The Reserve Bank Governor is proposing that banks should have to fund a much larger share of their balance sheet with equity rather than debt.  So weak is our system that one unelected person –  on this occasion, one without much specialist expertise – can, more less on a whim, compel bank shareholders to either put billions of dollars more into their businesses, or to markedly downsize those businesses (most probably some combination of the two).    So long as the Governor jumps through the right procedural hoops, there are no appeals, and there is little formal public accountability.     Perhaps political pressure will mount on the Bank?  In these circumstances, one can only hope so.

Today I wanted to focus on a couple of strands in the arguments often used by academics and regulators to support the case for higher minimum capital requirements.   (Upfront I should say that they were arguments I used to be persuaded by, and to deploy myself.)  The post is a bit discursive: I’ve partly used writing it to help clarify my own thoughts.

Champions of higher bank capital ratios often note that bank capital ratios a hundred (or more) years ago were materially higher than those we observe today.    A good example of what they have in mind is this chart, taken from a speech a few years ago by a senior Bank of England official.

These aren’t, typically, risk-weighted capital ratios, just capital as a percentage of total assets.

One argument tends to run along the lines that if bank capital ratios were so much higher then, it could hardly be harmful for them to be much higher now.  And that claim is buttressed by the observation that deposit insurance (and a more general tendency for governments to bail-out all creditors of large banks) should have tended to reduce the  capital ratios banks would choose to run, in ways that are not necessarily socially desirable.   Thus, it is argued, one can’t deduce anything from observed capital ratios in recent decades since they, so it is argued, just result from subsidies (implicit or otherwise) to banking.   These sorts of arguments are made extensively by, for example, Professors Anat Admati and Martin Hellwig in their 2013 book The Bankers’ New Clothes  (Admati and Hellwig have both been recent professorial fellows at the Reserve Bank, Admati in 2016 and Hellwig late last year).

In principle, there is clearly something to the argument.   Were governments to guarantee all bank creditors full and timely payment of all their claims, and impose no obligations on banks (shareholders or management) in return, some banks might well rationally (if dishonourably) choose to run with hardly any capital at all: all losses would be borne by the taxpayer and all gains would be captured by the shareholders and promoters.

That, of course, isn’t the world we live in.  Even in places where there is deposit insurance (these days, most advanced countries other than New Zealand), wholesale and commercial creditors aren’t guaranteed.   And even when there is a strong too-big-to-fail presumption around some institutions (probably including the big banks in New Zealand) that presumption doesn’t apply to all institutions –  and even when the presumption exists, it is never held with certainty.

Many writers in this area come from countries with pretty comprehensive deposit insurance (from a depositor perspective, the system is the same whether you bank with Wells Fargo or some one-branch bank in the middle of nowhere).  But that isn’t so in New Zealand, so we should still be able to garner some useful information from the choices made around banks where there is, almost certainly, no strong expectation of a bailout.   This chart is from the Reserve Bank’s dashboard.

The regulator-required minimum capital (to risk-weighted assets) ratios are all the same (with the temporary exception of Westpac, after the never-adequately accounted for episode discussed here).   But what is striking is that there is no systematic difference between the actual capital ratios of the big-4 locally incorporated banks and those of the four smallish New Zealand owned banks.

Perhaps you see things differently, but I’d assume that depositors (and probably all other creditors) in the big-4 would end up fully-protected in any event much short of the physical destruction of New Zealand.  Between parent support and the political imperatives, that seems a pretty safe bet (at least a 95 per cent chance).  Neither the parent nor the government is charging upfront for that likely support.  I’d also assume Kiwibank creditors would be bailed out, for a slightly different mix of reasons (it is still 100 per cent government-owned).   And, on the other hand, the chances of the Crown bailing out creditors of the four small New Zealand banks  –  other perhaps than in a crisis that was taking down the whole system –  seem much much smaller.  It might even be credible to suppose that the OBR tool would be used if one of those banks were to fail.

And yet there is a striking similarity in the capital ratios across all these banks (and a striking similarity in the margins above minimum regulatory requirements). It doesn’t appear that consistent with a story in which the big banks are now able to get away with artificially low levels of capital because of the actual or implied bailout and guarantee risks.   And that is especially so when one recognises that none of the four small local banks has a deep-pocketed parent who might be prevailed on to recapitalise the bank if it got into trouble.

There is a caveat to this comparison.   The smaller banks (including Kiwibank) have to use the standardised approach to calculating regulatory requirements, while the big four are allowed to use (a constrained form of) their own internal ratings-based models.    For many assets, the latter approach will result in a bank being required to use less equity funding (for the same actual loan) than is required under the standardised approach (narrowing that gap is one aspect of the Reserve Bank’s current consultation).  If the big-4 banks were required to report on the same basis as the other banks, their reported capital ratios would be somewhat lower, but it wouldn’t change the fact that none of the smaller New Zealand banks have actual total capital ratios now as high as what the proposed Reserve Bank requirements will involve in the future (taking account of the buffers above regulatory minima banks will choose to maintain).

So how do we think about the long-term historical experience, of the sort captured in that earlier Bank of England chart?  If we go back 140 years, British banks in this sample had ratios of equity to total assets of around 15 per cent, and US banks something more like 23-24 per cent.

If we are thinking about a small listed New Zealand bank mostly doing business lending, I was interested to see from Heartland Bank’s latest disclosure statement that total balance sheet equity was about 14.7 per cent of total balance sheet assets.

But if we are comparing big New Zealand or Australian banks to those in the US or the UK in 1880, we are really comparing apples and oranges.   The biggest single difference is the predominant nature of the credits.   The biggest single chunk of loans on the balance sheets of New Zealand banks now are residential mortgages (followed by farm mortgages) –  secured by the considerable collateral of the underlying assets. Nineteenth century banks were typically didn’t lend to house purchasers (or farm purchasers) –  for that matter, 1960s trading banks in New Zealand didn’t either.      Loan losses on diversified portfolios of residential mortgages loans are not typically high.  My supposition –  I haven’t checked this story out –  is that 19th century banks will also have typically had larger peak exposures to a small number of borrowers.

In the US in particular, geographic diversification was often almost impossible to achieve (branch banking restrictions and all that).  You might reasonably respond that New Zealand is small, but even today New Zealand has slightly more people than the median US state, and most US banks were historically more tightly constrained than even a single state (one of the reasons they’ve had repeated banking crises and, say, Canada hasn’t).

And one could add that 19th century Britain and the United States were countries with fixed exchange rates, the US wasn’t long out of a civil war, and other aspects of its monetary system made its banks prone to liquidity crises.  The experience of the last 50 years or so –  with floating exchange rates –  is that countries with fixed exchange rate have more difficulty coping with economic shocks than countries with floating exchange rates.    We’ve seen that most recently in places like Ireland and Spain.

It may also be relevant to note that 140 years ago concepts of limited liability (including in banking) were still relatively new.  It takes time for the market (broadly defined) to work out what financing structures are sustainable and appropriate, balancing risk and opportunity.

We have another class of financial intermediaries in New Zealand that, almost certainly, no one expects would be bailed out if they got into trouble.  Non-bank deposit-takers  are now under the regulatory oversight of the Reserve Bank, with minimum capital requirements imposed by the Minister of Finance by regulation.  But these are minima only.  If there is no credible expectation of a bailout if things go wrong, any capital ratio materially above the regulatory floor must presumably reflect the judgement of shareholders, depositors, managers etc about the best (for that firm) mix of debt and equity.  I don’t have time or energy to go through the accounts of all the NBDTs, but I dug out those for the Nelson Building Society, a longstanding entity that mainly does residential mortgage lending, and without a huge amount of geographic diversification.  They report a risk-weighted (using RB approved weights) capital ratio of 10.09 per cent (equity is 6.7 per cent of unweighted total assets).  NBS’s credit rating isn’t particularly high –  were I a depositor I’d probably be keen on them having a higher capital ratio – but for a small not-overly-well diversifed lender, there is no sign of the market demanding anything like the 20 per cent (risk-weighed) capital ratios that will be implied by the Reserve Bank’s current proposals.  (Checking another building society, the Wairarapa Building Society reports an 11.7 per cent risk-weighted capital ratio.)

Finally, I suspect a great deal of the push for higher capital ratios is at least buttressed by the Modigliani-Miller story.   One of the Bank of England papers in this area (one of those cited by the Reserve Bank) gives this nice summary of the idea

Modigliani and Miller (1958) showed that, under certain assumptions, moving to higher levels of funding in the form of common stock, and therefore lower levels of debt and financial leverage, would leave the total cost of funding unchanged. In particular, the Modigliani-Miller (MM) theorem implies that as more equity capital is used, return on equity becomes less volatile and debt becomes safer, lowering the required rate of return on both sources of funds. It does so in such a way that the overall weighted average cost of funds remains unchanged. This idealised situation represents the case where there is a complete (100%) offset in relative funding costs as the debt and equity compositions change.

In other words, financing structures don’t really matter much (on certain assumptions), leading to a view that it doesn’t really matter much then if officials and regulators insist on one financing structure (a large share of equity) over another.   Pretty much everyone accepts that Modigliani-Miller (MM) doesn’t hold perfectly, but equally that it does hold to some extent (all else equal, over time, expected returns will be lower  –  and less volatile –  in a business with a greater share of equity funding).    One of the reasons MM often doesn’t hold fully in practice is the tax system: most tax systems tax equity returns more heavily than debt returns (often double-taxing equity returns, both when earned in the company and then when distributed to the owners).

But that wrinkle isn’t an issue for locally-owned institutions in either New Zealand or Australia (both countries run dividend imputation systems).  In other words, even if there is a systematic bias away from equity in other countries (including in the financial systems), there is no reason to expect to see it here, for locally-owned entities.  So when we look –  see above –  at the risk-weighted capital ratios (or simple ratios of capital to assets) for small New Zealand owned financial entities, not only is there little or no bailout risks factored into the chosen ratios, but there should be no tax system bias either.

More generally, if MM were the key insight on financing structures –  as distinct from being one element in a complex mix –  shouldn’t we expect to see capital ratios scattered almost randomly between (something close to) zero and a hundred per cent?  After all, the financing structure doesn’t affect the total cost of finance.  But that isn’t what we see at all.  Sure, there are some companies (even listed ones) that choose to have no (net) debt at all, although even that choice seems often to relate to anomalies in the tax system.  Financing structures tend to bunch by industry, suggesting in each case something about the nature of the industry itself influences those choices (something that won’t always be apparent to keen regulators).  That appears to be true for the financial sector as well –  even in parts of it where there is no credible bailout risk.

I’m not opposed to regulatory minimum capital requirements.  If governments are going to either provide deposit insurance, and/or behave in ways that create a perception of probable bailouts, some regulatory minima are almost certainly needed.   But where there is no deposit insurance, and there is little or no bailout risk, private market choices about financial structures in banking look as though they should tell us something about the economics of the industry.   All else equal, there might be a good case for ensuring that minimum ratios for banks that might be expected to be bailed out are in the ballpark of those intermediaries with no such (probable) assurances.  But in a New Zealand context, there doesn’t seem to be anything in the practice of those smaller institutions that would point in the direction of regulatory minimum capital requirements anywhere near as high as what the Reserve Bank is proposing.

Sadly, it probably won’t surprise you now to know that in their consultative document the Reserve Bank does not engage with these sorts of perspectives or experiences at all.

On another matter, I noted the other day that someone had started a Twitter account linking to various posts from this blog.   Having listened to the arguments of the (anonymous to me) person behind that account, I have activated a Twitter account of my own.  Not many of my arguments usefully reduce to 280 characters, so for now anyway I expect to use it mainly for links to new posts, or perhaps the occasional article that I think readers might find interesting or an old post relevant to some topic that has come to the fore again.

I’ve been a little slow to get round to much comment on the Reserve Bank Governor’s proposals to require banks to fund a much larger share of their balance sheets with equity capital.  These aren’t small changes: from a starting point where they more or less accept that New Zealand bank capital ratios are already higher than those in most advanced countries, they want to compel banks incorporated here to adopt capital ratios that would be higher than (almost?) anywhere else in the world (including, notably, higher than in Australia).

I had a couple of initial posts (here and here) immediately after the consultative document was released, and one a couple of weeks ago on the way in which the Bank has continued to discount the results of demanding stress tests it has required banks to undertake.     Since I wrote that post the Reserve Bank has finally released (in response to OIA requests from me and others) various background papers.  One of them specifically addressed the issue of the stress tests.  Suffice to say, whatever the validity of some of the specific points the authors identified, it did not materially my view of an awkwardness that the Bank still has to contend with; repeated very demanding stress tests suggests a very robust system, and yet the Bank proposes to go out on a limb with its capital requirements for banks incorporated here.  Various other people have written comments on the Reserve Bank’s proposals, and I’d commend to your attention most of a column by my former Reserve Bank colleague Geof Mortlock, and some observations from Roger Partridge of the New Zealand Initiative on the striking absence from the consultative document of any serious attempt at a cost-benefit analysis.

It is striking just how little substantive supporting analysis, and robust testing of alternatives, there is in the consultative document.  And although they have finally released various background documents, some of which are interesting, as those papers stretch back over almost three years through a couple of changes of Governor, it is impossible to know what bits the current Governor is or is not drawing from in reaching his proposals.  There has been no substantive speeches from, or searching interviews with, the Governor or his deputy since the document went out.

Of course, the Bank has a long history of not taking consultation very seriously –  they’d jump through the formal required hoops, and perhaps even amend the odd working detail here or there, but there was never much of a sense of being genuinely open to alternative perspectives.   On this particular proposal, so much money is involved that one can only hope that they are eventually forced to do better.  Perhaps there really as a compelling case for going out on a limb as they propose, but if so that case has not yet been made.  On the specific issue –  imposing more-demanding capital requirements than almost any of our peers (eg small open floating-exchange rate countries, with moderate-sized locally-focused banking systems, and government finances in good order) – nothing in the consultative document even makes the attempt.  Apparently we are just supposed to take the Governor’s word for it that it is all fine; that he knows what is best for us.

There is a range of areas where the analytical support is very weak.  I might come back to some of them. But today I’m going to start at the end and highlight one absence that I found particularly glaring.   Having reached the conclusion that a 16 per cent capital requirement would be appropriate for the large locally-incorporated banks, there is almost no discussion at all as to how banks and the financial system more generally might respond, whether in the protracted transition or in the longer-run.   Which might be okay in some quasi-academic document (of the sort they cite from overseas, trying to estimate “optimal” capital ratios), but shouldn’t be remotely acceptable when a regulator is consulting on far-reaching proposals, directly affecting private businesses (and potentially firms and households more generally), that it wishes to put the force of law behind.   We should expect to see that regulator lay out its workings, and tell us how it thinks things will unfold, in the specifics of the New Zealand economy and financial system.  Only then can we really unpick and challenge their reasoning and assumptions (implicit or otherwise).

The bottom-line appears to be that they think bank lending margins will rise to some extent (they report  –  reasonably enough –  not believing that Modigliani-Miller offset effects hold in full, at least in a potentially protracted transition) but that otherwise banks’ shareholders will happily divert most of their profits over the next few years into reinvesting in the business.  But they show no sign of having tested those assumptions, let alone of having thought more widely.

Why, for example, would the Reserve Bank not suppose that existing locally incorporated banks would respond to large increases in capital requirements in part by pulling back on their willingness to lend?  There are two ways to increase actual capital ratios: increase capital or reduce the volume (at least the growth rate) of assets relative to your prior plans.  It is not as if no banks anywhere have ever responded to increased capital ratio expectations (market or regulatory) by looking to reduce risk-weighted assets (it was a common in the EU after the last crisis).  Whether or not, in the long run, Modigliani-Miller effects really hold nearly in full, shareholders don’t tend to believe they do,  and if the New Zealand authorities insist on higher capital requirements, lending into the New Zealand market is going to look less attractive to shareholders in banks subject to those requirements.  Perhaps the Governor thinks there is already too much credit in the New Zealand economy and wouldn’t be unhappy if it becomes harder to get.  But none of that is discussed or analysed in the discussion document.

Similarly, there is no discussion at all of the fact that we are now eight or nine years into a growth phase, and that most probably there will be another recession along at some stage in the next five years (the planned transition period).  Now, of course, in truth the best time to increase capital requirements was always five years ago, but it doesn’t change the fact that  –  with capital ratios already comfortably high by international standards –  the specific proposal is to increase them over the next five.  In recessions borrowers tend to become more reluctant to borrow, and (typically quite rationally) lenders become more reluctant to lend, but if we go into a new recession in the next few years with banks still facing several years of increased capital requirements, isn’t it quite plausible that banks would become even more reluctant to lend than usual, exacerbating –  or dragging out –  the downturn.  And recall that the Reserve Bank has nowhere near as much monetary policy leeway in the next downturn as it did in previous ones.  That might reasonably make one more nervous than otherwise about ramping capital requirements over the next few years even if one could make a decent case in the abstract.  But none of this –  none –  is discussed, not even to allay concerns, in the consultative document.

There is also no discussion or analysis of the way in which the proposals will affect Australian (and other foreign) locally-incorporated banks differently than New Zealand owned banks.   Dividend imputation means that debt and equity are taxed similarly for New Zealand owned companies.  But dividend imputation doesn’t hold for foreign-owned companies, and substantial increases in capital requirements will impose a direct additional cost on the shareholders in foreign-owned banks (in this case, the Australian parents).   In other words, the Governor’s proposals skew the playing field away from the Australian banks (large and more diversified) in favour of the domestic banks (small, undiversified, and typically capital-constrained).  The Governor is known to have some animus towards the Australian banks –  and on that score he might even have political sympathisers (at least from rabble-rousers like Shane Jones) –  but none of this is identified or discussed in the consultative document.   I’d argue that we are generally better off having big banks that are part of offshore banking groups. Perhaps the Governor disagrees, but if so the onus should be on him to make his case, not to attempt to slip through regulatory measures that consciously disadvantage the foreign-owned banks incorporated here.  It is far from clear that boosting the competitive position of a 100% state-owned bank (Kiwibank) is any sort of longer-term gain to financial system soundness or efficiency.

There was also no discussion in the consultative document on the potential lenders who will not be subject to the Governor’s proposed capital requirements.  For example, those requirements will not apply to non-bank deposit-taking lenders (let alone any lenders who aren’t deposit-takers at all).  NBDT capital requirements aren’t something the Reserve Bank can set itself (same goes for LVR restrictions, which is why LVR restrictions were never applied to the NBDTs) and so it would appear that one set of regulated intermediaries will have materially lower capital requirements than another set.  All else equal, mightn’t we expect to see at least some disintermediation to these lenders?   At the other end of the spectrum, banks that aren’t locally incorporated are also not subject to Reserve Bank capital requirements.  If the Governor proceeds with his proposals, wouldn’t we expect to see more lending gravitate towards these lenders (subject to the local incorporation threshold limits), and at the “big end of town” to banks that aren’t registered in New Zealand at all.   The SME down the street might need to get credit from a local lender, but Fonterra or Air New Zealand don’t.   These effects wouldn’t arise if authorities around the world were all raising capital requirements to a similar extent, but they aren’t.   Not even APRA.  And yet there is no sign the Reserve Bank has thought hard about the potential disintermediation issues.

And even if all banks (broadly defined) globally were subject to much the same capital requirements, one might have to think about disintermediation to non-institutional providers of credit.  If capital requirements on a portfolio of mortgage loans are increased markedly and there is incipient pressure for bank lending margins to rise, it opens the door for more securitisation options.   But, again, none of this is touched on in the consultative document.

There have been suggestions, notably from at least one investment bank/broking firm, that the Reserve Bank’s capital proposals could increase New Zealand lending interest rates by as much as 100 basis points.   That, frankly, seems unlikely to me, not because banks (especially the Australian banks) won’t pull back on the supply of credit or because bank shareholders won’t look to maintain high targets ROEs for a while, but because of the potential disintermediation from the existing big-4 institutions.   Those alternatives limit the extent to which lending margins could increase (while the potential for offsetting OCR adjustments limits the extent to which retail lending rates themselves would rise).     On my story, there is a cost to the efficiency of the financial system –  a key constraint the Bank is required by law to take account of.   The core big institutions –  already very robust –  might be made a bit stronger, but in the process they would be of diminished importance in the financial system.  Any gains from stronger core institutions could be compromised by the greater proportion of credit flowing through other channels.  (A topic for another day is that entire proposal is built around the idea that the costs policy should try to mitigate relate narrowly to the failure of regulated institutions, rather than to the gross misallocation of credit –  and investment resources – in the good times, whether or not any core institutions fail when the reckoning occurs.   But there is no sign the Reserve Bank has considered whether the allocation of credit, and lending standards, will be maintained if there were to be significant disintermediation.)

I could go on, but won’t for now.  My point wasn’t to attempt to isolate every possible channel, but to note that in their consultative document –  where they are judge and jury in their own case –  the Reserve Bank has provided no analysis of any of these issues, not even to set our minds at rest.   Just nothing.  We should be able to expect better.