Roger J Kerr says a crunch point is rapidly approaching as the demand for credit starts to exceed the supply

Roger J Kerr says a crunch point is rapidly approaching as the demand for credit starts to exceed the supply

By Roger J Kerr

Borrowing market conditions over recent times in NZ that have consisted of relatively free and easy credit are now changing abruptly.

The major banks have been tightening lending conditions and pulling back from loan deals they would have eagerly pursued 12 months ago.

A crunch point is rapidly approaching as the demand for credit starts to exceed the supply, with the banks now voluntarily rationing their capital employed on new lending growth.

Corporate borrowers who took advice to refinance their bank debt facilities earlier than the maturity dates required over the last 18 months should be very pleased with their proactive management of this particular financial risk.

Part of the reason for the much more cautious lending approach at this time is that some of the banks are experiencing funding pressures of their own from both the retail and wholesale sides of their borrowing book:-

  • Banks have been losing retail deposit funds to the attractive dividend yields offered by listed stocks on the NZX. Despite OCR cuts this year, the interest rates banks are paying to keep retail deposit funds in their coffers have actually increased.
  • The credit spreads the banks pay in offshore wholesale debt markets to raise funds have increased by more than 0.50% over the last 12 months. Credit watch negative post by the rating agencies on the Aussie banks and European banks experiencing challenges have contributed to investors in bank bonds wanting a higher return for their risk. Local banks are restricted under RBNZ funding limit rules to a maximum of 25% funded from offshore wholesale debt markets. The pressure comes on the funding books when retail deposit funding is not growing but the lending demand still increases.

Adding to these bank funding pressures is the requirement from the Australian banking prudential regulator, APRA, that some of the NZ arms of the Aussie banks must repay internal loans from the parent taken out when funding was very difficult at the time of the GFC in 2009.

The end result of all these credit and funding pressures now impacting on the lending market is that any further OCR cuts by the RBNZ will not actually result in lower interest rates for commercial and household borrowers.

Earlier fears by the RBNZ that they could add more fuel to the housing market fire by cutting interest rates to get the currency down and inflation up, are no longer relevant.

The two-tier interest rate market is now more firmly ensconced, which should allow the RBNZ to cut the OCR again to make the NZ dollar less attractive for offshore wholesale investors.

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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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21 Comments

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There's little or no reason to keep significant amounts of money in the bank. Just a risk that isn't rewarded appropriately.

The pressure comes on the funding books when retail deposit funding is not growing but the lending demand still increases.

You must be joking?

“In a barter economy, there can rarely be investment without prior saving. However, in a world where a private bank’s liabilities are widely accepted as a medium of exchange, banks can and do create both credit and money. They do this by making loans, or purchasing some other asset, and simply writing up both sides of their balance sheet.” Read more

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. Read more

More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks. Borio Page 17 of 38

Exactly. What a spurious claim by Kerr.

So what are you saying Stephen, you don't believe that the banks haven't implemented caps on their asset growth ?

Did I make that claim?

So NZ banks take retails deposits at unfavourable margins v wholesale rates because.....

Roger Kerr is spot on here that: "The pressure comes on the funding books when retail deposit funding is not growing but the lending demand still increases." The reason for this is because of the "Core Funding Ratio" regulatory requirements imposed by the Reserve Bank of New Zealand. If they don't attract enough term deposits they are forced to pay for long-term (5-year) funding in the wholesale market which, as Roger has noted, has become more expensive this year. You can read more about this on the Reserve Bank website here: http://www.rbnz.govt.nz/regulation-and-supervision/banks/prudential-requ...

Roger is indeed spot on. As he points out in his last sentence, this particular restriction of credit is not a bad thing. We need higher mortgage lending rates, but we need to keep the OCR capped - conflicting goals. Well I'll be darned if Mr Market and his invisible hand hasn't finally figured out the way!

This is why mortgage borrowers need to be careful about being complacent about low rates, with respect to the OCR, when it's increasingly less of a driver for mortgage lending rates. I'll double down on a prediction I made following one of Bernard's articles recently - this is largely the bottom for retail mortgage interest rates - we won't see carded fixed rates (except those with hefty restrictions) settle below 4%.

Check out RBNZ L3 - there is $150 billion of O/N funding that is considered to be eligible for "Core Funding Ratio" sticky money purposes. Some regulatory definitions really don't deserve to co-exist in the real world. Take away the dubious O/N funding statistic and Roger's claim that the RBNZ limits foreign wholesale funding to 25% and what is left?

That may be so, but it looks to me that banks have entered a self-preservation mode, so the actual regs are somewhat moot.

I suppose previous poor lending decisions inevitably demand nothing else or it's bank runs. Who wants to sell their $1 million residential property asset in exchange for stretched, under capitalised, low return bank liabilities, masquerading as money.

I couldn't tell, hence the question Stephen. However, irrespective of what funding avenues are available to them, and what constitutes their core funding ratio requirements, the one thing there is no question about at the moment is the fact that they most certainly have lending caps on across the various sectors of their business. And it isn't to do with poor lending decisions, its all to do with funding.

It's only worth $1m if someone has access to credit to buy it

It is true that "non-market" overnight funding does partially count towards the 1-year core funding ratio, although it only gets partially counted. However if the total value of deposits is not growing yet mortgage demandis growing, then the marginal cost of funding is set by wholesale international markets, and for "on market funding" ONLY long-term funding can be counted and used to finance loans. So the rising cost of this long-term committed funding in international markets will drive up the marginal cost of financing loans for banks and thus mortage rates. More detail about the liquidity policy that details the Core Funding Ratio available here: http://rbnz.govt.nz/-/media/ReserveBank/Files/regulation-and-supervision...

How does the RBNZ calculate the core funding ratio? View it's own statistics.

Thanks for this, and I have edited my comment above. I note that the Core Funding as of July 2016 is ~$317bn vs. the Total Funding is ~$387bn. So there is a reasonable chunk of the overnight funding that has been excluded from core funding, but your point is also taken that a reasonable chunk of overnight funding also is included in overnight funding. At the margin however, the way I set it right now, the *marginal* cost of funding to the bank is still driven by the wholesale market. Also, their average cost will be rising given that wholesale long-term committed market funding costs more than current deposit rates, and banks are having to fund the growth in their mortgage book without the same growth in their deposit book.

But it all counts for unsecured creditor OBR pre-positioning purposes, except the wholesale foreign funding segment which is set aside due to currency swap exemptions.

Agreed, that the total funding (not core funding) is relevant when thinking about OBR and solvency scenarios. However core funding may be a bigger driver when thinking about the marginal cost (and thus mortgage rate offered) for new lending in a business as usual scenario.

I accept the foreign wholesale lenders expect to get their pound of flesh at the expense of the domestic unsecured creditor stakeholders. It is clear for all to see Libor has ratcheted up over the last 12 months, but not the basis of the cross currency basis swaps and I am not close enough to the action in my retirement to know how far the credit spread has widened for local Aussie banks seeking USD funding, if not EUR. The later certainly attracts very expensive negative basis quotes to swap into USD.

. ..banks are having to fund the growth in their mortgage book without the same growth in their deposit book.

The former begets the later if the Australian parent banks wish to stump up the regulatory capital, which I doubt. Whereas foreign wholesale funding is off-balance sheet and already collateralised for each swap counterparty, regardless of default and subsequent insolvency. But since the original USD debt falls into the unsecured category - so what?

"hey are forced to pay for long-term (5-year) funding in the wholesale market which, as Roger has noted, has become more expensive this year."

And so?