In its latest Financial Stability Report, the bank says the impact of low global interest rates has resulted in increased risk taking and higher asset prices.

This is an international phenomenon, with the New Zealand impact most visible in higher house prices.

Banks and other lenders issued $10.5 billion in new mortgages in March alone, new figures show. Household debt has hit a record $250 billion, mostly in mortgages.

The Reserve Bank says a high proportion of new lending has had high debt-to-income and loan-to-value ratios (LVR).

This makes recent borrowers more vulnerable to a rise in mortgage rates, and exposes households and the financial system to a drop in house prices.

For highly indebted buyers, higher interest rates will push up debt-servicing costs significantly and reduce income remaining for consumption.

Highly indebted borrowers are also more likely to sell their properties in fire sales and fuel the perception of a housing market downturn.

Deputy governor Geoff Bascand says the recent tightening in LVR requirements, particularly for investor lending, will help to mitigate some of these housing risks and support more sustainable house prices.

“We will be watching how market conditions respond to the Government’s recent policy changes.

“If required, we are prepared to further tighten lending conditions for housing using LVR requirements or additional tools that we are assessing,” says Bascand.

In assessing the policy options, the bank has considered absolute impacts against the status quo as well as relative impacts between the different tools. The list of policies is not exhaustive and other options could be considered in future.

“If further tightening in policy settings is needed in the short term, the most straightforward approach would be to tighten LVR restrictions further.

“However, the marginal benefits – with respect to financial stability and house price sustainability – are likely to decline as LVR restrictions tighten further while efficiency costs would rise,” says Bascand.

In terms of new tools the bank’s assessment is a debt serviceability tool would be the best option for supporting financial stability and sustainable house prices over the medium term.

Restrictions on interest-only lending would likely have less impact on overall lending conditions than alternatives, while being challenging to implement and enforce.

The bank’s analysis of these options is still being completed and it has come to a preliminary assessment against criteria. 

Further LVR tightening

Financial soundness – Past Reserve Bank analysis indicates LVR restrictions have significantly improved the resilience of the financial system.

However, the marginal benefits to financial stability are likely to reduce if LVR restrictions are tightened further from current levels, while efficiency costs will increase.

Allocative efficiency – Costs arise from restricting credit access to otherwise creditworthy borrowers. These are partly mitigated by the existing exemption regime and speed limits.

Administrative costs – Implementation and enforcement costs are low as LVR restrictions are an established tool with reporting and compliance regimes in place.

The lead time for adjusting settings is two to three months.

House price sustainability – Past Reserve Bank analysis has found LVR restrictions can be effective in moderating house price inflation and reducing credit growth.

However, with rising house prices LVR restrictions become less constraining over time.

Investor demand – The LVR framework allows settings to be adjusted in line with underlying risk characteristics.

The current LVR settings are tighter for investors, and this differential could be maintained or increased if restrictions are tightened further.

Speed limits and exemptions also help to reduce impacts on first-home buyers.

Debt-to-income ratios (DTI)

Financial soundness – Reserve Bank analysis and international evidence suggest debt serviceability restrictions are an effective tool for stabilising housing cycles as they link credit growth to income.

DTI restrictions strengthen borrowers’ financial position and focus on a different dimension of risk – ability to service loans – than LVR restrictions (loan losses in case of default).

Allocative efficiency – Costs arise from restricting credit access to otherwise creditworthy borrowers.

These can be partly mitigated through design and calibration, including the use of speed limits and exemptions.

Administrative costs – A data collection process for DTIs is already in place, but further work will be needed to finalise the design of the tool and update bank systems.

The estimated lead time is six months.

House price sustainability – Evidence suggests debt serviceability restrictions are an effective tool for moderating house price cycles.

Their effectiveness is likely to be sustained over time to a greater extent than LVR restrictions.

Investor demand – DTI caps will tend to impact more on investors and higher-income owner occupiers, who borrow at higher DTI ratios on average.

The impacts on access to credit for first-home buyers could be further mitigated with speed limits.

Restrictions on interest-only lending

Financial soundness – Evidence suggests banks normally carry out credit assessments on a principal and interest basis, even for interest-only loans.

Interest-only restrictions are unlikely to have a significant impact on credit availability, but could have financial stability benefits by deterring credit demand from some higher-risk borrowers.

Allocative efficiency – This may have higher allocative efficiency costs than other tools.

Interest-only lending is used for a range of purposes, many of which may be positive for economic welfare, for example, to manage temporary income loss, free up cashflow for maintenance, or for business investment secured by residential property.

Administrative costs – Complex rules may be necessary to limit opportunities for avoidance, for example, by using revolving credit and mortgage top-ups.

Initial analysis suggests targeting interest-only lending with LVR requirements or adjustments to risk-weights may be easier to implement and enforce than a ban, but more work is needed.

The estimated lead time is at least six months.

House price sustainability – This is likely to be less effective in moderating housing cycles than LVR and DTI restrictions, given banks already undertake lending assessments on a principal and interest basis.

The share of interest-only lending – as a proportion of total lending – has not increased in the recent housing upswing.

Investor demand – Investors make more use of interest-only lending, particularly at loan origination, and hence some may be deterred from new borrowing by interest-only restrictions.

Investor demand for interest-only lending may also decline in response to the Government’s recent announcement on tax deductibility.

Bascand says the appropriate policy response depends on economic and financial conditions and may change with circumstances.

Implementing new tools such as restrictions on debt serviceability or interest-only lending is complex and would take time to work through.