Bank capital again

Just a quick post today, as submissions close soon on the Reserve Bank Governor’s plans to require banks to fund much more of their balance sheets with equity capital, and I still need to write mine.  The Governor stated last week that the Bank has already received 50 or so submissions.  I hope that, in the spirit of open government and genuine consultation, the Bank will put those submissions up on their website pretty promptly –  and not, as is more usually the case with them (but not, say, with parliamentary select committees), only when the Governor has made his final decision.

I’ve seen a few submissions, none of which seemed very positive on what the Governor was proposing.   It remains striking that, five months on from the release of the initial consultative document there has still been no serious attempt at a cost-benefit analysis, and only the promise that they will eventually do one –  conveniently aligning, no doubt, with the final decision the Governor makes, and too late for any challenge or scrutiny of the analysis or numbers to make any difference.   It is quite an extraordinary democratic deficit that a single unelected official, himself appointed by other unelected officials, gets to make decisions of this moment on his own whim, with no rights of appeal or review.  And the Minister of Finance sits by claiming it is none of his business.

That lack of any cost-benefit analysis is one of the central points in BusinessNZ’s submission.   I noticed interest.co.nz’s Gareth Vaughan attacking BusinessNZ for not offering support to the leg of the Reserve Bank proposal which will improve somewhat the competitive position of the small New Zealand banks (by narrowing the differences between the risk-weighted assets calculations between the big banks using internal models, and the rest using the standardised rules).   I happen to support that leg of what the Reserve Bank is proposing but –  sensible as it is –  it isn’t going to be of much benefit to anyone other than the small banks themselves, unless those banks are able to raise materially more capital themselves and take a larger share of the credit market.  As I noted in my post on this issue a couple of weeks ago

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.

The big issue around the Reserve Bank’s plans is the proposal to greatly increase minimum capital ratios, and that is the focus of comments and submissions should probably be.

I’ve devoted a couple of posts here to the sterling work of my former colleague, former RB risk modeller, Ian Harrison in reviewing in depth the succession of documents the Reserve Bank has put out over the months to try to buttress its case.   Most recently, there was this post on the lecture Ian did at Victoria University late last month (and earlier there was his paper “The 30 billion dollar whim”.

Ian has now released another paper, “Third Time Lucky?”,  in which he reviews at some length the latest paper the Reserve Bank published (last month) in support of its proposals.   That Reserve Bank paper was described to me last week by a reader with considerable experience and expertise in these and related fields as simply not up to the standard one should expect from an advanced country central bank.

The short answer to Ian’s question is no: a compelling case still hasn’t been made. In fact, when I read a near-final draft of Ian’s paper last week I found it a pretty complete –  if sometimes quite technical –  evisceration of the Bank’s work.  I get the impression that he would regard the comment about this paper not being worthy of an advanced country central bank as being unfair to other central banks: it simply isn’t up to an acceptable standard for any powerful regulatory body, much less one where decisions are made by a single unelected official.

Here are his key conclusions

1. Capital increases unnecessary.    The Bank has failed to support its case for a substantial capital increase in the information document. The best evidence and logical analysis shows reasonably strongly that increasing banks’ capital ratios will reduce welfare. We stand by our previous assessment that the costs could be very large. Estimates of the net present value costs in the tens of billions would not be alarmist.

2. Risk tolerance approach a backward step. The risk tolerance approach is not an advance in thinking about bank capital ratios. It tends to muddle the issues and can, conceptually, result in suboptimal decision making. Other supervisors have similar mandates to the Reserve Bank’s, but none have attempted to quantify it, and define ‘soundness’ in terms of the probability of a financial or banking crisis. Bank crisis is too subjective a notion to be a useful hard metric for bank capital policy. The Bank is trying to solve ‘a problem’ of its own making. On any reasonable assessment the banking system is sound. We do not need the Reserve Bank to ‘make New Zealand sound again’.

3. Modelling analysis is embarrassingly bad. There has been a corrosion of the quality of the Bank’s policy analysis. Some of the analysis of the inputs into the capital model is an embarrassment for New Zealand and a risk to the Bank’s credibility. APRA, which can understand the analytics, must be worried about the quality of the analytics decision making in an institution they may have to work with if there is a financial crisis some time in the future.

4. Bank missed a double counting in the capital requirement. The Bank missed the fact that they have already increased bank capital by 20 per cent by requiring advanced bank capital to be 90 percent of that required under the standardised approach. Even if the Bank’s analytical modeling of the optimal capital ratio was robust (which it definitely is not) it should be wound back by about a third to correct for this double counting.

5. Impact of foreign ownership continues to be ignored. The Bank has continued to ignore foreign ownership of the New Zealand banking system. It has ignored: the possibility that Australian owned subsidiaries will be sometimes supported by their parents, reducing the probability of a crisis; that there is little point in a subsidiary having a higher capital ratio than its parent; and the cost to New Zealand of increased profits to foreign owners.

6. Economic cost of crisis substantially overstated. The direct economic costs of banking crises have been grossly overstated. The Bank’s preferred estimate appears to be 63 percent of GDP. A more realistic assessment of the marginal cost of a banking crisis, for New Zealand as opposed to the underlying economic shock, would be no more than 10 percent of GDP.

7. Misrepresentation of the social costs of crises. The Bank has grossly misrepresented the literature it extensively quoted from, on the social costs and longevity of banking crises. The World Bank and the UN did not say that financial crisis have long lasting effects as the Bank claimed. The relevant message from the papers the Bank quoted from is that the social costs in any economic downturn are substantially mitigated in countries, which, like New Zealand, have robust social safety nets. We found no evidence of long lasting ‘wider social costs’ in some relevant New Zealand data. Suicide rates, divorce rates and crime rates did not deteriorate during the GFC recession.

8. Fiscal risks benefits overstated. Higher capital will have a limited impact on governments’ fiscal risks, which are already limited and manageable. Higher capital may not reduce governments’ gross fiscal costs at all if a government feels obliged to top up a banks’ capital to the new higher level after a crisis. Anything less could mean the banking system would continue to be ‘unsound’.

And from his Introduction

However, the Bank still didn’t seriously engage on the following critical issues.

• The need to adjust for the difference between New Zealand and foreign capital calculations when using foreign data on the relationship between capital and the probability of a banking crisis.

• The need to consider the use of the Open Bank Resolution (OBR) option, which is a partial substitute for capital, as part of the capital review process.

• The need to consider the impact of foreign ownership of New Zealand banks on the probability of a crisis.

• The need to take into account foreign ownership on the cost of additional capital. The Bank has only considered the impact of interest rate increases on economic output. It has ignored the fact that there will be a transfer to foreign owners because of higher lending rates/or lower deposit rates.

• The need to explain the gap between its assessment of the ‘soundness’ of the New Zealand financial system and that implied by the rating agencies’ assessments and the Basel advanced model results.

• The need to explain why the Bank now considers the New Zealand financial system is unsound, when it had determined that it was sound in fifteen years of financial stability reviews.

There is a new Financial Stability Report out in a couple of weeks.  It will be fascinating to see how the Governor has attempted to draft around that final point.

As a reminder, there is every indication that what the Bank is proposing will involve putting in place the highest effective minimum core capital ratios anywhere in the advanced world, despite a near-complete absence of supporting evidence or analysis, despite twenty years of championing the role of the OBR mechanism, and despite the complete lack of any open engagement on the question of why our Reserve Bank is so confident that it is appropriate to impose much higher core capital requirements here than those being imposed on the parents of most of the same banks in Australia.  There has been no serious benchmarking undertaken, or if it was undertaken none published.

And, of course, there has been no serious or sustained analysis of the transitional effects or the distributional effects.    Without something of that sort there is even less reason to have confidence that the Reserve Bank really understands, or perhaps cares much, about the gubernatorial whim they are pursuing.

5 thoughts on “Bank capital again

  1. Does anyone have a sense of the magnitude of likely haircuts in any likely implementation of the OBR regime? People will differ on where the line gets drawn for a haircut that would trigger a bailout; doubt anyone would doubt a bailout if the haircut were 50%; I think a bailout unlikely at 10% but others disagree.

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    • I guess it depends on the magnitude of the loan losses (and potentially the uncertainty around them). For a retail bank final losses would probaby be perhaps 10% of even less for creditors, unless of course the bank had gone really rogue in the couple of years prior to failure.

      My own view on OBR is that it is a good option for small banks, and may even be a good option to have to hold over the Aussies (altho that argument is probably weaker than it used to be) but that it would never be used for a major bank, because (a) any failure of a big bank inevitably involves the parent in real trouble, and the political pressure will be for consistent trans-Tasman resolution, and (b) without deposit insurance few NZ govts would withstand the political pressure of “why I should i, a depositor in ANZ lose money, while my brother in melbourne, also banking with ANZ doesn’t”. As I’ve noted here before I favour deposit insurance (funded with ex ante risk-related levies) partly to increase the likelihood that OBR could be used on wholesale creditors, domestic and foreign.

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      • It is depressing to think that sad stories around losses of 10% from bank savings accounts could trigger a bailout. If they could, then there’s a case for insurance. Bizarre that insurance and capitalisation inquiries are proceeding along separate tracks though.

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      • One of my benchmarks here is a story Alan Bollard used to tell, from his time as Secy to the Tsy, about the bailout of Air NZ in 2001. It involved no material wealth losses for anyone (shareholders had already lost) and most staff would presumably have been re-employed in replacement airlines, but the PM’s question was along the lines of “can you assure me that if we do nothing there will still be a koru flying next week?” Tsy had to answer ‘No’, and so her decision was to bail. (It would be interesting to hear the Clark version of that episode, but it sounds depressingly plausible, and not limited to her. )

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