A not very straightforward reversal by the Reserve Bank

Back on 27 August 2015, I wrote about the Reserve Bank’s refusal (having taken almost two months to consider the matter) to release anything material from the extensive work it had been doing on possible reforms to the governance of the Reserve Bank.

Somewhat frustrated by the obstructionism, I commented then

If the Official Information Act really provides protection for every single one of the papers covered by my request, including the titles of those papers, the Act is even more toothless than most had realised.  In fact, I suspect that this is a case of instititutional arrogance and over-reach by the Governor, who doesn’t really seem to regard himself as accountable to the public.  Perhaps the Governor is embarrassed, or frustrated, that the Minister of Finance or Treasury were not convinced by his particular arguments?  Perhaps he had staff simply look at one option, and ruled out of court any serious consideration of the wide range of options used internationally and elsewhere in the New Zealand public sector to govern powerful public agencies?  Whatever the explanation, he doesn’t want us to know.


As I’ve said previously, the Reserve Bank is much less transparent than it likes to make out.  This is just another example.  We’ll see whether the Ombudsman agrees with their interpretation of the Act.  Whether or not she does, this decision by the Governor is not the hallmark of an open and accountable public institution, committed to scrutiny and debate and to improving policy and institutions through the contest of ideas.

I had also requested information on any work on Reserve Bank governance from The Treasury.  With their accustomed more positive approach to the Official Information Act, they released a reasonable amount of material, which I wrote about here.  A paper dated 5 June 2015 confirmed (what I already knew) that the Reserve Bank work programme had ceased, and Treasury’s advice to the Minister (in a note on the Reserve Bank’s draft Statement of Intent) that work should be continued apparently went nowhere.

Several times since then, I have highlighted the Reserve Bank’s refusal to release any of the material on governance, despite it being a completed project.  I had lived in hope that one day the Ombudsman’s office would get to my complaint, and that the Bank might be compelled to release at least some of the material.

And then, out of the blue this afternoon, an email arrived from the Bank (apparently released simultaneously, and before I had even had a chance to read it, on the Bank’s website).  Here is the heart of their letter

At the time we responded to you in August 2015, we withheld information under section 9(2)(f)(iv) of the Act, on the basis that advice was being considered by the Minister and had been tendered to him.  In September, Associate Minister of Finance Steven Joyce told Parliament that the government had no plans to reform the governance structure of the Reserve Bank – meaning the advice to the Minister was no longer under active consideration. This is a change in circumstances that provides an opportunity for the Reserve Bank to revisit its decisions on your request. The Reserve Bank considers it now appropriate to release to you the following documents:

The Reserve Bank holds other information within the scope of your original request that we are continuing to withhold, as provided by the following sections of the Act, for the reasons described:

  • 9(2)(g)(i), to maintain the effective conduct of public affairs through the free and frank expression of opinions by or between or to members of an organisation or officers and employees of any department or organisation in the course of their duty;
  • 9(2)(h), to maintain legal professional privilege; and
  • 8(d) – the information is publicly available here – www.rbnz.govt.nz/research-and-publications/reserve-bank-bulletin/2014/rbb2014-77-01-02.

Back in September I had written about those comments from Steven Joyce, answering questions for the Minister of Finance from Greens spokesperson Julie Anne Genter.

I welcome the Bank’s change of heart.  But I doubt it is entirely sincere.  After all, it is now March, and the Associate Minister’s comments were made in September. I know the Reserve Bank is busy, but really…..   Moreover, they are not being straightforward in claiming that the matter had been under active consideration by ministers up to that point.  As the Treasury document, from June, already showed, the Bank had already ceased work on governance, and we can be pretty confident that cessation had occurred when the Minister of Finance had told them some time earlier still that he did not want to do anything about Reserve Bank governance. To reinforce the point, when they originally withheld all this material, back in August last year, they did not seek to invoke the argument that the material was under active consideration by the Minister (even though they included a laundry list of reasons for withholding).

I suspect the Ombudsman may finally have gotten round to investigating my complaint, and the Reserve Bank has decided to try to minimize its reputational losses by releasing this material now (and just prior to a long weekend etc), rather than wait for the Ombudsman to compel them to do so.  Even having done so, the Ombudsman will still have to decide on the other material which they have withheld.

I haven’t had a chance to read the papers the Bank has released.  They are all available at the link above.  I will probably write about the contents at some stage next week.

Meanwhile, Reserve Bank governance still needs reform, and  it is disappointing that the  current government has been so reluctant for the Treasury and the Reserve Bank to continue work on reforming an outdated model, that doesn’t align well with (a) the current functions of the Bank, (b) international practice in the governance of monetary policy and financial regulation, or (c) the governance of other entities in the New Zealand public sector.


A dairy stress test

I’ve been a bit slow to get around to writing about the material the Reserve Bank released last week about the dairy stress test it conducted with the five largest dairy-sector lenders late last year.

I’ve long been of the view (and on record here) that, almost no matter how severe the dairy situation becomes, dairy loans would not represent a threat to the soundness of the New Zealand financial system.  That is a top-down analysis based on

  • the size of capital of the New Zealand banking system (around $36bn),
  • the overseas ownership of all the main dairy-lending banks, and the absence of correlated exposures in most of them (dairy loans aren’t a big part of the Australian parents’ books),
  • the fact that any losses on the dairy book will crystallise gradually, allowing other retained earnings, or outside injections of new capital, to buttress the overall position of the New Zealand banks, and
  • that while dairy losses could in time be a part of a wider set of banking system losses (eg if severe losses also mounted on the housing portfolio), it is almost inconceivable that in such a scenario New Zealand’s exchange rate would not fall a lot further.  A NZD/USD exchange rate of, say, .39 (where it got to in 2000) covers over quite a lot of weakness in the international prices of whole milk powder (in turn mitigating the severity of the dairy losses themselves).

There are counters to each of these points, but in the end I think they come down to this: if the Australasian banks ever face really large losses on their housing loans, the banks could be in trouble.  I think that is very unlikely: house prices are held up by a combination of regulatory land use restrictions and population pressures, and vanilla housing lending has rarely if ever collapsed a banking system (as the Reserve Bank itself has acknowledged).  You might disagree, but my real point is that dairy loans themselves aren’t going to threaten the soundness of the system. Much wealth will be lost.  And many of the individual loans may have been ill-judged (by borrower and lender) but that is a different issue, and almost in the nature of a market economy operating under (the real world) conditions of uncertainty.

That is all top-down perspectives. But the stress test was useful precisely because it aims to be a bottom-up approach: working with the banks on how their actual dairy portfolios would behave under two pre-specified scenarios.  Note what the exercise wasn’t: it didn’t look at the implications for loans to dairy companies themselves, or to suppliers to the dairy industry (companies or farmer), and also didn’t look at the impact on loan losses elsewhere in the portfolio resulting from the stresses on the dairy sector itself (eg retailers or builders or residential mortgages or… in dairy-dependent towns).  Note that it was also only a rather provisional exercise, indicative more than definitive, and a basis for ongoing discussions between the Reserve Bank and individual banks.

stress test extract

That does tend to suggest we should use the higher loss estimates rather than the lower ones (since banks have fewer incentives to overstate the loss implications than to understate them).

Here are the scenarios the Reserve Bank specified.

stress test scenariosI’m largely going to ignore Scenario 1 from here on.  As the long-term average real milk price is probably only around the assumed 2017/18 level, Scenario 1 doesn’t represent much of a stress test at all.  The banks and the industry would have to be have been very rickety for a scenario like that to have presented a banking system problem.  I think the Reserve Bank should also have discounted these results, rather than highlighting them in their press release.

Scenario 2 does look much more like a real stress-test.  But even if one thought the series of payout assumptions might be reasonable (2015/16 won’t have been that low, but some of the out years could still be lower than assumed here), I was surprised by the dairy land price assumptions.  Despite a really severe adjustment in the payout path (absolutely, and probably relative to farmer expectations), dairy land prices are assumed to fall by just under 40 per cent (the cumulative effect of those three annual falls).

That might sound like a lot, but:

  • when the Reserve Bank did its housing stress test, it assumed a 50 per cent fall in Auckland house prices.  People still need to live somewhere, while they don’t need to farm cows.
  • we’ve already a dairy land price scare not long ago.  Here is a chart of the (“hedonic”)dairy land price index the Reserve Bank developed for REINZ (despite which, we don’t have general access to the series).

dairy farm pricesIn a single year, dairy land prices fell by more than 30 per cent –  and that was a severe, but very short-lived, fall in milk prices, and a rise in dairy non-performing loans that was still moderate compared to what we see in Scenario 2 in the current stress test.   Perhaps deliberately, the Reserve Bank’s stress test does not seem to have taken account of a second round of selling (forced or voluntary), and the potential for that to drive land prices well below what might be a longer-term equilibrium level.  Overshoots routinely happen in such markets, where liquidity is thin to non-existent, uncertainty is rampant, and potential buyers are few.  As Eric Crampton’s discussion highlights, one difference between now and 2009 will be that potential buyers are probably much more aware of how significant the barriers are to any offshore buyers (who might otherwise be a stabilizing force in the market).

Loan losses evaluated on total dairy land prices falls of perhaps 60 per cent might be a more realistic stress test –  recall, that stress tests aren’t central predictions, they are a scenario to test robustness against.  Loan losses went up by 5 percentage points on the move from the (not very stressful) Scenario 1 to Scenario 2.   The pattern of losses on loans should rise non-linearly as the test gets more stressful, and moving from a 40 per cent land price fall scenario to a 60 per cent scenario is a bit more of a land price adjustment than moving from Scenarios 1 to 2.

There are lots of other points of detail I could question (some things in the article just aren’t made as clear as they could be), but will just highlight one.

The Reserve Bank has long emphasized the desirability of having a capital framework for banks in which risk weights (whether imposed by the Bank, or flowing from the internal models of the major banks) do not have the effect of making capital requirements pro-cyclical.  If capital requirements fall in asset booms and rise in shakeouts, the capital requirements will tend to amplify credit and asset price cycles (an existing stock of capital will go ever further as the boom proceeds, and ever less far – encouraging banks to rein in lending even more –  as the bust proceeds).  And yet the stress-testing article suggests that pro-cyclicality is deeply embedded in the modelling, at least for the dairy portfolio –  itself the largest single chunk of banks’ commercial lending.

Here is what I mean.

risk weights dairy

This chart shows the average risk weight for the banks’ dairy portfolios under Scenario 1.  Recall that Scenario 1 was not very demanding at all, and yet the average risk weight on dairy loans increases by 60 per cent  (eg, from, say, 70 per cent to 112 per cent).  No doubt deliberately, the Bank does not reveal how much further risk weights increase in the much more onerous Scenario 2.     Even if it is not that much further, this sort of highly pro-cyclical pattern of risk weights looks like a bug that needs some serious attention.

To recap, in Scenario 2, bad debt expenses average 8 per cent of dairy exposures.

dairy bad debts

But, as the Bank noted (see extract above), not all banks were as conservative as others.  If we take the pessimistic end of the Scenario 2 range, we would have bad debt expenses of perhaps 11.5 per cent of dairy exposures.  But, as noted above, the near-40 per cent fall in land prices  in Scenario 2 still looks too shallow for such a fully-worked-through scenario.  If land prices were to fall 60 per cent would it be implausible that in such an scenario, with all the second round effects accounted for and allowing for the non-linear loss profiles, the banks could face losses not of the “3 to 8 per cent of their total dairy exposures”  that the Reserve Bank highlighted, but something more like 20 to 25 per cent of their total loans to dairy farmers?    I deliberately pose it as a question, rather than a confident assertion, and it is –  deliberately – the result of a stressed scenario, but it is probably a question people should be posing to the Reserve Bank.