RBNZ – Page 6 – Digital Finance Analytics (DFA) Blog

NZ Monetary policy supporting growth and inflation goal

The NZ Reserve Bank confirmed that at this stage some further monetary policy easing is likely to be required to maintain New Zealand’s economic growth around its potential, and return CPI inflation to its medium-term target level.

Further exchange rate depreciation is necessary, given the weakness in export commodity prices and the projected deterioration in the country’s net external liabilities over the next two years, Governor Graeme Wheeler said.

Speaking to an ExportNZ/Tauranga Chamber of Commerce audience, Mr Wheeler said that in mid-2014, New Zealand’s terms of trade were at a 40-year high, but over the past 15 months the economy has experienced several shocks. Export prices for whole milk powder have fallen 63 percent since February 2014, and oil prices are currently more than 50 percent below their June 2014 level. Net immigration and labour force participation are at historic highs, and the real exchange rate has declined steadily since April 2015.

Over the past two years, annual CPI inflation has been in the lower half of the 1 to 3 percent target band, except for the period since the December quarter 2014 when the fall in oil prices brought CPI inflation to very low levels. The Bank expects annual CPI inflation to be close to the midpoint of the 1 to 3 percent target range by the first half of 2016.

“Under the Bank’s flexible inflation targeting framework, the Policy Targets Agreement specifically recognises that annual CPI inflation will fluctuate around the medium-term trend due to factors such as exceptional movements in commodity prices – like those experienced since mid-2014,” Mr Wheeler said.

“There are, however, several risks and uncertainties around the inflation outlook. These include the future path of the exchange rate, which will be influenced by future commodity prices, and the speed with which the recent depreciation feeds through to higher inflation.”

Mr Wheeler said that, despite recent declines, the exchange rate remains above the level consistent with current economic conditions.

“At current levels of export prices, a more substantial exchange rate depreciation will be required to stabilise the net external liabilities position relative to GDP.”

Mr Wheeler added that there is potential for further downward pressure on global dairy prices. “Also, over coming months, the Federal Reserve and the Bank of England are likely to begin the process of normalising their interest rates, which could assist our currency lower.”

Turning to interest rates, Mr Wheeler said that current monetary policy settings are providing stimulus to the economy at a time when output looks to be growing around 2.5 percent, slightly below potential, and core inflation remains a bit below the mid-point.

He said that some local commentators have predicted large declines in interest rates over coming months that could only be consistent with the economy moving into recession. “We will review our growth forecasts in the September Monetary Policy Statement but, at this point, we believe that several factors are supporting economic growth. These include the easing in monetary conditions, continued high levels of migration and labour force participation, ongoing growth in construction, and continued strength in the services sector.”

Mr Wheeler said that, in returning inflation to the mid-point of the target band, the Bank has to avoid unnecessary volatility in output, interest rates, and the exchange rate.

“Our judgement in the current circumstances is that aiming to return inflation to around its medium-term target level in about nine to 12 months’ time is an appropriate speed of adjustment. This may not always be the appropriate speed of adjustment. Nor does it mean that the Bank will necessarily deliver a precise outcome as the economy is constantly experiencing shocks and disturbances that policy may need to counter or accommodate.

“Having the scope to amend policy settings, however, is a key strength of the monetary policy regime. In response to these developments, the Bank will review and, if necessary, revise its policy settings to meet its price stability objective. The time path of inflation may change as monetary policy is recalibrated, but the overall goal of meeting the specifications of the PTA will remain the central focus of policy.”

Mr Wheeler also noted that the Bank is conscious of the impact that low interest rates can have on housing demand and its potential to feed into higher house price inflation. Lower interest rates risked exacerbating the already extensive housing pressures in Auckland by stimulating housing demand, although, outside of Auckland, nationwide house price inflation is currently running at an annual rate of around 2 percent. However, in the present situation, raising interest rates would be inappropriate as it would put upward pressure on the exchange rate and further dampen CPI inflation.

“The Bank continues to be concerned about the financial stability risks and risks to the broader economy that would be associated with a major correction in Auckland house prices. In the current circumstances, macro prudential policy can be helpful in reducing some of the pressures arising from the Auckland housing market. The proposed LVR measures and the Government’s policy initiatives that it announced in the 2015 Budget should begin to ease the impact of investor activity.

“While a strong supply response over several years is needed to address Auckland’s housing imbalance, macro-prudential policy can help to lower the financial and economic risks while important regulatory and infrastructure issues are addressed and additional investment in new housing takes place.”

RBNZ Cuts Official Cash Rate to 3%

The NZ Reserve Bank today reduced the Official Cash Rate (OCR) by 25 basis points to 3.0 percent.

Global economic growth remains moderate, with only a gradual pickup in activity forecast. Recent developments in China and Europe led to heightened uncertainty and increased financial market volatility. Particular uncertainty remains around the impact of the expected tightening in US monetary policy.

New Zealand’s economy is currently growing at an annual rate of around 2.5 percent, supported by low interest rates, construction activity, and high net immigration. However, the growth outlook is now softer than at the time of the June Statement. Rebuild activity in Canterbury appears to have peaked, and the world price for New Zealand’s dairy exports has fallen sharply.

Headline inflation is currently below the Bank’s 1 to 3 percent target range, due largely to previous strength in the New Zealand dollar and a large decline in world oil prices. Annual CPI inflation is expected to be close to the midpoint of the range in early 2016, due to recent exchange rate depreciation and as the decline in oil prices drops out of the annual figure. A key uncertainty is how quickly the exchange rate pass-through will occur.

House prices in Auckland continue to increase rapidly, but, outside Auckland, house price inflation generally remains low. Increased building activity is underway in the Auckland region, but it will take some time for the imbalances in the housing market to be corrected.

The New Zealand dollar has declined significantly since April and, along with lower interest rates, has led to an easing in monetary conditions. While the currency depreciation will provide support to the export and import competing sectors, further depreciation is necessary given the weakness in export commodity prices.

A reduction in the OCR is warranted by the softening in the economic outlook and low inflation. At this point, some further easing seems likely.

RBNZ Updates On Basel III

The NZ Reserve Bank today published an article in the Reserve Bank Bulletin that describes the Reserve Bank’s implementation of the Basel III capital requirements. It is one of the clearest articulation of Basel III that we have read, and is recommended to those seeking to get to grips with the complexity of the evolving capital requirements. In addition, you can read our article on Basel IV (the next iteration) here.

The GFC highlighted several shortcomings in the policies and practices of some financial institutions, particularly in North America and Europe, and in the regulatory requirements for banks in respect of capital. In the lead-up to the GFC, some financial institutions were highly leveraged (that is, their assets were funded by high levels of debt as compared to equity), with capital that proved insufficient to absorb the losses that they incurred. In several countries, governments provided funds to support failing banks, effectively protecting holders of certain capital instruments from bearing losses, which came at a cost to taxpayers. The complexity of capital rules, interaction with national accounting standards, and differences in application resulted in inconsistencies in the definition of regulatory capital across jurisdictions. Further, insufficient capital was held in respect of certain risks. This made it difficult for the market to assess the true quality of banks’ regulatory capital and led some market participants to turn to simpler solvency assessment methods.

The BCBS responded with new requirements for bank capital, collectively known as Basel III, which built on the existing frameworks of Basel I and Basel II. Basel III strengthens the minimum standards for the quality and quantity of banks’ capital, and aims to reduce bank leverage and improve the risk coverage of the Basel Capital Accords. One of the purposes of Basel III is to make it more likely that banks have sufficient capital to absorb the losses they might incur, thus reducing the likelihood that a bank will fail, or that a government will be called on to use taxpayer funds to bail out a bank. Basel III also introduced an international standard on bank liquidity. Overall, these requirements increase resilience in the financial sector and reduce the probability of future systemic collapses of the financial sector.

The RBNZ Bulletin article explains the rationale behind the Basel III capital requirements, identifies and discusses their significant features, explains how the Reserve Bank has applied the requirements in New Zealand, and examines the development of the New Zealand market for instruments meeting the Basel III definition of capital.

The changes to the Capital Accord brought into effect by Basel III included: enhancing the requirements for the quality of the capital base;increasing the minimum amount of capital required to be held against risk exposures; requiring capital buffers to be built up in good times that can be drawn down in times of economic stress; introducing a leverage ratio requirement; and enhancing the risk coverage of the capital framework. Draft international minimum standards for liquidity were also proposed for the first time as part of the Basel III package. The liquidity requirements are not discussed in this article. The Basel III capital standards have been widely adopted worldwide. The Reserve Bank has largely adopted the Basel III capital requirements. As New Zealand banks were well capitalised at the time Basel III was issued, the Reserve Bank was able to put the Basel III capital requirements in place in New Zealand ahead of the timetable set by the BCBS for Basel III implementation.

Applying an Inflation Targeting Lens to Macroprudential Policy `Institutions’

The Reserve Bank of NZ just released a discussion paper on inflation targetting in the light of the macroprudential role of supervisory organisations.

Inflation targeting has been an influential and durable monetary policy framework. It has been widely adopted, and the attributes of inflation targeting have been widely lauded for their contribution to price stability. Yet in recent years the global financial crisis and the sovereign debt crisis have challenged macroeconomic frameworks, providing substantial impetus to concerns about financial stability. In this paper we examine macroprudential policy frameworks through an inflation targeting lens, to understand whether the positive attributes of inflation targeting can and should inform macroprudential frameworks.

We use the four attributes of inflation targeting – independence, transparency, accountability and the explicit inflation objective – to help frame debate about the institutions used to govern macroprudential policies. Overall, we argue that these attributes are important for effective macroprudential frameworks. There are, however, some points of difference.

First, the merits of independence are not as clear for macroprudential policy. One reason to appoint an independent policymaker is to take advantage of `expertness’. However, this advantage must be balanced against the possibility that the policymaker may pursue tradeoffs at odds with the mandate provided by government and the public at large. The scope for such tradeoffs is exacerbated if outcomes are not directly observable or if outcomes are not self-evidently related to the policies that have been implemented. These problems seem more substantial for macroprudential policy than for monetary policy.

We have also argued that macroprudential policies are interdependent and cannot be pursued entirely `independently’. Monetary and macroprudential policies are unified by their connection to social welfare, and policies should be implemented to optimize their marginal contribution to this overarching notion of welfare. In principle, policies must be coordinated if they are to be set optimally, but whether the interdependencies are material remains uncertain. Of course, macroprudential and monetary policy could be coordinated even if they were housed in separate institutions. There is a strong case for monetary authorities to be independent and/or for other constraints that prevent political authorities from monetizing budget deficits (since political authorities may have little regard to the inflationary consequences of doing so). While political authorities could use macroprudential policies indirectly to stimulate the economy and therefore increase tax revenue, it may be more difficult to use macroprudential policies to deal with such funding issues. Thus, the case for appointing an agent to run macroprudential policy independently of political authorities is arguably somewhat weaker.

The second observation we make is that financial stability objectives and intermediate targets should be made more explicit. Policymaking involves strategic interaction between policymakers and private agents, and is an exercise in influencing the behaviour and expectations of private agents. While announcing objectives can foster coordination in strategic games, we do not see that financial stability objectives, as commonly expressed, provide enough guidance about the macroprudential policies that will be implemented in future.

Our third observation is that macroprudential policymakers need to consciously address their communication of future policy actions. As advocates for transparency, we suggest that the institutions of policymaking should explicitly address when policy decisions will be announced and/or implemented, and greater attention should be paid to the menu of macroprudential policies. Macroprudential policies governed by principled rules-based behaviour would make clear what policies will be pursued and how they will be adjusted through time, but much work needs to be done before operational, state-contingent macroprudential rules can be identified.

Our fourth observation is that applying the accountability mechanisms of inflation targeting to macroprudential policies has been a desirable development, though these mechanisms should be strengthened further. We remain convinced that transparent communication to the general public remains a significant element in ensuring accountability.

Lastly, while the accountability institutions for macroprudential and monetary policies are well developed, oversight and accountability are materially constrained by the quality of current analytical frameworks. Such uncertainty makes it difficult to provide objective assessments of macroprudential policies. Looking forward, we must fully expect that macroprudential policies will evolve as views solidify about the most important distortions and the most important macroprudential mechanisms. Institutional frameworks should be flexible enough to accommodate such changes.

Note: The views expressed in this paper are those of the author(s) and do not necessarily reflect the views of the Reserve Bank of New Zealand

RBNZ Issues Consultation On LVR Rules For Auckland Residential Property Investors

The NZ Reserve Bank has published a consultation paper about proposed changes to the rules that banks must follow for high-LVR mortgage loans.

The proposals were announced in the Reserve Bank’s Financial Stability Report released on 13 May 2015. They would mean investors in Auckland property would generally need a 30 percent deposit if they’re borrowing for a property, while home buyers outside Auckland would see increased availability of high-LVR mortgages.

The specific proposals are to:

Restrict property investment residential mortgage loans in the Auckland region at LVRs of greater than 70 percent to 2 percent of total property investment residential mortgage commitments in Auckland.
Retain the existing speed limit of 10 percent for other residential mortgage lending, as a proportion of total non-property investment residential mortgage commitments, in the Auckland region at LVRs above 80 percent.
Increase the speed limit on residential mortgage lending at LVRs above 80 percent outside of Auckland to 15 percent of residential mortgage commitments outside Auckland.

A number of loan categories are exempted from LVR speed limits, and these exemptions will be retained under the proposed policy changes. Specifically, loans that are made as part of Housing New Zealand’s Welcome Home Loan scheme, and loans that are made for the purpose of refinancing an existing mortgage loan, moving house (without increasing borrowing amount), bridging finance or constructing a new dwelling will continue to be exempt from the policy.

The paper also offers further evidence on the different risk profiles of investment versus owner occupied loans in a down turn, including data from experiences in Ireland.

“Residential property investment loans appear to have relatively low default rates during normal economic circumstances. However, the Reserve Bank has looked at evidence from extreme housing downturns during the GFC, and this clearly indicates that default rates can be higher for investor loans than for owner occupiers in severe downturns. For example, as shown in table 1, forecast loss rates on Irish mortgages were nearly twice as high for investors as for owner-occupiers. Similarly, actual arrears rates were about twice as high for investor loans (29.4 percent) than for owner occupied loans (14.8 percent) as at December 2014. Furthermore, studies which have separately estimated default rates by LVR for investor loans and owner occupier loans suggest that investor loans are substantially riskier at any given LVR. The data shows an estimate of default rate based on current LVR. For example, if a loan was initially written at a 70 percent LVR and then prices fell 30 percent, the loan would appear in the chart below as LTV=100. This would have a mildly increased rate of default compared to a low-LVR loan for an owner occupier. But for an investor, the rate of default would be higher, and would have increased more sharply as a result of a given decline in house prices.”

Note: PDH is principal dwelling house, BTL is buy to let. LTV (loan to value ratio) is conceptually the same as LVR, but this dataset uses the current LTV (after the sharp falls in house prices) rather than origination LTV.

The consultation will run until 13 July. The Reserve Bank expects to publish a summary of submissions and final policy position in August, with revised rules taking effect from 1 October.

The Reserve Bank proposes that the policy changes take effect from 1 October 2015. This relatively long notice period is to allow banks to make the necessary systems changes in order to properly classify new lending. There is a risk that a notice period of this length could lead to some Auckland property investors rushing in to beat the policy changes. However, our expectation is that banks will observe the spirit of the proposed restrictions, and will act to curtail lending at LVRs of above 70 percent to Auckland property investors well in advance of 1 October.

Currently, compliance with the LVR policy is measured over a three-month rolling window for banks with monthly lending of over $100m, and over a six-month rolling window for banks with monthly lending of less than $100m. At the time that LVR restrictions were first introduced, all banks were provided with an initial six-month measurement period. This was done to accommodate outstanding pre-approved loans, and recognised the relatively short notice period provided. A longer first measurement period does not appear to be warranted for this change to the restriction, given more than four months’ notice of an intention to change the restriction. Further, the low speed limit for Auckland property investment mortgage lending does not provide much scope to smooth lending over a longer measurement period.

RBNZ Still Looking For Low Inflation Key

A paper from the Reserve Bank of NZ entitled “Can global economic conditions explain low New Zealand inflation?” by Adam Richardson, was published today.

While international economic factors help explain the vast majority of why inflation in New Zealand is currently low, they do not shed additional light on the small portion of low inflation that is difficult to explain. Instead, domestic specific factors likely help account for the unexplained component of CPI inflation and this is a current focus of internal research at the Bank.

Inflationary pressure in New Zealand has been persistently low since the onset of the global financial crisis. This can be seen in the New Zealand economy in two major ways. First of all, the Official Cash Rate has remained low in New Zealand for a number of years, currently sitting at 3.50 percent. Interest rates have remained low in order to support growth and keep the outlook for future inflation consistent with the target mid-point.

Second, the weak inflationary environment can be seen in inflation itself. Since 2012, core consumers’ price index (CPI) inflation has averaged 1.4 percent – within the Bank’s target range, but below the 2 percent mid-point.

Even when accounting for developments in the international economic environment and New Zealand’s own economic conditions, inflation in New Zealand is a little weaker than the Bank’s usual modelling frameworks would suggest. That is, with the benefit of hindsight, there remains a portion of current low inflation outturns that is difficult to account for.

Overall, this unexplained portion of current low inflation is modest, in comparison to the usual level of uncertainty and the contribution international economic factors have made to current low inflation. However, it is important for the Bank to investigate potential explanations, so we can make fully informed policy decisions.

Note: The Analytical Note series encompasses a range of types of background papers prepared by Reserve Bank staff. Unless otherwise stated, views expressed are those of the authors, and do not necessarily represent the views of the Reserve Bank.

RBNZ External Stakeholder Engagement Survey

The Reserve Bank today released in its Bulletin the results of the survey, conducted by global market research company, Ipsos, as well as the Bank’s responses. Ipsos’ overall finding of the Bank’s stakeholder relationships was that “this was a positive story and one that provides a pathway to even greater levels of trust and familiarity.” The survey found that stakeholders welcome the Bank’s recent efforts to broaden its communications. The survey was conducted in the latter half of 2014, covering the general public, business, industries regulated by the Bank, financial markets, educators and researchers, and government. The survey was based on a framework to assess the Bank’s reputation, based on levels of familiarity, favourability, trust, and advocacy.

RBNZ should be congratulated for being proactive in terms of feedback from its stakeholders. RBA, please note.

New Zealand’s Restrictions on Mortgage Lending in Auckland Will Benefit Banks – Moody’s

Last Wednesday, the Reserve Bank of New Zealand (RBNZ) announced that starting 1 October 2015 bank lending to home investors in Auckland, New Zealand, will be restricted to mortgages with loan-to-value ratios (LTVs) of less than 70%. The RBNZ also said it was raising the percentage of residential mortgage loans that can be originated outside of Auckland with LTVs of 80% or higher to 15% of all mortgage loans from 10%. These measures are credit positive for New Zealand’s banks because they will reduce banks’ exposure to riskier mortgage loans in Auckland, where house prices are at historical highs, having risen 14.6% in the 12 months to March 2015.

Moody’s says these steps would particularly benefit New Zealand’s four major banks, ASB Bank Limited (Aa3/Aa3 stable, a2 review for downgrade), ANZ Bank New Zealand Limited (Aa3/Aa3 stable, a3), Bank of New Zealand (Aa3/Aa3 stable, a3) and Westpac New Zealand Limited (Aa3/Aa3 stable, a3). These banks held approximately 86% of total system mortgages as of 31 December 2014. Additionally, Auckland, New Zealand’s largest city, constitutes the largest market for these banks, and the RBNZ reports that around 40% of mortgage originations in Auckland are to investors.

The introduction of an LTV limit on property-investor lending in Auckland will reduce the risk of recently originated mortgages experiencing negative equity, where the size of the loan exceeds the value of the property. Both house prices and household indebtedness in Auckland are at historical highs creating a sensitivity to increases in unemployment and interest rates. Although LTV restrictions are likely to dampen house price growth in Auckland, we expect the effect to bemarginal owing to supply shortages and the official cash rate, which the RBNZ sets to meet inflation targetsand remains accommodative by historical standards, continuing to support price gains. However, reducingbank exposures to high-LTV loans that are more exposed to a house price correction would benefit banks.

The LTV restrictions would not apply to loans to construct new residential properties, given the RBNZ’s focus on alleviating Auckland’s housing shortage. Although the new 15% cap on high-LTV loans outside Auckland will allow banks to lend more at higher LTVs, price growth outside of Auckland has been relatively subdued. By responding to current housing market developments and loosening restrictions, the RBNZ is making housing finance more accessible in areas of New Zealand where there are fewer risks of stimulating excessive price speculation.

The proposals are the RBNZ’s latest in a series of steps aimed at reducing excess leverage in the financial system and reducing the threat of asset bubbles. In September 2013, the RBNZ raised the capital requirements for high-LTV lending and in October 2013 imposed a 10% cap on high-LTV loans. In March 2015, the RBNZ released a consultation paper indicating that banks would likely need to hold more capital against investor loans than against owner-occupied mortgages. The RBNZ intends to release a consultation paper later this month outlining its most recent announcement.

NZ Property Investors Highly Geared – RBNZ

In the May Stability Report the RBNZ have drilled into the Investment Property sector. They say they will be publishing more detailed data, but the current article makes interesting reading. Housing investors have consistently accounted for over one-third of property purchase transactions over the past decade, with the share rising slightly following the introduction of loan-to-value ratio (LVR) restrictions in October 2013 (figure A1). Sales to investors in the Auckland market have picked up in line with the rise in sales activity since November, and this is likely to be contributing to recent strength in Auckland house prices. Investors are also a key source of new mortgage credit demand, with property investors accounting for approximately one-third of new mortgage lending over the six months ended March 2015.

Although New Zealand has not experienced a financial crisis associated with the housing market, a range of international evidence suggests that defaults on investor lending tend to be significantly higher than for owner occupiers during severe downturns. For example, Irish investor mortgage default rates were around 20 percent higher than total mortgage default rates in the two years following the GFC. Default probabilities were estimated to have been significantly higher than owner-occupiers at any given LVR. Evidence from the UK and the US also finds that default rates were relatively high among investors in severe downturns. The Reserve Bank’s proposal to apply higher risk weights to investor lending, and introduce a differential LVR threshold for investors relative to owneroccupiers in Auckland, is consistent with this evidence.

A key driver of the higher default propensity of residential property investors is higher debt-to-income ratios (income gearing) relative to owner-occupiers. For example, an investor who has borrowed to buy four houses will end up with much larger negative equity relative to their labour income, if house prices fall, than an owner-occupier with just one house and a similar LVR. Higher income gearing reduces the incentive for the investor to continue servicing the outstanding loans, resulting in a greater tendency for investors to default when they have negative equity.

Another possible reason for the higher risks associated with investor lending is that investor house purchases have, in some countries, tended to be concentrated in areas with high expected capital growth. These expectations are often based on recent house price appreciation.

Evidence from the US suggests that increases in house prices prior to the GFC were particularly pronounced in regions where the investor share of house purchases increased. In turn, areas with rapid house price inflation experienced relatively large house price falls in the aftermath of the crisis.

In New Zealand, a significant proportion of property investors have large portfolios, implying a large degree of gearing relative to their underlying labour income. For example, the 2014 ANZ Residential Property Investment Survey shows that 26 percent of surveyed investors held seven or more investment properties (figure A2). Around half of investor commitments are at LVRs of more than 70 percent. Preliminary Reserve Bank survey data suggests that investors tend to make greater use of interest-only loans, which may partly reflect investors’ ability to offset mortgage expenses against personal income for tax purposes. As a result, investor loans are likely to retain a higher level of gearing over the long term than their owner-occupier counterparts.

The risks associated with investor lending are likely to be greatest in the Auckland region. Rapid house price appreciation in Auckland has compressed rental yields, and this is likely increasing income gearing among Auckland investors. Auckland rental yields are at record lows, while national yields are close to their 10-year average (figure A3). Relatively strong capital gain expectations among Auckland investors may explain why they are willing to accept such low rental yields. According to the 2014 ANZ Residential Property Investment Survey, investors in Auckland expected house price inflation to average 12 percent per annum in the region over the coming five years, compared to 8 percent nationwide. CoreLogic data also show that investors in the Auckland region are more likely to use mortgage finance than investors outside the Auckland region.

RBNZ Announces New LVR Restrictions on Auckland Housing

New Zealand’s financial system is sound and operating effectively, but faces significant risks, Reserve Bank Governor, Graeme Wheeler, said today when releasing the Bank’s May Financial Stability Report.

Mr Wheeler identified three systemic risks facing the New Zealand financial system.

“Auckland’s median house price is 60 percent above its 2008 level, and house prices in Auckland have been rising rapidly since late last year. This reflects ongoing supply constraints and increased demand, driven by record net immigration, low interest rates and increasing investor activity. Prices in the Auckland region have become very stretched, increasing the risk of financial instability from a sharp correction in prices.

“A second area of risk for the financial system relates to the dairy sector, which is experiencing a sharp fall in incomes due to lower international prices. Many highly leveraged farms are facing negative cash-flows, and the risks will become more pronounced if low milk prices persist beyond the current season.

“The third key risk arises from the current very easy global financial conditions. Low interest rates are encouraging investors into riskier assets in the search for yield. Prices of both financial and real assets are becoming overextended in many markets. There is an increasing risk that the current benign conditions unwind in a disorderly fashion, disrupting the cost and availability of funding for the New Zealand financial system.”

LVR Restrictions

In response to the growing housing market risk in Auckland, the Reserve Bank is today announcing proposed changes to the loan-to-value ratio (LVR) policy. The policy changes, proposed to take effect from 1 October, will:

• Require residential property investors in the Auckland Council area using bank loans to have a deposit of at least 30 percent.

• Increase the existing speed limit for high LVR borrowing outside of Auckland from 10 to 15 percent, to reflect the more subdued housing market conditions outside of Auckland.

• Retain the existing 10 percent speed limit for loans to owner-occupiers in Auckland at LVRs of greater than 80 percent.

“We are proposing these adjustments to the LVR policy to more directly target investor activity in the Auckland region, where house prices relative to incomes and rent are far more elevated than elsewhere in New Zealand.

“The objective of this policy is to promote financial stability by reducing the rate of increase in Auckland house prices, and to improve the resilience of the banking system to a potential downturn in the Auckland housing market.”

Mr Wheeler emphasised that while the new measures aim to moderate housing demand, policies to ease housing supply constraints in Auckland remain the key to addressing the region’s housing imbalances over the longer term.

Deputy Governor, Grant Spencer, said that the Bank will issue a consultation paper in late May, providing further details and seeking feedback on the new LVR proposals.

“Prior to the proposed introduction of the policy in October, we expect banks to observe the spirit of the restrictions and not seek to expand high-LVR investor lending in Auckland.

“Given the importance of encouraging residential construction activity in Auckland, and consistent with the existing LVR policy, the proposed LVR restrictions will not apply to loans to construct new houses or apartments.

“Consistent with the LVR measures, the Reserve Bank is establishing a new asset class for bank loans to residential property investors. Banks will be expected to hold more capital against this asset class to reflect the higher risks inherent in such lending.

“Following a lengthy consultation process, we have decided that a residential property investor loan will be defined as any retail mortgage secured on a residential property that is not owner-occupied.”

A summary of submissions received in response to the consultation will be released later this month, and details will be provided on the implementation of the new asset class, including on the proposed capital treatment of residential investor loans.

The new asset class will take effect from 1 October 2015 for new lending, with a further phase-in period of nine months for the reclassification of existing loans.

“Given the broader risks facing the financial system, it is crucial that banks maintain their capital and liquidity buffers and apply prudent lending standards. Later this year the Reserve Bank will be reviewing bank capital requirements in light of global and domestic developments affecting the safety of the banking system,” Mr Spencer said.