The Reserve Bank says if it had been able to use its freshly minted macro-prudential tools back during the last financial cycle, there would've been a "compelling case" to do so from 2005, perhaps until 2009.
An article in the latest Reserve Bank Bulletin by Chris Hunt entitled The last financial cycle and the case for macro-prudential intervention notes that, with the benefit of hindsight, there would have been a compelling case for macro-prudential intervention from 2005 onwards to attack a build-up of systemic risk in the financial system.
"The temporary increase in capital or liquidity buffers, or the application of loan-to-value restrictions (LVR) on residential mortgages, would have materially enhanced the resilience of the financial system in the face of developments late in the decade. Macro-prudential intervention may have also tempered credit and asset price developments during the boom itself," Hunt, an adviser in the Reserve Bank’s Macro Financial Department, suggests.
The article doesn't mention that in 2005-06 Reserve Bank and Treasury officials teamed up in what was called a Supplementary Stabilisation Instruments project. This looked into tools, directly affecting the housing market and/or the market for residential mortgage credit, that could've been used to supplement the role of the Official Cash Rate in managing inflation. The tools they looked at included LVR limits.
In a letter to Finance Minister Michael Cullen in March 2006 Reserve Bank Governor Alan Bollard and Secretary to the Treasury John Whitehead concluded: "There are no simple, or readily implemented, options that would provide large payoffs in the near-term."
An LVR limit, on all loans secured on residential property by all lenders would have a direct impact on the most leveraged portion of the housing market, Bollard and Whitehead said.
"However, the rules for such a limit would be difficult to define and difficult to enforce. The pressure for disintermediation would be very great. The report also notes that the segment of the market most affected by this measure contains a high proportion of low income earners and first home buyers."
And the report itself said: "This instrument should not be developed further."
Concern from 2005 onwards
However, Hunt says his article provides some form of test of the new policy framework based on historical “data”.
"What we can say, with some degree of comfort, is that our indicator framework would have been signalling a concern with the build-up in systemic risk, particularly from 2005 onwards. At the very least the Reserve Bank would have been seriously considering macro-prudential intervention around this period."
In a speech by Deputy Governor Grant Spencer last week the Reserve Bank said it was doing just this now, - seriously considering the use of macro-prudential tools to help moderate house price inflation pressures. Spencer went on to say that the risks to financial stability may be greater now than they were in the pre-Global Financial Crisis housing boom.
Finance Minister Bill English and Reserve Bank Governor Graeme Wheeler announced a memorandum of understanding in May clearing the way for the Reserve Bank to use its macro-prudential tools, if it chooses to, on a temporary basis. It's hoped use of the tools would help dampen excessive growth in credit and asset prices and strengthen the financial system.
The four tools are;
1) Adjustments to the Core Funding Ratio - altering the amount of equity, retail funds and longer-term wholesale funding banks have to hold.
2) A Countercyclical Capital Buffer - effectively banks holding more capital during credit booms.
3) Adjustments to sectoral capital requirements - increasing the amount of capital banks must hold in response to risks specific to certain sectors such as housing or farming.
4) Quantitative restrictions on the share of high LVR lending to the residential property sector.
Hunt on how & when the Reserve Bank now says it might've used the tools last time
In his article Hunt says the Reserve Bank identified a material decline in lending standards towards the end of the boom phase, with anecdotal reports of “low doc” and high LVR lending first noted in 2005.
"From this point the level of the Reserve Bank’s concern grew, particularly in the context of heightened bank competition over 2006 which served to compress margins. The Reserve Bank was sufficiently concerned with reports of lower lending standards that it requested additional data on banks’ lending by LVR in early 2007," says Hunt.
"With a view that financial imbalances had become fairly generalised by late 2004, and enabled by cheap foreign funding, it is likely that the Countercyclical Capital Buffer, possibly in conjunction with adjustments to the Core funding Ratio, could have been usefully employed. These two instruments build the resilience of the banking system to any subsequent period of stress by increasing capital and liquidity buffers respectively."
"At the margin, these tools might also have the added benefit of dampening the upswing. While financial imbalances were fairly broad-based, certainly by 2005, the Reserve Bank could also have considered deployment of sectoral tools. One possibility would have been to follow the aggregate tools discussed above with residential LVR restrictions in order to focus more specifically on the housing sector," Hunt adds.
"The application of LVR restrictions may have been appropriate in the context of the decline in lending standards over 2006 and 2007. Sectoral tools could also have been deployed in response to much earlier signs of imbalances, perhaps over 2003 or early 2004 in the housing or agricultural sectors."
Hunt says any core funding ratio buffer in place would've been released first, with complete removal likely by late 2008 following the September 2008 collapse of Lehman Brothers.
"In terms of releasing any capital buffers, had they been in in place, it is likely this may have been undertaken in early 2009, or possibly late 2008. In the 2008 May Financial Stability Report the Reserve Bank saw a ‘prudent’ re-pricing of risk as banks passed on higher funding costs, although it was noted that there was a risk that if credit conditions tighten excessively the slowdown in economy will be exacerbated."
"Non-performing loans ticked up modestly over 2008. By May 2009 a material decline in asset quality had occurred, although from a low base, and there was an expectation of a further deterioration over the course of 2009. In addition, there were increasing reports of some borrowers facing difficulties obtaining credit. The Reserve Bank reiterated the message that banks should not tighten lending criteria excessively," says Hunt.