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Mortgage loans enter new stage of consultation

Reserve Bank of New Zealand (RBNZ) announced a staged review (on March 26, 2013) of bank capital adequacy requirements for residential mortgage loans.

Stage One of the review addressed the calibration of the correlation coefficient for Internal Model Banks (IMBs).

That stage was completed on May 8, 2013 when RBNZ published its new requirements for the calibration of the correlation coefficient for certain loans.

This consultation is the second stage of the review, and focuses on remedying definitional inconsistencies and ambiguities currently contained in the Bank’s capital requirements. It also proposes formalising RBNZ approval process and the on-going requirements for IMB.

Part one of this Paper deals with the definitional issues.

Greater consistency of definitions across banks is not only desirable from a level- playing field and capital point of view but also important in the context of the Reserve Bank’s Macro-Prudential Policy framework, which includes a loan-to-value ratio (LVR) policy to restrict banks’ high-LVR lending when certain conditions are met.

The effectiveness of this policy in particular depends on consistent and clear definitions.

Formalising Process

Part Two proposes formalising the IMB process, which includes the submission and approval process, and the on-going compliance obligations, as a part of BS2B.

These requirements are currently stipulated in a letter sent to all IMB, but have not been formally included in their capital requirements as set out in BS2B. This consultation paper proposes to include these requirements in BS2B, and to establish a compendium of approved models, such that an IMB may only calculate and meet its capital requirements by way of the version of the approved model in the compendium. This merely reflects the current de facto arrangements under which IMBs operate.

This consultation paper required stakeholders’ feedback on the consultation questions, including estimates of costs and benefits, by October 25, 2013. RBNZ will now analyse the feedback, publish a summary of submissions and updated versions of BS2A and BS2B, and then impose new conditions of registration.

Ratio Calculation

It is currently envisaged that the new requirements will take effect in first quarter of 2014, subject to feedback on the time required for IT system changes.

The LVR ratio is calculated as the ratio of the loan amount over the value of the property, times 100.

LVR = (loan amount/value of property)*100

Loan definition

BS2A and BS2B do not currently contain the same definition of the loan amount (the numerator in the LVR equation). BS2A states, “Loan value is the total amount, as at balance date, of (i) all claims secured by way of first ranking mortgage over the residential property; and (ii) all undrawn commitments to the borrower that when drawn down will be secured by way of first ranking mortgage over the residential property.” (Section 37)

BS2B states, “LVR is defined as the current loan balance; the current loan balance includes the EAD amount of any off-balance sheet exposures (Section 4.150A)”.

RBNZ believes that, as far as possible, both standardised and IMBs should be subject to the same definition of the loan amount when calculating LVRs.

The current situation where one group of banks includes all claims secured by the residential property, whereas the other group does not, leads to the calculation of LVRs that is inconsistent and therefore lacks comparability across both groups of banks (ceterus paribus).

Varying concepts

The first definition (BS2A) clearly includes all claims secured by way of first ranking mortgage, while the second definition (BS2B) does not state so explicitly.

Although the intention has always been for both groups of banks to calculate their LVRs on an equal basis as far as that is possible, BS2B may be interpreted as not including other claims secured by the residential property. It is the Reserve Bank’s understanding that this is how IMBs have interpreted the definition.

Standardised banks, on the other hand, currently add all claims to the loan amount.

Banks’ Call

Most mortgages are ‘obligations,’ meaning that if a customer defaults on any other loan that he or she has with the bank (for example a personal loan or a credit card debt), the bank can exercise the security it holds over the residential property.

This means a bank could force the sale of the house to recapture the outstanding credit card or personal loan balance.

In practice, a bank’s incentive to take this measure will depend on the size of the defaulted loan. A more common scenario might be that the outstanding balance is simply added to the mortgage loan.

This link from other loans, such as credit cards or personal loans, to the residential property suggests that all other claims should be included and that the definition currently in BS2A should also apply to IMBs.

The above is an extract. For full text, please visit www.rbnz.govt.nz

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