Reserve Bank Deputy Governor Grant Spencer confirms January increase to Core Funding Ratio, outlines tools under consideration to dampen future credit bubble

By Gareth Vaughan

The Reserve Bank says limiting banks' loan to valuation ratios (LVRs) is an option that could be implemented to clamp down on frothy asset price and credit booms, and has confirmed it will increase the Core Funding Ratio (CFR) to 75% from 70% from January next year, Deputy Governor Grant Spencer says.

In a speech to the Financial Institutions of New Zealand's 2012 Remuneration Forum today covering lessons for prudential regulation from the global financial crisis (GFC), Spencer said the CFR would be lifted from January 1, 2013. Spencer is a leading candidate to replace Reserve Bank Governor Alan Bollard, who steps down after 10 years in September.

Introduced in April 2010 as a move designed to reduce New Zealand banks' reliance on short-term overseas borrowing, the CFR sets out that banks must secure at least 70% of their funding from either retail deposits, or wholesale sources such as bonds with durations of at least a year. The central bank lifted the ratio to 70% from 65% on July 1 last year. Last November it delayed the planned increase to 75% from 70%, that had been scheduled for July 1 this year until the start of next year saying, as the Eurozone sovereign debt crisis woes mounted, the delay would give banks more flexibility if financial markets deteriorated further.

"We are confirming today our intention to increase the CFR to 75% on 1 January 2013," Spencer said.

Speaking to interest.co.nz on the release of his firm's annual Financial Institutions Performance Survey last week, KPMG Head of Financial Services John Kensington said the banks were ready for the increase.

Prudential toolbox failed to deal with 2002-2007 cheap credit bubble

Meanwhile, Spencer acknowledged the Reserve Bank's existing prudential regulatory framework failed to take account of the growing systemic risk arising from a boom in credit and asset prices between 2002 and 2007, which  "aggravated" the severity of the GFC.

"Many banks had adopted capital models that tended to reduce the capital backing of loans when markets were strong and increase capital backing when markets were weak. In this sense, the existing prudential framework failed to take account of the growing systemic risk arising from the sustained boom in credit and asset prices that occurred between 2002 and 2007," Spencer said.

"The lesson was clear: prudential policy should take more account of macro-financial risks as well as the micro-financial risks specific to individual banks."

Aside from the introduction of the new global capital adequacy standards, Basel III, Spencer said to prevent such a scenario occurring again, Reserve Bank staff have been doing "a lot of thinking" about potential macro-prudential policy instruments and how they might be used.

"In broad terms macro-prudential policies are aimed at reducing financial system risk by introducing additional safeguards, such as capital and liquidity buffers or collateral requirements that vary with the macro-credit cycle," Spencer said. "Such policies will also tend to have the effect of either: 1) dampening the credit cycle; or 2) dampening international capital flows and hence exchange rate pressures. For those reasons, macro-prudential policies might be expected to play a useful secondary role in helping to stabilise the macro-economy."

 Four instruments the Reserve Bank currently considers "viable candidates" include: the Counter Cyclical capital Buffer, which is described as an additional capital requirement that local bank supervisors may apply when credit is booming, and remove when the cycle is turning down. It's part of the Reserve Bank's Basel III plans (see more on this option here). Spencer also highlighted the Core Funding Ratio, adjustments to sectoral risk weights used to calculate Risk Weighted Assets under the Basel capital adequacy regime and limits on LVRs.

The inclusion of the last option is perhaps the most significant. The recent resurgence of the Auckland housing market comes with three of the country's big four banks growing their residential mortgage lending with LVRs above 90%. See more here.

"The Reserve Bank already has powers under the Reserve Bank Act to modify prudential instruments with the objective of financial system stability and efficiency. However, this is a new approach to prudential policy and as such we are developing, along with Treasury, an explicit macro-prudential governance framework to be agreed with the Minister of Finance (Bill English) as a basis for policy decisions going forward," said Spencer.

"We expect that the Reserve Bank will take the lead role in implementing macro-prudential policy, subject to consultation with Government."

He said macro-prudential policy will have an important influence on monetary policy, in a similar way to fiscal policy.

"Thus if macro-prudential policy is acting to dampen aggregate credit and demand, there should be less work for monetary policy to do. Because of this potential assistance from macro-prudential policy, there may well be situations where monetary policy seeks the support of macro-prudential policy, just as it may seek the support of fiscal policy. But macro-prudential can only be used to assist monetary policy if it is also consistent with its primary financial stability objective," said Spencer.

"An important point to note here is that, like fiscal policy, macro-prudential policy is likely to be on a slower time schedule than monetary policy. Changes in the counter-cyclical capital buffer, for example, will require six to twelve months notice for the banks to comply."

"Thus, while we will try to ensure that macro-prudential policy is consistent with monetary policy objectives, these policy settings are less amenable to fine tuning. In that sense, macro-prudential policy is likely to be taken as a background “given” when it comes to making short term monetary policy decisions," Spencer added.

Open Bank Resolution policy 'a complement not a substitute to help limit moral hazard in the financial system'

Spencer also touched on the Reserve Bank's Open Bank Resolution (OBR) policy, which it's looking to introduce as a potential tool to use to deal with a bank failure. The OBR framework requires banks to structure their systems so that, in the case of a failure where losses exceed a bank’s available capital reserves, the excess losses can quickly be allocated across depositors and other creditors. The policy has come under fire from the likes of Massey University Director of Banking Studies David Tripe, and bank lobby group the New Zealand Bankers' Association, with new CEO Kirk Hope recently telling interest.co.nz the OBR plan lacked policy justification.

However, Spencer said the OBR policy should be seen as a complement rather than a substitute for the various “recovery plan” tools in the event of a bank failure such as living wills and loss-absorbing debt instruments.

"OBR is also fully consistent with the Reserve Bank’s local incorporation and outsourcing policies that were introduced in the early 2000s to help protect New Zealand’s largely foreign owned financial system from shocks to parent institutions. It must be emphasised however that OBR is just one tool in the resolution toolbox. The government may or may not implement OBR when dealing with a bank failure; the choice will depend on a number of factors," said Spencer.

"But it is important for government to have this option available. OBR gives the government a realistic alternative to the costly bail-out option should a large bank get into difficulties. The policy also serves as a reminder to investors that there are no guaranteed institutions, thus helping to limit moral hazard in the financial system."

"The OBR option will help to protect both the financial system and the government accounts from a large bank failure," Spencer added.

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17 Comments

"In broad terms macro-prudential policies are aimed at reducing financial system risk by introducing additional safeguards, such as capital and liquidity buffers or collateral requirements that vary with the macro-credit cycle," Spencer said. "Such policies will also tend to have the effect of either: 1) dampening the credit cycle; or 2) dampening international capital flows and hence exchange rate pressures. For those reasons, macro-prudential policies might be expected to play a useful secondary role in helping to stabilise the macro-economy."
 
The collateral requirement should be applied to large deposits. When does the RBNZ ever lend to a NZ bank on an uncollateralised basis? Otherwise OBR is a joke when privileged covered bond holders enjoy unsubordinated access to low LVR mortgage pools.   
 
International captial flows are near impossible to control given our current account deficit position. Latest Treasury estimates expect this particular deficit to deteriorate in coming years.
 
Meanwhile, Spencer acknowledged the Reserve Bank's existing prudential regulatory framework failed to take account of the growing systemic risk arising from a boom in credit and asset prices between 2002 and 2007, which  "aggravated" the severity of the GFC.
 
Why do regulatory institution's mea culpas always come with that hollow ring of confidence?
 

Why do regulatory institution's mea culpas always come with that hollow ring of confidence?
How Bankers respond to their mistakes
"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men."
-- John Maynard Keynes, "The Consequences to the Banks of the Collapse in Money Values", 1931

> The Reserve Bank says limiting banks' loan to valuation ratios (LVRs) is an option that could be implemented to clamp down on frothy asset price and credit booms, and has confirmed it will increase the Core Funding Ratio (CFR) to 75% from 70% from January next year, Deputy Governor Grant Spencer says.
And why dont the banks limit our L/V ratio on new morgages to something we can afford... and decrease that down over the next 10 years to something we REALLY can afford.
Ah.. I know.... It's too late.
;)

I wonder if they might include residential property investment as a target sector with such an approach?
 
" ... adjustments to sectoral risk weights used to calculate Risk Weighted Assets under the Basel capital adequacy regime, ..."
 
Would that be helpful? Any reason why not?
 
Anyway, well done RBNZ, it's never too late to learn and particularly how to be more timely in your response to changing context. I hope you can perform well on this aspect going forward.
 
Cheers, Les.
www.nzmea.org.nz
 

Would that be helpful? - To whom Les - aliens that don't live here? Small businessmen rely on using their private dwellings as collateral to finance their business funding needs. How could we expect the banks to lend to SMEs otherwise, unless we force them to?   
 
 
Any reason why not? - Same as above and property speculators/landlords having the ear of government. We need to uncapture politicians from the shackles of the 'entitled'.

Thanks Stephen.
 
The kinds of, "Small businessmen[and ladies] [who] rely on using their private dwellings as collateral to finance their business funding needs." - wouldn't be affected, given this approach would not apply to said sme owners private dwellings = their own homes. It would only apply to residential property that is not owner occupied, ie. investment property.
 
The kinds of pressure exerted by, " ...speculators/landlords having the ear of government." - hasn't stopped RB applying this approach already to dairy sector lending, another key debt driving sector, like residential PI. A sector by all accounts that has one of the most powerful lobby voices in NZ and it didn't stop RBNZ doing what needed to done, albeit late. RB is independent, after all.   
 
 
 

Thanks for the heads up Les
 
RB is independent, after all
 
Yeah Right!
 
The dairy sector could still pull the banks down and needed some overt intervention to slow the lending volumes, more so in light of the SCF debacle - but inevitably taxpayers seem to have picked up the pieces there without too much discussion. 

Stephen - wry smile ....
 
Anyway is it not true that, "... some overt intervention to slow the lending volumes," has similarly been required in residential PI, for same reasons it's been required in dairy? For instance, there appeared to be an over reliance on the OCR regime to restrain debt growth, but it didn't. Hence the need for effective use of prudential measures.

Yes Les - but the risk concentration is not the same as corporate dairy, for instance . And in fact flung far and wide in respect of residential property. I am in agreement just cannot see how the necessary pressure can be justified in terms of electoral outcomes.

Fair enough Stephen, however I was also viewing the risk from the private national debt perspective and it's the size of this that put's us more in the rating agency sights than would otherwise be the case if RB had done, what they say they will do in future.
 
Hear what you say about "electoral outcomes". However RB staff, governors are not elected. One reason I'm keen on discussing this is, because if RB could do to dairy what they have under the present Act, then I think it is very probable they could do same in residential PI, for the justification I give above - so politics wouldn't enter into the equation, just like it hasn't (been allowed to it seems) with RB's attentions to dairy lending.

Les- how many one term governors are vying for the job. And who gets the chance to ratify the RB board's collective choice to replace Bollard.

Fair enough, however, there are more of us out here now that have a better idea of what they could do and we will not be so quiet about what they should do - no matter who is ratifying whom - if we see the same happening again, so I'm pleased RB seems to be heading in the right kind of direction:
 
http://www.realeconomy.co.nz/244-cpi_down_ocr_cut_makes_sense.aspx
 
"A better strategy for the Reserve Bank would be to:
 
• Target non-tradeable inflation;
• Use Loan to Value Ratios to control credit volumes; and
• Specify the amount of savings (deposits) banks are required to raise in New Zealand to limit offshore exposure.
 
“Had this been done 10 years ago debt levels and servicing costs would have been lower even if average interest rates had been higher.  Overall the New Zealand economy would now be better balanced with higher wages, more jobs, more savings and better housing affordability,” says Mr Walley.
 
Cheers, Les.

And:
 
"He said that after the ravages of inflation in the 1970s it was "understandable" that the Bank focused on the need to bring inflation down, "but conquering inflation was not enough to ensure stability".
 
http://www.telegraph.co.uk/finance/economics/9242592/Sir-Mervyn-King-admits-BoE-failed-over-financial-crisis.html
 
Err, like it wasn't obvious? What are we paying them for?
 
How much are they paying their PR consultants? Are they the same as those dealing with our own ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,
 

yet isnt farming is supposed to be one of our profitable sectors? 
regards

Steven - "profitable", who for?

Mist - interesting you should make the comparison between ag./dairy and where housing is headed - similar rules of the game, similar outcomes. Seems to me the rules effectively subsidise speculative investment in both classes via tax treatment and lending behaviour, hence values don't appropriately reflect revenue generation and here we are:
 
http://www.interest.co.nz/opinion/59088/opinion-property-mania-hurts-our-ability-build-business-and-wealth-says-gareth-morgan-
 
Until the rules change, we should expect more of the same.

Rbnz ocr cuts now priced in by markets. Better hurry AB before nz unemployment hits 8%. Interest rate cuts now a certainty. Homeowners dont fix whatever you do.