Booms, busts and the way between - YouTube

One of the lessons we learned following the global financial crisis is the capacity for boom bust cycles in economies to turn into really bad busts

and for those cycles to create real damage for both the financial systems and the economy.

Macro prudential policy is another part of our prudential policy framework.

Firstly it's about building the resilience of the financial system so that if risk is building up,

if there is extra risk being taken on by households and businesses,

that the financial system and financial institutions have the ability to withstand the cycle when it turns from boom to bust.

That's the first objective.

The second objective is really about trying to dampen some of the buildup in that risk to begin with.

It may be around trying to dampen rapid growth in credit, rapid growth in house prices,

or rapid growth in other asset prices that might be behind the buildup in risk that we're seeing in the financial system.

One of the biggest examples of a boom bust cycle that we've had here in New Zealand would be the commercial property and share market crash that we saw in the late 1980s.

Of course in the lead up to the crash, share markets were rising rapidly,

high levels of construction of commercial properties and very rapid increases in commercial property prices.

The share market crash came along, commercial property prices plunged and we saw the sector rapidly coming under water

and a lot of pressure put back on the financial system as a result of that.

Really macro prudential policy is about managing that risk, trying to ensure that the system is more stable through the cycle if you like.

There are 4 tools in the Reserve Bank's macro prudential policy tool kit.

The first is known as the counter-cyclical capital buffer.

This is really where we would require the banks to hold an extra margin of capital during the boom part of the cycle

so that when the boom turns to bust, if in fact it does,

the banks have an extra margin of capital that they can then call on to meet loan losses.

The second one is known as the sectorial capital overlay and this is very similar to a counter-cyclical capital buffer

but it's really about holding extra capital against a particular sector that the banks might be leaning to,

for example the household sector, the farming sector, or potentially the commercial property sector.

Again, very much about providing resilience but in a more targeted fashion.

The third tool is known as the loan to value ratio for residential housing lending,

and this is really a limit on the amount of high loan to value ratio lending

or low deposit lending that the banks are able to do for the household sector.

Also of course that high LVR lending potentially fuels rapid house price growth

and so that might be another reason why you would use that particular instrument.

The fourth tool is the core funding ratio and this is a tool that we already have in place in New Zealand.

It's a permanent fixture for the banks.

There are a number of reasons why we might change the core funding ratio.

Potentially if the banks are facing an increase in risk, the Reserve Bank could require them to hold more core funding,

funding that would be more likely to remain in the system during a downturn, so that's retail deposits for example.

By holding more of that stable funding, they'd be less likely to stop lending in a downturn

because the funding would remain in the system.

These are very much temporary tools. They're not intended to be used through time in a permanent fashion.

They're used when we see evidence of a problem

and so there may be long periods where the tools are not needed to be used at all.

Boom bust cycles or cycles in the economy and in the financial system are of course a fact of life.

Macro-prudential policy certainly won't prevent those cycles from occurring.

What it will do is provide some cushioning to the cycle.

It will hopefully clip the highs and the lows to some extent

so that the flow of credit and the flow of financial services in the economy continue through time.

It's not about preventing the cycle or dampening it completely.

It's about taking some of the extremes out of the cycle.