It probably isn’t a great look for a powerful government agency, avowing its desire to hear from anyone and everyone on its radical proposals, to have its spam filters set so that a vocal critic’s submission couldn’t be received (that was my experience last night).  But I did get a friendly response when I enquired what was going on, and no doubt they will get it sorted out today.

My submission is here

Submission to RBNZ minimum capital ratios consultation 15 May 2019

The Governor’s consultation document was released in December. It was the culmination of a review of aspects of the bank capital framework that had been underway for several years, but as the documents the Bank subsequently released made clear, much about the central proposal –  the large increase in minimum core capital ratios – had come together only at the last minute, none of the supporting analysis had been critically reviewed before the Governor adopted it as his cause, and the analysis started weak and never really improved.  No decent analysis has ever been presented about the transitional effects, including distributional effects and possible changes in the structure of the financial system.

In a mark of all that is wrong with the governance of financial regulatory functions in New Zealand, having signed on to the cause of much higher capital ratios, the Governor will now be judge and jury in a case he himself is prosecuting.  And there are no rights of appeal.   Good government has to mean something better than this.

The Reserve Bank’s December 2018 consultative document proposed three main changes:

·       Much higher minimum ratios of capital (CET1) to risk-weighted assets than previously,

·       Higher minimum capital ratios for systemically-significant banks than for other locally-incorporated banks, and

·       A significant narrowing in the gap between the calculation of risk-weighted assets as between the big banks using internal models and the remaining locally-incorporated banks using the standardised approach.

In my submission I supported the third of these proposals (which itself would be expected to lead to a reasonably significant increase in capital for the big banks) and opposed the other two.   Higher capital ratios for similarly-risky large banks might make some sense if the minimum requirements were themselves modest, but they aren’t (and rating agencies generally reckon that our larger banks are safer than the small ones –  which makes sense for various reasons, including the strong parents who own the larger banks).

The focus of the submission was on the proposal to increase substantially the minimum core (CET1) capital ratios.  Combined with the higher floor proposed for calculating risk-weighted assets, this proposal would –  it appear, but we could never be sure because no serious benchmarking was presented –  have made New Zealand regulatory minima among the very highest in the world.  No case was made in the consultation document for why that was appropriate, including why it was appropriate for New Zealand requirements to be so much more demanding than those in Australia.

Most of the material in the submission has probably already been covered in a succession of posts here over recent months, but here it is in summary form.

I started by noting that there seemed, at best, a scant prima facie for further large increases in minimum capital requirements.

Relevant context

An unbiased observer, looking at the New Zealand economy and financial system, would struggle to find a case for higher minimum capital ratios.   Among the factors such an observer might consider would be:

• The fact that the New Zealand financial system has not experienced a systemic financial crisis for more than hundred years (and to the extent it approximated one in the late 1980s, that was in the idiosyncratic circumstances of an extensive and fast financial liberalisation which left neither market participants nor regulators particularly well-equipped),
• Our major banks – the only ones that might pose any serious economywide risks – come from a country with very much the same historical record as New Zealand,
• Despite very rapid credit growth in the years prior to 2008 (increases in the credit to GDP ratios among the larger in the advanced world, spread across housing, farm, and other business/property lending), and a severe recession in 2008/09 and afterwards, the banking system emerged with low loan losses,
• Since then, banks have not only increased their actual capital ratios (and been required to calculate farm risk-weighted assets more stringently) but have also substantially improved their funding and liquidity positions (under some mix of regulatory and market pressure).
• Over the decade, bank credit growth (relative to GDP) has been pretty subdued and there has been little or no evidence (in, for example, Reserve Bank FSRs) of any serious degradation of lending standards.
• The balance sheets of the large banks remain relatively simple, and there has been no sign (per FSRs) of the sort of financial innovation that might raise significant doubts about the adequacy of existing models.
• In terms of the wider policy environment, government fiscal policy remains very strong, we continue to have a freely-floating exchange rate, and there has been neither legislation nor judicial rulings that will have materially impaired the ability of banks to realise collateral.
• And the Open Bank Resolution option for bank resolution has been more firmly established in the official toolkit (note that if OBR were fully credible then, in the absence of deposit insurance, there would be little case for regulatory minimum capital requirements at all).
• And repeated stress tests – over a period when the regulator had no incentive to skew the tests to show favourable results –  suggested that even if exposed to extremely severe adverse macro shocks, and associated large price adjustments for houses, farms, and commercial property, not only would no bank fail, but no bank would even drop below current minimum capital requirements.
• Consistent with this experience – also observed in Australia, the home jurisdiction of the parents of our major banks – the major banks operating here continue to have strong credit ratings (consistent with a very low probability of default), and the ratings of the parent banks are even higher.
• There has been no change in the ownership structure of our major banks, or in the implied willingness of the Australian authorities to support the (systemically significant) parents of the New Zealand banks were they ever to get into difficulty.

Add into the mix indications that New Zealand banks CET1 ratios, if calculated on a properly comparable basis, would already be among the highest in the advanced world –  in a macro environment with more scope for stabilisation (floating exchange rate, strong fiscal position, little unhedged foreign currency lending) than in many advanced countries –  and there would be a fairly strong prima facie case for leaving things much as they are.

But the Reserve Bank’s consultative document – and associated material, including speeches and interviews – engages substantively with almost none of this context.

There is little evidence the Bank has thought hard about financial crises.

…there is a strong (implicit) tendency in the document to treat financial crises as exogenous shocks, events arising out of the blue, which a decently-managed bank (or financial system) will face every once in a while, (be it once a century, or two).     But a moment’s reflection is all it should take to realise that that is simply the wrong approach to be using (especially when, as in this consultation, you are talking of proposals designed to reduce already-low risks to extremely low levels).     You could look at the Irish crisis, the Icelandic one, the US crisis, the Korean crisis of the 1990s, the Nordic crises of the early 1990s (and even the New Zealand and Australian experiences in the late 80s and early 90s) to appreciate that the system-threatening problems didn’t arise from exogenous shocks, but from several years of very degraded lending standards.     Exogenous shocks may have played some part in determining the timing and nature of the crystallisation of the problems, but they weren’t what determined that there would be a costly re-adjustment at some point.  If the Bank believes differently, the onus should have been on it to make its case.  There was no sign of such a case in the consultation document. 

Linked to this point, there is very little recognition (none in the main document, and very little in subsequent papers) that many or most of the output losses associated (in time) with financial crises have to do with the misallocation of resources (bad lending, bad borrowing, bad investing) in the preceding boom years.  Your documents recognise that one cannot simply measure output losses from a pre-crisis peak (typically a period with a positive output gap) but do not go anywhere near far enough to recognise the significance of this, rather larger, point. In such circumstances, estimates of potential GDP itself may be materially overstated.  As far as I can tell, the research papers you quote are open to the same criticism (which is not a defence for the Bank, but – probably – an indication of the predispositions of many of the chosen researchers and their institutional sponsors).

When an economy and financial system has gone through several years of badly misdirected lending, borrowing, and investment, not only is there an inevitability about output losses because of the bad prior choices crystallising, but there is a near-inevitability about both lenders and borrowers being hesitant about doing new business in the wake of the realisation of past mistakes.  Prior assumptions and business models prove invalid, and it takes time for risk appetite to revive, and to identify like projects that would prove profitable.  That is likely to be so whether or not banks emerge from the crystallisation phase with ample levels of capital.       At best, it is only the marginal additional output losses from banks falling into “crisis” (however defined) that is likely to be eased by much higher initial capital ratios – and yet you made no attempt to distinguish this effect.

The Bank has made no effort to provide a proper cost-benefit analysis, with key assumptions and sensitivities documented, but even what on has been presented the numbers just don’t seem to add up.

In his speech in February, the Deputy Governor indicated that the Bank’s own analysis suggested that the output cost of the proposed higher capital ratios would be “up to 0.3 per cent” of the level of GDP.  In other words, the annual insurance premium society would pay – even on your assumptions – might be 0.25 per cent of GDP.  As you note, the standard Treasury discount rate is a bit larger than what is used in many of the papers you cite, and applying such a discount rate to this expected annual cost gives a present value of lost output of perhaps $15 billion.    That is a high hurdle to get over when the gain on offer is the reduced (from already low levels) probability of output losses resulting (narrowly) from a financial crisis expected in, on average, 75 or 100 years’ time (your claim is that you want to keep the probability of crisis to no more than once in 200 years).   On plausible estimates of those marginal additional output loss savings, the cost-benefit simply would not stack up.  (And as Ian Harrison notes, none of these numbers appear to take account of the income loss to New Zealanders from imposing higher capital requirements on – and thus requiring higher expected equity returns to shareholders of – foreign-owned banks.)

There has been no attempt to adequately benchmark the Bank’s proposals against those of other regulators, and no sign that the Bank engaged closely with APRA in bringing them together.

It is grossly unsatisfactory that throughout months of consultation the Bank has made no effort to illustrate how its proposals for minimum CET1 ratios and the associated floors around the calculation of risk-weighted assets, compare with those planned by APRA for the Australian banks.

Such an exercise should have been relatively straightforward, especially if the Reserve Bank had done what most New Zealanders might reasonably have expected, and worked closely together with APRA in formulating its proposals.  Of course, New Zealand is a sovereign nation and the Reserve Bank (regrettably) has final decision-making powers in New Zealand but:

·       APRA has a considerably deeper pool of expertise, including at the top of the organisation, than the Reserve Bank of New Zealand,

·       The nature of the risks in the two economies and markets is quite similar (including similar legal institutions, and similar housing markets),

·       If anything there is a case for thinking that APRA minima would be ceilings below which New Zealand requirements for our large banks should be set (since we have the benefit of strong parent banks, and well-regarded supervisor of those banks, whereas the parents  – and parents’ supervisors – themselves are on their own, and we have also chosen to have the OBR as a frontline resolution option),

·       For the institutions that might pose potential systemic issues in New Zealand, any substantial increase in capital requirements can reasonably be seen as an attempt to grab group capital for New Zealand.  Why not work these things out together?

The onus should, surely, be on the Reserve Bank of New Zealand to demonstrate – make the case in detail – why the New Zealand subsidiaries of Australian banks should be subject to more onerous capital requirements than the parents, and banking groups as a whole, are subject to.  But not once has the Reserve Bank attempted to make that case.

The arms-length (or worse) approach re APRA seems hardly consistent with the spirit of the trans-Tasman banking regulatory accords that were reflected in the legislation of both countries some years ago, even recognising that New Zealand interests are not always identical to those of Australia.

And there has been no analysis published on the transitional effects, the distributional effects, whether any disintermediation might worsen the soundness and efficiency of the financial system.

The only estimates we’ve seen have been those for possible changes in lending margins for institutions affected by the proposed higher capital ratios. There has been no serious analysis published of the extent to which banks might become less willing to lend. And there has been no discussion about the extent to which business may migrate from regulated banks to either unregulated (i.e. not locally incorporated) banks here or abroad, or to finance companies, or of the possibility of disintermediation (such that more of society’s demand for credit is met without the direct interposition of a financial institution’s balance sheet). There has been no analysis of which economic sectors might be most severely affected. Large corporates for example will have plenty of alternative providers, probably at a price very similar to what they pay now, and many housing mortgages could be relatively easily securitised if necessary, but SMEs and rural borrowers might be more likely to bear the brunt of any price or capacity adjustment. Similarly, there was no analysis of where the brunt of any adjustment to deposit and wholesale funding interest rates might fall, but it seems reasonable to posit that wholesale creditors will not bear most of the burden.

Perhaps more concerningly still, there is no sign of any analysis of whether a financial system in which more business has gravitated to institutions not locally-incorporated or to disintermediated markets would be (a) sounder, and (b) more efficient. There is a risk that the core banks (already low risk) become somewhat safer, but that those institutions in future have a diminished role in the system. Most of the Bank’s analysis appears to, in effect, treat locally incorporated banks as the sum of the financial system, which is less likely to be the case in future if these proposals proceed. Failure to address these issues does not instill confidence.

And

… there was no discussion at all of the macroeconomic context in which these proposals would take effect. The proposals involved a transition over five years. Nine years into an economic recovery, with slowing domestic growth and growing global risks there has to be a fairly significant chance that the next significant recession will occur in the next five years (i.e. during the proposed transition period). That means a significant risk that regulatory policy would be exacerbating any downturn (through tighter credit constraints, reduced credit appetite, and potential higher pricing), in a downturn in which monetary policy is likely to be hard up against conventional limits (the Bank’s own analysis has suggested the OCR might be able to be cut only to around -0.75 per cent). Of course, if bank balance sheets were looking shaky it would be prudent to move ahead anyway – better ten years ago, but if not then now – but nothing in the Bank’s published analysis (past FSRs, stress tests, consultation document) nor in the credit ratings of the relevant institutions suggests anything like that sort of vulnerability. Without it, you will – with a reasonable probability – make economic management over the next few years more difficult (additional upfront potential economic costs), in exchange for the modest probability of making any real difference to (already very low) financial system risks over that period. It isn’t a trade-off that appears to be worth making – at least not without much more supporting analysis than we have had to date.

I also commented briefly on the signs of anti-Australianism that have emerged from senior Bank managers

We’ve also seen it in rather glib comments that perhaps the Australian banks might sell down their stakes in their New Zealand subsidiaries, in a tone which implies that Reserve Bank senior managers think this might be quite a good thing.    Anti-Australianism is a recurring theme in New Zealand political debate around banks, but it should have no place in the assessments or public comments of officials operating under the Reserve Bank of New Zealand Act.

In my view, New Zealand benefits considerably – in terms of financial system soundness and efficiency – from the fact that the major banks are all part of much larger banking groups, each headquartered in a friendly country with good institutions, and strong record of financial stability.   The Reserve Bank should not lightly jeopardise that situation with proposals that simply aren’t backed by robust analysis of the risks they are supposed to mitigate or of the costs of adjustment.

Before concluding

Serious recessions are things to seek to mitigate.  That is primarily the role of discretionary monetary policy, made possible by a floating exchange rate.  Serious misallocations of resources are likely to be costly, but the misallocations arise in the good times – when credit is growing strongly – not in the subsequent bust.  The marginal additional losses arising from financial crises themselves appear to be (typically) small, and these proposals in any case involve only a further modest reduction in an already low risk of serious problems (in a country with little history of serious systemic financial problems).  

There are limits to what any regulators and officials can do about initial misallocations, but my recommendation to the Bank would be to abandon the push for higher minimum capital ratios (while proceeding to level the playing field between advanced and standardised model banks) and to focus its energies instead on sharpening its ability to recognise, and respond vigorously to, any sharp deteriorations in lending standards promptly when and if they get underway.  Complement that with robust championing of  (a) the importance of the floating exchange rate regime –  especially in a country with neutral interest rates higher than the rest of the world –  and (b) of keeping the government out of the business of directing credit and, together with existing demanding capital standards, you are likely to best serve the interests of New Zealanders.  Better that approach than the (probably costly) steep increases in capital requirements proposed in the consultation document without anything like adequate, carefully and independently scrutinised, supporting analysis.    New Zealanders deserve better than they have had in the poor process and weak substance that together made up this consultation.

We can only hope that the Reserve Bank will be proactive and publish all the submissions shortly, not wait (as they often do) until the Governor has retreated to his high castle and contemplated for months.

There have been all sorts of unsatisfactory aspects to the process around this consultation.   There was no good reason why extensive socialisation, and testing, of the Bank’s analytical material –  such as it is –  could not have been undertaken well before the Governor signed up to one particular option.  In a system where the Governor is also the final decisionmaker, with no rights of appeal, that would have been even more useful and appropriate.  When they did publish the consultative document, they should have all the supporting material already available and published simultaneously, not released (as it was written) over several months subsequently.   And the quality of the material they have put out –  whether or not one agrees with the proposed bottom line –  just isn’t up to scratch.

That is the Governor’s responsibility, personally (although his Deputy, the Head of Financial Stability, presumably shares a lot of responsibility).   The Bank’s Board exists largely to hold the Governor to account, on behalf of the public and the Minister of Finance.  They really should be asking hard questions already about the substance and (in particular) the process, and insisting on a proper ex post review, including (for example) a survey of submitters and other stakeholders.   Early last year the New Zealand Initiative published a major report highlighting how poorly the Bank was regarded as a financial regulator.  Perhaps the particular failings that concerned people have changed a little in the transition from Wheeler to Orr, but it is difficult to believe that the Bank is any more highly regarded as a regulator now than it was then, and all the structural weaknesses –  which underpin the cultural problems – are still as they much as they were: too much power rests with a single individual, with little effective accountability.   It isn’t helped by the fact that neither of the key senior individuals has a strong background in financial stability or regulation.   New Zealanders deserve better.

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.