RBNZ says likes of loan-to-value restrictions, capital buffers are possible ways to help cool future overheating credit cycle

Reserve Bank Governor Alan Bollard says the central bank has identified several macro-prudential tools such as Loan-to-Value restrictions and counter-cyclical capital buffers it would consider using, potentially in tandem, to moderate a future overheating credit boom.

In a speech Bollard is making in Sydney today he says the Reserve Bank has been assessing a range of macro-prudential instruments over the past year that might have a role to play in contributing to broader financial stability in New Zealand. He says whilst these may help boost financial system resilience and possibly moderate credit cycles, expectations should be realistic about what can be achieved.

"A strong micro-prudential framework – focused on ensuring the balance sheets of individual institutions are robust to shocks – is still essential for a robust financial system, and remains at the heart of New Zealand’s efforts to maintain stability in the financial system," says Bollard.

His speech comes after the Reserve Bank said in November's Financial Stability Report that although a large number of macro-prudential tools were under discussion internationally, only a small number could have a future role in New Zealand. These include adjustments to the Core Funding Ratio, the use of counter-cyclical capital requirements broadly along the lines of the international Basel III proposals, adjustments to capital risk weights for particular sectors, and measures targeted specifically at the housing market such as restrictions on Loan-to-Value ratios.

In today's speech Bollard says while none of the macro-prudential instruments the central bank has considered would be a silver bullet in terms of moderating a credit cycle, some could make a useful contribution.

"It may be the case that macro-prudential tools could be employed more effectively to influence the credit cycle by adopting a multi-pronged approach where several tools are employed in tandem. For example, faced with evidence of excessive credit growth, counter-cyclical capital requirements could be used alongside increases in the Core Funding Ratio, and this might represent a more even-handed approach than focusing on either one alone," says Bollard. (Also see banks face at least two CFR increases).

"This approach might even be supplemented by a more targeted instrument such as a Loan-to-Value restriction. Using multiple tools in this fashion would also tend to reinforce the signalling effect on lenders and borrowers."

However, he says realism as to what can be achieved is needed.

"Even if credit cycles can be moderated, they will not be eliminated."

There had been no pressing need to use macro-prudential instruments to better manage the credit cycle of late given recent weakness in the credit cycle.

"However, we do need to keep preparing for how we might deal with credit and asset price booms when they recur in the future," Bollard says. "Our work so far on macro-prudential instruments suggests that we should keep our expectations modest, but we have identified several tools that we would contemplate using in the right circumstances."

He notes past "periods of unsustainably strong credit growth and asset price cycles" which have had damaging effects on the economy and the financial system. 

"We will certainly face similar developments in the future, so we want to develop our macro-prudential toolkit now to enhance our ability to deal with them when the time comes,' says Bollard.

Rapid credit and asset price growth had amplified general economic cycles and made monetary policy’s task of controlling inflation more difficult.

"We have seen the difficulties that can arise when interest rates alone are used," Bollard says.

"The collateral damage to the net export sector from the high New Zealand dollar exchange rate during the previous economic upswing prompted a search for potential tools to assist monetary policy. Now, in light of the broader and significant social and macroeconomic costs arising from financial system distress in the aftermath of the global financial crisis, there is greater will to consider additional tools."

However, he also notes that the Reserve Bank wants credit to be able to support economic growth.

Here's Bollard discussing specific tools:

While our work is ongoing, we would offer the following preliminary conclusions:

Credit-based tools

A range of credit-based tools has been used by the emerging economies, especially in Asia, for many years. They include a wide range of regulated caps, targets and limits. These tools are receiving increased attention by the advanced economies. Of these tools, we have looked specifically at loan-to-value restrictions.

Loan-to-Value Restrictions

Loan-to-Value restrictions (or LVRs) have been used by a number of countries in response to excessive credit growth and overheated housing markets and, on balance, appear to have met with some success. Such a tool could be particularly useful in circumstances when funding and credit margins move counter-cyclically, and so reduce the effectiveness of liquidity and capital requirements in braking credit growth during a boom. Another advantage would be that an LVR restriction could be imposed and enforced relatively swiftly, given that banks would require longer operational lead times to meet higher liquidity and capital requirements. However, the use of non-price or administrative restrictions is subject to greater long-term enforcement and disintermediation risks. Moreover, we are not aware of any instances where LVR restrictions have been applied to sectors other than housing.

Accounting-based tools

Expected Loss Provisioning

Expected loss provisioning is a return to the more forward-looking (and less pro-cyclical) standards of the 1990s, where general provisions may be based on the expected loss over the life of a portfolio of loans, rather than current loss experience. The two international accounting boards – the IASB and the FASB – have each published proposed models for expected loss accounting and the two boards have since been working to align these proposals. A return to a system of expected loss provisioning in due course can be expected to play its part in contributing to a less pro-cyclical financial system.

Liquidity tools

Core Funding Ratio

The Core Funding Ratio is a tool that can help promote greater financial system resilience by requiring banks to fund credit using more stable sources than they might choose in the absence of the requirement. This discipline is particularly desirable during periods of rapid credit growth, when recourse to relatively cheap short-term wholesale funding rather than more stable longer term funding is more likely.

As a tool to actively lean against excessive credit growth, our simulations suggest that the Core Funding Ratio could, in some circumstances, play a useful supplementary stabilising role by requiring banks to always maintain a proportion of core funding which is typically more expensive than shorter-term wholesale funding. Alternatively, the Core Funding Ratio could be used as a counter-cyclical policy tool. Although the Core Funding Ratio could be a less effective anchor on credit growth during a global boom (when funding spreads become compressed), it would still be effective in its primary role of ensuring that banks resort to more stable funding sources.

Capital-based tools

Counter-Cyclical Capital Buffers

A Counter-Cyclical Capital Buffer is a further potential tool for building resilience in the face of excessive credit growth, which could be very beneficial during the subsequent downswing. It has also been suggested that these buffers might help to dampen the credit cycle directly. However, our calculations suggest it would have only a small dampening effect on the upswing of the credit cycle through its effect on the cost of funds (unless one makes extreme assumptions about the size of the counter cyclical buffer or the market cost of capital).

Sectoral Risk-Weight Adjustments

Sectoral risk weights could be adjusted to boost capital requirements for lending to a particular sector, over and above that calculated under the existing Basel 2 framework. While sectoral capital buffers would offer scope to more closely target those sectors subject to rapid credit growth, we have found in simulations that the use of such buffers is likely to have only a modest effect on the pricing of credit for the affected sectors, unless dramatic adjustments are imposed. In principle, sectoral risk weights, generated by Basel II through-the-cycle risk models, should already reflect the risks of lending to the sector, including the risk of a cyclical downturn. Accordingly, we must, in the first instance, focus carefully on the integrity of the risk models used to support Basel 2, before contemplating additional overlays. In recent years, we have sought improvements to the banks’ Basel II risk models in New Zealand in key areas such as housing and agriculture, when it has become clear that risk assessments have been overly optimistic.

Moral Suasion

The potency of the tools we have considered as instruments to affect the credit cycle could be enhanced by a ‘moral suasion’ effect, in addition to any direct impact via the cost of funds or credit constraints. This might mean that our simulations and calculations understate the effectiveness of the various tools to influence the credit cycle. The deployment of any tool would send an important signal to financial institutions, investors, rating agencies and the general public about the central bank’s unease about rapid credit growth, and/or the risks accumulating in the financial system. It could thus help to reinforce a change in lending and borrowing behaviour. That said, we are naturally cautious about the strength of the moral suasion effect, particularly in the context of a credit boom (where risk aversion may be low), and if the instruments themselves were not widely considered by institutions to have ‘bite’.