How to make macroprudential policy work

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.


  1. Sometimes simple is best. A gearing ratio based on free tangible capital after deducting shares (because the companies are already geared), and intangibles. US banks in 2007 were adequately capitalised under Basle with about 11% capital on risk weigted assets but only had 3% free capital.

    On the other hand, an effective, predetermined bail-in mechanism for quasi equity and long term debt would let the debt market discipline the banks, or take the consequences if they didn’t.

    But we should never underestimate the ingenuity of the accountants, solicitors, and quants guys in finding the loopholes for the banks. You almost need a requirement that if the transaction/product doesn’t have a specific RBA/APRA approval then it is illegal and the actual people who deal it face gaol time.

  2. Interesting about LVR gaming Deep T – I believe Prof Keen advocates this approach, but coupled with the other big-dumb rule – only allowing a certain multiple of debt to imputed rent.

    Obviously this could work not only for PPOR but investment properties too., I think it was no more than 10 times nominal rent.

    e.g if you can rent Property A at $25000 a year, you can only borrow up to $250,000 to buy it, regardless of your own equity or income, e.g you could be earning $80K a year or $200K, doesnt matter – you can only borrow $250K

    You could probably employ this tool without getting rid of negative gearing…..maybe – I’d still add a 50% CGT on sale and eliminate stamp duty

    • TP,

      You are right on the x10 annual rent limit.

      Steve Keen proposes 2 ways to prevent bubbles (out of interest, I’m sure you’d have something to say about ‘jubilee shares’):

      “To prevent bubbles, we therefore have to reduce the appeal of leveraged speculation on asset prices, without at the same time choking off demand for debt for either legitimate investment or unavoidable borrowing. I propose two mechanisms: “Jubilee Shares” and “Property Income Limited Leverage” (“The PILL”):

      1. Jubilee Shares: To redefine shares so that, if purchased from a company directly, they last forever, but after a minimal number of sales (say seven), they become Jubilee Shares that last another 50 years before they expire; and

      2. Property Income Limited Leverage: To limit the debt that can be secured against a property to ten times the annual rental of that property.

      Property Income Limited Leverage

      Some debt is needed to purchase a house, since the cost of building a new house far exceeds the average wage. But debt greater than perhaps 3 times average annual wages drives not house construction, but house price bubbles.

      Property Income Limited Leverage (“the PILL”) would break this positive feedback loop by basing the maximum that can be lent for a property purchase, not on the income of the borrower, but on a multiple of the income-earning potential of the property itself.

      With this reform, all would-be purchasers would be on equal footing with respect to their level of debt-financed spending, and the only way to trump another buyer would be to put more non-debt-financed money into purchasing a property.

      It would still be possible–indeed necessary–to pay more than ten times a property’s annual rental to purchase it. But then the excess of the price over the loan would be genuinely the savings of the buyer, and an increase in the price of a house would mean a fall in leverage, rather than an increase in leverage as now. There would be a negative feedback loop between house prices and leverage. That hopefully would stop house price bubbles developing in the first place, and take dwellings out of the realm of speculation back into the realm of housing, where they belong.”

      It’s time the property market took the better PILL (kool-aid?)…

  3. Guys, you can not get rid of the cycle. Since time immemorial and in every economy there has been a credit cycle and the sharpness of the bust will determine the timing and extent of the upswing. All a prudential authority can do is to hope to knock the top off the cycle by using what ever means is appropriate at the time, which is going to be different every time. Hopefully that means that the downturn doesnt turn systematic. The last boom in Australia is proof of the hopelessness of any macroprudential policy. We had interest rates at 18% cf inflation at 10%, Basel 1 which was the ultimate big dumb rule, but we still had raging increases in commercial and residential property markets and that would have been in 1980s lending standards ie limited LMI and much higher deposit requirements. The banks were already in compliance with conservative LVR policies. We still had higher volatility of house prices and a large fall and then a number of years of flat nominal/negative real house price. And a commercial property smash.
    So what do all you MBers actually want? a slowing of house price increases, a fall, a permanent yield and rent control mechanism. And what would the longer term consequences of such regulation be?
    If you read Bernankes critique of the Great Depression the thing the liked the most about Roosevelt and his team was their sheer pragmatism: if something didnt work they tried something else and in the end they achieved success. That is and always be the case with monetary and prudential policy. The ends is the important outcome, not the means, but everything you read here is about coming up with a seemingly tractable “means” solution

    • Guys, you can not get rid of the cycle.”

      Sure, but you can mitigate its size and swings. As noted by the RBA’s own research, macroprudential tools have been successful in mitigating the credit cycle in other jurisdictions.

      As noted many times before, I’d also like to see planning constraints lifted so that land/housing supply becomes more responsive to changes to demand.

  4. Needless to say the effectiveness of any macroprudential policies would be greatly enhanced by effective policies liberalising the supply and lowering the cost of new land for residential but importantly also retail/office construction.

    One of the aspects of the so called ‘on-line shopping’ wars that is often overlooked is that many Australian retailers cannot compete simply because of the extortionate rents they are paying for the pleasure of securing space in the ‘shopping precincts’ zoned by local councils.

    Naturally those zonings are designed to protect society from the convenience of corner stores, cafes, professional services near where people actually live but in practice they play into the hands of the megamall landlords who appreciate the monopolies such zonings create.

    Funny how the much valued ambience of inner city suburbs is the product of people having lots of freedom to turn the front of their house into a corner store or pub or other small business.

    Negative gearing will mostly evaporate like morning fog in a functioning property market.

    • “on-line shopping wars” is a furphy. 2% of sales but increasing. retailers have the choice of going online instead / as well as having a shop front.

      retailers chose to locate where they think best for the medium term having regard for higher rent and higher sales in shopping precints.

      trend from the United States seems to be window shopping for larger items followed by online orders.

      Online stores in Australia are doing nicely although would like to see postage/freight costs come down so that they can compete globally.

  5. If the RBA set rules on income/loan ratio, then why bother with having commercial banks at all? Just borrow directly from the RBA!!

    While the market can often gets things wrong, distributed decision making process is still better than a centralized one. The role of a reserve bank is to provide ‘sanity’ via negative feedback price signals to promote stability. The RBA is not God, and they make mistakes just like everyone else.

    To stop the mal-investment in housing, the RBA needs to be radical : they must directly deal with the property market. Buy a portfolio of real estate assets, sell when prices goes up, and buy if prices drop, maintaining a median income/price ratio between 3-4, similar to how they link interest rate and inflation.

    Property prices in Sydney is now above that of Hong Kong!! It is time for affordable housing to be added to the RBA mandate.

    • ‘Property prices in Sydney is now above that of Hong Kong!! It is time for affordable housing to be added to the RBA mandate.’

      Can you imagine the reaction from the mainstream media and real estate industry?

  6. I don’t see how any bank or bank employee can “game the system” for an LVR restriction. Lenders at the moment don’t allow secondary housing borrowings.

    In fact the vast majority of loans are sub 80% LVR anyway, and the loans above 80% have values capped by both the lenders and the Mortgage Insurers.

    I can see why the policy of LVR restrictions would appeal to those here, but in reality it would only affect FTB’s who generally buy at the bottom end of the market with low value loans which are better conducted than many upgraders.

    I can see every reason to restrict credit to a group of troublesome borrowers, but I see no reason to restrict loans to a group who conduct their borrowings better than satisfactorily. Why do people wish to punish a group who do nothing more than want a home?

    I don’t follow the logic.

    • It’s very simple : your LVR loan is for 80%, then the bank gives you an overdraft account/personal loan where you can draw additional 20%.

        • I know for a fact that something like this does occur, and the person obtaining the loans pays a ‘fee’ for this. Not only that but some borrowers even add this ‘fee’ to the amount borrowed for the deposit.

          Not sure if this is common or how much money is involved but my source says there are a few doing it…

          • This person obviously works within Megabank and knows the person who is doing this. The idea to do it was learnt from others…

          • Buzz – if it was possible I would know about it. It’s not possible unless someone borrowed well in advance, maybe well over 6 months, in which case why not just save the money in the normal course. Sometimes taking the easy way is too hard.

    • Peter – “Lenders at the moment don’t allow secondary housing borrowings.”

      Does this mean that you cannot get a second mortgage against a property ?

      I seem to recall in the past that a bank would lend you up to their limit and then refer you to their finance company for any additional borrowings. There would be 2 mortgages – 1 with the bank and one with the finance company.
      Issues with AGC almost brought down Westpac in the early 90s.

      • Nezam – Westpac sold AGC many years ago to GE. That isn’t done anymore. Esanda, CBFC etc are out of that area of lending. Custom Credit no longer exists – times have changed and the remnants of those organisations mainly do equipment finance, if they exist at all.

        What I mean is that a buyer can’t get a personal loan specifically to fund or partially fund the deposit. They may have a pre-existing personal loan for a car or some other reason, and they will accept that, but borrowed deposits are not acceptable. Any large deposit to the applicants account that is not part of regular savings has to be explained – eg salary bonus, bond returned, car sold etc.

        Family gifts are acceptable. However having the required deposit and sufficient income is not a guarantee of a loan. Lenders want to see evidence of financial responsibility.

        If you are talking about a true second mortgage (registered on title) which might be taken later for perhaps a business purchase, then that is a different scenario, those funds are not used in the house purchase.