why the New Zealand banks hate the LVR restrictions

The latest data that the restrictions the Reserve Bank put on high Loan to Value loans is having the desired effect will be making both banks and property speculators rather nervous. In a single month high LVR loans have gone from 25% of bank lending to 11% and although other loans have partially offset this drop in volume, if the drop continues it will flow through into lower profits for bank shareholders and a drop in both volume of house sales and potentially prices.

There are many misconceptions about interest rates and bank profits. The foremost of these is that banks make more money under high interest rates. This is far from the truth. A trading bank makes profit from interest rate margin, the difference between its deposit rate and loan rate. This stays fairly constant whatever the base OCR is. The other factors affecting profit are demand for loans, the volume, and the fees a bank charges, along with control of its day to day operating expenses like any other business (staff, rent etc). It is a misconception that banks make more money when the OCR is high and mortgage and other credit rates are high. The margin stays the same as when the OCR is low and mortgage rates are low. Indeed because demand (volume) is reduced at higher rates, competition between the banks for a dwindling number of borrowers can reduce this margin. So at high rates margin compression and reduced volume lowers profits. Lower volume also lowers income from fees.

Conversely, in a low interest rate environment, a higher margin (no need to compete as fiercely) and higher demand/volume, along with increased fee volume, means far greater profits for the banks.

So it is not the OCR rate and its flow on effect to borrowers that affects bank profits directly, it is the indirect effect on volume that hurts. So why does the LVR restriction alarm banks so much? Because it is a direct lever on volume. The OCR is a crude, and especially when fixed rate mortgages are popular, slow acting method of reducing demand. The Reserve Bank has to wait months or even years for fixed rate mortgages to roll over before the OCR increases affect everyone. With the LVR restrictions demand for certain types of loans is reduced immediately, as the data shows.

A worst case scenario for bank profits is further “prudential measures” that have a similar immediate effect that the banks can’t fudge, like increased capital requirements or restrictions on other types of borrowing like investment properties. If these were accompanied by OCR increases the effect would be chilling on the property market.

The stated intention of the rule changes is banking system stability, saving the banks and low deposit borrowers from themselves. This is a fine balancing act as New Zealand and Australian banks have extended so much mortgage credit to their respective property markets that any significant falls in property values could bring about the very instability governor Wheeler is trying to prevent by attempting to stop the property market running full speed into a brick wall. Property in New Zealand, and by extension the banks that are exposed to it, are too big to fail, but also too big to be left alone. Successive governors and governments, by allowing such a massive mortgage debt burden to accumulate, have created the most appalling Catch 22 situation. Whichever way it plays out, someone is going to get hurt.

If nothing is done and property values continue to spiral, existing home owners will feel wealthier but if the property market crashes as per Ireland or the US they may be exposed to the fallout as general taxpayers with bank bailouts, or their personal savings under the Open Bank Resolution. In addition first home buyers will either give up or be forced to borrow absurd sums of money. Alternatively if the Reserve Bank is too successful with its demand reduction measures the crash they are trying to avoid from higher prices “flaming out” will instead happen because of lower prices. Same result but existing home owners will be burned instead.

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