Bernard Hickey: Reserve Bank a world leader in setting policy

New Zealand is a world leader again in central banking and the Reserve Bank should be congratulated for blazing a pathway on the issue of core funding ratios. This is fast becoming an arcane area of regulation that is driving mortgage and deposit rates higher despite a low official cash rate. It will also safeguard our banks from a funding drought if there is another freeze on global financial markets.

News out before Christmas from the Basel Committee on Banking Supervision of the Bank for International Settlements (the central bankers' bank) confirmed it has adopted many of the principles set out by New Zealand in its core funding ratio policy last year.

The ratio is essentially a set of rules that forces banks to raise more funds domestically, at longer terms and from regular mum-and-dad investors. It is great news for long-suffering depositors who have been at the bottom of the food chain.

Before the crisis, our banks dived straight into the hot international money markets to raise funds whenever they wanted to lend heavily in the property markets. In those glory years, banks were able to pass on relatively low interest rates to homebuyers, helping to blunt the effect of the Reserve Bank's monetary policy. Over the boom years from 2002 to 2007, when our banks were effectively borrowing money overseas at rates that were influenced as much by Alan Greenspan as by Alan Bollard, they increased their percentage of non-resident funding from around 30 per cent to around 40 per cent. This meant banks concentrated all their marketing and loss-leading campaigns on mortgage lending rather than raising deposits, because they knew they could easily get money offshore. By the end of 2007, the Reserve Bank calculated that just over 40 per cent, or $50 billion, of our banks' funding requirements came due every 90 days in these money markets.

There was a risk, if financial markets froze, that our banks would not be able to roll over their debt. This is what happened to British bank Northern Rock in September, 2008. Northern Rock grew to become the fifth-largest mortgage provider in Britain by using overseas money and by the end 70 per cent of its funding came from these wholesale markets. When those markets froze, there was a run on Northern Rock as regular depositors feared a collapse.

That is the nightmare scenario for our Reserve Bank, which brought in some rules to limit the exposure to these money markets. It has specified that at least 65 per cent of banks' funding must be from core sources that mature in one year or more. That ratio will rise to 75 per cent by the end of 2012. The banks' current core funding ratio is now around 65 per cent, but will have to grind higher over the next three years. This means they are having to compete much harder for term deposits and limit their lending growth by keeping mortgage rates higher. Two-year mortgage rates have risen almost 1 per cent since April, while term deposit rates have risen almost as much, despite the OCR being at 2.5 per cent. The Reserve Bank describes this side effect of the core funding ratio as an automatic stabiliser for the economy, helping to raise interest rates when the economy is heating up without the central bank having to hike the official rate. This, in turn, will help exporters by keeping the exchange rate more stable at a lower level.

It's been two decades since the Reserve Bank led the world with its independence and inflation targeting. It's great to see its core funding ratio doing the same again.

bernard.hickey@interest.co.nz