KEY POINTS:
The media has been discussing various means to reinforce the Reserve Bank's ability to control the housing market, other than purely through interest rates and the official cash rate - the interest rate set by the Reserve Bank.
One suggestion is to use the capital adequacy rules. One advantage of this is that the Reserve Bank has existing powers under banking legislation and it could be done quickly, without Government intervention.
One disadvantage is that the banks will squeal like stuck pigs.
At the time the first international agreement on capital adequacy came in, I specialised in banking regulation in the world's largest law firm in London.
For nearly a decade the greater part of my practice involved advising banks on issues of capital adequacy. I know exactly how sensitive the banks are to issues of capital.
If, however, experience counts for nothing, it is simple to show how powerful the effects of a change in the rules would be.
It works like this: if a bank wants to lend money, then that loan (the "risk asset") has to be covered by a certain percentage of capital (not cash or reserves as is being stated, just capital defined in specific ways.)
The international minimum (under the "Basle I" agreement) is for 8 per cent capital in relation to the amount of all the bank's risk assets (all its loans and exposures).
But most developed countries including New Zealand apply higher ratios - usually between 12-14 per cent.
In relation to house prices the loan is regarded as an asset with lower risk. So the bank is allowed to have half the usual amount of capital for that loan, compared with a commercial loan (technically this is expressed by saying that there is a 50 per cent risk weighting on mortgages).
Disastrously, a new international agreement (Basle II) allows the 50 per cent to be reduced to 35 per cent, a recipe for higher house prices internationally. And for even more restricted lending to businesses with 100 per cent risk weightings on their loans.
This system explains the huge growth in bank lending for housing over the past 20 or so years and helps to partly explain the consequent growth in house prices, as well as the difficulty businesses have in getting loans.
Mathematically it is simple to see that if the risk weighting changes from 50 per cent to 100 per cent then the banks will require twice the capital to maintain their loans. The pips will squeak - and that is why the banks hate the idea.
Urged on by the banks, commentators persistently misunderstand this regime, saying for example, that changes to the risk weighting will "run counter to Basle Capital Accords". This is untrue.
The international requirements are minimum standards. Countries are free (and encouraged) to have stricter standards.
We do not, for example, keep the 8 per cent minimum any more but insist on much higher ratios.
Some countries do not allow a 50 per cent risk weighting for mortgages. Other objections are more theological in nature, to the effect that "prudential rules should not be used for other purposes". Not being a theologian, I do not agree.
The real question is whether a change in the risk weighting will be effective to control our housing markets. In its study last year, the Rural Bank was dubious. I can think of five possible objections.
First, banks are sensitive to capital. If the weightings change then either they must raise more capital (costly) or reduce their lending.
An abrupt change could potentially halt further lending of almost any kind.
Any changes should not, therefore, be made immediately from 50 per cent to 100 per cent but only in carefully monitored stages. And probably they should apply only to mortgages made from now and not to existing ones.
Second, banks may respond not by increasing capital but by squeezing their capital ratios down by a percentage or so, thus weakening themselves.
The Reserve Bank has power to control this but would need to be alert and ready to exercise its powers.
The Reserve Bank would be assisted by the financial markets and rating agencies which would regard badly any such reduction of capital ratios.
Third, banks might respond by sourcing loans offshore.
They could use local banks as agents to book deals which go on to the balance sheets of their (mainly Australian) parents. But the parents also need capital and if they lend to New Zealand as well, will be restricted in their lending ability at home.
Avoidance by foreign sourced loans is a possibility and might be dealt with by a variation of Dr Cullen's proposed mortgage levy - but only on foreign-sourced loans.
While the National Party objects to a general levy, it may be that many New Zealanders would think the worse of politicians who object to a levy on foreign institutions which were attempting, in effect, to avoid the application of New Zealand regulations to the great disadvantage of our businesses and exporters.
The fourth objection relates to timing. The reason that the official cash rate is ineffective, most agree, is that most mortgage loans are at fixed rates.
I have already argued that in order to avoid a severe shock it might be better to apply new risk weightings only to new loans.
But in any case, for contractual reasons the new risk weightings could affect the pricing and availability of new loans, not existing fixed ones.
So a change in risk weightings may not have an immediate effect - not one, anyway, that is faster than the operation of the official cash rate.
The final objection is political, since most of the banks are Australian.
We have already come under pressure from Australia to bring our banking rules into line with theirs.
The banks will howl loudly and those howls will be also directed to Australian politicians. Would either the Reserve Bank or the Government want that?
My view is that, quite apart from inflation issues, over a period of time the Reserve Bank should aim to institute a permanent 100 per cent risk weighting for mortgages, to create a level playing field between house purchases and commercial loans.
And it should put an end to the system where, ostensibly for reasons of prudential regulation, banks are effectively encouraged to discriminate in terms both of pricing and availability of loans against businesses in favour of the property investor.
I wonder where the allegedly business friendly National Party stands on that?
* Tony Shea is a former Professor of Law at City University, London and head of the international financial institutions section of Clifford Chance, London.
