In Monday’s Crikey, Senator Andrew Bartlett identified a number of factors that bear on housing availability and hence affordability. He made the eminently sensible point that all factors bearing on housing availability and affordability need to be taken into account when considering what action might be taken.
One of the rarely mentioned factors when this subject is being discussed is the role that banks play.
The loans secured by residential mortgages are more attractive to banks than other types of lending because of the regulator’s prudential rules on the capital adequacy of banks.
These rules (applied by central banks under the Basle Agreement) limit a bank’s adjusted total assets to 12.5 times their defined capital base (broadly equivalent to net shareholders’ funds). One of the adjustments made to total assets under these rules is to deduct all or part of low risk assets from total assets before applying the formula.
Federal Government securities therefore have a nil rating and do not require any capital allocation. Housing loans, because of their traditionally low default ratio, and other loans secured by mortgages over residential properties, except for some low-doc loans, are reduced by the formula to 50% of their value.
The effect of this last rule is that $100 million of a bank’s capital base is needed to cover a portfolio of $1,250 million of commercial loans (unless those loans are secured by residential mortgages), but the same amount of capital will cover double that amount, $2,500 million, of a portfolio of housing loans.
Clearly, under these rules, the net profit generated by the housing loan portfolio will be significantly higher and will provide a significantly more attractive return on shareholders’ funds, than a portfolio of other types of lending assets based on the same amount of capital.
Consequently, to attract housing loan borrowers, banks are now lending higher proportions of house values to borrowers who have been permitted (encouraged?) to accept loans that will take a higher percentage of incomes to service. Moreover, given the ready availability of finance, it has become feasible for developers to build larger houses than was previously the case and to seek higher prices for land releases.
Clearly the regulator’s rules on banks’ capital adequacy affect both the supply and demand sides of housing availability (and therefore affordability) but these influences, taken together under recent and current circumstances, do not cancel each other out; rather they act to accentuate the problems.
The impact of these rules seems to have been largely neglected by policymakers but, I believe, they are one of the more important aspects that should be taken into account in deciding future action.