The Reserve Bank says our banks are under-capitalised, and will announce new capital requirements for them next month with the aim of avoiding a Government bail-out in the event of a global financial shock.

“The world is a dangerous place!” These were the opening words of a statement by US President Donald Trump a week ago. And it seems our Reserve Bank governor may agree.

Adrian Orr released the RBNZ’s report into the stability of New Zealand’s financial system on Wednesday, and warned banks and insurers they need to be holding more capital in part so they can withstand shocks coming from outside our own, reasonably sound, financial system.

The uncertainty and disruptions arising from the Trump administration’s protectionist policies and trade wars are raising concern over global financial stability.

“While domestic financial risks have eased [in the past six months], global financial vulnerability has risen. We have significant build-up in debts and asset prices and the ongoing geo-political tensions and trade challenges overhang financial markets,” Orr said.

“This vulnerability is highlighted by the current elevated volatility in equity and debt market pricing at present and that will be on a watching brief.”

Orr said there is a risk that New Zealand’s monetary conditions could “suddenly, dramatically change” based on something that did not originate from New Zealand.

“We could have a financial shock unrelated to something happening here.

“That is what is happening in some parts of the world at the moment – for example emerging market countries are finding much higher borrowing costs and tighter financial conditions at a time when they actually want looser conditions, because money is actually flowing back into the US for some obvious reasons – the higher interest rates – and less obvious reasons, so a sense of a flight to quality in case something bad happens.”

Orr said he was personally less concerned about the “trade wars” that have been commanding media attention.

“They are quite slow moving, we can see them happening and businesses can prepare.  At the moment we are one of the least directly trading nations to the US-Chinese discussions. It’s the financial shocks that can lead to the unanticipated – particularly if you have highly-leveraged households and agricultural sector.”

The Reserve Bank has been using this “period of relative calm” to assess whether the banking system has sufficient capital to weather future extreme shocks – and has concluded that our banks and insurers are under-capitalised.

Orr said our banks need to be holding more capital so they are “sufficiently resilient to extreme shocks” and able to avoid having to call on the Government to bail them out. The RBNZ is currently finalising increased capital requirements for the banking system, and will announce them in mid-December.

New Zealand’s banks are highly profitable – more so even than their Australian parents. Orr effectively said that they had been making hay while the sun shone, but now would need to hold back more of their profits as a buffer to absorb any potential unanticipated losses, as well as starting to invest more in their core infrastructure and risk management.

“The banking system remains profitable, which is a good thing – we like profitable banks and we like well-capitalised banks,” he said. “While positive overall, some of the banks’ profitability has been driven through their low costs and we believe partly achieved through some under-investment in core infrastructure and risk management frameworks.”

Asked if New Zealanders should be concerned that the banks are currently under-capitalised, he said “all countries should be”.

“I mean bank capital ratios have declined continuously in the past 30 plus years even though bank crises have been as frequent as they have ever been. Bank capital is the number one safety valve for citizens of a country because that allows us to absorb losses before it becomes taxpayer losses and/or future generations’ losses.”

He was not specific on how much extra capital the banks would be required to hold, saying simply that it was “north of where we are”.

“What we have been doing is a thorough review on a risk basis for New Zealand around what is the minimum and then what are buffers that make it better for the risks that New Zealand banks face.

“There is no science to this so we have been calibrating it to where we have sufficient capital to where the banking system is both sound through many economic conditions as well as efficient, so we are finding that optimal, that sweet spot, and that sweet spot is north of where bank capital has currently been.”

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