Box C: Regulatory leakage from the LVR restrictions framework
‘Regulatory leakage’ describes financial activity that escapes the regulatory perimeter, and moves to financial products, markets, or institutions not subject to the particular regulation. In respect of LVR restrictions, regulatory leakage could involve avoidance activity by the regulated banks, including activities designed to ‘game’ the restrictions or exploit loopholes. It could also involve borrowers shifting to non-bank financial intermediaries and other sources of finance.
Such developments could undermine the effectiveness of LVR restrictions. The restrictions are intended to address the recent increase in systemic risk by dampening house price growth and housing related credit growth. If significant amounts of high-LVR lending continue to occur despite the restrictions, any dampening effect will be limited.
Regulatory leakage from the LVR restrictions may also affect the resilience of the financial system if lenders that are not subject to the restrictions have capacity to significantly increase their lending. If those lenders were or became systemically important, or if they were particularly risky, the shift of lending away from the prudentially regulated banking system could increase overall financial system risks.
The extent to which regulatory leakage will occur depends on how lenders and borrowers respond to the new incentives created by the restrictions. Some foreign lending institutions have expressed interest in entering the New Zealand market in response to LVR restrictions, but none has done so yet. Some existing non-bank mortgage lenders have reported increased borrower demand, although it is unlikely that they will have sufficient capacity to materially undermine the effectiveness of LVR restrictions.
The LVR policy has been designed to reduce the scope for regulatory leakage:
- The restrictions are not permanent, reducing the opportunities and incentives for borrowers and lenders to undertake significant activity outside the restriction.
- They cast a wide regulatory ‘net’ – banks account for close to 97 percent of lending to households in New Zealand – limiting opportunities to undertake lending outside this net.
- The restrictions are framed as a ‘speed limit’, allowing banks to continue to provide some high-LVR lending, reducing the benefits to any new entrants to the market.
- The framework also imposes limits on some obvious avoidance activity, such as lending secured by second mortgage.
- The Reserve Bank has also emphasised it requires banks to adhere to the ‘spirit’ of the policy, as well as the specific regulatory requirements when undertaking lending decisions.
Further, when calibrating the restrictions, the impact of potential regulatory leakage on the effectiveness of the framework was taken into account, and is reflected in the final calibration. There is potential for the restrictions to be re-calibrated to address specific regulatory leakage, if necessary.
The Reserve Bank has been pleased with the positive engagement with industry during the consultation process, which has helped to address many of the potential problems associated with ‘leakage’ arising from implementation of the LVR restriction.