Debate about rising house prices in Auckland and elsewhere has included discussion on the risk weights the Reserve Bank requires banks to apply to their housing lending.
Some of this discussion has focused on the impact risk weights may have on the volume of credit, and house prices.
Risk weights play an important part in the Reserve Bank's supervision of the banking sector.
They help to determine the amount of capital the banks need to set aside to cover losses on their lending to different sectors. In essence, the riskier the sector, the more capital must be held against lending to it.
The risk weights factor in things like the borrower's capacity to repay the money, the type of assets put up as security for the loan, and the amount of security relative to the size of the loan.
History provides some insight into the importance of these various factors.
As a result of these risk factors, risk weights vary for different types of lending, with housing having a lower risk weighting than business or rural lending, which typically involve more risk.
The risk weights are not set in order to incentivise any particular lending type over another.
Instead, they reflect the different risks inherent in different types of lending, leading to capital holdings against loans that are appropriate for the risks involved.
This tends to result in higher lending margins on riskier loans, but does not imply that banks will always lend to housing ahead of other sectors.
In principle, banks will set loan margins so risk-adjusted returns will be similar across sectors.
The Reserve Bank sets its risk weights in accordance with the international standards set by the Basel Committee on Banking Supervision, adjusted to fit the New Zealand context.
Risk weights on housing lending in New Zealand are relatively high by international standards, the average in New Zealand being almost three times that of the Canadian average or around 1.5 times that of Australian or UK banks, according to a recent International Monetary Fund study.
So the New Zealand regime does not favour housing lending compared with international norms.
The Basel Committee standards followed by the Reserve Bank provide for risk weights to be adjusted in accord with local risk factors, such as the position of the housing cycle.
However, this facility is not designed to accommodate economic or social objectives.
Rather it is intended for overall financial stability purposes - such as preventing an unusually large build-up of lending risk in a particular sector.
A build-up of lending risk can, in some circumstances, leave banks overexposed to a sector where an asset bubble develops and eventually bursts, threatening the stability of the financial system overall.
Adjusting risk weights to account for these risks can help build greater resilience in the face of such bubbles and, used early, could help prevent bubbles developing in the first place.
Recently, regulators around the world have been developing macro-prudential tools, which include the potential adjustment of sectoral risk weights.
It is one of a suite of macro-prudential tools the Reserve Bank has been assessing for potential use in the future, including in situations where house prices may be accelerating to unsustainable levels.
But adjusting sectoral risk weights in this manner is not for everyday use and should be used under very specific conditions.
It may be the case that an alternative macro-prudential tool, such as loan to value ratio (LVR) restrictions, could be more appropriate in any given set of circumstances.
The framework the Reserve Bank is developing will establish the parameters for using macro-prudential tools.
This will include when and in what conditions they might be appropriate, as well as clarifying governance and accountability issues.
A public consultation on macro-prudential policy is expected to be released in late March.
Grant Spencer is deputy governor of the Reserve Bank