The RBA governor’s speech this week certainly stirred up a few pieces of controversy, not least has been pointed out by MB’s Houses & Holes and Unconventional Economist when Mr Stevens suggested the pointlessness of macroprudential policy:
We need, however, to approach such measures with our eyes open. Macroprudential tools will have their place. But if the problem is fundamentally one of interest rates being too low for a protracted period, history suggests that the efforts of regulators to constrain balance-sheet growth will ultimately not work. If the incentive to borrow is powerful and persistent enough, people will find a way to do it, even if that means the associated activity migrating beyond the regulatory perimeter. So in the new-found, or perhaps re-learned, enthusiasm for such tools, let us be realists.
For Capt’ Glenn to actually state that macroprudential tools “will ultimately not work” is absurd. Did he mean that badly thought through, incomplete policies don’t work or have unintended consequences? Let’s be kind and assume that our RBA governor does not make absurd comments? So what does work?
Previous to the above comment the governor stated:
…where the interest rate that seems appropriate for overall macroeconomic circumstances is nonetheless associated with excessive borrowing in some sector or other. In such a case it may be sensible to implement a sector-specific measure – using a loan to value ratio(LVR) constraint or a capital requirement.
I’m a great believer in controlling taxpayer supported Mega Bank using smoothly graduating capital requirements as risk increases using transparent risk assessment methodologies. However, I don’t think that’s what was meant. Rather the reference is more likely to be about big dumb rules which mean that if a bank crosses a line then they get whacked.
Using LVR limits to control lending is a big dumb rule which certainly will have an effect on bank’s lending but also encourages gaming by banksters. Limits on LVR effect the demand for housing not directly the price by reducing the number of borrowers but actually increasing the demand from lenders to lend into housing as it would be seen as low risk.
A simple LVR limit of 80% for Mega Bank would create a whole industry dedicated to filling the gap between what the borrower has as a deposit and the LVR limit for Mega Bank. Having a limit of 80% rather than a significantly increasing capital requirement for lending above that LVR, would be an open invitation to gaming. Of course, Mega Bank is subject to increasing capital requirements as LVR increases, its just that and as I’ve posted on numerous occasions, they’ve gamed their internal risk based models so that the penalty is more nominal than really hurtful.
As an example, South Korea has an 80% LVR lending limit for home loans but the housing market continues to show bubble like qualities. On closer examination of the how the market works exposes a number of methods to get around the LVR. Specifically, its typical for a renter to enter into long term leases for housing and pay the rent in advance. The landlord can use that up front rent to uses as a deposit on the property or another property.
Nevertheless, although I’m pointing out that big dumb rules need to be thought through, LVR restrictions or penalties being applied with interest rate policy is certainly a measure which would curtail a housing bubble.
What does work better in applying macroprudential policy with interest rate policy is restrictions and penalties, or the reverse, is the level of serviceability of the loan. The big dumb rule is debt to income ratios which are rarely used in this country. Mega Bank and others use complex serviceability calculators which take detailed account of income and expenses at the time the loan is taken out. Whilst different banks or arms of Mega Bank use different calculators, they are based on similar principals which means the RBA could easily create a standard which could be calibrated by each bank for their own purposes but understood by the RBA. The RBA could set capital weights for lending above the standard so that it becomes expensive to lend outside the criteria. At appropriate times the policy could relax the penalties.
As an effect on house prices, the amount that is lent on a given income has a direct effect on house prices. The median income to median house price is one of the most important ratios of all.
For the RBA to control, through macroprudential policy, how much of a borrower’s income is spent on housing is a very important tool in controlling housing bubbles and encouraging spending or productive lending. Isn’t control of interest rates and at the moment, decreasing interest rates primarily about reducing the amount that borrowers spend on their mortgages?
Macroprudential policy does and will work if its thought through and modern tools and technology are at last employed by the regulators for good.