Gareth Vaughan argues if we look at banks' housing loan exposure from a financial stability perspective, they simply must hold more capital against it

By Gareth Vaughan

With the Reserve Bank having recently declared the banking system "robust to a severe dairy stress test," it begs the question as to what could be big enough to really rattle the banking system, or financial stability, to its very foundations.

There are plenty of potential overseas scenarios that could threaten financial stability in New Zealand. An economic meltdown in China, a prolonged freezing of international credit markets, a major act of terrorism, war, etc, etc.

But back in NZ the Reserve Bank, prudential regulator of our banks, has effectively declared NZ's banks safe from a major dairy derived disaster. Remember about $38 billion, or 10%, of their lending is to the dairy sector.

If we accept the Reserve Bank's conclusion from its dairy stress test, then domestically only one sector banks lend to can be considered a threat to financial stability. And that sector, of course, is the housing market.

My argument is that if as it clearly is, housing is the biggest domestic threat to NZ's financial stability, banks should be holding more capital against their housing loans.

As the Moody's chart below demonstrates, NZ banks have about 55% of their lending exposed to housing. To give some context of size, total household debt stood at $228.5 billion as of January, which is equivalent to 93% of last year's $246 billion Gross Domestic Product. Mortgage sizes are at record highs, and as my colleague David Hargreaves recently noted, NZ's household debt to disposable income ratio is at a record high of 162%.

More capital required to cover business & rural loan losses than losses on housing lending

Against this backdrop it's worth pointing out that banks' Reserve Bank enforced capital rules mean they hold less capital against housing loans than they do against lending to businesses and farmers to cover any losses. A perusal of disclosure statements from ANZ, the country's biggest bank and number one mortgage lender, and from state owned bank Kiwibank, demonstrates this.

ANZ, like ASB, BNZ and Westpac, is allowed to use the Internal Ratings Based (IRB) regulatory capital approach. This means they develop their own models to calculate their regulatory capital requirements and must then get them approved by the Reserve Bank. All other banks, including Kiwibank, run what's known as the standardised approach where the Reserve Bank prescribes their requirements.

The latest disclosure from ANZ shows what's known as a risk weighted exposure of $14.5 billion on $57.5 billion worth of on-balance sheet residential mortgages. The sum of risk-weighted exposures represents the total credit exposure the bank has accepted. ANZ thus has a total capital requirement held against its mortgages to cover potential losses of $1.163 billion. 

Just to reiterate for ANZ that's about $1.2 billion of capital held against total mortgages of $57.5 billion.

ANZ has an exposure-weighted risk weight on residential mortgages of 24%. In contrast, ANZ's risk weight on $36.2 billion of corporate, including rural, lending is 56% with total capital held against this lending of $1.73 billion. Thus capital held against corporate lending exceeds what ANZ holds against mortgage exposures by $567 million, or a third, even though mortgages top the bank's corporate lending by $21.3 billion.

Kiwibank has risk weighted exposure of $4.464 billion on $12.8 billion of on-balance sheet residential mortgages. Thus its minimum capital requirement is $357 million, and as a standardised bank, Kiwibank has a 35% risk weighting on its mortgages. Kiwibank has most of its much smaller business lending exposure ($728 million) at a 100% risk weighting, with a small slice of this at 50%.

The Reserve Bank chart below gives an example of how risk weights impact the amount of capital banks hold against different asset classes.

Although NZ banks' capital rules are the responsibility of the Reserve Bank, they are based on international standards set by the Basel Committee on Banking Supervision. 

The table below details regulatory capital covering the big five banks' mortgage lending.

*ANZ, BNZ and Westpac figures as of September 30 last year, ASB and Kiwibank figures as of December 31 last year.

As we reported last July, NZ's big banks do have higher risk weights on mortgage lending than their Australian parents. That's despite Australia's 2014-15 Financial System Inquiry requiring the parents of NZ's big four banks to raise about A$12 billion of capital to lift their mortgage risk weights to at least 25% from about 16%.

'Overall lending is weighted towards residential lending and away from the productive sector'

Even within the banking industry not everyone thinks it's a good idea for banks to favour residential mortgage lending over business lending to the extent they do.

Here's some comments I reported in 2012 from BNZ's CEO of the time Andrew Thorburn. He touched on the financial stability issue noting a house price fall of 10% could lead to greater wealth destruction than caused by the 1987 sharemarket crash. And he also noted a "massive long‐term bias towards" investment in residential property at the expense of the productive sector.

Thorburn acknowledged the imbalance in favour of investment in residential property over productive businesses was "writ large" in New Zealand banks' balance sheets.

"Almost 50% of BNZ’s lending book, for example, is supported by residential housing, and it’s pretty much a rock‐solid asset for us, as it is for our competitors."

The expression "safe as houses" had deep resonance for bankers, he added.

"I can’t speak for the other banks, but it has long concerned me that overall lending is weighted towards residential lending and away from the productive sector, at a very time when New Zealand is slipping down the OECD ladder of GDP per capita, at a time when so many young New Zealanders are unemployed or think they can make a better living in Australia and other places, and during a period in which we’ve essentially maintained our standard of living as a nation by borrowing from the savings of people in other countries. Long‐term, this is unsustainable," Thorburn said.

And;

New Zealand is one of the few developed countries in the world without a capital gains tax applying to investment in residential housing. We also support negative gearing and have no stamp duty on property purchases," said Thorburn.

"As a consequence, we have seen in this country a massive long‐term bias towards investment in residential property - a non‐productive asset in investment terms, albeit a critical life requirement for people and families."

Thorburn, incidentally, is now CEO of BNZ's parent, National Australia Bank.

A precedent

In terms of the Reserve Bank making banks increase capital held against a specific asset class, there's a recent precedent, which looks a very wise move in hindsight. 

In 2011 the Reserve Bank made the big four banks increase the risk weights on rural loans to up to 90% from 50%. (It was 100% prior to 2008, and other rural lenders including Rabobank, are at 100%). Alan Bollard, Reserve Bank Governor at the time, told a parliamentary select committee banks had been very lucky dairy prices had rebounded. Bollard said as the Global Financial Crisis (GFC) kicked into gear, with dairy prices going up, farmers rushed out to borrow and consolidate and banks "rushed out to lend."

"It's pretty clear to us and it should be to them as well, that they over-stretched themselves," Bollard told the select committee in 2011. "Actually some of them have been very lucky that dairy prices have picked up again."

With dairy farmers now looking at three consecutive seasons of payouts below the breakeven level estimated by the Reserve Bank to be $5.30 per kilogramme of milk solids, who would now argue the 2011 move to make banks hold more capital to cover potential losses on rural loans was not the correct one?

Houston, we have a problem

Widespread concerns about Auckland house prices have been well documented over the past two or three years. Here's but a few examples:

Reserve Bank Governor Graeme Wheeler recently noted Auckland has a house price to income ratio of 8.5 times, with the rest of NZ at 5.1 times. A median multiple of 3.0 times or less is generally regarded as a good marker for housing affordability. This follows the Auckland Council saying last October it wants to see the city’s median house price to median household income ratio halved to 5:1 by 2030 in an attempt to improve housing affordability.

A Bloomberg report over Easter shows NZ house prices have risen the most across a range of countries over recent years.

"Since the global property market bottomed out at the start of 2012, house prices have risen most in New Zealand, Australia and South Africa. Increases of more than 30 percent in the three countries compare with an average gain of 11 percent in the sample," Bloomberg reports.

Yale Econometrics Professor Peter Phillips, an economist who has studied asset bubbles extensively overseas and has been tipped to win a Nobel Prize, co-authored with Auckland University Economics Lecturer Ryan Greenaway-McGrevy, an academic paper identifying Auckland's housing market as being in bubble territory. As of the end of February, the median Auckland house price was up $215,000, or 40%, in three years to $750,000, according to the Real Estate Institute of NZ.

And credit ratings agencies remain wary of the threat to NZ's financial stability from strong house prices. Here's Standard & Poor's from last October;

"In New Zealand, we believe that robust house price growth - particularly in Auckland - is elevating risks in the financial system; hence, on August 14, 2015, we negatively revised our Bank Industry Country Risk Assessment (BICRA) on New Zealand and at the same time took various negative rating actions on financial institutions. This negative BICRA change followed an extended period whereby New Zealand's previous economic trend was negative primarily because of property concerns," says S&P.

So we do have a problem with high house prices and housing affordability. And our bank's have the lion's share of their lending in a sector that poses the biggest risk to NZ's financial stability. Things could get particularly tricky if there was a spike in interest rates, even back to something resembling historically normal levels off current lows, or if unemployment surged and loan default rates started rising. Note the average bank two-year mortgage rate is currently about 4.5%, but was as high as 9.9% in March 2008. And the current 5.3% unemployment rate is way below the 11.4% recorded in 1992.

Reserve Bank reviewing banks' capital requirements but unsympathetic to higher mortgage risk weights

So why not simply increase the amount of capital banks must hold against their housing lending, along the lines of what the Reserve Bank did to rural lending in 2011?

The Reserve Bank is currently reviewing bank capital requirements and the IRB capital modelling used by the big four banks. So why not simply bump up the risk weights required on mortgage lending to say, 50%? After all that's where they were until lowered to current levels in 2008. Bizarrely this reduction was made the same year the GFC was sparked by a US housing market collapse.

Actually rather than bump up capital requirements on home loans to 50% of risk weighted exposures, why not make it 20% of total mortgage exposures? The banks could have say, a three year period to phase this in.

Doubtless bank bosses, their shareholders and lobbyists, anticipating less profitable mortgage lending and higher costs, would vigorously protest this impost. They'd also point to the fact that housing loans tend to sour at a lower rate than rural, commercial and business loans as demonstrated by the Reserve Bank chart below. 

Banks will also argue stress testing, including of their housing lending, shows they could survive a serious economic shock including chunky rises in unemployment and home loan default rates. But the problem, as those working in and around the dairy sector will discover, is this comes at a wider cost. Forced asset sales and reduced lending to those who really need it are just two likely side effects. The risk weighted ratio system can make it hard for entrepreneurs to borrow, especially in tough times when entrepreneurship is especially needed, because they're deemed to be risky. Yet it supports a housing bubble because residential mortgages secured by houses are deemed safe.

The key point from a financial stability perspective is if things get ugly in the housing market, the impact on the entire financial system (and New Zealanders' wealth) is much greater than if rural, commercial property or business loans sour significantly.

Based on previous comments from the Reserve Bank, the regulator appears unlikely to significantly raise risk weights on housing loans. Here's Reserve Bank Deputy Governor Grant Spencer from 2013;

Risk weights play an important part in the Reserve Bank’s supervision of the banking sector. They help to determine the amount of capital that the banks need to set aside to cover losses on their lending to different sectors. In essence, the riskier the sector, the more capital must be held against lending to that sector. 

The risk weights factor in things like the borrower’s capacity to repay the money, the type of assets put up as security for the loan, and the amount of security relative to the size of the loan. History provides some insight into the importance of these various factors.

As a result of these risk factors, risk weights vary for different types of lending, with housing having a lower risk weighting than business or rural lending, which typically involve more risk.

The risk weights are not set in order to incentivise any particular lending type over another. Instead, they reflect the different risks inherent in different types of lending, leading to capital holdings against loans that are appropriate for the risks involved. This tends to result in higher lending margins on riskier loans, but does not imply that banks will always lend to housing ahead of other sectors. In principle, banks will set loan margins such that risk-adjusted returns will be similar across sectors.

Thus the Reserve Bank views mortgage lending as less risky than business and rural lending, and doesn't see itself having a role in promoting economic and social objectives such as increasing lending to the productive sector and away from property speculation, as outlined by Thorburn above.

LVR move derisking mortgage books

To be fair to the Reserve Bank, it did take a step towards derisking home lending in 2013. This came through limiting banks to doing no more than 10% of their new mortgage lending to borrowers without equity in their property, or a deposit, equivalent to at least 20% of the purchase price. The so-called loan-to-value ratio (LVR) restrictions. In last November's Financial Stability Report the Reserve Bank noted the share of bank mortgage debt with an LVR of more than 80% has fallen to 14% from 21%, "increasing the resilience of bank mortgage portfolios."

We've now also seen the Reserve Bank introduce a rule that Auckland residential property investors seeking a mortgage require a 30% deposit, whilst outside Auckland banks can now do up to 15% of their new mortgage lending to borrowers with LVRs exceeding 80%, regardless of whether the borrowers are owner occupiers or residential property investors. As a result, house prices have started rising in regions outside Auckland.

Give us a leverage ratio

The Reserve Bank has steadfastly refused to introduce the leverage ratio, which is part of the Basel Committee on Banking Supervision's post GFC international banking reforms. This ratio weighs all assets equally and serves as a backstop, potentially helping prevent banks from lending too much money into "safe" and therefore unproductive assets such as housing.

The Australian Government's recent Financial System Inquiry (FSI) recommended the introduction of the leverage ratio, which is defined as Tier 1 capital as a percentage of total assets and off balance sheet exposures with an initial minimum of 3%. The FSI report said the risk-weighted approach to capital requirements should be supplemented with a leverage ratio that protects against potential weaknesses in the risk-weighting system.

"The major (Australian) banks currently have a leverage ratio of around 4–4½ per cent based on the ratio of Tier 1 capital to exposures, including off-balance sheet. An overall asset value shock of this size, which was within the range of shocks experienced overseas during the GFC, would be sufficient to render Australia’s major banks insolvent in the absence of further capital raising," the FSI said.

"A highly leveraged institution has smaller buffers available to absorb loss before insolvency. Leverage can also amplify the effect of shocks on an institution’s balance sheet. This may spread shocks to other institutions and cause systemic risks. A number of countries have introduced leverage ratios, including the United States, the United Kingdom and Canada. Australia does not currently have a minimum leverage ratio requirement, although APRA has indicated that it may introduce one in line with the Basel framework."

Specifically the FSI recommended the introduction of a leverage ratio "that acts as a backstop to authorised deposit taking institutions’ risk-weighted capital positions." This has been endorsed by the Government, with the Australian Prudential Regulation Authority instructed to implement the recommendation.

Here, however, the Reserve Bank has said it won't introduce the leverage ratio because the one-size-fits-all aspect of it is poorly targeted and can give a misleading picture of risk in some situations. The leverage ratio would "undermine the value of the existing risk-based approach to the calculation of required capital," which if properly applied "renders a leverage ratio unnecessary," the Reserve Bank has said.

But David Mayes, Professor of Banking and Financial Institutions at the University of Auckland and a former chief manager and chief economist at the Reserve Bank, last year urged his former employer to introduce the leverage ratio saying; "Risk weighted capital ratios tend not to be very good limiters of problems. Most banks which get into serious difficulties are meeting the requirements for risk weighted capital. But it's much more difficult to finesse the leverage ratio requirements."

Another tool in the toolbox

There's also another tool in the Reserve Bank's macro-prudential toolbox, alongside the LVR restrictions, that could be implemented to force banks to hold more capital against home loans. Formally this tool's called adjustments to sectoral capital requirements, which is an additional capital impost that may be applied to a specific sector (such as housing loans) in which excessive private sector credit growth is judged to be leading to a build-up of system-wide risk.

Surely there's a strong argument, based on the evidence outlined above, that this build up in system-wide risk stemming from housing loans is as clear as day right now?

So what are the Reserve Bank and government waiting for?

Because if things went pear shaped in banks' residential mortgage books we may be left searching for the remnants of the NZ economy under the ashes of the housing market.

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