IMF wants big changes to reduce housing risks

The IMF wants some big changes to make our banking system safe from a potential housing slump. Photo: Lynn Grieveson

The headlines around the International Monetary Fund's two flagship reports on New Zealand's economy and its financial systems were benign enough. But its recommendations to reduce property tax breaks and toughen financial regulation pose serious challenges to the status quo for New Zealand's banks and the Government's approach to dealing with the risks of an over-blown housing market. Bernard Hickey sifts through the recommendations and finds the IMF wants some big changes to make our banking system safe from a potential housing slump caused by renewed turmoil on global financial markets.

Australia's banks have had a tough 24 hours at home with the surprise announcement in the Australian Budget of a A$6.2 billion tax on liabilities, but a swathe of changes recommended by the IMF here in New Zealand on Tuesday could be just as substantial for them in the long run.

If adopted, the recommendations would also have big implications for savers, borrowers, taxpayers and property owners. They could potentially increase interest rates for mortgages and term deposits, make housing less attractive as an investment, make it harder to borrow heavily to buy houses and introduce a limited guarantee for term deposits. The government and the Reserve Bank both welcomed the reports and said they were open to the proposals, which also included a much more intrusive approach to regulating banks and higher capital requirements for them.

The IMF's flagship annual report on New Zealand's economic settings and its first assessment of New Zealand's financial system stability in 12 years were positive generally about the health of the economy and the financial system. But the IMF also focused the reports on a warning about the housing market and detailed proposals to reduce the risks of a housing correction.

"Imbalances in the housing market, banks’ concentrated exposures to the dairy sector, and their high reliance on wholesale offshore funding are the key macro-financial vulnerabilities in New Zealand," begins the executive summary of the IMF's Financial System Stability Assessment (FSAP).

More than half of the banks' loans were now backed by residential property and they were still relatively dependent on foreign funding, the IMF said.

"A sharp decline in the real estate market, a reversal of the recent recovery in dairy prices, a deterioration in global economic conditions, and a tightening in financial markets would adversely impact the system," it said.

The last full IMF assessment of New Zealand's financial system was done in 2004 and also warned about a lack of active supervision of banks and a reliance on wholesale funding. The latest assessment by 16 IMF staffers over nearly six months and two visits to New Zealand led to a 92 page report.

The IMF conducted stress tests of the banks with the Reserve Bank and found the system could cope with a 35 percent fall in house prices, but said the financial sector still needed strengthened oversight, bigger capital buffers and a better system for dealing with the collapse of an institution that protects smaller savers.

The IMF recommended:

1. A DTI cap. The Reserve Bank should extend its macro-prudential tool kit to include both its existing Loan to Value Ratio (LVR) restrictions and a Debt to Income (DTI) multiple cap. The Reserve Bank is already doing a cost benefit analysis of a DTI, but had hoped to have in its toolkit sooner. New Finance Minister Steven Joyce asked in February for the analysis, which would also have to be followed by a full consultation with banks. Most expect that to delay the inclusion of the DTI in the Reserve Bank's toolkit until well into next year. Joyce told reporters yesterday he expected the Reserve Bank would begin its consultation shortly, although it was not clear whether this was the cost benefit analysis or the full consultation with banks. The IMF also called for the process of adding to the Reserve Bank's tool kit be made more transparent with public disclosure of the Reserve Bank's advice and the Minister's opinions.

2. Higher capital levels. The Reserve Bank should require the banks to put aside more of their own capital as a buffer to deal with any property downturn linked to turmoil on global financial markets. Under its stress test scenarios, bank capital levels fell and banks had to use some of their profits to top up capital rather than pay out big dividends to their Australian parents, but they remained above minimum thresholds for capital. The IMF said the Reserve Bank's current capital review should require the New Zealand units of the Australian banks to hold even more capital than their Australian parents. Higher capital levels would force the banks to slow their lending growth and put up interest rates for both term deposits and mortgages.

3. Protect small depositors savings. The Reserve Bank should either bring in a deposit insurance scheme, or at least say that term deposits of up to $10,000 be protected in the event of any bank collapse. Currently, under the Reserve Bank's Open Bank Resolution system for dealing with a bank collapse, all depositors are subject to the risk of a 'haircut' where their savings are reduced and used to recapitalise the bank. Joyce said the government was looking at tweaking the Open Bank Resolution to include such a protection for smaller savers. The IMF said a $10,000 exemption for the haircuts would mean 80 percent of the number of accounts would be protected, but the bulk of the term deposits could still be given haircuts if necessary.

4. Beef up the Reserve Bank's supervision. The Reserve Bank should begin on-site inspections of banks and be granted more resources to do more of this sort of supervision, which is the norm in Australia and elsewhere. The Reserve Bank has relied more on self discipline, market discipline and off-site supervision in the past. The IMF also recommended the Reserve Bank's powers to appoint a liquidator be strengthened and that there be a clearer and more independent role for the bank in dealing with a crisis.

5. Reduce tax incentives for property. The IMF said in both its annual review and in the financial assessment that the government should look at reducing the tax incentives for property.

"Recognizing the steps being taken by the authorities to address the demand‑supply imbalance in housing markets, Directors generally highlighted that further tax measures related to housing could be considered to reduce incentives for leveraged real estate investments by households," the IMF said.

"Such measures could help redirect savings to other, potentially more productive, investments and, thereby, support deeper capital markets."