APRA provides cover for the RBA’s entry into the currency wars

By putting the squeeze on home lending, the regulator is providing cover for the central bank to slash rates and enter the ‘currency wars’.

APRA gives RBA some wriggle room

For the first time in many years, the Reserve Bank can lower Australian interest rates without the fear of dangerously boosting the residential property market.

Accordingly, it has much greater freedom to reduce rates to combat a rising dollar than has been the case in recent years.

The new environment comes about because banks are currently imposing a mini credit squeeze on home lending.

Dwelling prices are created by a multitude of factors, but by far the greatest is the availability of bank credit. A large number of buyers calculate what they can pay for a dwelling by determining what the bank will lend them.

If banks slash the availability of credit, it will always cause a fall in dwelling prices. Likewise, any significant rise in credit availability boosts prices. It was the abundant availability of bank credit that drove the recent house price boom.

The current squeeze is nothing like past credit squeezes and has been brought on by the Australian Prudential Regulation Authority who believed that Australian banks were over leveraging their dwelling portfolios, in the light of tighter world standards. So, the banks were required to raise a large amount of capital via shares and hybrid issues.

This makes it harder to maintain earnings per share and dividend rates. It was akin to the practice of giving children in my generation a dose of castor oil as a punishment.

But there was a twist. The banks were informally informed that if they did not restrain home lending growth to around the 6 to 7 per cent mark — it had been growing by around 10 per cent — they would receive another dose of nasty castor oil. In other words they would be required to issue more capital.

Most banks hastily retreated because they did not want to raise more capital.

The most obvious way of limiting growth is to tighten lending rules and APRA is also requiring this.

Obviously, different banks have different stress test rules, but a common one is to stress test a potential borrower against rising interest rates.

A 2 per cent stress test was widely used in the past. Many banks have now raised their stress test rate to 3 per cent or higher, which cuts back the amount they can lend.

The main buyers in the market have been investors and there is also a clamp down on that type of lending. There has been some sloppy form filling by some banks at the branch level, which saw some loans to investors classified as home dwellers. That has also been tightened up.

Last week, APRA put out a bulletin that confirmed that the squeeze was working and that growth was being curtailed and better stress tests imposed.

None of these moves help bank profits, so there has been a lot of muttering and grumbling behind the scenes but very few critical public statements.

But it should be emphasised that if the banks, at APRA’s insistence, cut back dwelling lending too far it will cause dwelling prices to collapse and create large bad debts.

The prosperity of banks is closely linked to dwelling prices. So far the credit squeeze has been carefully monitored, this is because everyone understands the likely repercussions if it goes too far.

If interest rates continue to fall, then the stress tests may need to be tightened further in order to restrict growth and avoid the need for raising more capital.

What many banks are doing to keep the wheels of growth turning is to look for sound small enterprises to lend to.

Meanwhile, this new home lending situation has come about at a critical time because the Australian dollar is now holding close to the US76c mark, when the Reserve Bank is looking for a currency exchange rate below US70c.

Given that Australian interest rates are higher than other countries of similar standing, money is now flowing Down Under which works to boost the currency and some are forecasting that the exchange rate could rise as high as US80c.

Thanks to APRA, the Reserve Bank can now attack the currency with lower rates without the risk of putting a rocket under house prices.