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.

So, what to make of the Governor’s final decisions on bank capital?

If you are a bank or bank shareholder, you are presumably just grateful for small mercies, the modest extent to which the Governor changed his mind and allowed the banks to use cheaper forms of capital to meet the new requirements.   Consistent with that, the share prices of the parent banks recovered some ground yesterday.

Since banks are scared of their regulators and –  both here and in Australia –  are very reluctant to seek judicial review, despite the very strong sense of pre-determination about this process, and the evident failure to engage seriously with substantive concerns raised by submitters, there isn’t much else they can do.  Their behaviour –  willingness to provide credit into this economy –  can, and probably will, adjust.  But if they won’t, or can’t, do anything more about the policy decision, grizzling won’t get them anywhere.  Rightly or wrongly, big banks don’t command much public sympathy.

But I’m neither a bank nor a bank shareholder, so I have some different perspectives.

First, a couple of process-y points out of yesterday.     We learned from the Governor’s press conference that the banks themselves had been briefed on the announcement early yesterday morning at meetings at the Bank.  They had to sign up to a non-disclosure agreement to attend, but once the meeting was over they were allowed to leave and go about their business, hours before the public announcement.  Given that the information they’d been given was highly market-sensitive (as we saw in the movement of both bank share prices and of the exchange rate) this was extraordinarily cavalier on the part of the Bank –  only 3.5 years on from the last lock-up they ran, where systemic failures on their part allowed a leak from the lock-up itself, in turn leading to a discontinuation of regular lockups.

There was also a lock-up for journalists yesterday morning  (who weren’t allowed then to leave before the public announcement, not even if they promised to be on their best behaviour). One journalist told me it was pretty chaotic (adminstratively –  access to power etc), but my real concern is what protocols and procedures were in place that would have prevented the sort of leak we saw in 2016 (which involved a journalist in the lock-up emailing the information back to their office).  Apparently, there was also a non-disclosure agreement, but how much protection would that have been if someone had attempted a repeat of 2016?

One element of yesterday’s announcement that was new, relative to the consultation document, was a commitment to an annual review of how things are going as the new policy takes effect (progressively over the next seven years).  That looks, on paper, quite a reasonable initiative by the Bank, except that……the Bank will be reviewing how a controversial decision they themselves took will be going (more specifically, staff who work to the Governor will report to the Governor their assessment of how the Governor’s own decision is going).   It isn’t exactly a recipe for hard-headed or sceptical evaluation.  It reminds me of the clause that was in the Reserve Bank Act that required us to report in each Monetary Policy Statement on how monetary policy had been conducted – the original intent clearly being some critical self-scrutiny.  The provision fell into disuse, until I persuaded people that we really should follow the law.  A box was added to each MPS to deal with the issue.  Unsurprisingly perhaps, in the almost 15 years since no fault was ever found with any past monetary policy action or choice.    That isn’t really to criticise the individuals involved –  except perhaps Governors: the incentives were just set up badly.    Wouldn’t it be better to have some independently-appointed party evaluating things, perhaps not every year, but halfway through the seven years and at the conclusion of the process?   If, that is, the intent was serious, rather than being mere window-dressing.

But none of those are the big issues that emerge, unaddressed, from yesterday’s decision.  The Bank claims to have another document coming, later in the month, that will articulate how they have responded to various points made in submissions, and why.  Maybe that will offer some useful insight in time (maybe), but for now we have only what they released yesterday, which included a 20 page document on the decisions themselves and a 111 page regulatory impact assessment and cost-benefit analysis.

Much of the latter was fairly much a warmed-over rehash of material they had published earlier in the year.  Believe their numbers and New Zealanders collectively will be about $1.3 billion each and every year better off a result of (being compelled) to take this insurance policy.  That is equal to about 0.4 per cent of GDP, a number which might not sound a lot but (a) is pretty large for an estimate of any microeconomic reform measure, and (b) capitalises up to a very large number (on their preferred discount rate, probably well in excess of $40 billion).

The costs and benefits taken into account in reaching this number include both GDP effects and GNI effects.  Specifically, one area the Bank has greatly improved on in the final document is that it now takes explicit account of the fact that higher bank capital ratios will result in materially higher total dollar profits accruing to foreign shareholders in banks.  This had been an omission Ian Harrison was particularly forceful on in his submissions and papers on the capital proposal.     In other words, some larger proportion of GDP won’t be accruing to New Zealanders, and the cost-benefit analysis rightly focuses on the impact on residents.

Here is the Bank’s helpful summary table.

Red effects are costs, while green effects are benefits.  Focus on the costs first.

The first of them is the lower level of GDP (permanently lower) as a result of the higher interest rates estimated to flow from this proposal.    The number  – minus 0.21 per cent of GDP –  is a bit smaller than the Bank estimated in the original documents, consistent with them allowing some of the additional capital to be raised from lower-cost instruments.  We don’t know it with certainty, but there hasn’t been that much argument about this number. I’m happy to work with the Bank’s number, while noting that most of the alternative views are of a larger negative effect, not a smaller one.

The second negative effect is the income (rather than wealth) transfer effect to overseas shareholders.    Again, there is some uncertainty about the precise magnitude of the number, but I doubt anyone will argue very much with the broad scale of the number.  The Bank treats the gross effect and the tax offset as separate items, but on their estimates the after-tax effect is equal to -0.2 per cent of GDP.

Thus, the cost of the insurance policy –  on the Bank’s own estimates –  is equal in total to -0.41 per cent of GDP.  Use their discount rate and plausible assumptions about growth in potential GDP (see my treatment of this earlier), and that is akin to spending a discounted present value $40 billion to buy the insurance the Bank is now compelling us to take.  That’s a pretty pricey policy.  The precise magnitudes of the costs have margins of uncertainty around them, but we are near-guaranteed to be paying a substantial premium each and every year,  as long as this policy is in place  (the current Governor, of course, can’t commit beyond his own terms, and there have been numerous changes in the regulatory environment over the decades).

For that (relatively certain) cost, the (expected) benefits had better be good.     The Bank reckons (with inevitable margins of error) that they are equal to 0.83 per cent of GDP each and every year.    And where do they get that number from?  They assume –  it is simply an assumption –  that by bumping up the capital requirements so much they can  –  singlehandedly –  avert a really serious financial crisis at some point in the future which would have (unaverted) a cumulative output cost of 63 per cent of GDP.

Unfortunately, the Bank shows little sign of having really thought hard about the nature of financial crises or really large nasty economic adjustments.  It is all very abstract and ungrounded. Neither in the earlier consultation documents nor in yesterday’s paper was there any sign that the Bank had sought to distinguish the costs that might arise from a crisis itself as distinct from the prior bad borrowing/lending decisions, and resulting misallocation of resources, that may have predisposed a banking system to a crisis.   Higher capital ratios may be able to do some good in minimising the former costs, but it is very unlikely they will make any useful difference to the latter ones, especially if one is starting from capital ratios already high by modern historical and international standards.  In their defence, they will claim to have taken assumptions from “the literature”, much of which was generated by motivated researchers (often working for central banks) looking to build a case for higher capital ratios.  None of the Bank’s work seems to stand back from the numbers and equations to ask what should be elementary questions (even if not always easy to answer).   I touched on many of these points in my submission, from which here are some extracts.I made these points in my submission.

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 also showed no sign of having done any sort of comparative analysis (of that sort done previously on my blog e.g. here https://croakingcassandra.com/2017/07/06/reservebank-dtis-and-the-cost-of-crises/, or here https://croakingcassandra.com/2019/03/04/banking-crises-are-bolts-from-the-blue/ or by PIIE’s William Cline) comparing the output and/or productivity experiences of countries that underwent financial crises with those that did not.  This is particularly important in thinking through the experience around 2008/09, when many countries experienced crises and many others did not, all overlaid on what appears to have been a common global productivity growth slowdown.     Reasonable people might differ as to how best to do such an adjustment or assessment, but the Bank shows no sign of having even tried.  Any plausible assessment of this sort would, however, conclude that plausible additional output losses saved by reducing the probability of any particular loan book incurring losses large enough to run through capital would be much lower than the estimates the Bank uses.    Note also that the Cline methodology still overstates the amount that higher capital ratios alone might save, since his output path comparisons include (for the crisis countries) both kinds of losses – from the initial misallocation of resources, and the pure crises effects.   Only the latter should be relevant in assessing the costs and benefits of higher minimum capital ratios.

As a simple illustration of some of these points, the US experienced in 2008/09 one of the very worst financial crises in advanced countries for many decades and New Zealand experienced only a very minor financial crisis.  And yet the paths of GDP per capita for the two countries were strikingly similar: both were underwhelming, but it isn’t credible to ascribe all the underperformance of the US economy to financial crisis effects, when various other countries had similar experiences (actually US productivity growth (a) slowed prior to the crisis, and (b) post-crisis has been less poor than in many non-crisis countries, including New Zealand).

A much more plausible estimate of the actual GDP savings as a result of averting the true marginal economic costs of a crisis, might be more like 10 per cent of GDP (and even that is large, especially in a floating exchange rate economy).    Assume GDP is, say, 1.5 per cent lower than otherwise for seven years –  simply as a result of the bank failures, not of the crystallisation of bad decisions pre-crisis – and I reckon you’d have a much sounder basis for evaluating the merits of higher capital ratios.    The Bank didn’t even include a number like that in the range of scenarios they looked at (the lower bound they used was 19 per cent, and yet even so in around 15 per cent of their –  skewed high –  scenarios the benefits weren’t worth the costs we’ll all be paying).

On a similar note –  the Bank showing no sign of actually having thought hard about financial crises, nasty economic adjustments etc, as distinct from dropping numbers in a model –  is the issue of stress tests.  As I and others have pointed out repeatedly, the various stress tests the Bank (and APRA) have run over they years suggest that the banks would come through in pretty good shape even really severe assumed shocks (eg a halving of house prices and a deep and pretty prolonged recession, very large sustained rise in unemployment).   That was with the capital levels banks chose to hold, faced with the minimum capital requirements in place for much of this decade.   We all know, too, that the banks came through just fine the 2008/09 recession, despite a huge credit boom and substantial asset price inflation in the years prior to that recession.  How then can so much higher capital ratios be justified?

As it happens, the Herald yesterday reported that MPs had grilled them on exactly this point as a select committee hearing (on Wednesday) on the latest FSR –  good to see some scrutiny.  Here is how Hamish Rutherford reported what the Governor said

“While they’re interesting tests, they are not a one in 200 year test,” Orr said of the stress tests, theoretical studies of how banks would cope in times of financial or economic strain.   “They’re a one in 50 year test…”

They had a similar line in yesterday’s document

While stress tests are one useful lens on the calibration of capital requirements, there are several reasons why there is no automatic link between the two. First, a given stress scenario will not capture all possible risks facing the banking system, particularly the type of extreme scenario that is being contemplated in the capital ratio calibration of a 1-in-200 year event. The Reserve Bank’s stress tests typically assess a severe but plausible macroeconomic downturn event, the type of which may happen once over a period of several decades. Second, it is difficult to capture the real-world complexities of a financial crisis. Moreover, stress tests only consider the banking system as it is currently. As a result, stress tests did not play a strong role in determining 16 percent as the capital ratio required to deliver a 1-in-200 year risk appetite.

Frankly, it is almost nonsensical –  perhaps worse, intentionally –  to suggest that the sorts of shocks applied to the Australian and New Zealand banking system in these stress tests are no more than “once in several decade events”.    As I’ve pointed out on several occasions –  and the Bank has not sought to rebut – there is no example of a modern floating exchange rate economy (and floating matters in the ability to absorb shocks) in which the unemployment has risen by 8 percentage points.  There is no example in modern times in which real and nominal house prices have fallen materially more than the sorts of shocks the Bank assumed.  And although modern history doesn’t encompass 200 years, it encompasses 40 or 50 years experience for perhaps 30 advanced economies (1200 or more annual –  but somewhat correlated of course –  observations).

If these aren’t the sort of shocks the Governor has in mind when he thinks of his 1 in 200 year event, perhaps he could tell quite what such an event looks like?  So far, through all the consultation documents, there has been no hint of that characterisation.    He can’t, surely, have in mind a rerun of the Great Depression –  largely a consequence of pre-modern monetary mismanagement, in a climate of fixed exchange rates.  If not, then precisely what sort of historical event –  or even what sort of stylised event –  is he making us pay this huge premium to try to avert?

When he simply refuses to tell us, reasonable people might reasonably fall back on the very stringent stress tests –  and all those new supervisors he tells us he plans to hire –  to suggest that some of the highest effective capital ratios in the world (right now) are about all the (capital) insurance we probably need.  The Governor noted yesterday the banks tend to hold less capital than is socially optimal, which happens because a pattern of government bailouts encourages those who deal with banks to believe they’ll happen again (viz, most recently here AMI).  But we’ve had minimum regulatory capital ratios in place for decades now, so simply asserting that –  left to themselves – (big) banks might hold less capital than is optimal, tells us nothing about the merits of further increases from the current starting point.

There are plenty of other points I could raise. For example, the Bank depends their discount rate on the grounds it is consistent with the literature, without ever acknowledging that New Zealand interest rates are consistently higher than those in other advanced countries –  still true today.

But the final main point I wanted to note was around international comparisons (or, rather, lack of them).   Right through the year, from the first release of the consultative document to the documents supporting the final decisions yesterday, the Bank has never attempted to provide a robust comparison of its own capital proposals (now decisions) with the capital requirements in other similar advanced countries.  That is particularly extraordinary in the case of the Australia, given that our big banks are all subsidiaries of Australian parents and also affected by APRA’s capital requirements.  It should have been a simple and straightforward matter to have

(a) illustrated the headline differences in the minimum ratios APRA proposes and those the Reserve Bank has chosen,

(b) adjusted for the higher floor the Reserve Bank is choosing to apply (risk-weighted assets for IRB banks will have to be no less than about 90 per cent of what the standardised approach would imply, a much higher floor than used elsewhere, and

(c) to have provided a compelling rationale for the resulting (substantial difference).

Here is a quote from an article in this morning’s Australian

The New Zealand reforms require the big four banks to have tier one capital of at least 16 per cent of risk-weighted assets, and total capital of at least 18 per cent. Of the 18 per cent, at least 13.5 per cent will be common equity tier one (CET1) capital of the highest quality, with other tier one capital including redeemable preference shares contributing 2.5 per cent, and tier two capital including long-term subordinated debt accounting for a further 2 per cent. In comparison, Australian rules require banks to have a CET1 capital of 10.5 per cent.

It is a substantially more onerous regime here, with the differences further widened by the differences in the floors in place for IRB bank risk-weighted asset calculations (all else equal, the difference could be as much as another 2.5 percentage points of CET1 capital).  These are huge differences, never articulated by the Bank and never persuasively defended –  even though, for examples, our banks have large (well-capitalised) parents, and the Australian parents/groups do not.

At FEC the other day, the Deputy Governor attempted to defend the extreme caution

Asked whether the idea of coping with one in 200 year storms was too conservative, deputy governor Geoff Bascand said New Zealand was subject to “an enormous array of shocks”.

“Obviously seismic [shocks], but also as a small, open, trading economy with very high debt levels, we’re exposed to international shocks of potentially great momentum, and so a high level of resilience has some real worth to it.

Bascand has previously tried to claim that New Zealand is materially more risky than Australia –  a claim I rebutted here and here.   I didn’t see the specific claim repeated in yesterday’s document.  Instead, in effect they fall back on bluff and obfuscation, by simply not providing good robust international comparisons, not attempting to justify their stance, and hoping no one much notices.

All this, an enormously expensive additional insurance policy, in a banking system that is already sound and well-capitalised, really does end up looking as though we will pay the (high) price for nothing more than a gubernatorial whim.

(On a final note, for all the talk of seven year transition periods, remember that firms (banks) will adjust their behaviour based on expectations, now knowing the essence of  the regulatory environment they will face in New Zealand for the next few (Orr) years.  We’d already seen in the Bank’s credit conditions survey that conditions are already tightening, largely due to regulatory factors –  points not addressed yesterday or in the FSR.  We should continue to expect to see the largest transition –  actual scale and distribution uncertain –  in the next year or two, not somehow evenly spread over the coming seven years.)