Banking crises are not bolts from the blue

The Herald’s economics columnist Brian Fallow devoted his column last Friday to the Reserve Bank’s proposal to massively increase the proportion of their balance sheets banks would have to fund by equity.  He ended on what seemed to be a moderately sceptical note.

So we are left trying to weigh a highly debatable but significant cost against an incalculable benefit.

As I’ve noted here, the sort of cost-benefit calculus we can glean from various Reserve Bank publications just doesn’t stack up at all.    In his speech the other day (which a couple of readers have suggested I was too generous towards), the Deputy Governor indicated that the level of GDP might be up to 0.3 per cent lower (permanently) as a result of these changes.    Call it an annual insurance premium of 0.25 per cent of GDP (and bear in mind that the estimates Bascand is using don’t take account of the implications of most of our banks being foreign-owned, which raises the cost to New Zealand).

If we knew with certainty that:

(a) adopting these much higher capital ratios would prevent a crisis in 75 years time that would have otherwise cost 40 per cent of GDP (recall that the proposals aren’t supposed to prevent 1 in 200 year crises, but are presumably supposed to prevent 1 in 150 years crises, and 75 years is halfway through 150 years –  the crisis could happen next year, or in year 149), and

(b) that the new higher capital ratios would be applied consistently for the next 75 years

that might be a borderline reasonable bet –  the benefits might roughly match the costs.

If you thought instead there was no more than a 50 per cent chance that the new policy would be applied consistently for 75 years  (and given how politics, personalities, and conventional policy wisdom has changed quite a bit, to and fro, since 1944 that seems generous) , you’d need to be preventing a crises twice as large for the insurance policy to be worthwhile.

As a benchmark for how serious these events can be, you could think about the United States since 2008.   Over 2008/09, the United States experienced the most severe banking crisis of (at least) the modern era, since (say) the creation of the Federal Reserve.   (The Great Depression itself was, of course, worse, but it was mostly a failure of monetary policy management and institutional design rather than a banking crisis).

I’ve shown this chart previously.  Real GDP per capita for the US and New Zealand from 2007q4.

crisis costs 2019

The United States was the epicentre of the systemic banking and financial crisis.  New Zealand did not experience a systemic banking crisis at all.  At least on the OECD’s estimates, the output gaps of the two countries were pretty similar in 2007.   And there is no just credible way you can come up with estimates that have the United States doing (cumulatively, in present value terms) 40 per cent of GDP worse than New Zealand.   Do the comparisons of the US with other OECD countries that didn’t run into serious banking problems –  eg Australia, Canada, Norway, Israel, Japan –  and you still won’t find cumulative output losses sufficient to justify the sort of tax the Reserve Bank of New Zealand wants to lump on our economy.

In fact, for what it is worth, here is the cumulative labour productivity (real GDP per hour worked) growth of the United States and those non-crisis countries for the period 2007 to 2017 (from the OECD databases).

United States 10.6
Australia 14.0
Canada 9.6
Israel 10.1
Japan 8.3
Norway 3.0
New Zealand 4.4

Sure, there are all sorts of other things going on in each of these countries.   But bad as the 2008/09 banking crisis was in the United States, it is all but impossible to come up cumulative cost estimates that would reach even 20 per cent of GDP (crisis country experience over the experience of non-crisis countries).

And if the Reserve Bank continues to believe otherwise, the onus should be on them to make the case, to set out their arguments, assumptions, and evidence.

(Note, that none of this is to suggest that the 2008/09 recessions were anything other than undesirable and costly.  Recessions generally are.  But there are lots of low probability bad things in our world, and not all of them are worth paying the price to try to prevent.)

But even having come this far, I’ve risked conceding too much to the Reserve Bank ‘s story.  In part, that is because the storytelling implicitly treats higher capital ratios as sufficient to spare an economy all the costs associated with a banking and financial crisis.  And in part (but not unrelated to the previous point) because it tends to treat systemic banking crises as bolts from the blue –  unlucky bad draws imposed on a country when the Lotto balls are selected.   Neither is true.

Unfortunately, Brian Fallow seemed to buy into some of this sort of implicit reasoning in his column.

But in a complicated and perilous world it is idle to suggest that stress tests or banks’ internal modelling can accurately quantify the probability and magnitude of a major economic shock that could threaten the solvency of banks. Or even forecast the nature of the shock: another global financial crisis, perhaps?

The last one inflicted the deepest recession New Zealand had suffered since the 1970s.

A pandemic against which we are pharmacologically defenceless? It’s 100 years since the Spanish flu killed more people than WWI.

International hostilities breaking out in some surreptitiously weaponised but systemically vital realm of cyberspace?

Or a more conventional geopolitical conflict? The current crop of world leaders do not inspire confidence.

One might note first that the stress tests the Reserve Bank requires banks to undertake have deliberately used highly adverse combinations of shocks (rising unemployment, falls in house prices etc).  They are deliberately designed to look at really adverse events.

One might also note that –  contrary to the implication here and in Geoff Bascand’s speech –  the banking crisis (failure of DFC, need to recapitalise BNZ) did not “inflict the deepest recession New Zealand has suffered since the 1970s”, rather it was one (probably rather modest) factor in a range of contributors (disinflation, structural reform, fiscal adjustment, downturns in other countries etc).

But what I really wanted to focus on were the final three paragraphs in that extract, which imply that banking crises arise out of the blue.  And they just don’t.  They never (or almost never) have.  Might they in future?  Well, I suppose anything is possible, but we can’t sensibly take precautions against everything.

The prospect of a serious pandemic is pretty frightening.  But awful as the episode 100 years ago was, it didn’t result in systemic banking crises.    Cyber-warfare sounds pretty scary as well, but it isn’t remotely clear how higher bank capital requirements protect us against that.   World War Two was dreadful, but it didn’t result in systemic banking crises either.    There was a serious financial crisis at the start of World War One, but it was a liquidity crisis not a solvency one, and capital requirements (then, or in some future unexpected outbreak of hostilities) are pretty irrelevant in a crisis of that sort.    Do the leaders of the world as individuals or a group command much confidence?  Well, no, but then in the last 100 years or so periods when it was otherwise seem rare enough  (the PRC and USSR border war of 1969 anyone)?  I suppose if we go back far enough a repeat of the Black Death –  wiping out a third of the population –  wouldn’t be great for the value of bank collateral, but (a) capital proposals aren’t supposed to counter 1 in a 1000 year shocks, and (b) you might think there would be bigger things to worry about then (and a high likelihood of statutory interventions to redistribute gains and losses anyway).

Systemic banking crises –  one where banks and borrowers lose lots and lots of money and 5 per cent, 10 per cent or more of bank loans are simply written off in a short space of time –  simply do not arise out of the blue, as decent well-managed banks and universally responsible borrowers are suddenly hit by some totally unforeseeable event.  Rather they are –  always and everywhere – the outcomes of choices made over the years (typically only a handful) previously.    Lenders and borrowers make bad –  wildly overoptimistic  –  choices, some just going along for ride, others actively pushing the envelope.  In the process, real resources in the economy in question are misallocated, perhaps quite badly, but that cost is something that is really only apparent (only crystallises) when the boom comes to end, whether it ends in a whimper or a bang.   Sometimes government policies can play a direct part in helping to generate the mess.  In the United States, for example, the heavy state involvement in the housing finance sector greatly exacerbated the imbalances that crystallised in 2008/09.  In Ireland, for example, entering the euro and taking on the interest rate fit for Germany and France when Ireland might have been better with New Zealand interest rates, was a big part of the story.  Fixed exchange rates have often been a significant factor, both giving rise to initial imbalances, and aggravating the difficult resolution afterwards).  Transitions out of periods of heavy regulation can play a role too: in New Zealand (and various other countries) in the late 80s, neither lenders nor borrowers really had much idea of operating in a liberalised financial system.  You can go through every modern financial crisis –  and probably plenty of the older ones too – and point to the excesses, the over-optimistic lending and borrowing that accumulated in the preceding years.  Japan –  crisis of the 1990s – was yet another prominent example (Zambia in 1995, a crisis I was quite involved in, was the same).

Would higher required capital ratios have prevented any (many) of these episodes?  One can’t answer with certainty.  They might have prevented some bank failures themselves, but that isn’t the issue I’m focused on here (which is about the bad lending/borrowing in the first place).    Perhaps a few banking systems really went crazy because creditors thought they could offlay all the risks on the state, but that isn’t a compelling story more generally.  After all, shareholders still stood to lose everything.   A more plausible interpretation (to my mind) of those periods of undisciplined lending/borrowing is that people simply misjudged the opportunities, and got carried away by excess optimism, in ways that meant they just pay much less attention to the potential downsides.  The world was different (so people were being told, or they told themselves).  If so, most of the misallocations of real resources would happen quite independently of the levels of bank capital requirements that were imposed.  And you can mount an argument that high capital requirements may tend to encourage banks to seek out more risks than they would otherwise take, especially in buoyant times, concerned to keep up rates of return on equity.    Even if that doesn’t happen, disintermediation would see more risks to be taken on in the shadows –  no less resource misallocation in the process, but rather less visibility to the authorities and resolution agencies.

Perhaps good and active bank supervision can prevent those excesses, and misallocations, building up.  But that is a (very) different case from one in which ever-more-demanding capital buffers  supposedly eliminate (or reduce to minimal levels) the costs when the bad lending crystallises.  It isn’t a case the Reserve Bank has made –  and they probably wouldn’t, as historically they have been (rightly) fairly sceptical about the value hands-on supervision can add.  And it is a case I am pretty sceptical of.   And for which there is not much evidence (even allowing for the fact that crises avoided tend to be not very visible).   Much as APRA likes to suggest it is an example (in the 2000s) I don’t think they were really tested.

Bank supervisors –  and their bosses in particular –  breath the same air as everyone else in a society, and when lending and borrowing in a particular country is going badly off course, it is unlikely that the bank supervisory agency will be taking (for long) a very different stance from those around them, and those who appoint them.   This isn’t an argument about corruption –  although regulators perceived to be realistic and responsive will no doubt attract a better class of well-remunerated job offer –  but about political and economic realism.  But even if better Irish regulators (say) could really have made a difference in the 2000s, what was really needed were different lending/borrowing practices, not just more capital.  More capital wouldn’t have avoided a nasty aftermath (even if it would have reduced some fiscal costs) –  and at the peaks of self-confident booms, capital is cheap and easy to raise.

And so we are brought back to the specifics of New Zealand where:

  • repeated stress tests conclude that our banking system is resilient to very very nasty shocks,
  • the Reserve Bank tells us at every FSR that the financial system is strong and sound,
  • we have control of our own monetary policy, including a floating exchange rate (34 years today),
  • we have healthy public finances,
  • we have little active involvement of the government is directing finance

Against that backdrop, and against the experience in which it is hard to conclude that banking crises themselves (as distinct from the bad lending that later gave rise to them) are worth more than a few percentage points of GDP, in a country not prone to systemic financial crises (the episode doesn’t even meet the test in many collections of crises), with our banks owned mostly from a country also with no track record of frequent serious financial crises, the case just hasn’t been at all convincingly for compelling banks to fund so much more of their balance sheets with equity.  Doing so will, on the Reserve Bank’s own telling, involve real economic costs.  For benefits that are, at best, tiny and far-distant.

It is disconcerting that in none of the Reserve Bank’s material do they ever show signs of engaging with any of this sort of analysis.  Instead, they have a policy preference and prefer assertions and flimsy analysis to any serious engagement with the issues and experience.

My former colleague Geof Mortlock has another piece on making the case for splitting up the Reserve Bank and creating a separate Prudential Regulatory Agency.  I strongly agree with him on that –  and have argued the case here last year.  Geof is probably more optimistic than I would be about what bank regulators can add, but on this particular item we seem to be as one.   Among his long list of what is wrong with the Bank’s conduct of its financial regulatory functions, introduced thus

Geof Mortlock argues the Reserve Bank is about as much use as a financial regulator as is a cricket umpire who is nearly blind and who understands little about the game

is this:

the recent release of bank capital regulation proposals that would see banks in New Zealand being required to hold a very high level of capital compared to other countries, with potentially adverse consequences for borrowers’ access to credit, an increase in interest rates and adverse impacts on the economy – and all on the basis of shockingly flimsy analysis by the Reserve Bank.




21 thoughts on “Banking crises are not bolts from the blue

  1. Michael
    One of the odd aspects of the RBNZ’s concerns about the long-term health of the NZ banking system is the seeming conflating of concerns about solvency and liquidity.
    Id have thought that solvency was reasonably assessable and a vague concern about something happening decades off could be discounted? Recognizing that “bolt from the blue” events such as earthquakes, pandemic or war have to be recognized. But liquidity is tricky because of the mania/panic phenomena.
    Do you feel that RBNZ has drawn a line between the two sorts of problems banks can face? And if so what are their measures to ensure the solvency of NZ-inc were there another GFC ?
    A second question. Given that the NZ$ floats and few liabilities of our government, banks, households, or businesses are in other than NZ$, don’t we have an excellent shock absorber should one of the bolt-from-the-blues arise? During the GFC the NZ$ plunged, which was hardly a bad thing for those with net offshore assets.


    • Your second question is easy, yes indeed (altho it is a better shock absorber for the entire economy than for specific sectors – the Black Death revisited might still collapse house prices and leave huge numbers of borrowers in default and unable to sell as any meaningful price). In fact, two RB staff did a good article on the exch rate as shock absorber a few years ago (when the Bank wasn’t trying to play up risks)

      On the solvency vs liquidity question, as Geoff indicated in the Q&A session the other day, they treat them as largely separable (which seems mostly reasonable, altho any concerns about solvency can quickly spill into serious liquidity problems).

      You asked “And if so what are their measures to ensure the solvency of NZ-inc were there another GFC ?”, but from context I assume you mean liquidity there? They would argue that the core funding requirement etc has gone a long way to deal with the particular liquidity risks (dried up wholesale term funding markets) we had in 2008/09, and they would also regard the tools used in 2008/09 – wholesale guarantees and domestic market activities – as relatively easy to pull off the shelf. They are, at present, trying to make more robust the provisions we rushed in in 2008, allowing banks to repo securities made up of their own mortgages to the RB.

      My bigger concern about the next serious recession is more macro in nature: they haven’t done anything to ease or remove the near-zero lower bound and talk far too confidently about what QE and the like can achieved.


  2. I a more sanguine on the potential for supervision to have a positive impact. APRA’s recent macro prudential measures seem to have had an impact. That said, I very much agree with the point you are making about banking crises typically being due to endogenous risk build ups rather than random exogenous shocks as stress testing so frequently assumes. That I think is one of the reasons that stress test results are not as bad as people expect. The banks apply the stress to fundamentally sound balance sheets while the external inputs like house price falls are drawn from a different distribution where poor lending has degraded the quality of the loan book

    Good post


  3. I think this capital raising has more to do with reducing the annual $5 billion in dividends transferred to Australia each year. Each year our Australian banks strip out in dividends pretty much all of the retained earnings in Shareholders funds. What that means is that todays highly profitable bank is not tomorrow’s stable bank because once retained earnings is stripped each year, only the shell remains.


    • In general, there is no reason to retain earnings in any business beyond what is needed to support increases in assets. “Stripping out profits as dividends” is the purpose of every business.
      The two banks I checked – ANZ and BNZ – both have a pattern of increasing retained earnings, followed by an occasional conversion of a chunk of retained earnings into share capital. For the years 2014-2017, BNZ paid dividends of about 2/3 of profit, then in 2018 they “paid” a big dividend as a conversion into share capital. ANZ also converted a big chunk of retained earnings into share capital in 2018. As the banks grow (BNZ’s assets grew from $80B to $100B over this period), some additional capital is needed, even at the current capital requirements.
      So the claim that “only the shell remains” is flatly untrue, as you could have checked by looking at the financial statements.


      • pauldunmore, that is why I have consistently argued against looking at the Capital structure as Capital is a historical record and is currently represented by Assets and Liabilities. If you look at the Cashflow statement that accompanies the Balance Sheet for the ANZ as an example,

        The Profit for the year in 2018 is $1.9 billion and the Cash dividend paid is $4.6 billiion. Part of that is offset with a new capital issue of $3 billion which makes the net dividend paid out $1.6 billion. Therefore the previous year profit has been almost completely stripped out for the 2018 year.

        The Profit for the year in 2017 is $1.8 billion and the cash dividend paid out is $1.7 billion.

        Again pretty much proof that what I say is true, prior years profits are mostly stripped out in cash dividend payments each year leaving a shell.

        You would know if you checked the Financial Statements in its entirety.


      • ggs, as a retired accounting professor, reading the details of financial statements is something of a hobby of mine. (I should get out more!)
        The cash flow statement was the source of my dividend information. It shows, as you do not quite say, that ANZ paid a few hundred million less than the profits each year out to its shareholders as a dividend; the part that was retained was eventually converted to share capital. There is absolutely no reason for ANZ to retain most of its profits in the business, so this strategy seems exactly what one should expect. The accounting standard requires that cash flows be reported gross rather than net, so that the conversion was correctly reported as an outflow of $3B as a dividend with a simultaneous inflow of $3B for new share capital, even though there would not actually have been a pair of offsetting $3B cheques. Adding $3B to equity over a few years is certainly not “leaving a shell.”
        If you don’t look at the capital structure, I am glad that you do not manage any of my investments. The Balance Sheet is not the whole story – the income statement and cash flow statements and notes are also important – but it is an important part of the story. And for a bank, where the most important assets and liabilities are pretty much marked to market, the value of the capital is essentially a current number, not an historical one. Goodwill would be the main omission from the balance sheet.


      • There is a reason why Capital plus retained earnings is “represented by” Assets less Liabilities which does actually mean that it has transformed. No need to look at the Capital structure at all as it now exists in the form of Assets less Liabilities. Not too sure why I need to explain this to a professor?

        In fact liquidators or receivers would completely ignore the capital structure as it is the Quality of the assets that is available to meet liabilities that is of any importance. Who cares what the shareholders have put into the company when a solvency issue arises ie the assets are less than the liabilities.


      • The US Federal Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.Reserve requirements must be satisfied by holding vault cash and, if vault cash is insufficient, also by a deposit maintained with a Federal Reserve Bank.

        The current rate held either in vault cash or a deposit maintained by the US Federal Reserve Bank is 10% of the deposit liabilities with some minimal exemption thresholds. Prior to QE the US Federal Reserve would have just held US cash. Currently they are mostly holding US Treasury bonds instead of cash.

        If you compare our banks cash reserves(we have no RBNZ requirements) with the US Federal Bank Reserve requirement of 10%, our banks cash reserves hardly registers as a percentage of the deposit liabilities. Obviously the focus should be on holding cash reserves rather than stripping most of the profits and therefore the associated cash out by paying $5 billion plus a year to Australia leaving a shell NZ company.


      • “Not too sure why I need to explain this to a professor?”
        Because it is gibberish. Your story in your last two posts would have got you a fail grade in a first-year accounting paper; it misrepresents basic accounting concepts in several different ways.


      • pauldunmore, we are talking about solvency as a topic and not investment opportunity. Clearly you are struggling with differentiating the two concepts. Perhaps you need to understand the topic heading before rattling off in a tangent?


      • pauldummore, if you are looking at your year 1 accountancy papers for a solution, it is no wonder you are rather confused.

        The solvency test consists of two parts. Note that the focus is on the quality of the Assets to meet Liabilities Liabilities.

        Trading solvency/liquidity – the company is able to pay its debts as they become due in the normal course of business; and

        Balance sheet solvency – the value of the company’s assets is greater than the value of its liabilities, including contingent liabilities.

        The Companies Act 1993 requires that in some situations directors sign a solvency certificate. Sometimes this considers only the ability to pay debts as they fall due. Directors need to consider all circumstances that the directors know or ought to know that affect the value of the company’s assets and liabilities.


      • Troll? Actually more a rather bored Chartered Accountant with a Masters degree with honours from the University of Auckland on a $200k employee wage (yes I am a working accountant) with a $9 million investment property portfolio planning my next holiday. Fortunately this Labour/Greens/NZFirst government is keeping me in a job with all this quick fix not carefully thought out tax changes that is frightening many people who keep me rather occupied.

        Thinking maybe the Greek Islands would be my next Xmas holiday destination. Perhaps a US holiday in June. I did enjoy Vegas/LA/San Diego over the recent Xmas and New Year holidays.


  4. …out of interest then, how best to dent “the excesses, the over-optimistic lending and borrowing”? i.e. if more capital and/or supervision isn’t the answer and such periods aren’t bolts from the blue


    • There a few things that contribute:
      – use a floating exchange rate, so that your country’s interest rates can adjust to your country’s conditions,
      – don’t try to suppress risk too much, or eventually you will lift the restrictions and people won’t quite know what they are doing,
      – keep govts out of trying to direct lending (eg US housing finance market)

      That list will take a country a long way. But in part one just needs to be realistic about the human spirit, People will – and perhaps even should – get excited about new possibilities, they’ll take risks, and there will be mistakes. There have been in NZ and Aus in the decades after 1991, and in Canada in the 60 years of a floating exchange rate, but the attitudes of lenders and borrowers have been sufficiently conditioned to keep the mistakes within bounds, and avoid systemic crises,

      The risks are greater when a country is very fast-growing, and in catch-up mode. That, of course, hasn’t been us for a century or more, altho when the 2025 Taskforce wrote about the idea of catching up to Aus by 2025 it was one of risks (in transition) that they warned of.


      • Met up with my mortgage broker and he indicated that the banks personnel now do not have targets which once upon of time would have completely dominated their entire job description. This came about from the Australian Royal Commission that pointed to poor lending practices due to daunting monthly targets. This softening of lending targets has flowed onto their subsidiary banks here in NZ.Their focus at the moment is ensuring lending standards rather than meeting any lending targets.

        The effect is a tightening of credit supply but surprisingly we are seeing a downward pressure on lending interest rates when you would expect upward pressure which you would normally associate with a rationing of supply.


      • What it does mean is that banks are rather flush with Savers deposit liabilities and is under pressure to lend out but is constrained by higher lending standards rules and the likelihood of increased cash injection from higher Capital requirements which also needs to be lent out in order to meet shareholders annual dividend expectations.

        Increased Capital requirements point to lower costs of lending rather than higher in this scenario.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s