Reserve Bank wants to increase the amount of capital banks must set aside to cover potential losses from high loan to valuation ratio home loans

Reserve Bank wants to increase the amount of capital banks must set aside to cover potential losses from high loan to valuation ratio home loans

By Gareth Vaughan

The Reserve Bank says it wants to increase the amount of capital the country's big four banks must set aside to cover potential losses from high loan to valuation ratio (LVR) home loans. Such a move could, in theory at least, make such lending more expensive for the banks.

The central bank today said it's reviewing the housing loan capital adequacy requirements currently in place for banks, and issued a consultation paper entitled Review of bank capital adequacy requirements for housing loans (stage one).

In the paper the Reserve Bank notes average housing risk weights for the big four banks are in the range of 25% to 31% compared with an average of about 38% for other banks including Kiwibank. However, the potential increases outlined in the paper would still see risk weights on housing loans lower than the 50% they were for all home loans up until 2008.

Housing loan requirements determine the amount of capital banks must set aside to cover potential losses from lending to the housing sector. The current rules were set in early 2008 as part of the Reserve Bank’s implementation of the international Basel II capital adequacy regime, replacing Basel I.

“The aim of the current review is to ensure that banks’ baseline capital requirements for housing loans properly reflect risk in the housing sector, particularly in relation to LVRs," Reserve Bank Deputy Governor Grant Spencer said. "The (Reserve) Bank is proposing higher capital requirements for high LVR loans."

“A review is timely right now given the Reserve Bank’s current proposal to introduce a macro-prudential policy regime. It makes sense to get the baseline capital requirements right before the macro-prudential framework is introduced,” Spencer said.

A key proposal in the consultation paper is to increase what's known as the Basel II 15% correlation. This is a measure of the way losses on mortgages will be correlated between what the Reserve Bank describes as systemic versus idiosyncratic risk. For example, a fall in house prices is a systemic issue whilst a marriage break up between two borrowers is a factor that will only affect their specific loan. The higher the correlation, the greater the portion of economy-wide risk in the portfolio.

The three examples cited in the consultation paper propose leaving the correlation at 15% for mortgages with LVRs under 80%, and increasing it as high as 25% on loans with LVRs of 90% and over, and as high as 23% on loans with LVRs between 80% and 89%. Increases of this magnitude would lead to an estimated average percentage increase in regulatory capital for housing loans of 23%.

ANZ Bank NZ, the country's biggest bank, had an implied risk weighted exposure of NZ$13.3 billion on NZ$51.5 billion of home loans as of December 31, giving a total capital requirement of just over NZ$1 billion, or slightly more than 2% of its total retail mortgage exposure.

High LVR loans 30% of new lending

Reserve Bank Governor Graeme Wheeler recently said bank loans where the borrower has less than 20% equity represent up to 30% of new lending. Credit rating agency Fitch recently affirmed its AA- credit ratings on New Zealand's big four banks - ANZ, ASB, BNZ and Westpac - but noted the proportion of mortgages with LVRs in excess of 80% were a potential risk to the banks' asset quality and profitability.

And recent analysis by interest.co.nz shows the country's big five banks, combined, grew residential mortgages where the borrower has less than 20% equity by NZ$3.3 billion, or 10%, during 2012. Across the big five, which includes Kiwibank, home loans with LVRs above 80% are up NZ$4 billion, or 12.5%, to NZ$36 billion since the Reserve Bank first mandated the banks break down their home loan books by LVRs in 2008.

In its consultation paper the Reserve Bank notes; "If economic conditions change for the worse, and in view of the current state of the housing market, there is a risk that borrowers most exposed to adverse changes in general economic conditions could all come under pressure at the same time, with a corresponding impact on the quality of banks' housing loan portfolios. This is an important motivation for reviewing the balance between systemic and idiosyncratic risk within banks' housing portfolios."

The central bank says it recently analysed data on banks' loss rate, by LVR category, from 2008 to 2012. It noted this period only saw a "mild economic downturn" so loss rates don't necessarily represent those that could be seen during a severe economic downturn.

"That said, while there was some variation across banks, the data implied that loss rates on high LVR loans generally increased more (in several cases substantially more) during the recent economic downturn than loss rates on lower LVR loans. In our view this provides good support for the proposition that higher LVR loans have more systemic risk than lower LVR loans."

The Reserve Bank estimates a 30% fall in average house prices would wipe out owners' equity in most high LVR loans completely.

Home loans regarded as less risky than other loans

The Reserve Bank describes its review of home loan capital adequacy requirements as micro-prudential policy. Separately, one of the four so-called macro-prudential tools the Reserve Bank is looking at is adjustments to risk weights on sectoral lending. Basically this means changing the amount of regulatory capital banks must hold against loans in case they go pear shaped.

The following comes from an article I wrote in February entitled; What to expect from the RBNZ's search for new tools.

Regulatory capital minimums on residential mortgages are lower than those on other lending such as business and farm loans, personal loans and credit cards. For example, a recent ANZ disclosure statement shows a 26% risk weight on retail mortgages, a 59% one on corporate (business and farm) loans, and 73% on other retail including personal loans and credit cards.

It's also worth noting the rules differ among the banks. The big four banks - ANZ, ASB, BNZ and Westpac - use what's known as the internal ratings-based approach. This means they build their own models to calculate their regulatory capital requirements and must then get them approved by the Reserve Bank. All other banks run what's known as the standardised approach where the Reserve Bank prescribes their risk weights.

For the big four, capital requirements are determined by multiplying risk-weighted assets by 8%. (See table below).

By increasing the risk weight on an asset class, such as home loans, banks' incentive to lend to that sector could be reduced because it should cost them more to do so. And if banks' pass their increased costs on to customers, the latter will pay higher interest on their loans. However, the Reserve Bank argues banks' own funding costs, their assessment of the riskiness of a loan or sector, and their competitive positioning are, and always will be, the most important factors setting loan pricing.

In terms of credit growth, let's look at what has happened since the Reserve Bank tightened the rules on the big four banks' farm loans in June 2011. It did this in the wake of falling dairy payouts and concern over loose rural lending by the banks. The changes mean the big four banks now have to apply risk weights of up to 90% of a farm loan instead of 50%. All other banks already had to apply risk weights of 100% to all farm loans.

Note the Reserve Bank did initially delay the increases to farm loan risk weights after banks said the move would see farmers paying between 30 and 50 basis points more to borrow.

And what has happened to rural lending growth since June 2011? It's up NZ$2.6 billion to a record high of NZ$49.77 billion. The Reserve Bank warned in November's Financial Stability Report the dairy sector appeared more vulnerable to a sharp decline in the payout than at the time of the peak in dairy prices four or five years ago.

Submissions sought by April 16

Meanwhile, Spencer said the Reserve Bank would also review other aspects of banks’ capital holdings against housing loans. Any changes stemming from the review will mean changes to the Reserve Bank’s existing regulatory requirements for banks.

Submissions on the proposals close on April 16. Such a tight timeframe is unlikely to thrill the banks. However Finance Minister Bill English has said he expects to sign a deal with Wheeler by the middle of the year on the central bank's macro-prudential tools.

(Updates add further detail).

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?

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It's a "consultation paper"....in plain English a 'please may we prevent you from destroying the NZ economy with your 95% plus LVR activity and credit creation monopoly rights'....please!

Too late and the escape route is set in concrete. Or do I mean template?

Mr Spencer let's talk about the derivative books, are they properly capitalised to reflect the risk depositors are about to endure while the RBNZ steadfastlly manipulates their interest returns down via the OCR.
 

Isn't it just the ultimate in irony when the public knows what the regulators should be doing to properly regulate (i.e. fulfill their duty to the public) - yet they instead spend their time announcing work on the next ruse - and getting paid an exorbitant amount by us to do so?
 
Put Winston in charge and you'd have Mr Spencer either doing what he's supposed to be doing or back in the int'l job market looking for the next sucker administration.
 
 

"Winston in charge".......gawd stone the pollies.

Wolly.  When last given Ministerial responsibility, for example, he very promptly sorted out the unfair taxation regime faced by the thoroughbred racing industry - a promise he had made to the industry prior to the election in exchange for their support.  It (the punative tax which made their industry unable to compete on a level playing field with other gambling industries) I am told is likely the only reason we even have a throughbred industry these days.  And I would suggest it is a likely good industry to retain and develop.   
 
Basically he knows how to get things done.
 
Whether you agree with what what those things he gets done are is a different issue.  The point is he is EFFECTIVE.  John and co. are famous for their 'flip flopping' .. why, because John surrounds himself with a bunch of folks who are INEFFECTIVE.  Witness Peter Dunne, Pita Sharples and John Banks.  If you want to defend the record of effective implementation of policy for these guys against Winston's recrd - be my guest.
 
Otherwise all you are doing is twittering prejudices.  What prejudices they are is what would be interesting.

With all due respect Kate this is nonsense. If you think JK chose to be in cahoots with these twits you must be deluded.

MMP?

Um, say what?  Not only did he choose to go into cahoots with them - he made each of them Ministers!!!!
 
See below his smiling face with these best buddies;
http://www.stuff.co.nz/dominion-post/news/politics/6122810/Maori-Party-deal-signed
 
http://www.stuff.co.nz/national/politics/6088040/Banks-Dunne-strike-a-deal-with-National
 
PS - and then there was the cup of tea ....

Not a great deal to work with Kate. What would you do? Remove Banksy and lose control? National work MMP exactly as Labour did. JK is just working the system as required and hats off to him!

But he is working the system with the support of ineffective ministers - that's the whole point.
 
Helen gave ministerial portfolios to Winston Peters and Jim Anderton - both of which achieved things in those portfolios. Yes, Dunne got Minister of Revenue - guilty as charged. JK could have chosen not to rule Winston Peters out .. worked to Winston's advantage that 'cup of tea'. And Helen had supply and confidence agreements with the Greens (like JK does with the Maori Party) but never gave the Greens any ministerial portfolios.
 
Hats off to ..? You must be jokin', mate - you're paying for those ministerial salaries.

Hi me again Kate. Late one last night by the look of it?. I'm sorry but WP held the country to ransome - and for what? That period of politics was one of the worst in NZs history. Truly disgraceful.. He has achieved a couple of milestones in respect of the "gold card", and sure he may have resolved the tax issues for the racing industry, but frankly this is minor stuff in the grand scheme of things. I would prefer to spend a few dollars on conservative intelligent individuals salaries, than squander countless millions on some ministers stupid pet project - just to win votes. Aka Labour and the interest free student loan fiasco. And how much did Cullen pay for our trainset?and how much was it written back recently. JK appears on the face of it to have a good grasp of "big picture" stuff.

Hi me again Kate. Late one last night by the look of it?. I'm sorry but WP held the country to ransome - and for what? That period of politics was one of the worst in NZs history. Truly disgraceful.. He has achieved a couple of milestones in respect of the "gold card", and sure he may have resolved the tax issues for the racing industry, but frankly this is minor stuff in the grand scheme of things. I would prefer to spend a few dollars on conservative intelligent individuals salaries, than squander countless millions on some ministers stupid pet project - just to win votes. Aka Labour and the interest free student loan fiasco. And how much did Cullen pay for our trainset?and how much was it written back recently. JK appears on the face of it to have a good grasp of "big picture" stuff.

With high LVR loans on the books, the banks are effectively picking up a greater share of the risk with respect to the purchase of the property. I would then expect that they are charging a proportionately higher interest rate to reflect that. This could also be a tool that would have some slight affect at keeping prices down, as the mortgages would also be less affordable.  
The banks need to be more accountable for their lending policies, and the RBNZs move seems to be a clumsy way to get there.

Not a clumsy way Murray 86. It's already happening. All asset classes are risk weighted now, requiring differing levels of capital to be held by the banks. The issue is what should be included in capital? This keeps changing to suits the times. We are currently at basil III. And secondly the bands for LVRs are very generalized. Meaning if bank has excess capital in one segment this could be utilized say in high LVR lending. The two could be quite distinct. Finally take the scenario we have now where two segments could be experiencing stress simultaneously - take farming (drought), and new home buying (high LVRs) a risk of price collapse. RBNZ really has no idea how to factor in how one could impact on other? Heavy reliance on agriculture or anything for that matter is a dangerous investment methodology. Yet this is exactly what RBNZ has prscribed for last 5 or 6 years. As opposed to a diversified lending portfolio.

Not a clumsy way Thanks Kane02. if not clumsy, your reply certainly seems to indicate it is very generalised as in their loan portfolio is Risk Weighted. I was talking about individual loans, not the entire portfolio.
As we have seen, their lending practices end up putting depositor funds at risk, yet it is the depositors who are being asked to carry the cost of that risk, without the banks being accountable to them other than banking else where. As in other discussions I still believe that Banks should be accountable, by carrying the cost of insurance cover on their risk that will protect their depositors funds (not investors). This cost should not be able to be passed on to depositors. Thus for the cost to be minimised the bank would then have to be able to demonstrate that they are effectively and efficiently managing and weighing the risks of their respective loans. They still make boat loads of money off the depositor funds provided to them, why should they be able to pass the cost of their risks off onto their depositors whilst protecting their profits?

The banks need to be more accountable for their lending policies, and the RBNZs move seems to be a clumsy way to get there.
 
When wasn't it so? - the world's financial regulatory institutions' policies are in complete disarray.
 
We have to witness the consequences every day and then put up with the always too late and impractical utterrances. And they want to be paid from the public purse -both now and in retirement. Thankfully the later is about to disappear as the Auatralians have so aptly revealed.

The Reserve Bank estimates a 30% fall in average house prices would wipe out owners' equity in most high LVR loans completely.
 
I'd say that it would definitely wipe out any owners equity where they had 30% or less.

So such a move will more properly price High LVR loans because of the higher risk.  Price for these loans will go up. ?
And for me.  Who owes just a little bit on quite a lot of property.  And thus a very low risk borrower.
Will I be offered lower interest rates. ?  Should be.  But not holding my breath.
 

What alternative was there. The greenies.. It's laughable!!!

Very nice piece Gareth.
I suspect the banks will push back hard on this one.
Your point about how the banks have grown rural lending despite higher capital requiements is interesting.
At the end of the day the only real way to slow lending growth quickly is to put up interest rates, particularly after nearly 5 years of record low rates...
cheers
Bernard
 

Your point about how the banks have grown rural lending despite higher capital requiements is interesting.
 
Bewrnard, where else do farmers get the money to pay the interest on their loans?
 

Hey, ive got a mate with 1000 cows, he has has 16 mill of debt, want to take the risk for %2 return?
Low interest rates destroy capital values.

or capital appreciation? which is tax free?
Personally me expectation for the next 20 years is low interest rates aka the Great Depression...maybe even 30 years...hence a low average OCR (<4%) is my pick for that time period, even <3%.
So what do farmers etc do in a prolonged period of such low OCR?
Most are not Keynesians so refuse to consider any form of economic stimulation and in fact seem more austrian which is austerity and hence contraction...a big bust...
Strikes me that they are praying for their worst nightmare...
regards
 

If the return is so low why borrow so much. Is your friend being just a tad greedy? Why should anyone care if he does not survive. He could have been less aggressive and possibly have hadlittle or no risk. Farmers are not known for being bright which is why they are farming.

I suspect there are at least 2 reasons,
1) Isnt the debt is tax deductable? 
2) isnt the eventual profit is tax free as there is no CGT when you sell up to retire?
Apart from that, not sure if is just the farmer, in fact I suspect not,
3) A good accountant has probably given them such advice and that with care they can claim WFF and maybe even a community services card and get free healthcare aka all those beneficiary bludgers. 
Funny thing but Ive met  a few farmers over the decades and I wouldnt say they were not up to the challenge of farming, sure its not rocket science (neither is my job) but its pretty involved and quite complex.
Given how complex and impacting the financial world now is I'd wonder on most ppl doing wel when directly exposed like farmers are.
regards

16mill debt on 1000cow farm????

Who loaned the farmer the $16 million?

CO, you caught me out, i was just trying to put risk into the argument. However in my defense the dairy farmer Rabo are tipping over in Taranaki had 5.4 ,mill on 300 acres, what 250 cows? Thats $24,000 a cow debt, now thats Wow!!!!

Don't worry Aj there probably some out there who match your 'mate' exactly!  ;-)
 
Yes, one has to wonder about some of the Rabo lending decisions ;-) They used to be quite conservative.  I know a farmer, who they funded, who converted a farm - $47kg/ms it cost all up - stupid.  Multiple farm owner who sails so close to the wind all the time, but they keep on funding him - duh. 

Do you have any examples?  ie "too high" I mean the OCE is 2.5%, not even 7% of a few years ago, hence Im mystified why its "too high" today unless the banks are acting like a cartel.
I admit I have no idea what a farmer would pay in interest, can ppl give me some examples?   7%? 10% 12%?  I would think 12% way too high, but 7% seems reasonable...
On the face of it I dont agree on the imparment, I think there is some "evidence" that farmers have taken on too much debt to by over-valued properties based on historically high dairy payouts that couldnt last.
If its been high for 30 years then frankly that is business as normal, if you cant prosper in the this normal then you shouldnt be in (any) business, or at least that sector.
regards

The issue is overvalued land prices and farming assets. If we are seen to be in a situation of "historical low" interest rate and yet Farmers are struggling because of debt, it just means that he is overgeared compared to his profitability....if interest rate is ever to rise, his business will be gone.
 
So far for the last 5 years, interest rates has been falling because of world recession and money printing by the Developed economies, this seems to be the continuing scenerio for the next year or so....but we never knows what tomorrow will bring ...I am sure Cypriots never imagined that their Deposits will be gone a week ago too.

Agree on the overvalued issue, however farmers are not unique.....Have to wonder on how much planning or thought was put in for the future.  Im called "risk adverse" and "never profit from opportunities" not strictly true.  Somehoe I find ithard to feel sorry for ppl who one minute try and put me down for being conservative and in the next while its all gone wrong and expect me to cover for their losses...p*sses me off no end.
My view of the next 2~3 years is this will continue to limp along....if we were lucky limp for 20~30 years with a gradual de-leverage aka Japan...I think it will be rougher myself.
Cypriots seem to be OK now, so its the russian mafia who take all the hair cut....I wouldnt want to be a cypriot pollie voting yes to that.
This though is round one, cypriots housing is massively over-valued and hence once this is "clear" they will be seeing huge losses IMHO like 50%+.  They need to take a bigger cut than 40%, more like  80% to clear this crippling second event or they will be like Ireland and in the poo anyway.
Thing to consider is this is now a precident...."we'll only do it once" yeah right.  
If I had some decent cash reserves I'd go out and buy gold today myself...
regards
 
 
 

why do people do interest-only loans, isn't that gambling on the capital going up? jail the gambler.. i mean borrower, and lynch the loan shark.. i mean banker