The University of Auckland's David Mayes argues reducing the impact of financial downturns should be a higher priority than it is

By David Mayes*

There is a lot of talk in this country about minimising financial booms by using the debt-to-income ratio (DTI) to measure loan serviceability. It is a very crude measure, says David Mayes, Professor of Banking and Finance at the University of Auckland Business School. And in any case, that is not where our priorities should lie.

Mayes says that New Zealand has fewer ways to limit the costs of financial downturns than other advanced countries. Righting that imbalance through deposit insurance, deposit and resolution funds, and measures to better manage non-performing loans should come before further attempts to control financial booms.

 "There has been much less emphasis in this country on limiting the impact of a falling housing market and a general economic downturn than elsewhere in the developed world."

He says the Reserve Bank's long-standing Open Bank Resolution (OBR) policy – which allows a bank to remain open after being placed under statutory management – is designed to limit risk-taking, and to encourage private sector solutions for troubled banks.

"But OBR is expensive, because New Zealand does not have deposit insurance, so depositors are likely to feel the impact, and that in turn is likely to have a larger effect on consumers than elsewhere."

Nor are deposit insurance or resolution funds available. The accumulation of such funds when the economy is doing well tends to slow lending growth, and when used, they dampen the effect of a downturn on consumption and economic activity.

Mayes says we also lack other mechanisms that are common elsewhere for reducing the harm of financial downturns, including:

• a system for ameliorating problems with mortgage defaults

• insurance through the public sector

• the facility for sale by banks to a corporation that could restructure mortgages

"The lack of such a safety net is largely due to fears of 'moral hazard', but this does not alter the fact that in a downturn, the costs are higher under the existing framework," says Mayes.

A further approach to minimising the costs of a down phase, which is yet to be addressed in New Zealand, but which is being considered elsewhere, is the handling of non-performing loans, he says.

"The typical cycle with such loans is, first, to fail to recognise their actual or potential size as problems start to emerge, and second, to make insufficient provision for non-performance."

Then, when problems do become apparent, the bank faces twin difficulties, he says. Any actual losses cause capital ratios to fall and more capital is needed at the very time when it is hardest to raise in the market; and, the pressure on capital will result in a much harsher credit crunch, with the bank unable to resolve problem loans or make new, profitable ones.

"In looking at what macro-prudential tools ought to be used, we should therefore avoid focusing on those that restrict lending. This is particularly the case for DTIs, which constrain serviceable loans in order to have sufficient impact on loans that might become non-serviceable in the event of a downturn.

"The focus needs to be on the ability to handle problems in a downturn, at a low cost to society."


*David Mayes is a Professor of Accounting and Finance at the University of Auckland Business School.

This article was first published in UABS Insights, and is reproduced with the permission of the University of Auckland Business School.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment or click on the "Register" link below a comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current Comment policy is here.

3 Comments

The risks of moral hazard are always present in modern Bankig practice , where profits are distributed to shareholders and losses are carried by the public .

If you really want to manage the banks lending behavior , it would be a good idea to remove the right to recourse for reckless lending .

Banks are a big part of the housing crisis we face , they are lending :-
1) Against properties where the fundamental value is not what is being paid for the property , as evidenced by the extent of negative gearing based on the expected 'yield" in relation to the purchase price
2) Where the long term ability of the borrower to repay may be in question.
3) Without careful consideration of the effects of something as apparently benign as a 2% rise in borrowing costs , which pushes installment costs up by around 50%
4) I have come across this strange behavior where development land was bought at an arms length for $1,0 million , then settled a few weeks later for $1,4 million to a related party , and then a few weeks later for $18 million to a related party and now has a mortgage of $1,0 million registered over it .

I suspect the real issue is that the developer did not have the 1/3 rd deposit for the initial purchase price for the vacant land , so there have been some sharp practice to mask the issue.

This type of financial "engineering " which is more like financial gymnastics can only work, at worst with the collusion of the lender , or at least the lenders knowledge or "turning a blind eye "

It can end very badly .

Where this type of loan becomes an NPL the bank should have no recourse , because they have created the problem for themselves .

In other words , I suggest that if the Bank extends credit to marginal or high risk customers or businesses , and they have not done a proper thorough assessment, the Bank should have no recourse if the customer defaults .

This will ensure that lenders dont act recklessly

"with the bank unable to resolve problem loans or make new, profitable ones"

Given we are in an everything bubble, the chances of making "new profitable loans" when SHTF feels kinda low.

In the next slump those who lose least will win most. Outside the box thinking will be required to "ünfreeze" the system and get people out there spending again. Debt forgiveness without strings attached? As this is the most unlikely pill that could be swallowed, it gives one a clear picture of the kind of downturn the next one will be - deep and long. I suggest that a universal deposit guarantee scheme could return. If OBR is all we got then the herd will send their billions back overseas - further stressing the banking system. Stubbornly high borrowing rates on existing loans coupled with heavily restricted new lending could become a new normal - a vicious cycle. Cash will be king.