Loan to value ratio caps and increased sectoral capital requirements seen as the biggest threats to bank profitablity out of the RBNZ's macro-prudential tools

By Gareth Vaughan

Of the four macro-prudential tools under consideration by the Reserve Bank, sectoral capital requirements and residential mortgage loan to valuation ratios (LVR) are the biggest threat to bank profitability and growth with ANZ the most at risk among the big four banks, Australian-based analysts at RBS Morgans say.

The Reserve Bank issued a consultation paper earlier this week on the four macro-prudential tools, which would only apply to registered banks and wouldn't affect existing loan agreements. They are:

- The countercyclical capital buffer, effectively banks holding more capital during credit booms;

- Adjustments to the minimum core funding ratio, altering the amount of retail funds and longer-term wholesale funding banks have to hold;

- Sectoral capital requirements, or increasing bank capital in response to sector-specific risks;

- Restrictions on high loan-to-value ratio (LVR) residential mortgage lending.

Submissions close on April 10. See our full, detailed story on the consultation paper here.

Potential Aussie adoption seen as biggest threat

For the big four Australasian banks the biggest threat from the tools would be if they were adopted in Australia, the RBS Morgans analysts say, given New Zealand retail banking is only 10% of overall profit..

"We see the sectoral capital requirements and mortgage LVR caps as the biggest threats to (bank) profitability and growth. In our view, ANZ’s overweight position in New Zealand mortgages and farm lending leaves it most at risk among the Australian banks."

"Australia's big four banks source only about 10% of their group profit from New Zealand retail banking, so these proposed changes will have only a small impact on their total earnings. However, given Australia faces similar household debt and house price issues to New Zealand, any successful application of macro-prudential tools might pressure Australia to adopt similar rules."

"If so, we think Australian regulators will target mortgages (eg, LVR caps) and this is likely to slow housing loan growth," the RBS Morgans analysts add.

Finance Minister Bill English says the government expects to reach a Memorandum of Understanding on the macro-prudential policy with the Reserve Bank by mid-year. All of the tools are designed to be used on a temporary basis until financial system stability is restored.

The Reserve Bank will introduce the counter-cyclical capital buffer from 2014 as it implements Basel III capital adequacy rules. The RBS analysts note this forces banks to hold additional capital as a buffer if the credit growth to nominal economic growth ratio exceeds its long-term trend by at least 2%.

"Given the extra capital would be required across the industry, banks with less capital than peers will be more at risk. Among the Australian (owned) banks, ANZ and BNZ have the lowest core tier 1 ratio and would be most affected by any increased capital requirement imposed by the Reserve Bank."

The sectoral capital buffer is similar to the counter-cyclical capital buffer, but is targeted at sectors where risk is rising and may pose a threat to the stability of the overall financial system.

ANZ most exposed to beefed up sectoral capital buffers

"The Reserve Bank envisages the sectoral capital buffer would take the form of either a temporary overlay to sectoral risk weights (eg, mortgages or agricultural lending) or a capital add-on tied to the share of a bank's risk-weighted exposures to the targeted sector. The targeted buffer will be applied only to new lending, and therefore would not directly impact banks’ existing loan book," the RBS Morgans analysts say.

"However, any rise in capital requirements will increase pricing for new loans in the targeted sectors as banks seek to maintain profitability. Loan pricing is likely to increase, which would reduce demand for the new lending."

The two sectors most likely to be affected are housing loans and agricultural lending.

"ANZ has the largest exposure to both segments in New Zealand and is especially overweight in agricultural lending."

The third proposed macro-prudential tool is to make banks boost their stable sources of funding. The banks currently have a Reserve Bank enforced minimum core funding ratio requiring them to source 75% of total funding from retail deposits, wholesale funding of at least a year's duration, and capital.

"The New Zealand bank sector’s core funding ratio currently exceeds 85%, so the existing policy will have little impact. However, any temporary boost to the ratio to dampen excess credit growth might constrain lending growth and boost demand for, and the cost of, deposit funding. We think BNZ is most at risk from a decision to increase the core funding ratio in New Zealand," the RBS analysts say.

ANZ, Westpac most exposed to LVR caps

As for LVR caps, this tool may take the form of a ban on new mortgages exceeding a specified LVR, or quantitative restrictions on the share of high-LVR lending, either as a proportion of the lender’s housing loan book or of new housing lending.

"We think that the worst-affected lenders are likely to those banks with the most high-LVR mortgage lending in New Zealand, because more of their new loans are sourced from higher LVR segments such as first home buyers. ANZ and Westpac have the most high-LVR mortgages."

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. Home loans with LVRs above 80% are now 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.

As of December 31, borrowers had less than 20% equity on 24% of ANZ's residential mortgage book, or NZ$12.9 billion worth of loans.  ASB was at 21%, or NZ$8.2 billion, Westpac at NZ$8.5 billion, or 24%, BNZ at NZ$4.1 billion, or 14%, and Kiwibank at NZ$2.3 billion, or 19%.

The analysts note that the use of LVR restrictions is spreading from emerging economies to the likes of Canada, Sweden, Norway and Israel. They point out that international evidence suggests imposing LVR caps during booms slows credit growth and house price appreciation.

"We think LVR caps are the most intrusive of the proposed tools and the biggest departure from the current reliance on capital and funding rules. The big risk is they could distort the mortgage market by locking out potential borrowers, especially first home buyers, and provide an opening for unregulated finance companies to bypass the rules and offer high-LVR loans."

The analysts note that, compared with Australia, lenders' mortgage insurance provides less protection for banks’ mortgage risks in New Zealand where it's used less widely and its coverage is generally 20% of the loan compared with 100% in Australia.

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