How could changing bank capital ratios affect New Zealand’s housing market?

Aimed at strengthening bank positions in the event of future financial turbulence, the Reserve Bank of New Zealand is currently enmeshed in a consultation process it calls the Capital Review.

This Capital Review is poised to send a ripple effect across New Zealand’s financial sector, as it has the potential to change how much capital banks are required to hold against institutional and retail loans.

For many Kiwi homeowners the nuances of Aotearoa’s banking and financial sector may seem drab and difficult to digest, but for business owners, mortgage holders and savers, the review has the potential to impact when you choose to make your next move.

Following the global standard for capital, banks in New Zealand must presently glean a minimum percentage of capital from their owners – that is stakeholders such as shareholders, public organisations and employees.

There’s a two-tiered purpose for this, the first being so that negative market performance sees the bank’s capital take the first hit, as opposed to money borrowed by the bank from depositors.

The second, is to encourage more conscientious management from each institution as we all know you’re more conservative when spending your own money.

Given global headwinds, uncertainty and a slowing domestic economy, the RBNZ has been considering the need to adjust the ratios by which banks hold the capital required for lending, since March 2017.

Proposed changes would almost double the requirement for ‘high quality’ capital sourced from ‘owners’ to the tune of billions – meaning that banking institutions would, depending on current levels of capital, have to reach into their pockets to find an estimated 20-60 percent more funding.

Met with heavy criticism from the financial sector, the proposed changes have the potential to push interest rates upward, lower asset prices and slow economic growth as banks look to pass extra costs on to customers, experts say.

To fully understand how these changes could trickle down to those in the residential property market, one must first understand that banks use a risk weighting system for how much capital each institution holds against every loan.

At the top end of the spectrum, requiring the most capital input thanks to classification as ‘high-risk’ investment endeavours are; property development and agriculture, followed by corporate lending with residential lending at the lower end of the spectrum.

While generally speaking, residential mortgagors have some of the lowest equity levels on their home loans, the risk is relatively low for banks given the large spread of residential lending and that borrowers would choose to lose most other investments – businesses and the like, before defaulting on the family home.

For this reason, banks hold lower capital against these loans.

If the RBNZs proposals are adopted come November 2019, then capital intensive loans for sectors such as commercial property, agriculture and development, would be subject to higher funding costs.

If costs are to increase across these sectors, we may see a larger than normal push of funding into residential housing due to the relatively lower cost of investment for this category.

Should this occur, critics have said, it would add further impetus to a residential housing market on the rise, which is arguably of a higher risk to the domestic economy given New Zealand’s relatively high debt-to-income level when compared with the rest of the developed world.

It’s a sentiment echoed in Sir John Key’s response to the RBNZs call for feedback to its consultation paper ‘Capital Review Paper 4’.

As chair of ANZ Bank New Zealand, New Zealand’s largest bank with almost a third of the home loan market, Sir John Key explains that residential lending requires half as much capital as other lending classifications.

“The housing market would experience some upward margin pressure given that virtually all current mortgage lenders would be affected by the capital proposals,” Sir John Key writes.

“The potential reallocation of bank capital towards the housing sector would increase the concentration risk on this sector, and leave banks more exposed to any sharp correction in residential property prices, potentially increasing financial stability risks,” he adds.

In all, 170 submissions were received in answer to the RBNZ’s fourth consultation paper, with the findings due to be released next month.

While some economists have picked the OCR to drop as low as 0.5 percent come mid-2020, it looks likely that that the residential property market may indirectly feel the flow-on effects of the RBNZs Capital Review.

Whether this is in the form of less credit to lend, or passing on the cost of new credit requirements through slightly raised interest rates, remains to be seen.

However, the historically low interest rates we’re enjoying at the moment, paired with positive spring sale performance offers a timely reminder that we find ourselves in the midst of a pretty positive time for both buyers and sellers of residential property across New Zealand.

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