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Regulatory response to housing bubble all in the past

It’s possible David Murray’s Financial System Inquiry may make some recommendations on bank capital. It’s also possible the Reserve Bank of Australia may introduce some so-called “macro-prudential” measures to address particular concerns around asset bubbles.

What we know is speculation around these themes will continue to be rife until a final pronouncement is made. But it’s also important to realise the Australian financial system regulators have actually been quite specific throughout this period of heightened anxiety.

"But it is wrong to assume if regulators act, the measures will be publicly announced."

This isn’t a case of Alan Greenspan’s infamous “I know you think you understand what you thought I said but I'm not sure you realise that what you heard is not what I meant”.

Whether it is RBA officials or the new chairman of the Australian Prudential Regulation Authority Wayne Byres, the message is straight forward: the regulators have a range of devices in their “tool kit”; they are not convinced of the efficacy of any particular tool; they won’t rule out any particular tool; and they remind people to think about how they have used their tools in the past.

Most recently speaking at the annual conference of Finsia, the association of financial professional, Byres said "I don't want to rule anything in or out at this point”, adding he “wouldn’t disagree” with comments made by RBA assistant governor Malcolm Edey.

Edey’s line was “there is an essential continuity about what is being looked at now and the framework already in place, which has served us well for quite some time”.

Byres was quite explicit about how the supervisor was thinking: “[macroprudential policy involves] conventional supervision, conventional regulation and, in simple terms, getting people to be prepared for adversity in the future . . . People love the term macroprudential, because it sounds like it is really novel, but there is not a lot new”.

Both at this event and in recent months, the Australian regulators have suggested they are alert but not alarmed. The speculation around macro-prudential measures typically refers to actions in New Zealand or Canada or Europe where they have included public changes to allowable loan-to-valuation ratios, for example.

This is not to say Australian regulators will not act and Byres has spoken out about leverage ratios and his concerns different banks in different jurisdictions have quite radically different approaches to measuring the risk in their loan portfolios.

But it is wrong to assume if regulators act, the measures will be publicly announced. In the past, they haven’t and have included idiosyncratic adjustment to prudential buffers or indeed stern letters to boards.

Interestingly though, the regulators have emphasised their past actions, particularly during the housing bubble of 2003-04.

Having been a banking commentator at this time for the Australian Financial Review, I well remember that period. I looked at it again for a series on how Australia avoided the financial crisis.

A decade ago, the RBA took the lead on “jaw-boning” the market. For some period of time, bank officials gave speeches pointing out the obvious: the returns on property investment in yield terms were historically low and hence investors were gambling on capital growth in house prices.

That went on for several months until, at a relatively nondescript economics conference in Melbourne that I attended, then head of economic analysis, now deputy governor, Philip Lowe said “whether you want to call it a speculative bubble, I don't mind. Whether it is unrealistic expectations of future price increases, I don't mind if you call it that”.

While Federal Treasury had been calling the housing situation a bubble, the impact of even a relatively junior – at the time – central banker saying it was altogether different. The timing of the pronouncement was also interesting: after the bank had raised official rates.

Like today, international agencies including the International Monetary Fund had been drawing attention to Australian housing.

Housing came off the boil. At the time it was attributed to interest rates rises, jawboning and the natural reaction of the market in supplying more housing stock in response to the high valuations.

What came to light in the years after however was that these were only the most visible responses. Behind the scenes, the regulators had been doing much more. Indeed, in today’s lingo they undertook some macro-prudential responses.

APRA used its considerable flexibility in setting prudential buffers but also in what it chose to emphasise in direct dealings with banks.

Critically, in September 2004, APRA instituted higher capital penalties for non-prime home loans and tightened the criteria APRA-supervised lenders had to adopt in order to continue to receive concessional risk-weighting on those mortgages, in effect restraining the development of a sub-prime mortgage market in Australia.

At the time, then APRA chairman John Laker said APRA's existing standards "did not address recent product innovations in mortgage lending such as 'low doc' loans and loans originated via mortgage brokers and other third-party channels. The revised standard aims to ensure that the lending/credit policies . . . address the likelihood of increased risk in certain types of non-conventional mortgage lending".

Today the heat is in certain categories of investor lending but one can imagine the regulators are again addressing “the likelihood of increased risk in certain types” of mortgages.

(I’m basing this conjecture on history, I have no specific insight into what the regulators are saying or doing.)

That move though was itself the result of a major process of stress testing of the institutions under APRA's charge through 2002-03. The stress tests covered not just banks, building societies and credit unions but also the mortgage insurance industry. APRA was sensitive to a structural reliance in Australia on mortgage insurers who insured the lenders - not the borrowers - against any shortfall in the case of a delinquent loan.

APRA raised the capital requirements for mortgage insurers who in turn passed that extra cost onto their customers (lenders) who passed it on to theirs (borrowers), having a dampening impact on the market.

APRA also used its stress testing as a policy tool. In one stress test series the banking sector forecast a loss of about 10 basis points on their portfolios in a downturn – APRA forecast 100.

History notoriously echoes rather than repeats but for all the spreadsheet models being generated on what will happen to specific data points in unfolding scenarios, the message from regulators then – as now – is beware of false precision.

When I was writing this series for the AFR, Laker told me with the awareness of the emerging risk in the housing market at that time the "industry, the central bank and the regulator" had “worked well” together to smooth out what could have been a tough ride.

Policy tools were many and varied and usually not public.

At the heart of this latest regulatory debate and speculation is the issue of sharing costs and returns, between institutions, customers and taxpayers. Who pays if there is a bubble and it pops?

The Bank for International Settlements has just released a working paper looking at the trade-off between bank returns and risk. Fetchingly titled “The redistributive effects of financial deregulation: wall street versus main street”, by Anton Korinek and Jonathan Kreamer, the paper notes “the financial sector benefits from financial risk-taking by earning greater expected returns. However, risk-taking also increases the incidence of large losses that lead to credit crunches and impose negative externalities on the real economy”.

It’s a seriously technical paper but it shows a regulator has to “trade off efficiency in the financial sector, which is aided by deregulation, against efficiency in the real economy, which is aided by tighter regulation and a more stable supply of credit”.

The paper concludes with what may seem obvious, that risk taking can have costs for society but if financial intermediation is constrained, it limits output in the economy with implications for wages.

The key is to not restrain risk taking but to concentrate in sectors which want the risk, such as venture capital.

“Thus it is important for regulators to distinguish between financial risk-taking and intermediating risk capital to the real economy”.

That’s the challenge Australian regulators – and the FSI – are grappling with today.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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