Have the LVR restrictions improved the resilience of the banking system?

As part of sound regulatory practice, the Reserve Bank wants to further its understanding, and the public’s understanding, of how the policy has influenced financial stability. This paper contributes to this objective by developing a modelling framework that quantifies the extent that the loan-to-value ratio (LVR) policy has improved the resilience of the banking system to a severe downturn in house prices. We find that the LVR restrictions have significantly improved the resilience of the banking system. The LVR policy has reduced the scale of mortgage defaults and credit losses that would occur in a housing downturn, due to a reduction in risky loans on bank balance sheets and the mitigation of a potential house price decline. This resilience benefit has been partly offset by a fall in capital requirements that results from lower credit risk, reducing the banks’ buffer for absorbing credit losses. Nevertheless, the LVR policy is estimated to have reduced mortgage losses – as a share of the capital banks hold against their housing loans – by 12 percentage points. The policy is found to have mitigated about half of the deterioration in bank resilience from 2013 that would have occurred in the absence of the policy. Our estimates are sensitive to judgements on key variables and inputs. The resilience benefit of the LVR policy is contingent on the level of housing market risk that would exist without the policy. This suggests a stronger case to deploy the LVR tool when the risk of a house price decline is high. We were unable to model the resilience benefit of restricting property investor lending with confidence, although a provisional estimate suggests that the benefit may be large. Therefore, the headline estimate may understate the resilience benefit of the LVR intervention. A comprehensive assessment of the policy’s efficacy needs to consider the cost of the policy, which is outside the scope of this paper.