Reflecting a bit further on the Reserve Bank Governor’s decision to increase very substantially the proportion of locally-incorporated banks’ balance sheets that need to be funded by capital, and on some of the points I’ve made over the year, I was trying to distinguish in my own mind quite how the Governor seems to see bank capital (the differences it can/does make) and how I see it.   This post is an attempt to jot some of that down, and to clarify a bit further some of my own thinking.

Loss absorption at or very near the point of failure isn’t really a point of difference.

Take a bank approaching the point of failure, with signs that the value of its assets might be less than the liabilities to creditors (including depositors).  If some fairy godmother suddenly injects a lot more capital, not only might the bank not fail at all, but if it does nonetheless fail the losses creditors will face will be greatly reduced.   Creditors/depositors generally like capital and will typically charge a higher price to lend their money to a bank that is perceived not to have very much of it.  That is a market process, and is how small entities (in a system with no deposit insurance, such as New Zealand at present) function routinely.

Government bailouts have the same sort of effect at/near point of failure, whether they take the form of guarantees that are paid out in liquidation (eg South Canterbury Finance under the deposit guarantee scheme) or a government recapitalisation of a bank as a going concern (eg, in a New Zealand context BNZ in 1990, or numerous more recent examples abroad).     The money taxpayers put in is a cost to them (us) and a gain to the creditors/depositors who would otherwise face losses.

The bailout transaction is a transfer: from the government (taxpayers) to the subset (large or small) of creditors and depositors.   If most creditors/depositors are locals that transfer doesn’t make New Zealanders as a group worse off; it largely just transfers resources to one particular class of New Zealanders.   As a society we might reasonably be unwilling to pay a high (permanent) costs, from newly intensified regulation, simply to avoid the possibility of such transfers once in a while.

You and I might not like such bailouts but the fiscal cost of them isn’t a good reason for much higher capital requirements.  Apart from anything else, it shouldn’t really be a concern of the central bank –  which isn’t a fiscal authority and was charged by Parliament with focusing on the possibility of “significant damage to the financial system” from bank failures, a proxy for potential damage to the wider economy.    If the potential fiscal cost of bank failures were to be a prime consideration, you might then expect the government (responsible for fiscal matters) to have some considerable and formal say in decisions around bank capital.  In doing so, they might evaluate the deadweight losses from slightly higher taxes to fund bailouts (if they happened) against the costs to the economy of higher minimum capital ratios and, in principle, decide which was less costly to society as a whole.    (Or they might look at the feasibility of tools like the OBR, which might allow losses to lie where they fall, potentially reducing the likelihood of bailouts.)

In fairness to the Governor, the Bank’s arguments for much higher capital ratios here have not rested heavily on fiscal cost arguments.  But it is something higher bank capital can (probably/largely) mitigate, at least if injected at/near what would otherwise be the point of failure.

Instead, the Bank/Governor have made much bigger claims for what much higher bank capital requirements can do, and they are really where the differences lie.

This paragraph is taken from the Bank’s decision document

It is an established finding in the economic and financial literature that shareholders invest less capital in banks than is socially optimal. This problem has been evident since the middle of the 20th century.  The problem arises in large part because shareholders and creditors expect governments to bail out banks that are at risk of failing and whose failure would bring widespread social and economic costs. The expectation of bail-outs means creditors are prepared to lend to banks when capital levels are low, generating socially sub-optimal levels of bank capital.

I think they overstate their case (“an established finding”) but as a theoretical point it seems fine: in an over-simplifed model, if everyone thinks governments will bail out large banks in trouble (without properly pricing that risk in, say, risk-adjusted deposit insurance premia), creditors will not insist on banks holding as much capital and failure events will be more common.  More risky lending is also likely to be done, since shareholders can capture the upsides, while downside risk to creditors is off-laid to the Crown.  Not everyone will behave that way and managers/Boards still have reputational risk to consider, but if bailout risk is real (which it demonstrably is, including here) and can’t be dealt with/limited directly (an open question, at least in a realpolitik world) it would be simply foolish not to have some sort of minimum capital regime.

But that doesn’t really help us, in thinking about what should be done right now.  It makes for good rhetoric perhaps, but only among people who aren’t aware (a) that regulatory minimum capital requirements have been in place for decades (in fact, even in the dim darks, double liability for bank shareholders was often a requirement –  the chair of the Reserve Bank Board wrote about such things earlier in his career), and (b) of the sorts of capital ratios maintained by intermediaries where there is little or no credible prospect of bailouts.  The Reserve Bank –  and their peers abroad – has made no attempt to show that, absent bailout risk, banks would operate with higher capital ratios than they have now.  Perhaps that is a more pardonable oversight in countries with comprehensive deposit insurance regimes, but it is much less excusable here.

And the rhetoric conveniently elides what is really a very important distinction.    Take government bailout risk out of the picture, and banks –  including their shareholders –  and their customers (“the market”) will work out financing structures and pricing that provide some reasonable balance of risk and return.  There would probably be a spectrum of types of institutions –  rock-solid ones offering lower interest rates to potential lenders, and more risky ones.  Individuals can make choices about which to deal with.   It is how things work in the rest of the private sector.  And there would be failures from time to time.  Shareholders would lose their money.  Creditors would lose (some of) their money.    Borrowers with revolving credit lines might face disruption to their ability to pay their bills.   Employees and managers would lose their jobs,  And so on.  But all those parties can (in principle) evaluate and price those risks, and choose different options if the particular risk on offer (job, deposit, or whatever) is too high for comfort.

The way government bailout risk affects bank’s own choices (“moral hazard”) is not really the central issue at all.    What is really going on in Reserve Bank thinking is the idea of externalities; the adverse effects of a bank failure on other people.  Effects that bank managers and shareholders have no incentive to take account of in making decisions about capital structures.  There are no market feedback mechanisms (or, more realistically, insufficiently strong ones) to encourage them to do otherwise.   What drives the Reserve Bank is a belief –  and it really is not much more than belief –  that (a) these potential externalities are very large, and (b) that much higher bank capital requirements can make a material and substantial difference in allevating them.   I think the evidence of economic history is that they are wrong on both counts.

Listen to the Reserve Bank or read their material and you will be presented with tales of woe, reminders of the 2008/09 crisis, and talk of huge economic and social costs.  Many of the numbers that are cited are shonky at best (I’ve touched on that in previous posts and may come back to the issue next week).  But what you won’t be presented with is any careful evidence or analysis to show how much higher capital ratios would have prevented these costs (not just alleviated them at the margin, but substantially prevented both the crisis itself and the costs the champions of change seek to highlight).

There is little or no engagement with economic history including the specifics of what was going on –  including elsewhere in policy –  in the lead-up to the (relative handful of examples of) advanced country financial crises.   And there is almost no recognition of the fact that financial crises (or, more specifically, major bank failures or near-failures, involving large credit losses) do not happen in isolation, because some uncontrollable unforeseeable thunderbolt hits a particular economy.      Rather the seeds of future crisis are laid in a succession of bad lending and borrowing choices –  borrowers here matter quite as much as lenders – typically over a period of several years.     Of course, in one sense the “badness” of those choices only becomes apparent later, when the losses happen, and thus the argument risks being a bit circular, but it can be framed this:   lending standards, and a willingness to borrow, become much freer and looser than the standards that prevail in more normal times.

If we look back over economic history and financial crises those mistakes seem to arise in a variety of contexts.  Sometimes it is when government regulations directly mess up the market.  One could think of the US housing finance market in that context.  Sometimes, governments skew important relative prices – in pursuit of other apparently worthwhile objectives.  Here one could think, for example, of small countries that previously had high interest rates entering the euro and finding (a) finance more readily available than usual, and (b) good times interest rates people hadn’t seen before for a long time.  In a similar vein, one could think of newly liberalised markets, where no one much (regulators, borrowers or lenders) really knows quite what they are doing and what risk and opportunity really look like in the new world (one could think of the late 80s New Zealand –  or Australia or the Nordics – in this vein).  Or of stunning new growth phases –  much of which might be genuinely well-grounded –  that create a pervasive (among governments, borrowers and lenders) air of optimism, a belief that the world is different, an uncertainty about just what will and won’t prove robust.  Perhaps Ireland and Iceland fitted in that camp to some extent –  some in New Zealand in the mid-late 80s thought that was us too.)

In these climates eager borrowers and eager lenders get together and make choices, that have very little to do with bank capital levels, that often prove, with time, to have been misguided.  But although neither side knows it, the damage is really done when the initial loans are written and resources used on projects that really aren’t economic. In this phase there are often what look and feel like positive externalities –  the extreme optimism and exuberance (and high incomes) that pervaded much of Ireland in the early 00s for example.  Some people probably got into houses –  and are still grateful for it –  who otherwise wouldn’t have done so in the housing finance boom in the US.

Higher bank capital might stop the eventual realisation of the losses falling directly on bank creditors and depositors (that redistributive effect, see above) but it won’t stop the losses themselves (on the bad projects that were funded), it won’t stop those particular markets seizing up and demand no longer being there (no one much wanted to build any more new offices in late 1980s Wellington after the scale of the incipient glut became apparent), it won’t stop people across the economy (lenders, borrowers etc) having to stop and reassess how they think the economy works, their view on what might really be viable projects and so.   And they won’t stop the realisation of wealth losses –  the wealth that was thought to be there has gone, the only question is who now actually bears the losses.

Perhaps if pushed Reserve Bank officials would concede these points, but since they haven’t been pushed  they continue to claim, and act a basis justified only if, all the economic and financial losses associated in time with significant bank failures (or near-failures) are (a) caused by those failures (or near-failures) themselves, and (b) relatedly, would be avoided if only capital levels were (much) higher.    Neither makes sense. Neither squares with the experience of history.  But in the process they massively over-estimate the economywide benefits of their regulatory interventions.

Quite possibly there are some adverse economic effects from the failure of a significant bank that aren’t already made inevitable by the bad lending (and borrowing) and misallocation of resources and misperceptions of opportunities that created the difficulties in the first place.  There is a fair degree of consensus on the desirability of avoiding the quite intense short-term disruption (and it is short-term, not reverberating decades down history) of the closure of a major retail bank – that was the logic of the OBR mechanism –  but there is no way that the cost of such a closure, conditioned on big credit losses having happened anyway, are anywhere near 63 per cent of GDP (the number used in the Reserve Bank’s analysis).  To believe otherwise is to (a) grossly overstate the power of policy (specifically bank capital policy) and (b) to seriously underweight the capacity of the market and private sector to adapt and adjust.

And in all this I’ve implicitly assumed –  as the Bank does – that much higher minimum bank capital ratios do not have other deleterious effects themselves.  For example, it isn’t impossible that higher bank capital ratios, imposed by regulators, will induce more risk-taking behaviour from at least some industry participants, trying to maintain previous target rates of return on equity.  It probably isn’t a dominant element of the story, where there are reasonable market disciplines as well, but there is some evidence of such behaviour.

Perhaps more concerning is the risk that by focusing very heavily on even higher capital ratios –  in systems that have already proved robust –  supervisors and regulatory agencies put their focus in quite the wrong place.    Recall the comment from the Bank’s own appointed academic expert, David Miles.

The RBNZ has adopted a principle of being conservative as regards bank capital to offset possible risks from its light-handed approach to supervision. That is a choice and one partly based on the view that having very large resources devoted to intrusive oversight of banks is not the most efficient road to go down. That is a conclusion that engineers and safety experts often apply when dealing with the design of structures. There is a choice between building bridges many times stronger than you expect them to need to be OR you having large teams of inspectors who pay frequent visits to examine all bridges and monitor flows of traffic over them.  It is clear that nearly all countries follow the first strategy.

That may be a useful guide for bank supervision.

If it really is sustained periods of greatly diminished lending standards that lead to most of the eventual costs the Bank is worrying about, it might be better for the Bank to be focusing more of its energy on understanding bank lending standards and how they are changing, and on understanding and drawing attention to important distortions in the policy or regulatory system that may be misleading borrowers and lenders alike, and so on.  I’m not that optimistic that bank regulators can really make that much difference –  for various reasons (including their own personal incentives) it is hard to imagine even the best central banks being that influential with governments, or being paid much heed by banks (let alone borrowers and investors not reliant on local credit).  But really high capital ratios have a substantial cost to the economy and it just not obvious that they are particularly potent as an instrument to limit the sorts of (overstated) costs the Bank worries about.  Other big policy distortions, messing up incentives, making it harder to lend or borrow well, might just be one of the messy facts of life.   High capital ratios will always appeal to central bankers –  when your only tool is a hammer, all problems tend to be interpreted as nails –  but they are costly for the economy and whatever gains (beyond the merely redistributive) they offer seem, from experience, likely to be slight.

And what we do need when things go badly wrong, and a whole of reassessment is taking place, is a robustly counter-cyclical monetary policy.  The worst costs of serious economic shocks and misperceptions crystallised are around sustained unemployment for the individuals affected.  Neither monetary or bank regulatory policy can do much about potential GDP growth or productivity, and they can’t prevent real wealth losses when bad choices have been made in the past,  but they can do a great deal to alleviate the adverse cyclical consequences, to keep unemployment as low as possible, consistent with price stability, and deviations from that (unobservable) point as short as possible.