At lunchtime I went to hear Reserve Bank Deputy Governor Geoff Bascand make the case for his boss’s proposal to require the locally incorporated banks operating in New Zealand to fund a much larger proportion of their balance sheets with equity capital.  I will write tomorrow about a range of other points that were, and weren’t, made.  But for now I wanted to pick up just one number he used in making the case.

In the course of his presentation, Bascand used a slide which reported the Bank’s view that these changes in capital requirements will lower the long-run level of GDP by a bit less than 0.3 per cent.  I hadn’t seen the number before (maybe it was in the documents, in which case I missed it), but what struck me was Bascand’s suggestion that this is “not a very big number”.

Looked at quickly, perhaps that is true.  But it is a price the economy will have to pay each and every year.  Using the standard Treasury discount rate (6 per cent real), the present value of those costs is about 5 per cent of one year’s GDP ($15bn or so in today’s money).   The precise number isn’t certain –  could be less, could be more – but whatever the cost, we are stuck with it, year in year out, for as long as this policy proposal was in place.

And what are getting in return for our lost $15 billion?

And that is where things get very uncertain.  The Bank will tell us that we are avoiding the terrible costs of a financial crisis.  They will quote various numbers at you, but on this occasion Geoff Bascand included a slide in which a typical advanced country financial crisis had a cumulative economic cost (lost output) of 23 per cent of GDP.

But even if one uses that number as a starting point, an increase in capital ratios of the sort the Bank proposes aren’t going to save all that lost output because:

• as I’ve noted repeatedly, much of any output loss associated (in time) with a financial crisis is the result of the bad lending and misallocation of real resources that may have led to the crisis, but did not result from it. It would happen anyway. We don’t know what the right split is –  as I noted yesterday, I’m not aware of any papers that really make the attempt –  and the Reserve Bank hasn’t told us its estimate, and
• we aren’t starting from near-zero capital, but from actual capital ratios that even the Bank concedes are relatively high by international standards at present, and
• even these capital requirements are not supposed to spare us from all crises, just keep them to no more than 1 in 200 years.

It is the additional reduction in output losses (not the total loss) resulting from these  capital proposals that has to be compared to the annual output loss (the “insurance premium” if you like) of simply putting the policy in place.

As I noted yesterday, the policy proposals aren’t supposed to protect us from a 1 in 200 year crises, but they should protect us from, say, a 1 in 150 year crisis.   Perhaps we –  generously in my view, on my reading of the historical experience –  take the view that the further increase in capital requirements can save us from a 10 per cent of GDP loss when the crisis happens.

We don’t know when in the 150 years the actual crisis will happen, so lets assume that it happens in year 75 (half way through).    We could discount back that saving –  10 per cent of GDP 75 years hence – at a 6 per cent discount rate and the resulting present value is about 0.15 of GDP.   In other words, the present value of what we save –  that quite severe event, but a very long way in the future – is a bit less than one year’s insurance premium.

Another way of looking at that number is to take the 10 per cent of GDP (not) lost and spread it out over 150 years.   That becomes an annual saving of 0.06 per cent of GDP.  In exchange for which we pay a premium of getting on for 0.3 per cent of GDP.   It would take a future crisis event hugely more costly to make the insurance even remotely worthwhile.

And all that assumes we know that we’ll actually protect ourselves.  But we don’t.  Up front, we know that the banks at present are pretty strong (as even the Reserve Bank acknowledges, and that is what the stress tests show).  There is no chance that this really severe crisis will happen in the next few years.   And, on the other hand, there is no pre-commitment mechanism to guarantee that the new capital requirements are kept in place for 50, 75, or 150 years.  No pre-commitment mechanism, and no probability either –  just look at how often regulatory rules change, in this and many other areas.

And while the Reserve Bank’s GDP loss numbers are about long-term levels, there is also the transition to consider.  Most probably, in the course of the transition credit will be less readily available.  Most probably, during the transition the next recession will occur (not because of the policy change, but just the passage of time and accumulation of external risks),  and in that environment banks seeking to pull back on credit or widen margins are likely to result in a bit more of output cost than the long-term estimate.

In other words, if the Bank goes ahead with this proposal, we will be poorer by up to 0.3 per cent per annum for each and every year the new rules are in place.  There will, most likely be some additional losses in the transition period.     And to gain what?   Basically nothing in the next few years – lending standards have been sufficiently robust there is no credible way over that period banks will run through existing capital over that horizon, let alone the new higher levels.  And beyond that, the annualised gain (or PV of a lump sum saving decades ahead) is just tiny on plausible estimates of the marginal GDP savings higher capital ratios might one day deliver us.

To sum up, there are certain to be annual costs, exacerbated in a transition.  There is no certainty future Governors will stick to the policy even if it is adopted this year (if they don’t we will have paid the premium and got nothing), and even if they do it would require incredible (ie literally unbelievable) future GDP savings – in the event of a far-distant crisis –  to make paying the insurance worthwhile.

0.3 per cent per annum –  in a country struggling for all the productivity it can get – might look like “not a very big number”.   But the protection it purports to buy us looks to be of derisory, and highly uncertain, value.  Against that backdrop, the (capitalised) $15 billion price tag could be spent on a lot more worthy things.   The Deputy Governor’s speech attempts to tie the Bank onto the wellbeing bandwagon (“Safer banks for greater wellbeing”).  Well, you can buy a really large amount of, say, mental health services (to take a theme from this morning’s Herald – and from Bascand’s speech) with a $15 billion lump sum.