Some benefit from RB capital proposals…but probably not New Zealand

I might have written about something in this morning’s Herald but, despite being one of that diminishing number of hard copy subscribers, they still haven’t sent out the promised email on how to activate online access to the Premium material.   How hard can it be?

And so it is back to the Reserve Bank’s proposals to substantially increase the amount of capital banks have to have to fund their current level of business.

There was a column on yesterday, by Gareth Vaughan, that will have warmed hearts at the Reserve Bank.     It begins this way

The Reserve Bank of New Zealand’s proposals to significantly increase the amount of capital New Zealand banks must hold should be a good thing for both banking competition and NZ taxpayers.

I’ll come back to the competition argument in a moment, but do note that the “good thing for NZ taxpayers” argument is not overly plausible.   The chances of a large bank failing are already very very small (see successive Reserve Bank stress tests) and –  on the Reserve Bank’s own telling (recall the Deputy Governor says that GDP will be perhaps 0.25 per cent lower each and every year) – the insurance premium is high.   (And that is before mentioning OBR –  supposed to help handle bank failures – or the fact that higher minimum capital ratios would also increase the gross amounts required in any crisis government recapitalisation.)

Vaughan presents the issue as a contest between the Australian banks and our doughty heroes the small New Zealand banks.  Of the former we read

Get set for opposition from the big four banks and their allies, including business lobby groups and professional services firms, to ramp up in coming weeks.

Make no mistake. The big four banks are very grumpy about these RBNZ proposals. This much is clear even though little has been heard from them publicly to date.

But the small New Zealand banks, so we are told, are much more sympathetic.   Why?  Because what the Reserve Bank is consulting on is actually a bundle of two, quite logically separate, proposals.

  • the first is to increase the minimum core capital (CET1) ratios for everyone (to 16 per cent of risk-weighted assets for the big 4 banks, and 15 per cent for all the other locally-incorporated banks.  I’m predicting that not a single directly-affected bank actually favours that increasse.   After all, if they thought it was such a good idea there is nothing to stop them running with a larger share of equity funding now.
  • the second is to treat the big 4 banks (which are allowed to use internal risk models, under Reserve Bank oversight, to assign risk weights) more similarly to the other locally incorporated banks, which have to use the “standardised” Basle weights, which are generally (although not always) higher.    At present, the Reserve Bank estimates that the big banks’ calculation of risk-weighted assets is only about 75 per cent of what it would be if they had to use the standardised weights.  The Bank proposes to put in a floor that would prevent the big banks have risk-weights (across the whole portfolio) less than about 90 per cent of what the standardised weights would produce.    (This floor is much higher than what is being applied elsewhere: APRA, for example, is planning to use a 72.5 per cent floor.)

The smaller locally incorporated banks are very keen on the second strand of the package.   And why wouldn’t they be?   They will be quite keen on larger banks having to hold higher headline capital ratios than they do too.  Again, why wouldn’t they.

I’m generally sympathetic to what the Reserve Bank is trying to do in reducing the possible gaps between the sorts of risk weights banks using internal models can use and those other banks have to use (and was sympathetic to that cause when I sat on the relevant policy committee at the Reserve Bank).   That is particularly so as the Reserve Bank has been very reluctant to allow other banks (notably Kiwibank) to use the internal models approach.   One could even mount an argument that, in the New Zealand context with simple balance sheets, little or nothing is gained by retaining the IRB class of banks (and risk-weighting at all).

But, at least in principle, the IRB system wasn’t designed to provide a competitive edge to big banks. In principle, it was designed to recognise that bigger banks had more sophisticated risk systems and (again in principle) that it would possible to show that in some areas the actual risk on a particular class of credits was lower than the –  inevitably somewhat arbitrary –  standardised weights would capture.   Separately, one could also argue that big banks would typically have more diversified portfolios than small banks   (think of how the old Taranaki Savings Bank might have fared had Mount Egmont had one of its larger eruptions).

In practice, the incentives are all wrong.  For regulatory capital purposes (for their own risk management it might be different) IRB banks had every incentive to try to game this system –  not even necessarily consciously –  and the regulator would always struggle to keep up.  It might be a rather crude response, but the floor at around 90 per cent seems like a reasonable approach (especially if it is transparent, and it is thus relatively easy to translate capital ratios calculated that way to compare with ratios in other countries with lower floors).  Perhaps there are compelling arguments against, but if so the big banks have not yet advanced them in public.

Here, from the Reserve Bank’s website, is a chart of the current CET1 ratios


The first thing to note is that the smaller banks generally have higher (headline) CET1 (core equity capital and retained earnings) than the larger banks.  The smaller New Zealand banks had an average ratio of 13.4 per cent of risk-weighted assets, and the large Australian banks had an average ratio of 11.4 per cent.     Apply the 90 per cent floor to the calculation of risk-weighted assets and that big bank average would drop by up to 2 percentage points.   In short, calculated the same way (the way the Reserve Bank proposes in the future), the big banks might now have an average CET1 ratio of perhaps 9.5 per cent, and the small banks are averaging 13.4 per cent.     And the Reserve Bank’s consultative document proposes that the 90 per cent floor would come into effect straightaway, pretty much as soon as the final decision is announced –  no five year transition period there.

It makes considerable sense that the big Australian banks have lower capital ratios than these New Zealand banks.  The former are  diversified parts of big Australasian market-listed banking groups.  In other words, not only is there a parent to provide support (if needed), but a mechanism for raising additional capital if things go wrong.    By contrast, not only are the New Zealand banks smaller, but only one is listed.  And only one has a parent (Kiwibank, owned by three separate arms of the New Zealand government).  Note that it is not the regulator who has required these differences –  9.5 per cent vs 13.5 per cent, measured similarly –  but rather “the market” (shareholders, directors, and management have together made choices that those small banks require higher capital ratios in New Zealand to compete effectively).

And, as it happens, in at least two of those cases (TSB and Co-op) current capital ratios are so high that the Reserve Bank’s proposals to increase minimum capital ratios won’t be very binding at all (the minimum for these banks will be 15 per cent).  Recall too that domestic owners of banks benefit from dividend imputation, such that any additional cost of additional capital is less than is the case for other banks.

Without very much market discipline (in most cases), it is hardly surprising that the small local banks will regard the Reserve Bank’s proposals as a win for them.  They won’t need to raise much more capital (in most cases), and the big banks will have to raise a lot.  If the proposals succeed, whereas the big banks have been able to have considerably lower core capital ratios than these small banks, in future the big banks are likely to end up with higher ratios.    One might question “to what end?” (in a policy/economics sense), but for the small banks it looks like a clear win.

Who else might think of these proposals as a clear win (and consider offering the Reserve Bank support)?   Why, surely the people who aren’t directly affected by them at all?  And that would include?   Well, for example, any foreign bank with operations here that aren’t locally-incorporated.  Impose a heavier regulatory burden on the locally-incorporated local competition, and what is not to like.   People whose business would be helped by more local bond issuance (corporate bonds or securitised assets) might also look benignly on what the Governor is proposing.

I don’t suppose any big foreign banks will actually be submitting in support.  After all, if the Reserve Bank proceeds with its proposals it will represent probably the most demanding capital regime in the world, and other regulators in other countries –  with their eyes on more capital – might in future point to New Zealand as some sort of model.   My point is just that one shouldn’t be surprised if there are some people who are quite keen on the changes, and only some of those making that case will be not self-interested.

The thrust of Gareth Vaughan’s argument (and there is no reason to suppose his argument is self-interested, any more than mine is on the other side), is that greater competition will follow from the proposed changes, and that that can only be good for the consumer of banking services (lender, borrower, or whatever).  But it is hard not to read what he is writing as mostly just anti Australian banks, regardless of the consequences for New Zealanders (household or businesses).  This is the final paragraph of his column

The owners of NZ’s big four banks have been the cats that got the cream over the past decade. The RBNZ’s capital proposals threaten to end, or at least disrupt, their halcyon days. Should the RBNZ proposals go ahead unchanged there could be some short-term pain for borrowers and savers. Given the market power of the big four banks it’s difficult to rule this out. But a level capital playing field ought to boost competition in NZ banking, and longer-term, should we face a banking crisis, taxpayers ought to be less on the hook than they would be under the current bank capital regime.

Perhaps he could show us a plausible scenario in which a large New Zealand bank –  with capital ratios already well higher than they were – fails?  Reserve Bank stress tests (and anything else they’ve published) has so far failed to do so.

But what about this  prospective greater competition?   Surely for the New Zealand consumer as a whole to be better off, we would need to see more capital, not less, voluntarily committed to the New Zealand banking market.  And how likely is that?

Sure the competitive position of the small banks is going to be improved, relative to what it is now, but –  as noted earlier –  only one of those smaller banks is a listed vehicle, and neither TSB, SBS, or Coop have means of raising lots more core capital without dramatically changing their ethos or ownership structure.    Perhaps Kiwibank might manage to wrangle lots more capital out of NZ Post, NZSF, and ACC….or perhaps not.  And how confident could we be that New Zealand would be better off with a very fast-growing government-owned bank, subject to few effective market disciplines.  That sort of entity has often been on a fast road to something very nasty.

And what of the Australian banks?  Perhaps they won’t look to divest some or all of their New Zealand operations, but it is hard to believe that in the wake of these proposed changes they will be keen on growing their New Zealand books (except perhaps putting big corporate loans on the balance sheet of the parent?).

All in all, it sounds like a recipe for wider intermediation margins all round, and less banking sector capacity in New Zealand.  Relatively speaking the small banks might win at the expense of the larger banks, but (a) that just has the feel of corporate welfare without needing to involve the Provincial Growth Fund, (b) most of them look capital-constrained (if contemplating seriously taking on the big banks and replacing capacity) and (c) more importantly, it isn’t clear how those wider intermediation margins and reduced capacity would enhance the efficiency and competitiveness of the New Zealand economy.   Rates of return on investment in the Australian bank subsidiaries probably will fall to some extent, but people like Vaughan –  and the Governor –  should be careful what they wish for.

(And, as a final reminder, levelling the playing field around the floor on the calculation of risk-weighed assets is a totally separable issue from what the minimum CET1 ratio should be.  If current levels of capital are consistent with systemic stability –  as the Reserve Bank repeatedly assures us in its FSRs is so – raising the floor in the calculation of risk-weighted assets could have been accompanied by a reduction in the minimum ratio of capital to risk-weighted assets without affecting by one iota the riskiness of the banks concerned.  I’ve made the case elsewhere for why the argument for higher minimum capital looks threadbare.)