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.