The Reserve Bank of New Zealand (RBNZ) has released a consultation paper on its proposed macro-prudential framework and is calling for submissions by 10 April 2013.
The policy objectives are to promote greater financial stability through building additional resilience in the financial system in times of rapid credit growth, rising leverage or abundant liquidity, and to dampen excessive growth in credit and asset prices. The proposed framework is not intended to replace existing prudential or monetary policy, but rather work alongside it, providing extra protection to the financial system when stability is at risk. While the focus of micro-prudential regulation is largely to ensure the soundness of individual financial institutions, as demonstrated by the global financial crisis, micro-prudential policies were not sufficient to address under-pricing of risk, an excess of risk taking, and increasingly leveraged household, business and financial sector balance sheets. The RBNZ's proposed macro-prudential policy aims to address these policy limitations.
The four macro-prudential tools being considered by the RBNZ are the Countercyclical Capital Buffer (CCB), the Core Funding Ratio (CFR), Sectoral Capital Requirements (SCR), and Restrictions on High Loan-to-Value Residential Mortgage Lending. These tools are outlined in more detail below.
The RBNZ favours a discretionary and relatively simple approach to implementing the proposed tools, which are to be applied in a forward looking manner and without affecting existing loan agreements. In times of financial crisis, the RBNZ's priority would be to ensure that the flow of credit is not unduly constrained, subject to the banking system being adequately capitalised. The proposed macro-prudential framework would apply to banks incorporated in New Zealand and loan-to-value restrictions would apply to all registered banks. That being said, should circumstances warrant it (for instance, activity shifts to non-regulated sectors), the RBNZ would consider extending the framework to other financial institutions.
The Countercyclical Capital Buffer
The CCB framework will be implemented in January 2014 as part of the RBNZ's implementation of aspects of the Basel III regime in New Zealand. The CCB may require banks to maintain a buffer of high-quality capital to provide a cushion of protection against subsequent losses and increases in risk-weighted assets resulting from credit downturns. At the time of any downturn, the CCB would be released without impacting on lending to borrowers. The RBNZ has suggested a CCB rate of up to 2.5% of risk-weighted assets in periods of excessive credit growth but with the possibility that the buffer may be higher depending on the circumstances at the time.
Core Funding Ratio
The minimum CFR has been in place since 1 January 2013 requiring banks to source at least 75% of their funding from stable sources such as retail deposits, long-term funding and capital. As part of the macro-prudential toolkit, adjustments to the CFR would be applied in times of excessive liquidity and credit growth. In times of significant deterioration in external funding market conditions, the CFR could be adjusted downwards to assist banks in managing their way through a stress period without having to shrink their balance sheets.
The more stable funding sources are considered to increase the 'stickiness' of funding, making banks better able to withstand periods of funding market stress, therefore limiting contagion effects and negative feedback to the real economy. Additionally, the RBNZ considers that should a higher CFR slow credit growth, this will reduce the risk that households and businesses will over-leverage and asset prices become over-inflated.
Sectoral Capital Requirements
SCR are proposed to target sectors, or more narrowly at subsectors, where excessive risk is being taken on and therefore may pose significant risk to the stability of the financial system.
SCR would be applied to provide a temporary additional cushion against potential losses in a particular sector either as an overlay to sectoral risk-weighting or as a capital add-on based on a proportion of banks' risk-weighted exposure to a sector.
As well as sending a strong message to banks and market participants about the riskiness of lending to a particular sector, the RBNZ considers the additional capital requirements would lead to decreased lending and demand for credit in that sector. Further, any increase in the cost of funding may also cause banks to reduce their exposures to the particular sector and, if the increased funding costs are passed on, the rise in borrowing costs may help reduce credit demand. Where sectoral risks are considered to be low, no macro-prudential SCR will be in effect.
Restrictions on High Loan-to-Value Residential Mortgage Lending
Proposed restrictions on high loan-to-value (LVR) lending may take the form of a prohibition on loans that exceed a specific proportion of the property value or as quantitative restrictions on the share of high LVR lending either as a proportion of a lender's housing loan portfolio or new housing lending.
Binding LVR restrictions would reduce the borrowing capacity of potential borrowers, helping to reduce pressure on real estate prices. Lower borrower leverage also means that larger drops in house prices would be required to put a borrower in a position of negative equity which, the RBNZ considers, would result in fewer defaults as borrowers would be able to sell or refinance if in difficulty. Restrictions on high LVR lending would require banks to modify their lending practices resulting in a significant tightening of credit conditions.
The proposed decision-making framework
The RBNZ proposes that there would be four key steps in the macro-prudential policy process:
- A systemic risk assessment, focusing on whether debt levels and asset price imbalances are, or are likely to become, excessive and whether lending standards may be overly lax.
- Assessing the case for macro-prudential intervention, or whether other policy responses may be more appropriate. The RBNZ will also want to ensure there has been adequate communication of the risks to the banks and public, as they would prefer to change behaviour without recourse to additional prudential measures.
- Selecting the appropriate instrument, weighing the likely benefits against the costs of intervention, including distortions to the financial system (e.g. adverse impacts to efficiency of the financial system) and potential leakages (e.g. shifting certain lending to the non-bank sector).
- Implementation. A Memorandum of Understanding between the Minister of Finance and the RBNZ (which should be signed by mid-2013) will provide a framework for the consultation between the RBNZ and the Minister that will occur before any implementation decisions are made, by setting out the agreed objectives, instruments and operating guidelines for macro-prudential policy. In addition, the RBNZ's Financial Stability Report will be the key accountability document setting out the case (or not) for macro-prudential intervention as well as ongoing reporting of the appropriateness and effectiveness of policy decisions.
It is hard to find fault with the RBNZ having some additional "tools in the toolkit". Recent experience has shown the management of the OCR to be a relatively blunt instrument that does not always achieve the desired effect, and without credible tools to back it up, the RBNZ has struggled to change market behaviour via moral suasion alone.
Market participants will be keen to ensure that any new tools are applied in such a way that does not impose unnecessary costs on them (at a time when they are already shouldering a lot of additional cost through open bank resolution, anti-money laundering and FATCA projects – among others).
The content of the Memorandum of Understanding with the Minister of Finance will be interesting, as the use of tools such as restrictions on LVRs has the potential to become quite politicised because it could shut first home buyers out of the market without impacting on wealthy baby boom investors. The Finance Minister has already been reported as saying that decisions will be made independently by the RBNZ, as "the temptation for some politicians to fiddle with the economy at the expense of long-term pain would be too great [otherwise]".
We expect that the RBNZ will be cautious in using any new tools. An additional background paper prepared by the RBNZ notes that the design and implementation of macro-prudential frameworks and instruments is a work in progress in most countries, and experience with many of the instruments is limited. Questions remain to be answered concerning the appropriate timing and calibration of the instruments. The RBNZ notes that it expects to learn more about the instruments over time, both from its own experiences and from other jurisdictions.