Reserve Bank outlines design plans for tool it could enforce on banks to limit the debt-to-income ratio of home buyers

The Reserve Bank (RBNZ) says it could have a debt-to-income (DTI) limiting tool for lenders to use on borrowers taking out home loans ready to go in March 2024, should the policy survive the 2023 election.

In the latest consultation paper in the long running saga of the RBNZ's quest to add a DTI tool to its macro-prudential toolkit, the regulator covers off a range of "design questions" needing to be answered before a DTI limit can be implemented.

DTI limits are calculated based on a simple ratio of borrower debt divided by borrower income. The RBNZ emphasizes that it hasn't made a decision to activate DTI restrictions and isn't consulting on a particular DTI setting at this stage. It plans to consult separately on calibration in 2023, before any decision is made to actually use the restrictions.

"Debt serviceability restrictions are a macroprudential policy tool used to support financial stability and sustainable house prices by reducing the risk of ‘boom-bust’ credit cycles that amplify downturns in the real economy. They complement loan-to-value ratio (LVR) restrictions on mortgage lending, another macroprudential tool the Reserve Bank has been using in recent years," the RBNZ says.

The new consultation paper features views on how banks should measure income and debt when they calculate DTI ratios, how banks should deal with complex lending situations such as multiple borrowers, whether there should be exemptions to the DTI restrictions, and whether DTI restrictions should be the same or different depending on the type of property owner for example, investment or owner-occupied.

"Banks have told us they need around 12 months to prepare their systems for possible implementation of DTI restrictions. If we do decide to implement DTI restrictions, the earliest date we could do so is likely to be March 2024," the RBNZ says.

If DTI restrictions are ever actually enforced, the RBNZ says they'll feature a ‘speed limit’ combined with a threshold or cap, as is the case with LVR restrictions.

"For example, the DTI restriction could be set at a maximum of 20% of [a lender's] new mortgage lending, the speed limit, at a DTI over seven [being] the threshold or cap. We intend to set the speed limit based on the value of new loans, rather than the number of loans, which again is the same approach as for the LVR restrictions," the RBNZ says.

Long running saga

The RBNZ has wanted to have the option of using a DTI tool since at least 2016 but struggled to secure government support from firstly the National-led government and then the current Labour government due to concerns about the potential impact on first home buyers. It finally gained support from Finance Minister Grant Robertson in June last year.

Introduction of the tool has also been opposed by banks, with bank lobby group the New Zealand Bankers' Association maintaining "there's a real risk of adverse customer impact" if the RBNZ introduces a DTI tool.

In a consultation paper in November 2021, the RBNZ assessed the impacts of introducing a DTI cap for borrowers of six or seven times gross income and a test interest rate floor for bank lenders of 7% or 8%, but stressed these were merely illustrative models. It also talked down the potential impact of DTIs on first home buyers.

Then in April this year the RBNZ said it would push ahead with developing a DTI tool framework, but would leave banks to set the interest rates they use to to test new borrowers' ability to cope with rising interest rates. It argues DTI restrictions are likely to be more effective than test rate floors in supporting financial stability and sustainable house prices, adding DTI restrictions also have less impact on access to debt for first-home buyers because they borrow at lower DTI multiples on average than property investors and existing owner-occupiers.

Treatment of personal income 

The RBNZ plans to measure borrowers' income on a gross pre-tax basis. It says this approach has the advantage of simplicity, and is independent of any future tax changes.

"We propose to allow all forms of personal income to be included within the DTI calculation, including wages and salaries, rental income, boarder income, investment income, foreign income, bonus income, and income from Government benefits," the RBNZ says.

"Business income will also be included, to the extent that it is available to service residential mortgage debt and other personal debt."

In terms of variable income such as commissions and bonuses, the RBNZ is proposing to let banks apply their own internal lending policies but is seeking feedback on this.

Treatment of debt

The RBNZ is proposing to include all forms of personal debt such as mortgage debt, credit card debt, personal loans, and student loans within the DTI calculation except buy now pay later (BNPL) debt.

"In our discussions with banks, some have stated that they treat BNPL as an expense rather than debt. This is because it can be difficult to calculate borrowing limits under BNPL, and also BNPL is not currently included in the information held by credit agencies. Banks have also noted that in most cases BNPL accounts for only a very small proportion of total debt."

"For these reasons, our current view is that BNPL can be excluded from the DTI calculation and the draft framework reflects this. However, we welcome feedback on this point," the RBNZ says.

Business income & debt

Given the purpose of DTI restrictions is to reduce systemic risk associated with residential mortgage lending, the RBNZ says business debt should generally be excluded from the DTI calculation when held separately from mortgage debt.

It proposes to include in DTI calculations taxable business profits, regardless of whether the profits are taken as personal income or retained within the business. Taxable profits would exclude interest payments on business debt because these are normally treated as a business expense. For businesses with more than one shareholder, profits would reflect the borrower’s equity share in the business.

"Where business income is being used to service residential mortgage lending, this income should be included in the DTI calculation."

"Provisionally, we are minded to deduct principal payments on business debt from the calculation of business income, as these directly reduce the amount of income available to service residential mortgage debt. We are minded not to allow forecasts of future business income to be permitted, as it would introduce too much uncertainty into the calculation - but we note that the speed limit could be used to accommodate customers with high levels of forecast business income," the RBNZ says.

Complex lending scenarios

The consultation paper also looks at what are described as complex lending situations, where it could be difficult for lenders to calculate a DTI ratio. The RBNZ suggests these scenarios could account for between 5% and 10% of all residential mortgage lending.

"There are two main potential sources of complexity: firstly, complex structures such as trusts and look-through companies; and secondly, situations with multiple borrowers and multiple properties, particularly where the borrowing entities are interlinked but do not fully overlap," the RBNZ says.

It's proposing a combination of allocating complex lending to a general speed limit, and when calibrating the speed limit, ensure it's sufficiently large to cover complex lending situations, and developing rules or guidance for the calculation of DTI ratios in complex lending situations.

"Specifically, we have drafted a set of rules that we consider should cover a significant share, 50% or more, of complex situations. For the remainder of situations, which we refer to as ‘very complex’, lending would be allocated to the general speed limit. We welcome feedback on these rules," the RBNZ says.

Exemptions

An exemption regime is proposed for the DTI restrictions that's similar to the one for LVR restrictions. This would include exemptions for; loans made under Kainga Ora’s first home loan scheme, loan refinancing, loan portability, bridging finance, new housing construction, and loans granted in error.

"We consider that the rationale for these exemptions applies equally to DTI restrictions as it does to LVR restrictions," the RBNZ says.

DTIs won't be differentiated by borrower type

Meanwhile, the regulator says it has also considered whether to differentiate the DTI restrictions by property or borrower type.

"However, feedback received from some banks indicates that this could add significant complexity. Moreover, the analysis we presented in our 2021 DTI consultation document showed that investors borrow at much higher DTIs on average, and hence would still be the group most affected under a uniform DTI limit," the RBNZ says.

"Therefore, for simplicity we propose to apply a uniform DTI limit across all mortgage lending and this is reflected in the draft framework."

And, as with the LVR restrictions, the RBNZ plans to measure lender compliance over a rolling period being three months for larger banks, and six months for smaller banks. This will enable banks to manage "lumpiness" or variation in the flows of high-DTI lending, the RBNZ adds.

The RBNZ also says it plans modelling analysis to better understand the potential impacts of different DTI settings, including interactions with other policies such as the LVR restrictions.

"Submissions on this consultation close on 14 December 2022. Once we have considered the submissions, we will draft a final version of the DTI framework, which will need to be approved by the Reserve Bank Board. We expect to publish the final framework, along with a summary of submissions, in March or April 2023."

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