higher loss reserves on certain types of lending can have supply side impacts because a lot of growth can only occur because there are capital costs that have to be financed by a bank.

The Reserve Bank response to submissions I wrote about yesterday is an example of why market specific (house prices are in a b*****! we must act now!) interventions with a good goal like improving financial stability and lowering systemic risk through avoiding a lot of mortgage writedowns if house prices ever fall and high LVR borrowers have negative equity, are not necessarily a good idea.

This sort of regulation is “good” in the sense that the RBNZ really cares about financial stability now it has some fancy new macro-prudential kung fu to implement. It isn’t good in that there is barely any discussion of basic supply and demand factors affecting house prices, particularly in Auckland.

But anyway the focus on housing is really crazy in light of how massive Basel III capital and liquidity requirements are in terms of changes to bank lending processes and risk management processes.

It’s like worrying about rules for adding a conservatory to your house when the global building authority has issued a mandate saying “you have to use office tower strength reinforced concrete with earthquake shock absorbers for your residential foundations”.

My dream is that one day more people will be as passionate about supply side effects flowing through from higher capital and liquidity requirements before even thinking about the enhanced (negative) supply side effects high LVR restrictions could have.

Remember all of those finance companies? They were providing the risk capital that built most of the apartment buildings and subdivisions to get to a point where New Zealand still doesn’t have enough apartments and houses on decent sections.

Now, banks can’t lend like some of their more aggressive property lending teams did pre-2008 and the second tier finance sector has restricted itself to “sure thing” deals. The other alternative is hedge funds looking for extremely high rates of return for short term loans that won’t ever be capitalised.

Why oh why can’t we have a better media? This stuff isn’t hard to get your head around. It’s just a basic supply and demand story. Supply of housing is restricted both by lower credit availability and by council and environment court red tape. Add in a demand curve shift to the right from immigration and this could have been an ECON101 essay question.

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.

The OECD Is Wrong About Deposit Insurance

The OECD has been hard at work preparing a fancy report that tries to impose globalist policies on New Zealand. One of their suggestions is that New Zealand should move to implement bank deposit insurance over the Open Bank Resolution model which would impose haircuts on bank depositors and wipe out shareholders in order to eliminate or significantly lower the cost of a big bank bailout.

The problem with globalist agencies trying to tell a sovereign country what policy options it should pursue is that it does so without any consideration of that country’s unique experience with that policy in the past is.

Remember the Crown Deposit Guarantee Scheme? That enabled our banks and finance companies to survive the worst of the “global financial crisis”. It also cost taxpayers billions of dollars – and led to our largest ever fraud trial coming to you soon in the form of South Canterbury Finance.

Deposit insurance, in the aftermath of Cyprus, which showed that all bank deposits are fair game in a bail-in, is nonsensical. The immediate reaction of South Canterbury Finance after getting into the Crown Deposit Guarantee was to ramp up its risky lending. Why? Because the cost of failure had been shifted from bondholders and shareholders to taxpayers.

In the case of the big banks, an argument can be made that, along with lower levels of syndication (shorter distance between borrower and owner of that mortgage) and absence of deposit insurance, our banking sector is slightly more risk averse than other banks around the world. When you add in recourse lending (you can’t walk away from an underwater mortgage without risking bankruptcy), New Zealand’s financial stability plan is working just fine thank you very much.

Already, the market is confused because there is no telling how the NZ government would react to a major bank getting into trouble. While Open Bank Resolution is quite explicit as to what the process is, political reality and convenience dictate that it would provide an optimal chance for a government to grandstand and “save the day”.

Bank depositors still do not understand that they are in a debtor/creditor relationship with their bank. Standard risk management principles apply even to regulated and well capitalised banks in this country. The OECD is wrong about deposit insurance because the marginal banks would be able to expand their loan books at a higher rate than their fundamentals would justify.

As economic thinkers, we want the taxpayer to be liable for the least amount of risk prudent in a risky global environment. The commentary written by globalist organisations like the OECD, IMF and World Bank aren’t that helpful in working towards sensible policy in New Zealand.

We have our own bundle of preferences that the median voter wants that are bad enough, adding dumb ideas that increase moral hazard risks and asymmetric information between regulators and the regulated does not help sensible bank regulation at all.


Bank Stress Testing And Open Bank Resolution

Bank stress testing is an interesting thing to think about. The goal is to model what would happen to bank income statements and balance sheets in the wake of “shocks” like house prices returning to realistic levels or people realising that paying debt back just gives executives bonuses and less disposable income for cool stuff.

The Reserve Bank’s latest Financial Stability Report includes some discussion of recent bank stress tests done in collaboration with the Reserve Bank of Australia.

The impaired asset expense estimations even when the “shocks” happen are extremely low. An impaired asset expense is recognising on an income statement that you’re unlikely to have a loan repaid.

This flows through to whether the bank makes a profit or loss. If they make a loss, they have to raise additional capital in order to retain high Tier 1 capital ratios under Basel III requirements.

There is $35 billion in wholesale funding that banks have to rollover to replace over the next 3 years. With the euro-zone crisis still nowhere near being resolved, and the LIBOR scandal, will there even be a functioning wholesale money market in 3 years?

To say that there will be is arrogant in the extreme. Just look at how quickly the overnight lending markets evaporated after Lehman Brothers. We have no idea what could trigger another freeze. What if Greece exits suddenly and the charade that the euro-zone still has some semblance of solvency evaporates?

The RBNZ and RBA worked with the banks’ own models in order to conduct stress tests. They do not say whether they adjusted the banks’ figures to reflect the incentive they have to under-report substantial losses they would incur if certain shocks happened.

There is also not much discussion on whether impaired asset expenses peaking at 2% is realistic at all. This is odd. Why? Because if a major shock happens and New Zealand goes into a deep recession, we have no way of telling how the dominos will fall.

What I mean by this is that we can’t say what will cause different businesses to make shutdown decisions in the wake of a deep recession. Some business owners might fear the worst, layoff their employees promptly and suddenly an extra 30-40 mortgages start falling behind.

What happens if impaired asset expense ratios go above 2%? And if banks aren’t able to raise capital either domestically or on the wholesale money markets?

They become insolvent. Their capital ratios fall below their Basel III requirements. There is a risk that no capital injection can be arranged and so we turn to the proposed Open Bank Resolution strategy.

While I won’t go into detail about how the Open Bank Resolution process will work, I will make one comment : what if the initial losses are far greater than what the Reserve Bank has considered in building their model?

Banks actually have a major incentive, if the government is going to guarantee solvency support of the unfrozen portion of their assets, to make hay while the sun shines.

Paying bank executives 7-figures salaries in gratitude for shifting potential taxpayer liabilities into the tens of billions of dollars, when there is no recourse for clawing back excessive compensation and excess returns that have been clawed off the table, is folly in the extreme.

We cannot tell what the actual level of losses will be. We cannot tell what the actual impaired asset expense will be if a major bank collapses a year or so after a deep recession.

This means that the most honest value of government solvency support to a bank admitted to the Open Bank Resolution scheme is $X billion to $XX billion.

Furthermore, if the RBNZ takes over an insolvent bank, are there measures in place to insure futures contracts are rolled over to avoid cash settlement? What if a $10 billion notional US Treasury position isn’t rolled over? Do term depositors or taxpayers stump up for that?

If I was employed by the RBNZ I would be actively “war gaming” things outside the model. What if the Australian government, for political reasons, doesn’t want its super funds to eat the losses of an insolvent big bank? What if the Australian High Commissioner takes a trip to the Beehive and tells Bill English that the New Zealand government will eat the losses in partnership with the Australian government?

Bank stress testing based on the numbers is better than no bank stress testing at all. But there needs to be some clear thinking about what “outside the model” potential hurdles might need to be overcome.