A week or two back I foreshadowed a forthcoming paper by my former colleague Ian Harrison reviewing the Reserve Bank’s proposals under which the banks would have to greatly increase the volume of capital simply to carry on doing the business they are doing now.

Like me, Ian spent decades at the Reserve Bank.  But much of his time was spent specifically in the area of banking regulation and bank supervision, including leading much of the modelling work done a few years ago as part of the Basle III process, which resulted in something like the current bank capital requirements.   He knows the detail in this area, has consulted on this sort of stuff since leaving the Bank, and has invested a great deal of time and effort over the last couple of months in getting to grips with the Bank’s proposals, reviewing the various papers they’ve published, and going back and reviewing the papers the Bank has cited in support of their case.   The result is his (50 page) review document.   Here are his key conclusions (overlapping in various places with points I’ve made in post here). Ian does not pull his punches.

Part two: Key conclusions

1. The ‘risk tolerance’ approach is a backward step that ignores a consideration of both the costs and benefits of the policy. The soundness test is based on an arbitrarily chosen probability of bank failure that ignores the cost of meeting the target. The Bank has ignored its own cost benefit model which did take the probability of bank failure, the costs of a failure, the interest rate costs of higher capital and societal risk aversion into account.

2. Bank decision based on fabricated evidence. The Banks’s decision to pursue a 1:200 failure target was purportedly based on evidence from a version of the Basel advanced model. It was manipulated to produce the right answer. Initially, a 1:100 target was proposed, but when this couldn’t generate a capital increase, the target was switched to 1:200 at the last minute.

The Bank’s model inputs were not credible. It was assumed that all loans were higher risk business loans and that the probability of loan default, a key model input, was more than two and a half times the estimates the Reserve Bank has approved banks to use in their capital modelling.

The Bank’s analysis was embarrassingly bad, so it attempted to cover this up with a subsequent information paper that was written after the decision was made, and after the Consultation paper was released. It reached the same conclusion on the required level of capital, but only by assuming a 1:333 failure probability, and by using model inputs that were still not credible.

3. A 1:200 target can be met with a capital ratio of around 8 percent. If the Basel model were rerun using credible inputs if would probably show that a 1:200 failure rate can be met with a capital ratio of around 8 percent.

4. The policy will be costly. The Bank has down played the interest rate impact of the policy, saying any increases will be ‘minimal’. Based on its own assessment of the interest rate impact, the annual cost will be about $1.5-2 billion a year. The present value of the cost of the policy could be in excess of $30 billion.

A homeowner with a $400,000 mortgage could be paying an additional $1,000 a year. A business with a $5 million loan could be paying an additional $50,000.

5. The Bank’s assessment that the banking system is currently unsound is at odds with rating agency assessments and borders on the irresponsible. The rating agancies’ assessment of the four major banks is AA-, suggesting a failure rate of 1:1250. The Bank is now saying that, at current capital ratios, the banking system is ‘unsound’ because the failure rate is worse than 1:200. Or in other words the New Zealand banking system is not too far from ‘junk’ status. The international evidence does not support the Bank’s contention that the probability of a crisis is worse than 1:200. The Bank has ignored the fact that banks will need to hold an operating margin over the regulatory minimum, and has not adjusted New Zealand capital ratios to international standards to make a fair like-for-like comparison.

6. The Bank‘s analysis ignores the fact that the banking system is mostly foreign owned. Foreign ownership increases the cost of higher capital because the borrowing cost increases flow to foreign owners. Foreign owners will support their subsidiaries in certain circumstances, which reduces the probability of a bank failure. There is little point in having a higher CET1 ratio than Australia, because if a parent fails then it is highly likely that the subsidiary will also fail, because of the contagion effect. A New Zealand subsidiary might still appear to have plenty capital, but depositors will run and the Reserve Bank and government will have to intervene.

7. The Australian option of increasing tier two capital has been ignored. APRA is proposing to increase bank capital by five percentage points, but will allow banks to use tier two capital to meet the higher target. This provides the same benefits, in a crisis, as CET1 capital, but at about one fifth of the cost. New Zealanders will be required to spend an additional $1.2 billion a year in interest costs for almost no benefit in terms of more resilience to a severe crisis.

8. The benefits of higher capital are modest. Most of the costs of a banking failure are due to borrowing decisions made before the downturn. This will impose costs regardless of the amount of capital held. With current levels of bank capital failures will be rare, with the main cost likely to be a government capital injection. The experience with most banking crises, in countries most like New Zealand, is that governments have recovered most of their costs when the bank shares are subsequently sold.

9. The Bank is mis-selling insurance. The Bank is selling a form of insurance to the New Zealand public, but it vague about the premium costs and has exaggerated the benefits. The premium is the $1.5-2 billion. The benefit would be around a 10 percent reduction in the economic cost of a financial crisis, with an expected return of a few tens of millions.

An informed, rational public would not buy this policy.

10. New Zealand banks already well capitalised compared to international norms. A recent PricewaterhouseCoopers report argued that if New Zealand bank capital ratios were calculated using international measurement standards they would be 6 percentage points higher, placing New Zealand in the upper ranks of well capitalised banking systems. The Reserve Bank critised some details in the report, but has not produced is own assessment as Australia’s APRA has done.

11. The Bank has forgotten about the OBR.   The Open Bank Resolution (OBR) bank failure mechanism, was originally conceived as a substitute for higher capital to reduce fiscal risk, and to reduce the costs of a bank failure. While banks are been required to spend almost $1 billion on outsourcing policies to supportthe OBR, it does not appear in the capital review at all – despite the Governor’s arguments that the main justification for capital increases is to reduce fiscal risk.

The bottom line?

An informed, rational public would not buy this policy.

But, as it happens, an informed rational public won’t get a say. The Governor proposes and (under New Zealand law) disposes: prosecutor, judge, jury, and appellate court in his own case.

Partly, I gather, for his own amusement, and partly to help respond accessibly to some specific assertions/arguments in the more accessible material the Bank has put out to support the Governor’s case, Ian has a separate document, the Pinocchio awards.

The Governor is a great deal smarter and more analytically capable than Donald Trump, but on Ian’s reading, he is resorting to the financial regulator’s equivalent of questionable Trumpian rhetoric to champion the indefensible.  Against Trump there are the courts and Congress.  Against a Governor with a whim and the bit between his teeth……well, nothing really.

It would be interesting to see what the Reserve Bank makes of Ian’s arguments and evidence.

UPDATE: A fairly accessible summary of some of Ian Harrison’s key argument in this article by veteran journalist Jenny Ruth.