Brian Fallow: The man to curb your enthusiasm

The Reserve Bank can influence house prices through lending conditions, but it can't 'fix' the property market, says Geoff Bascand. Photo / 123RF

OPINION:

Geoff Bascand struck a distinctly cautionary tone in a valedictory speech this week.
The Reserve Bank's stalwart deputy governor since 2013 and head of its financial stability function, Bascand retires in the New Year.

"I think there is a good deal of evidence in favour of optimism bias amongst borrowers and lenders, or perhaps simply an expectation of being rescued if things go sour," he said in an address to the Financial Services Council on Tuesday, before quoting Adam Smith: "The chance of gain is by every man more or less overvalued and the chance of loss is by most men undervalued".

As if to make his point, ASB's latest survey of housing market sentiment released the day before found a further rise in house price expectations, with 68 per cent of respondents confident prices will increase over the next 12 months and only 6 per cent expecting a fall. And this after a year in which the REINZ house price index climbed by a whisker under 30 per cent to stratospheric heights.

Bascand is a strong believer in macro-prudential measures like loan-to-value ratio (LVR) curbs and potentially the "probably better" tool of debt-to-income restrictions.

They redress, he said, "the inherent tendency of banks to be pro-cyclical, underestimating credit risks when asset prices are rising". They also complement monetary policy, particularly in times of low interest rates, rising house prices and increasing household borrowing.

Using interest rates to lean against excessive borrowing is undesirable when inflation is low, as it was when LVRs were introduced, he said.

"And so the macro-prudential policies we use to mitigate boom and bust cycles in the economy provide additional freedom for monetary policy to do its role, whilst containing risks from excessive leverage."

But they could not be expected to "fix" the housing market. "We can lean against house prices by increasing the cost and restricting the availability of credit, but we cannot alter the supply of land or buildings and should not be held responsible for the housing market."

In addition to setting across-the-board macro-prudential requirements like capital ratios and LVR limits, the Reserve Bank has a supervisory role regulating individual banks.

Bascand is unapologetic about a more active and — the banks might say — intrusive approach there.

"We have doubled supervisory capacity, placed much of it closer to regulated entities in Auckland, and increased the weight on positive assurance and verification," he said.

"Less 'tell us everything's okay' and more 'show us'." If more intensive scrutiny of risk and compliance means a more adversarial relationship between the Reserve Bank and the financial institutions it regulates, well, so be it.

"I have always been a market-oriented economist," Bascand said. "Unfortunately there are many instances where market and self-discipline forces have been found wanting on their own. Our review of banks' attestation processes revealed significant weaknesses in board governance processes, with directors signing to the veracity of financial and risk compliance on the basis of no awareness of issues, rather than proactive review and positive confirmation vouching for their integrity."

Reserve Bank deputy governor, Geoff Bascand. Photo / Mark Mitchell

The range of risks that bank boards, and their watchdog too, need to be mindful of is growing.

Cyber-security, of which the Reserve Bank itself had an unpleasant experience this year, is one.

Climate change is another.

Risk management is the day-to-day business of financial institutions, he said, but understanding how those risks can accumulate at a system level, or be under-priced due to implicit government guarantees, is appropriately a focus for the central bank.

We can take it then that Bascand would reject the scornful view critics of a laissez-faire disposition take, of central banks' increasing focus on the disclosure and management of climate risks.

The Reserve Bank is one of more than 100 central banks collaborating on climate change through the Network for Greening the Financial System.

And the Basel Committee on Banking Supervision, the primary setter of international standards for the prudential supervision of banks, has just issued draft principles for the management and supervision of climate-related financial risks.

In addition to financial stability risks, the Reserve Bank expects climate change to increasingly affect its central mandate of price stability.

Reflecting on this in last month's monetary policy statement it says: "Tightening domestic carbon policy will continue to generate price pressures for fuel and high-emissions industries, such as transport.

"Home ownership costs, such as insurance and council rates, are already rising in response to the actual and expected physical risks presented by rising sea levels and more extreme weather events. Housing costs are also likely to increase if building standards increasingly encourage energy-efficient buildings, which are more expensive. Over time, higher home ownership costs may also be reflected in rent prices." But how much those impacts are mitigated by changes in spending patterns as consumers substitute away from high-emissions products is uncertain, it says.

On top of those risks there are the still unfathomable implications of technological innovations affecting payment systems and the future of money itself.

Parliament's finance and expenditure select committee is conducing an inquiry into crypto-currencies and stablecoins, and the Reserve Bank is seeking views on issuing its own digital currency.

Central bank digital currencies at the retail level have the potential to radically impact the banking system in ways that are not yet sufficiently analysed or understood, Bascand said. In short, risks abound.

"The nature of financial innovation, New Zealand's inherent vulnerability to shocks — economic or physical — and the incentive biases that mean private sector financial institutions never fully internalise risks, mean that central bankers must continually look forward, understanding and mitigating potential vulnerabilities and building resilience to the shocks that will at some time eventuate," he said.

"Most probably, the next shock will be something different again, one none of us have predicted, which is why we conduct our annual stress tests, and place the emphasis we do on strong balance sheets."