Harbour Asset Management is calling for the Reserve Bank to lower its target for bank capital and to phase the new regime in over at least 10 years while allowing for at least one pause to take stock of the actual impact.
The likely economic costs and increases in interest rates will be larger than the Reserve Bank’s 20-40 basis point estimate, and a 50-70 basis point increase is more likely, Harbour says.
A 50 basis point increase in the annual interest cost of a $500,000 mortgage is about $2,500.
The central bank is proposing to lift the minimum amount of tier 1 capital banks have to carry from 8.5 percent – and just 4 percent before the global financial crisis – to 16 percent and to phase the change in over five years.
Harbour argues in its submission on the proposal that 14-14.5 percent would better optimise the trade-offs between increased bank safety and economic costs.
The Reserve Bank estimates that the banks on average currently carry about 12 percent tier 1 capital – given that large margin between the minimum requirement and what banks actually do, a 14-14.5 percent target would likely be closer to 16 percent in practice anyway.
“We think that significant policy change has uncertain impacts and we recommend taking relatively smaller steps over a longer horizon with a definitive date to pause and re-examine the evidence,” Harbour says.
Harbour has about $4.7 billion in funds under management and says it is a significant investor in both bank debt and bank equity and that it has deep relationships across the bank sector.
The transition costs in themselves could be greater than anticipated. “We found the RBNZ proposal relatively silent on the costs and benefits of transition and the case for the relatively fast – five-year – timetable for higher capital was not made persuasively,” it says.
Other observers, such as ASB Bank and ANZ Bank, have suggested that the Reserve Bank could use monetary policy to offset the upwards impact of higher capital on interest rates, but Harbour says some of the literature advises against such an offset.
“With rates in New Zealand already near inter-generational lows, the scope for monetary policy to offset an unexpected significant tightening in monetary conditions as a result of a rapid adoption of higher bank capital is limited,” it says.
While the Reserve Bank’s latest paper on its bank capital proposals released earlier this month admits it hasn’t done a cost-benefit analysis yet, its assertion that investors in banks will accept lower returns because additional capital will make the banks safer relies on the Modigliani-Miller Offset, named after the two economists who devised the theory in 1958.
Harbour says it doubts the Modigliani-Miller model holds in the context of Australia’s big four banks owning New Zealand’s big four banks.
“We think bank shareholders – and debt holders – are unlikely to accept significantly lower potential returns for holding higher capital,” it says.
“We had numerous discussions with the Australian Banks and institutional shareholders and the evidence in capital markets in our opinion is that capital structure matters, particularly when the cost of debt is largely fixed.”
The cost of debt held by the New Zealand subsidiaries of the Australian Banks “is largely set by the credit rating of the overall corporate.”
Harbour also doubts that bank shareholders will accept a cut in dividends so that the banks can use their retained earnings to increase capital – the Reserve Bank has said the big four New Zealand banks could reach 16 percent tier 1 capital within five years by retaining 70 percent of their earnings.
“We do not think that increasing equity in New Zealand banks via retained earnings is an option that will be palatable for shareholders if doing so requires dividends to be cut,” Harbour says.
That makes it more likely that banks would raise fresh equity, sell non-core assets, lift the interest rates they charge on loans while reducing the interest rates they pay on deposits or reduce lending to riskier customers.
The latter is an argument other commentators have suggested, notably KPMG partner John Kensington who has said banks could restrict lending to dairy farmers or construction companies.
Another of the Reserve Bank’s proposals is that it limits the advantage the big four banks get from using their own internal models to calculate how much capital they need to no less than 90 percent of standardised capital models.
The Reserve Bank has said that currently ANZ Bank has to hold just over half the amount of capital that Kiwibank is forced to hold to back every $100 of mortgage lending and that the change would help level the playing field.
Harbour says that limiting that advantage alone means the big four need to increase their capital by about 16 percent or about $4.5 billion.
Harbour also suggests that “calls for $20 billion to $30 billion more capital in the banking system need to be assessed in a wider context as capital is scarce.”
The trade-offs in moving to a 16 percent tier 1 capital requirement over investment in social housing, the electricity network, highway safety, early adoption of 5G, decarbonisation, pre-school education, child health and more spending on disease prevention, “are very evident,” it says.
“Our view is that this is higher than an optimal long-term level of capital, given competing needs.”