Weekend Economist: A matter of prudence

In considering possible non-standard policy responses to the current situation, both the RBA and APRA have a clear preference for the tools deployed in 2003. The aforementioned joint paper also notes that APRA believes that the type of response to systemic or industry wide concerns, which was used in 2003, “is more likely to be effective than a narrow focus on a particular aspect of lending standards such as the loan to valuation ratio” (i.e. the RBNZ model).

While the paper seems to cede specific responsibility to APRA for the implementation of any macro prudential policies, the Reserve Bank is likely to have considerable influence. The RBA governor is the chair of the Council of Financial Regulators and the bank has a longstanding responsibility for financial stability as confirmed in its common understanding with the government in its statement of the conduct of monetary policy (2010).

The minutes emphasised the economic rather than financial stability risks: “Members further observed that additional speculative demand could amplify the property price cycle and increase the potential for property prices to fall later. The main risks in such a scenario would likely be to the stability of the macroeconomy rather than the financial system, particularly if households were to react to declines in their wealth by cutting back on their spending.” The implication is that the bank is less concerned about borrowing and lending decisions than the potential for rising prices and associated changes in price expectations to influence the broader economy.

The concentration of strength in investor activity poses additional challenges for a targeted policy response. In a July 2013 report to the Reserve Bank, Luci Ellis, head of financial stability department, discusses the effectiveness of various types of macro prudential policies that have been adopted in other countries². The LVR model is generally assessed as being ineffective in an investor driven boom partly because investors generally have lower LVRs than owner occupiers – especially first home buyers. However, we note that in emerging markets, where LVRs tend to be much lower than in the advanced world, very onerous restrictions have been put in place at times – it is not the tool, but the degree to which it is willing to be applied that often determines its effectiveness. There is no precedent for such onerous policies being used in advanced economies.

The other issue around the effectiveness of such policies is around the risk of leakages to the unregulated sector. There is anecdotal evidence of such leakages in the New Zealand episode. Whereas NZ has a very limited non-bank sector, Australia has a much larger unregulated sector. For Australia the unregulated housing sector currently represents around 5 per cent of new loans, having peaked at 20 per cent of total loans in 2007.

A second form of regulation considered in this report was limits on debt servicing ratios although “recent research shows that higher income households can manage much higher ratios without falling into stress”.

Of most promise from the perspective of this study were changing “interest rate buffer guidelines”. In this policy, lenders are required to calculate allowable loan amounts using higher interest rates than those currently prevailing. The interest buffer could be counter- cyclical, increasing when rates fall, and could become an automatic stabiliser for the financial system. Of course such a policy would reduce the impact of monetary policy in one of its most important channels. Such a policy change would be subject to considerable implementation and regulatory lags particularly if, as appears the case, it is not necessarily favoured by APRA.

APRA has embraced the counter-cyclical capital buffer which has been built into the Basel III framework. However the Basel authorities do note that the capital buffer might not be effective in dampening booms mainly because the amounts of capital involved are unlikely to sufficiently raise borrowing costs in a speculative boom, where shadow banking is also likely to be a major part of the flow of new credit, and the implementation lags are too long.

Finally, some countries have introduced dynamic provisioning where higher provisions are required against over exuberant lending – such a policy reduces profits directly during the upswing. Banks may dispute a regulator’s assessment of the appropriate provision without clear evidence of the loss information in a comparable downswing. It is unlikely that such a policy would be imposed in Australia.

In conclusion the report finds: “The discussion above suggests that many of the suggested policy tools for dealing with property booms carry problems of their own.... Within the dimensions of lending standards, more focus should probably be given to serviceability and amortisation than LVR or low doc lending”.

A reasonable conclusion is that Australia is unlikely to introduce the New Zealand style of direct macro prudential controls. APRA may lift its intensity of communication to ADI boards and, possibly, even impose a further round of stress testing, although banks now regularly conduct stress testing. It seems unlikely that, at this stage, it would adopt the policies of 2003 where it raised the risk weighting on home loans and increased the capital requirements of mortgage insurers.

The Reserve Bank is likely to maintain or step up its public warning around house prices and investor activity.

Recall that even in the frenzy of the official concerns around the investment boom in the early 2000s, the increased capital charges on home loans were not introduced until 2003 – a year after the first two rate hikes in May and June 2002.

In taking the 2003 precedent further it is relevant to compare the current pace of growth of new lending to the peak in that earlier period. With current annual investor credit growth running at 10 per cent compared to the peak in that earlier period of 30 per cent it seems that we are probably some way away from any policy action be that either direct or through increased rates.

Westpac does not expect anything like that pace of build-up in investor credit in 2014 and 2015.

Our forecast for the RBA cash rate is that the next move is likely to be an increase in the September quarter 2015. That will be driven by an improving global outlook; a modest lift in the momentum of consumer spending and non-mining investment and a falling unemployment rate. House prices and credit growth are also likely to be rising but not of themselves at a sufficiently rapid pace to trigger a rate hike.

Consequently we see no reason to change our forecast for the first RBA rate hike next year.

Bill Evans is chief economist with Westpac.

References

1) ‘Macro prudential Analysis and Policy in the Australian Financial Stability Framework’, September,2012 (joint paper by RBA and APRA), http://www. rba.gov.au/fin-stability/resources/2012-09-map-aus-fsf/pdf/2012-09-map- aus-fsf.pdf.

2) ‘Macro prudential policy: what have we learned?’, Luci Ellis, Head of Financial Stability Department ,Reserve Bank of Australia, http://www.rba. gov.au/foi/disclosure-log/pdf/131413.pdf.

3) ‘The term “macroprudential”: origins and evolution’, Clement, BIS, 2010, http://www.bis.org/publ/qtrpdf/r_qt1003h.pdf.

4) ‘Statement on the Conduct of Monetary Policy’, October 2013, http://www.rba.gov.au/monetary-policy/framework/stmt-conduct- mp-6-24102013.html.