When a Reserve Bank press release turned up yesterday afternoon, announcing that the Reserve Bank had temporarily increased the minimum capital requirements for Westpac’s New Zealand subsidiary, after breaches had been discovered in Westpac’s compliance with its conditions of registration, my initial reaction was a slightly flippant one.  It must, I thought, be nice for the Reserve Bank to be able to impose penalties when banks don’t do as they should, but it is a shame that there is no effective penalty operating in reverse.   When the Reserve Bank misses its inflation target, imposes new controls with threadbare justification, flouts the principles of the Official Information Act, allows OCR decisions to leak, or attempts to silence a leading critic what happens?  Well, nothing really.

But as I reflected on the Reserve Bank’s statement and the Westpac New Zealand, both reproduced here, I became increasingly uneasy.

This is what we know from the Reserve Bank

Westpac New Zealand Limited (Westpac) has had its minimum regulatory capital requirements increased after it failed to comply with regulatory obligations relating to its status as an internal models bank.

Internal models banks are accredited by the Reserve Bank to use approved risk models to calculate how much regulatory capital they need to hold. Westpac used a number of models that had not been approved by the Reserve Bank, and materially failed to meet requirements around model governance, processes and documentation.

The Reserve Bank required Westpac to commission an independent report into its compliance with internal models regulatory requirements. The report found that Westpac:
·currently operates 17 (out of 35) unapproved capital models;
·has used 21 (out of 32) additional unapproved capital models since it was accredited as an internal models bank in 2008; and
·failed to put in place the systems and controls an internal models bank is required to have under its conditions of registration.

The Reserve Bank has decided that Westpac’s conditions of registration should be amended to increase its minimum capital levels until the shortcomings and
non-compliance identified in the independent report have been remedied.  …..

In addition, the Reserve Bank has accepted an undertaking by Westpac to maintain its total capital ratio above 15.1 percent until all existing issues have been resolved.  The Reserve Bank has given Westpac 18 months to satisfy the Reserve Bank that it has sufficiently addressed those issues or it risks losing accreditation to operate as an internal models bank.

There is nothing additional in the Westpac statement, but they don’t appear to dispute either the Reserve Bank’s findings or its response.

There are a few things to clear away.  First, the temporary increase in the minimum capital requirements for Westpac New Zealand does not constitute a financial penalty at all.    Arguably that might be true even if it increased the actual amount of capital Westpac had to hold (Modigliani-Miller and all that), but this measure does not do that.    The Reserve Bank statement tells us that as 30 September, Westpac’s total capital ratio was 16.1 per cent.

That doesn’t mean it is no penalty at all.   I’m sure there has been a great deal of very uncomfortable anguishing in recent months both among Westpac New Zealand directors and senior management, and at head office (and the main board) in Sydney.  APRA is likely to have taken a very dim view of this sort of mismanagement by an Australian bank’s subsidiary.  And, of course, a lot of scarce staff time is now going to have be devoted to sorting these issues out over the next 18 months.  That resource has an opportunity cost –  other things those people could have been used for, which might have boosted the bank’s earnings.

But what I found more striking was how little either the Reserve Bank or Westpac statements said about breaches of conditions of registration which appear to go to the heart of our system of prudential supervision.

There is, for example, nothing at all in the Westpac statement about how these errors happened (use of numerous unathorised models, dating back to 2008), and not much contrition either.  The closest they come is this

WNZL is disappointed not to have met the RBNZ’s requirements in this area.

And our system of banking supervision is supposed to, at least in principle and in law, rely very heavily on attestations from each individual director that the bank they are directors of is fully in compliance with the conditions of registration (which includes provisions around calculation of minimum capital requirements and associated models).  But there is no apology from the directors, and no sign that any director has lost his or her job.   Potential heavy civil and criminal penalties –  including potential imprisonment –  are supposed to sufficiently focus the attention of directors that depositors and other creditors can rely on the information banks publish.  Westpac’s clearly haven’t been able to rely on their disclosure statements for almost a decade.  And yet there is no specific mention of the directors in the Reserve Bank’s statement either.

There is also nothing in either statement (Reserve Bank or Westpac) about the quantitative significance of the errors.   The Reserve Bank tells us that they accept that Westpac did not deliberately set out to reduce its regulatory capital, but intent and effect are two different things.    These problems appear to have been known about for more than a year –  Westpac tells us they first reported them in their September 2016 Disclosure Statement.  But was the effect, over the years since 2008, to reduce the amount of capital Westpac had to hold relative to what it would have been if they’d been using Reserve Bank approved models?  Or does no one –  at the Reserve Bank or Westpac –  yet know?   When the issues are sorted out will Westpac New Zealand be required to restate its capital ratios for the whole period since 2008?

The Reserve Bank’s own processes also seem lax at best.    And this comes closer to home for me, since I sat for a long time on the Bank’s internal Financial System Oversight committee.  The precise mandate of that committee was never fully clear –  in a sense, it was to provide advice on whatever issues the Governor wanted advice on –  and we didn’t typically do individual bank issues at this level of detail.  But that Committee provided advice to the then Governor to go forward with Basle II and, in particular (back in 2008), to allow the big banks to use internal-models based approaches to calculating regulatory capital requirements.    I don’t recall if anyone ever asked how we –  the Reserve Bank –  could be confident, on an ongoing basis, that an internal-models bank was actually using approved models.  But had anyone done so, I’m pretty sure the answer would have been along the lines of “director attestations” and the stiff potential civil and criminal penalties directors could face for what are, after all, strict liability offences (directors don’t have to be shown to have intended to mislead –  it is enough that their statements were subsequently found to be false.)

For a long time the concern was that any questions we (the Bank) asked of bank management would weaken the incentive on directors to get things right –  they might, after all, claim they had relied on us.   But that mentality had been changing in the last decade –  eg the Reserve Bank started collecting private information that creditors don’t have access to.     But where were the questions around Westpac’s models?  After all, it wasn’t a single model where someone overloooked getting Reserve Bank sign-off, but roughly half of all the models, stretching back years.

If there is nothing in the Reserve Bank statement about steps the Bank may have taken to improve its own monitoring and recordkeeping (given that they had to grant approval, how did they not know that so many models were being used and had had no approval?), there is also nothing about any steps they may have taken to assure themselves that there are not similar problems in any of the other IRB banks.   Have they even asked the question?  Surely, one would think, but mightn’t we expect to be told?

As I noted, there was no mention of the directors in the Reserve Bank statement.  But did the Reserve Bank consider taking prosecutions against Westpac’s directors, who signed false disclosure statements over the years from 2008 to 2016?  If not, why not?  If the directors believed (as presumably they did) that the statements they were signed were correct, did they have reasonable grounds for that belief?  What procedures or inquiries had they instituted over eight years that (a) they had confidence in, and (b) still proved wrong?  The Reserve Bank insists on independent directors: those on the Westpac NZ board look quite impressive, but what were they doing all those years?

If the Reserve Bank has lost confidence in a system of rather condign punishment of directors, perhaps it should tell us so, and seek legislative changes.  But if it really still believes that director attestations have a central role in the framework, surely this is as good an episode, and time, to make an example of someone as there is ever likely to be?  After all, it was about a core aspect of the regulatory framework (capital requirements), and comes at times when there are no jitters around the health of the financial system.  If there is no penalty for directors, no doubt directors of other banks will take note.

And then there is the question of the other (apparent) breaches of the conditions of registration. I don’t make a habit of reading Disclosure Statements (and don’t bank with Westpac anyway –  although, come to think of it, the Reserve Bank Superannuation scheme, that the “acting Governor” is a trustee of, does).  But I had a quick look at the latest Westpac statement.  On page 2, there is half page of disclosures of things Westpac NZ is not compliant with.  Several appear to be dealt with by yesterday’s announcement, but another five don’t.   Perhaps they are all pretty small matters –  they look that way to this lay reader – but banks are supposed to be fully compliant.   It is the law.

From the Reserve Bank’s side, the press statement went out in the name of Deputy Governor (and new Head of Financial Stability) Geoff Bascand.  But he has been in the role for less than two months now.  By contrast, “acting Governor” Grant Spencer was head of financial stability from 2007 to 2017, spanning the entire period of the use of internal models, and one of his direct reports, the head of prudential supervision, has also been in his role that entire time.    One would hope that the Reserve Bank’s Board is now asking some pretty serious questions about just what went on, about how the Reserve Bank has handled these issues over the last decade, and about how much confidence New Zealanders can have in an avowedly hands-off system.

Most probably, the empirical significance of this protracted breach of the rules will prove to have been small.  For that small mercy, we should of course be grateful.  But it is also small comfort because the fact that such breaches could go on for so long –  and the statements aren’t even clear how they came to light – leaves one wondering about what other gaps we (or the Reserve Bank, or Westpac or other IRB banks) might not yet know about.  Often enough, such problems only come to light when it is too late.   In many other central banks and regulatory agencies, if they hear about this episiode, there will be tut-tutting along the lines of “well, that is what you get when you don’t have on-site supervision of banks”.  Personally I wouldn’t want to see New Zealand go that way, but my confidence in our approach has taken a blow in the last 24 hours.

The Reserve Bank has a review of capital requirements underway at present.  I hope final decisions are not going to be made before a new Governor is in place.   There is plenty of unease around the use of internal-models for calculating capital requirements –  especially for rather vanilla banks such as those operating here.  Personally, I’d be comfortable moving away from that system, back to a standardised model for calculating capital (which would, among other things, put Kiwibank –  somewhat put upon by the Reserve Bank – and TSB on the same footing as the large banks).  But, for now, the law is the law, and needs to be seen to be enforced.  A breach of this sort, with little serious direct penalty, risks undermining confidence in our system.

And, of course, there is the small matter of openness.  Not every aspect of the Reserve Bank’s dealing with an individual bank can be published, but there are a lot of questions –  including about the Reserve Bank itself –  to which we really should be entitled to more answers than the Bank has yet given us.

I hope some journalists are willing to pursue the matter further.  Questions could be directed to David McLean, the well-regarded Westpac NZ CEO, to the Board members past and present (especially the independents), perhaps to the parent bank in Sydney, and –  of course –  to Grant Spencer and Geoff Bascand –  if not before then at their next (financial stability) press conference, which is now only a couple of weeks away.