Deputy Reserve Bank governor Geoff Bascand appears to be going all out to demonstrate that New Zealand’s banks are not financially sound enough in order to justify the central bank’s proposals to double how much capital banks must hold on their balance sheets.
“At one time, the owners of a bank had plenty of skin in the game; in fact, there was a time when banks got most, or all, of their money from their owners,” Bascand says in a speech to the Institute for Governance and Policy Studies at Victoria University this afternoon.
But the case is very different now: “The average New Zealand bank gets around 92 percent of its money by borrowing it,” he says.
“Compare this with the average business in New Zealand for which this figure is about 55 percent,” he says.
“It is not clear to me why this discrepancy between banks and other business is so large but perhaps at least part of it can be explained by the fact that, historically, governments have been much more reluctant to allow a bank to fail than other types of businesses, which may lead banks to operate closer to the edge.”
The Reserve Bank is responsible for ensuring New Zealand’s financial system is sound, something it signs off on twice a year.
Comparing banks to other types of companies isn’t a fair comparison – banks’ basic function is to act as financial intermediaries, borrowing in the form of bank deposits and similar interest-bearing instruments and lending that money to people buying houses, farms and businesses and other assets, clipping the ticket along the way to cover their costs and to make profits.
The amount of capital a bank holds, what Bascand says is skin in the game, is like an insurance policy against the value of the assets it lends on dropping below the loan value.
“I would like to note that banks themselves lend on these very same ‘skin in the game’ principles, for example, by requiring mortgage borrowers to provide a deposit,” he says.
Bascand posits the case of a young couple who had just bought their home only to see its value plummet 30 percent because of a banking crisis to illustrate that the cost of bank failures includes social and human costs.
New Zealand house prices have never fallen as much as 30 percent in any type of crisis, whether caused by bank failures or recessions.
During the global financial crisis, New Zealand house prices fell 10 percent after inflation – 15 percent actual – from peak to trough and then recovered within the next five years or so.
Even in the depths of the GFC, the most alarmist commentators weren’t suggesting New Zealand house prices would fall as much as 30 percent.
Australasian banks proved among the world’s most resilient through the GFC. Bascand made no mention of the many published and unpublished stress tests the Reserve Bank and the individual trading banks have carried out since the GFC, all of which showed the banks passing with flying colours.
As Bascand explains, banks in New Zealand are currently required to hold at least 10.5 percent of risk-weighted assets in different types of capital.
That is the same level set by the Basel Committee on Banking Supervision, “a group of international banking regulators and central banks,” he says.
The Reserve Bank is proposing to lift this to 18 percent with 16 percent of that being pure equity – from 8.5 percent currently – because it doesn’t want any form of quasi-equity, securities that normally behave as debt but which can be converted into equity if required, to be acceptable as tier 1 capital as is currently the case.
Australia’s banking regulator, the Australian Prudential Regulation Authority, has a similar proposal to take total bank capital to 19.5 percent, but it is leaving its equity requirement at 6 percent, where it sits currently, and it expects most of the increase above its current 11.5 percent minimum total will be satisfied by quasi-equity. That’s considerably cheaper than equity: about a fifth the cost by one estimate.
Bascand notes that the reaction to the Reserve Bank’s proposals has been mixed. “Some commentators believe our proposals are entirely reasonable and justified, while others believe that our proposals are too extreme.”
International ratings agency Fitch Ratings, for example, has called the proposals “radical” and “well beyond the international norm,” while rival agency Standard & Poor’s said on Monday that they will be a “burden” on the Australian parents of New Zealand’s four major banks.
The Reserve Bank has estimated the big four Australian-owned banks, which account for about 88 percent of New Zealand’s banking system, will need to find about $20 billion of additional capital over the proposed five-year phase-in period.
The central bank has said its calculations of how much capital banks should have are based on what is necessary to limit any bank collapses to one-in-200-year events. Bascand says that’s the same risk tolerance adopted in Europe by regulators of insurers, but that the Basel and New Zealand frameworks go further, “requiring banks to calculate risk-weights on a once-in-a-thousand year basis.”
He says there is a trade-off between the amount of capital and economic output and “it is generally accepted that there will be some impact on interest rates and, ultimately, output.”
But there are “few efficiency gains to be made by going beyond the current proposal of 18 percent” and that the central bank doesn’t think the impact on long-term output will be “significant.”
“With regards to our responsibility to maintain an efficient financial system, we think we have it about right.”
The Reserve Bank has estimated interest rates might rise by 20-to-40 basis points, although others have made much higher estimates including UBS saying it would be 80-to-125 basis points. That would take a 4 percent two-year fixed rate mortgage to as much as 5.25 percent, all other things being equal.
But the central bank has dismissed UBS’s assessment as “an outlier.”
Bascand says the Reserve Bank’s models “suggest the impact on lending rates will be little more than ‘noise,’ something that will likely be drowned out by wider economic factors.”
Over the longer-term, the impact might shave GDP by an aggregate 0.17 percent. “We think that’s a small price to pay for reducing the risk of a crisis and the economic and social chaos that accompanies it.”
An offsetting benefit may be a lowering of borrowing costs for the government because of the reduced need for any bank bailouts, he says.
Bascand dismisses critics of the proposals who say they go way beyond agreed international principles, repeating previous arguments that “’headline’ capital requirements are not always as they appear”.
“International comparisons of capital ratios are inherently difficult to make due to differing regulatory frameworks which are sometimes not fully transparent.”
He cites Bank for International Settlements and S&P studies that he says show New Zealand requirements are currently at the lower end of the norm and that the changes will still see the country remain well within international norms.
“While these cross country studies have not played much, if any, role in our analysis of determining what we think is the appropriate capital calibration for New Zealand, they do demonstrate that our proposals are by no means extreme,” Bascand says.