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.