Box A: The Reserve Bank’s proposed macro-prudential framework

This page contains information on the Reserve Bank’s proposed macro-prudential framework from the May 2013 Financial Stability Report.

In April, the Reserve Bank concluded a public consultation on a framework and set of instruments for macro-prudential policy purposes.1 This box summarises the proposed framework, including some issues raised from the consultation.

The global financial crisis (GFC) highlighted the significant economic costs that can arise through instability in the financial system. As many countries have experienced in recent years, boom-bust cycles in credit and asset prices can be extremely destabilising for banking systems and can create large economic costs. They can also pose a significant fiscal risk for the government balance sheet. In addition to strengthening regulatory standards for bank capital and liquidity, many countries are developing macro-prudential policy frameworks to reduce the risks to the financial system from these cycles. Macro-prudential policy involves the temporary use of various prudential instruments in the face of rapid credit growth and/or other risk factors such as rapid growth in asset prices, rising leverage or abundant liquidity. Such conditions were prevalent in the lead up to the GFC.

The Reserve Bank’s proposed macro-prudential policy framework aims to promote financial system stability by:

  • building additional resilience in the financial system during periods of rapid credit growth and rising leverage or abundant liquidity; and
  • dampening excessive growth in credit and asset prices.

The Reserve Bank has consulted on four tools it has identified as being helpful in addressing one or both of the above objectives: adjustments to the core funding ratio; a counter-cyclical capital buffer; sectoral capital requirements; and loan-to-value ratio (LVR) restrictions for residential mortgages. The two latter tools are targeted measures intended to help address credit imbalances in specific sectors of the economy.

As noted in the consultation paper, macro-prudential instruments would be used to help manage extremes in credit and asset price cycles, although the tools would need to be deployed early enough to ensure they would meet the intended objectives. By their nature, macroprudential tools are likely to entail a range of costs that would need to be carefully weighed against the benefits of using them. Potential efficiency costs include the risk of disintermediation – where credit growth is displaced to non-bank lenders not subject to the policy requirement.

Most submissions to the consultation supported the proposed objectives for macro-prudential policy, although some questioned why it might be needed given existing prudential regulation. The main rationale is that existing ‘micro-prudential’ regulation may not be sufficient to contain a build-up in financial system risk during extremes in the credit cycle, particularly if there are substantial increases in asset prices or increases in household or business sector leverage. Some submitters also asked whether macro-prudential tools could more actively assist monetary policy goals, exchange rate management, or housing affordability. As noted in its consultation paper, the Reserve Bank believes such tools will generally support monetary policy but are unlikely to be as powerful as the Official Cash Rate. The tools do not appear well suited for directly pursuing other economic policy goals and, under its Act, the Reserve Bank’s reason for using such tools must be for financial stability purposes.

Much of the focus in the submissions was on the use of LVR restrictions. Key concerns were around the potential adverse effects such restrictions could have on first-home buyers, small businesses, and the Canterbury rebuild. Some submitters suggested that LVR restrictions could best be applied with exemptions for some borrowers or targeted at particular regions where high-LVR lending was more prevalent.

The Reserve Bank’s aim would be to apply the restrictions at times when high-LVR lending was judged to be posing a significant risk to financial system stability. Setting exemptions would not necessarily be appropriate and could significantly dilute the effectiveness of the instrument. Although LVR restrictions overseas have sometimes exempted first-home buyers, this would only be possible if first-home buyers were not driving the risky borrowing. Targeting LVR restrictions to particular regions may be feasible but would entail significant practical difficulties and could create other distortions. A variant of the LVR restriction proposed in the consultation would set a limit on the share of high- LVR lending that could be undertaken, providing banks with scope to continue to provide some high-LVR loans to creditworthy borrowers.

Many submitters noted the risk that macro-prudential tools such as LVR restrictions would displace lending away from banks towards other lenders not subject to the policy requirement. The Reserve Bank believes that the risks of disintermediation would be mitigated partly by its intention to use LVRs and other tools in a temporary fashion. It is also worth noting that disintermediation does not necessarily reduce the effectiveness of macro-prudential policy in meeting the objective of increasing financial system resilience. However, it might become necessary to extend the framework to non-bank lenders and this is an issue that the Reserve Bank intends to consider further.

Comments about effectiveness focused more on the objective of dampening the credit cycle than on the objective of increasing financial system resilience. Some submitters thought that LVR restrictions would be more effective at dampening the credit cycle than instruments such as the counter-cyclical capital buffer or sectoral capital requirements. It was suggested that, faced with an additional capital requirement, banks might simply opt to run down existing capital buffers if these already exceeded the new requirement. This would result in little impact on funding costs or interest rates for new lending. Moreover, submitters noted that the impact of additional capital or core funding requirements on lending rates would likely depend on a combination of factors, including: banks’ internal policies and models, the state of equity and debt markets, competitive conditions in lending markets, and general economic conditions. These points are largely in line with the Reserve Bank’s views. The full range of such factors will need to be assessed when choosing whether and when to deploy macro-prudential instruments.

Most submissions also sought further clarity on the indicators and judgements underlying the Reserve Bank’s future macro-prudential policy decisions. The Reserve Bank intends to publish such guidance in its regular Financial Stability Reports.

The Reserve Bank is continuing to review the submissions and will publish a full summary. The next steps in the establishment of the macro-prudential policy framework are expected to include a Memorandum of Understanding between the Reserve Bank and the Minister of Finance. This will set out the objectives of the policy, the Reserve Bank’s powers to use macro-prudential policy, an agreed set of policy instruments and governance and accountability arrangements. Following this, it is expected that the technical implementation details for each of the instruments will be incorporated into the Banking Supervision Handbook over time. This design process will draw on further consultation with the banks.

 

1“Consultation Paper: Macro-prudential policy instruments and framework for New Zealand” (PDF 227KB)