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  • Writer's pictureMeurig Chapman

The capital conundrum: Why banks lean towards residential mortgages

Why do banks find house lending far more appealing? In this blog, we aim to unravel the intricacies of this capital-driven strategy and shed light on why banks, particularly in New Zealand, lean towards home loans over business loans. 


Coincidentally, announced a few days ago, Commerce and Consumer Affairs Minister Andrew Bayly was quoted saying, “The coalition government's select committee banking inquiry could look at how to encourage banks to lend more to ‘productive’ sectors of the economy rather than having such a big focus on ‘unproductive’ housing lending”.  


As we navigate the intricate web of capital requirements and risk assessments, it becomes evident why New Zealand banks prioritise residential mortgages over corporate lending. The balance between regulatory compliance, capital efficiency, and profitability shapes the strategic choices of these financial institutions, ultimately influencing the trajectory of lending in the Kiwi banking sector. 


Understanding capital requirements

One of the reasons is how much capital is required to be held for residential property lending compared to other asset classes.


The RBNZ Act 1989 grants the Reserve Bank the authority to impose conditions on registered banks, including maintaining capital ratios above specified minimum levels. To meet these conditions, banks must comprehend their Risk Weighted Assets (RWA) and allocate a minimum amount of capital across various investments.


Standardised vs IRB Approach

Banks in New Zealand are classified as either Standardised or Internal Ratings-Based (IRB) banks. The latter, including ASB, ANZ, BNZ, and Westpac, are accredited to use the IRB approach, while other local banks follow the Standardised approach.


For the sake of simplicity, we will focus on the Standardised approach in this blog, leaving the explanation of the IRB approach for future articles.


Risk Weighted Assets Calculation

The calculation of Risk Weighted Assets is a crucial element in determining the capital banks must hold. For our exploration, we will compare how Risk Weighted Assets are calculated for Residential 

Mortgages and Corporate lending under the Standardised approach.


Residential mortgages vs Corporate lending

New Zealand banks predominantly lend to individuals and small businesses. In the Standardised approach, Risk Weighted Assets for residential mortgages are split into Non-Property Investment and Property Investment, further categorised by Loan To Value Ratio (LVR).


Consider a residential property loan of $1 million with an LVR of 75%. The Risk Weighted Assets for this loan would be 35%, requiring the bank to hold capital of $350,000. The Common Equity Tier 1 capital required for this transaction is 4.5%, amounting to $15,750.


On the other hand, a business loan of $1 million, not secured by a residential mortgage, incurs a 100% Risk Weighted Asset. The bank would need to hold a Common Equity Tier 1 capital of $45,000 for this loan, marking a significant difference of $29,250 compared to the residential mortgage.


The bottom line

In the vast landscape of banking, dealing with billions of dollars on the balance sheet, the preference for residential mortgages becomes clearer. Banks in New Zealand, driven by capital efficiency and regulatory compliance, are inclined to focus on home loans, particularly when performance targets hinge on Return on Equity or Profit after Capital charge.


Stay tuned for future blogs where we explore the nuances of the IRB approach and its impact on banking dynamics.

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