Tightening LVR restrictions

The Reserve Bank’s faux “consultation” on tightening LVR controls closes today. If you felt so inclined the consultation document is here, but it isn’t clear why you’d bother except for the record. Poor performance by powerful government agencies shouldn’t go unremarked.

I have put in a a short submission, simply to document some of the many problems with the consultation.

submission to RB on tightening LVR restrictions Sept 2021

Much of the text simply elaborates points I noted in a post last week. But here are a few extracts

More substantively, there is no discussion at all in the consultation document of the Reserve Bank’s capital requirements or the capital positions of the banks you are putting more controls on. As you will be well aware, the risk-adjusted capital ratios of New Zealand banks are high by international standards, and will be increased further – as a regulatory requirement – over the next few years.   Capital is, and always should be, the key buffer against loans going bad, and we know that the New Zealand framework imposes relatively (by international standards) high capital requirements in respect of housing loans, including high LVR ones.   It is simply unserious – or a desire to operate ultra vires – not to engage with the capital position of the banking system.  That is especially so as your consultation document acknowledges that tighter LVR controls will impair the efficiency of the financial system.  Given that acknowledged cost, there has to be a clear gain to financial system soundness (the other limb of your statutory goals/purposes) from any new regulatory impost, but your document makes no effort to quantify such a gain (reduced probability of failure), or to demonstrate that tighter LVR controls are the least-cost way to generate such a reduction.   There is not, I think, even any attempt to engage with the “1 in 200 years” failure framework that the Bank dreamed up a few years ago to support the capital proposals it was then consulting on.


The Bank’s consultative document also attempts to make quite a bit of an argument that somehow LVR restrictions now can dampen the size of future “boom-and-bust cycles” in the economy, even going so far as to claim these incremental restrictions will improve the medium-term performance of the economy. But none of this argument engages with the (very healthy) capital position of the banking system and at times it seems internally contradictory.  Thus, in paragraph 47 the Bank worries about dampening effects on consumption and economic activity from “increased serviceability stress” as a result of some future increase in interest rates, but never seems to recognise that the reason the monetary policy arm of the Bank would be raising interest rates is to dampen demand and inflationary pressures.  If anything, the Bank’s argument would seem to suggest that more high-LVR lending would, if anything, and in those circumstances increase the potency of monetary policy, and reduce the extent of any required OCR increases.    More generally, the Bank continues to place a considerable reliance on claims about a significant housing wealth effect on consumption that appear inconsistent with New Zealand macroeconomic data over many decades, and which appear to over-emphasise existing homeowners while largely ignoring the loss of wealth/purchasing power for those who do not (yet) own a house.


In conclusion, the Bank has simply not made any sort of compelling case for further tightening of LVR restrictions. At very least, such a case would have to involved a careful and documented cost-benefit analysis, that included engagement with the bank capital regulatory regime.  There is no pressing financial stability risk, and so this proposal – in practice, these new rules – has the feel of action taken for the sake of action, perhaps to provide some cover for a government that fails to address the house price issue at source, or to fend off (misguided) critics of the Bank’s LSAP monetary policy programme.   That isn’t a good or acceptable use of the powers of the state. 

To the extent the initiative is about protecting borrowers from themselves – as your communications sometimes suggests – it may be nobly intended but is no part of the Bank’s statutory responsibility (and thus not a legitimate basis for use of regulatory powers). Perhaps as importantly it seems to assume the current crop of central bankers and regulators knows more about the risks of house prices falling substantially and sustainably than (a) borrowers and their bankers (each with money on the lines) and (b) than their central banking predecessors over 30 years did (each Governor having at some point or other anguished about the risks of falls, even as central and local government policy continued to underpin the decades-long scandalous lift in real house prices). No evidence is advanced for either proposition.


My former Reserve Bank colleague – now Tailrisk Economics – Ian Harrison had a similarly cynical view on the consultation process but also put in a short submission, which he has given me permission to quote from.

Ian makes a number of serious analytical points about the substantive weaknesses in the Bank’s document


It is clear that, from the content of the consultation paper and the time given for submissions, the consideration of submissions and final decision making, that this is not a serious consultation, and that submissions will mostly be ignored.  In that vein not all of this submission is entirely serious.  Part A discusses some key elements of the Bank’s analysis.  It shows that the Bank’s concerns appear to be driven by a data error and a lack of understanding of how loan portfolios evolve over time.

The Bank has suppressed lending to housing investors following the Minister’s wish to give first time homebuyers a better chance of securing a property.  Now that this demand has emerged the Bank wants to choke it off. 

This is based on an almost irrational obsession with housing lending risk.   Even when high LVR loans are a small part of banks’ portfolios, and its own stress testing shows that housing losses will account for a relatively small part of overall losses in fairly extreme stress events (about 28 percent), it does not seem to be able to resist tinkering with quantitative interventions.

The easiest and most effective solution to the identified problems would be to increase housing interest rates, but that option is not even mentioned.

Part B of this submission provides a different professional perspective on the Bank’s behavior.

But sometimes points are made more potently – at least in responding to unserious spin masquerading as policy analysis – by satire. And this is Ian’s Part B

Part B 

Meduni Vienna, Department of Psychiatry and Psychotherapy

Währinger Gürtel 18-20
1090 Vienna, Austria 

Consultation report

 Patient : R. Bank 

Date:   7/9/2021


From our consultation with the patient R. Bank we observed the following clinical symptoms.  Our consultation conclusions are based on the patient’s writings (in particular the document loan-to valuation ratio restrictions) and our observations of behavior over the last three years.

Moderate paranoia: The patient had a tendency to blowup the risks of everyday life into impending disasters.

Hyperactivity: There was a pronounced tendency to do things when nothing needs to be done.

Megalomania: The patient exhibits the classic signs of megalomania: overestimation of one’s abilities, feelings of uniqueness, inflated self-esteem, and a drive to maintain control over others.

Misplaced empathy:  The patient exhibited some concern that others may make mistakes but uses this as a reason to exercise control over them.

Irrationality: There was a lack of capacity to identify real problems and connect them with solutions.

Unwillingness to listen to others:  The patient will pretend to listen to alternative views but this is almost always a sham.


  • Heavy sedation
  • Counselling

The patient should be removed from positions of authority until there is a pronounced improvement in behavior.

Albert Pystaek Phd., Dip. A.E.M, Fm.d, Head of Clinical Psychiatry

Perhaps they should start a bank?

In the last few days speeches by two of the Reserve Bank’s senior managers have been published.   The first was from the Deputy Governor Geoff Bascand –  delivered on no obvious occasion to “banking industry representatives in Wellington” –  and the second by Toby Fiennes, formerly head of supervision (operations and policy) but now reduced to Head of Financial System Policy Analysis, at one of those commercial training ventures that are always keen to have (free) speakers from places like the Bank.

Bascand and Fiennes have often been among the better people in the upper reaches of the Reserve Bank.  I’ve been on record suggesting –  before the appointment and since –  that Bascand, if not ideal, would have been a better appointee as Governor.  His speeches have typically been quite materially better than those of his senior management colleagues –  more akin to what we see from people at Deputy Governor level in other advanced country central banks –  although that is true more of his speeches on economic topics than those on banking and financial stability.    Perhaps that isn’t surprising –  his background was in economics, and he had no background in financial stability or regulation until he took up something like his current job three or four years ago.

In this post I want to focus mostly on Bascand’s speech.  He is the more senior figure and is across all the functions of the Bank –  including apparently enjoying the confidence of the Minister as a member of the statutory Monetary Policy Committee.   And if Fiennes’s speech raises one or two points, Bascand’s is really quite egregious in places.

As befits one of Orr’s deputies, the speech pays due obeisance to the public sector employees’ campaign to change the name of the country.     The title?  “Banking the economy in post-COVID Aotearoa”.    As it happens, they the drop one more “Aotearoa” into the first page before reverting, almost without exception, to “New Zealand” (actual name of the country, actual name of the Reserve Bank of New Zealand) for the rest of the speech.

The bottom line message of the speech, however, seemed to be an injunction to banks to lend more.  So much so that, as per the title of this post, one was left wondering why if Messrs Orr and Bascand know so well what the profitable risk-adjusted opportunities are they don’t step down from their secure and quite highly-paid public sector perches and start a bank, or at least offer their services to the credit and risk departments of some existing insurgent bank.

It starts on the first page

In the face of these challenges, the banking sector could choose to hunker down and seek to ride out the storm until the good times roll again. Or, the banking system could continue to step up and play a crucial part in supporting New Zealand’s economic recovery and maximise its potential competitive advantage of relationship lending and customer information. …..

Maintaining institutional resilience while continuing to serve customers in an uncertain environment will demand expertise, courage and an unwavering belief that the people and businesses of Aotearoa will find a way to come out of these challenges.

In periods of extreme uncertainty, isn’t the rational –  and prudent – response of most people to “hunker down”?   And this is an environment of really quite extreme uncertainty –  a point I’m sure we will hear emphasised (again) by Orr and Bascand next week when they put their monetary policy hats on and deliver the Monetary Policy Statement.

But here –  playing with other peoples’ money – they want bank managers to ride blindly –  but “courageously”-  into the cannon fire, as if they (Orr and Bascand) either know better than the shareholders what is in those shareholders’ interests, or just don’t care.   And it is pretty rich coming from people who, with their monetary policy hat on (the tool actually designed to support recoveries) are doing almost nothing.

It is really remarkable for the lack of nuance and subtlety.  I scrawled in the margin against that first paragraph “presumably some mix?”     I doubt there has ever been a market-oriented banking system that-  in a severe downturn – has ever either called in every loan possible at the first sign of trouble, or rushed out boldly to encourage a wide range of borrowers to take more credit.    But there is nothing of this in Bascand’s speech, nothing either about how serious downturns should prompt both lenders and borrowers to reassess the assumptions they were working on, in turn prompting greater caution –  the more so, the more uncertain the path ahead.     Thus it is fine for central bankers to fling out rhetoric about “unwavering belief”, but no one knows which forward path the economy will actually take, how long it will take to get securely on that path, or what crevices there might yet be along the road.  It will make quite a difference to plenty of credit assessments –  whether for existing debt, or those interested in taking on new debt (around many of whom there may be adverse selection risks).

A bit later on there is an entire section of the speech on “Reserve Bank actions to support bank lending”.    It is about as thin.

For example, we get overblown claims like this

Cash flow and confidence became key to New Zealand’s financial stability.

I know “cash flow and confidence” was a mantra of the Governor’s but –  and as the Bank itself would tell us any other time –  the financial system’s soundness was much greater than implied by this assertion of Bascand’s, reinforced a sentence later when he tries to claim that various initiatives had “kept the financial system stable”.   These measures, apparently, included the small cut in the OCR (virtually no change in real terms), whatever the LSAP did to long-term rates, and a list of other regulatory measures which –  useful as most may have been –  will have done little or nothing to “keep the financial system stable”.   System stability is mostly about disciplined lending in the good times.  All evidence suggests –  and other Reserve Bank commentary suggests they agree –  we had that.  One of the risks at present is that if anyone in the banks paid much heed to the Reserve Bank’s rhetoric, those lending standards could be considerably debauched now.

Bascand goes on, being really rather self-congratulatory

Taken together – and without being too self-congratulatory – these initiatives have had a significant impact on supporting the short-term financial needs of households and businesses. This was important to limit failures of businesses with good long-term income prospects, and prevent mortgage defaults and foreclosures for borrowers facing temporary decreases in income.

All this without a shred of evidence to support his claims to have made much difference at all.   In this Bascand world, banks would have been rushing into mortgagee sales, closing businesses galore, without any regard at all for longer-term relationship prospects etc, if it hadn’t been for the Reserve Bank.    It is the same spin we used to get from the Governor, and the same lack of evidence.     We’ve had fairly sound and well-managed banks for 100 years or more –  recall that the closest to a bank failure in the immediate post-liberalisation period were two government-owned entities-  but the Governor and his Deputy believe that they are the hope and salvation.

Bascand goes on to talk threateningly about banks retaining their “social licence to operate” –  if there is such a thing, it is really no business of a central bank charged only with prudential supervision of banks.  And then we get to what seems to be the climax of his lecture on lending

But a key determinant of the success of New Zealand’s economic recovery to come will be the willingness of banks to lend to productive, job-rich sectors of the economy so that we can collectively take advantage of New Zealand’s enviable position of having eliminated community transmission. Now is the time for banks to prudently drawdown on their buffers to support their customers. Shareholders will have to be patient for longer-term payoffs, but this forward-thinking, long-term approach will stand bank customers, banks, shareholders, the financial system and Aotearoa in the best position.

Given banks are anticipating a deterioration of their loan portfolios, hunkering down and tightening lending standards may seem to them to be the optimal response to perceived increased risk. However, given banks dominant role in New Zealand’s financial system a synchronised lending contraction across the banking sector would risk a ‘credit crunch’ amplifying the economic downturn (Figure D). Therefore ultimately it is in banks’ own interest to maintain the flow of credit and contribute to the long-term stability of the banking system by preventing large scale borrower defaults and disorderly corrections in asset markets.

There is so much problematic about this it is difficult to know where to start.  There is. for example, the small point that highly productive sectors tend –  almost by definition, and it is a good thing –  not to be ‘job rich”.  For the rest, as noted earlier, you get the impression that people with no experience in banking at all –  or indeed in Bascand’s case any in business at all –  are best-placed to tell private businesses and their shareholders what is in their own best interests.  Based on what evidence, what analysis?   And isn’t it all rather lacking in nuance, since few of these sorts of decisions are ever all or nothing.   And despite the wider economic responsibilities of the Bank, it isn’t even obvious where Bascand thinks these profitable creditworthy projects are to be found –  or how he could be confident of his judgement even if he and his staff could identify some.     Surely a more general answer would be that private agents (banks and other firms and households) are best placed to make their own assessments about choices and risks, but that macro policy (and perhaps now public health policy) can provide the best possible supporting climate for those private decisions to be made.  As it is, even later in this speech Bascand concedes that “our economic challenges remain severe”.   Not exactly a climate for much private sector risk-taking, whether by banks, firms or households.  But it might, for example, be time for a monetary policy central bank to start doing its job.

Risking other peoples’ money was the theme of that bit of the speech. But Bascand also took the opportunity to comment on the Governor’s bank capital review –  the one that will require a huge increase in bank capital to support the existing level of business.   The one that banks, and many outside experts –  not, contrary to the Governor’s claims, just those paid by banks –  warned would lead to some credit contraction, some disintermediation from the banking system, and some higher costs.

Likewise, capital metrics were strong going into this crisis, boosted by Basel III regulatory requirements, a number of years of favourable economic performance, and preparations for the impending implementation of the Reserve Bank’s Capital Review. The COVID-19 crisis has underscored the importance of banks having sound capital buffers; increased provisions for expected credit losses have, so far, been easily absorbed by existing capital buffers. Healthy capital buffers are necessary not only to ensure banks survive crises, but to ensure banks survive ‘well’ and are able to continue to lend to creditworthy borrowers throughout a downturn. The Reserve Bank remains committed to fully implementing the outcomes of the Capital Review. However, as we indicated this past March, this will be delayed one year and not occur until July 20212. We expect to communicate further on the implementation of the Capital Review by the end of the year.

There are really two main points here.  The first is the claim –  that Orr has made repeatedly –  that banks were well-positioned this year partly because they had been acting preemptively to raise more capital in anticipation of the higher capital requirements, which were supposed to be phased in from this year.  Victoria University banking academic Martien Lubberink has addressed directly this claim in a post on his blog.   As everyone recognises, capital ratios have increased since prior to the previous (2008/09) recession, under the influence of some mix of regulatory and market/ratings agency pressure.  But here is Martien’s chart showing total capital ratios for several of main banks operating here for the period, in early 2018, since Orr took office.

total capital ratios

He has another chart showing core (CET1) capital ratios, which also suggests no lift in capital ratios over the last couple of years.

The Bank has been attempting a difficult balancing act: trying to assure us (of what is almost certainly true) that the local banks are very sound, but at the same time trying to get cover for the scheduled large increase in capital requirements.  There would be some reconciliation if banks had been raising actual capital in anticipation of those new requirements but….the Bank’s own data, the useful dashboard, confirms that it just isn’t so.    It is just spin, it is a lot worse than that.

Oh, and note that Bascand reaffirms that the Bank is still committed to moving ahead with the higher capital requirements –  even though it expects the banks to come through the current severe test just fine.    The implementation was delayed by a year back in March, but that is now five months ago, and July 2021 really isn’t far away –  particularly in a climate of heightened uncertainty, including about likely loan losses out of the current recession.  So on the one hand the Deputy Governor and his boss are out their urging banks –  almost suggesting it is some sort of moral duty –  to lend more freely, and on the other hand they are still pushing ahead with their plans to hugely increase actual capital requirements, something even their own modelling suggested would have adverse transitional effects in more-normal times. (Oh, and did I mention all while doing nothing to actually lower real interest rates across the economy, in ways that might improve servicing capacity on current debt, and provide a boost to aggregate demand and –  over time – to credit demand.)

And here I want to refer to the other speech, by Toby Fiennes; in particular this extract (emphasis added)

At the end of May we released our six monthly Financial Stability Report (FSR) which assesses the health of the financial system. This assessment presents particular challenges during more volatile and uncertain times; we want to report openly and fully about the state of financial stability and the risks that we see, but we have to be mindful of the risk of exacerbating the situation, and further undermining confidence.

We used stress tests to inform ourselves and our audience about banks’ and insurers’ resilience. We developed two scenarios to test the banking system, which had similar economic projections to the Treasury’s COVID-19 scenarios 4. Results from our modelling indicated banks would be able to maintain capital above their minimum capital requirements under a scenario where unemployment increased to over 13 percent and house prices fell by a third. However, a second more severe scenario showed the limits of bank resilience. Under this scenario with unemployment of over 18 percent and house prices falling by half, banks would likely fall below minimum capital requirements without significant mitigating actions.

I should note that bank capital buffers have increased significantly in the past decade, in response to actual and forthcoming increases in regulatory requirements; therefore the banks entered the Covid-19 pandemic in a sound position. Additionally, since early April the Reserve Bank has prohibited banks from paying dividends to their shareholders, which further supported the capital positions of New Zealand banks. This gives banks headroom to continue to supply credit, which will play a large role in supporting the economic recovery.

Note that he repeats the same outright misrepresentation –  the bolded phrase –  as his boss.

But it was the rest I was more interested in.  He highlights again the updated stress tests reported in the FSR.    I might be more pessimistic than most economists, so I reckon the 13 per cent unemployment scenario sounds like a good and demanding test.  As with previous similar RB stress tests, Fiennes reports that the banks come through just fine –  at least so long as they don’t markedly lower their lending standards in response to regulatory pressure.  But again –  as was argued during the capital review debates last year –  if the system is resilent to such an adverse shock before capital ratios are raised, what possible credible case can their be for markedly further raising capital requirements?  Especially when the Bank is trying to twist banks’ arms to maintain/increase new lending?   There is just no apparent rigour or coherence to the Bank’s position.

Much the same goes for the line about prohibiting dividends.  I didn’t have too much problem with the temporary ban when it was announced  – on good prudential grounds that in the very unlikely event that our banks got into serious trouble we didn’t want resources being transferred back to the parent, leaving larger losses for New Zealand creditors and taxpayers.   But it is just bizarre to suppose that banning banks from paying dividends will increase their willingness to make new good loans.  If anything, it is only likely to reinforce unease about doing business in New Zealand (at the margin), and since credit demand has fallen notably –  a point Bascand acknowledges-  and actual capital ratios were well above current regulatory minima it isn’t obvious that some shortage of capital in the New Zealand business was likely to be a big influence on lending policy just now.  The suggestion that suspending dividends will “play a large role in supporting the economic recovery” is without support, and if seriously intended is almost laughable.

There is more in Bascand’s speech I could devote space to.   At least what I’ve covered up to here is within the Bank’s statutory mandate re the soundness of the financial system as a whole.    The same can’t be said for this stuff, pursuing the Governor’s personal political agendas on issues where there may be real issues, but they have nothing to do with the Bank’s mandate or powers.

Financial inclusion has become an increasingly important part of the Reserve Bank’s policy agenda in our capacity as a Council of Financial Regulator member and our own Te Ao Māori strategy. The Strategy helps to guide the bank in understanding the unique prospects of the Māori economy, how Māori businesses operate, and what lessons the Bank may learn in setting systemically-important policy with this view in mind. An important part of the Strategy is making clearer the unintended consequences of our policies on unique economies like the Māori economy.

Or one of the Governor’s favourites, climate change.  Here I will just quote one line from the speech

Managing major and systemic risks to the economy, such as climate change, sits squarely within our core mandates.

It simply doesn’t    The Bank has an important, but narrow, statutory role and set of powers around the soundness of the financial system.  Climate change(and policy responses to it) may well represent a significant threat to our economy, our way of life, and so on. But unless –  and even then only to the extent –  it poses a threat to financial stability, not taken account of by private borrowers and lenders, it is really no particular business of the Bank.  Any more than other serious risks –  management of Covid itself as just a contemporary example –  are anything much to do with the Bank.

But the Governor has personal ideological agendas to pursue, and (ab)uses public resources and staff to pursue them.

Standing back from the Bascand speech, what is really rather striking –  and disappointing –  is the lack of an overall framework, the lack of any real rigour or discipline, and a lack of straightforwardness.  Clearly his boss has a cause –  more lending –  to pursue, but like Orr Bascand offers no reason to suppose, or evidence to support the implication, that banks are not acting prudently or appropriately.  And never seriously engages with the implication that if the banking system is sound now and has plenty of headroom, why would it make sense for the Bank to be imposing big new capital requirements, which will assuredly be reducing the willingness of banks to lend.

But, as I noted earlier, if the opportunities are so real no one is stopping Orr and Bascand leaving their safe official perches and starting –  or joining –  a risk-taking bank.  A good supervisor would, however, be keeping a very close eye on any bank riding courageously into the cannon fire –  of extreme economic uncertainty, severe challenges –  in the way Bascand appears to suggest.

Perhaps better if Orr and Bascand turned their minds, and attention, to using monetary policy in the way it was designed to be used, instead of sitting idly by six months into a severe economic shock, with real interest rates barely changed, and the real exchange rate not changed at all.





Almost literally unbelievable

Our central bank that is.

Except that I had to believe it.  The Governor himself was being quoted again in a Stuff article and the video footage of a full interview with his deputy (on the economics and markets side) Christian Hawkesby was on interest.co.nz.

On Tuesday, as I wrote about in my post yesterday, we had the Governor telling us that monetary policy would have no more than a supporting role –  despite being the main cyclical stabilisation tool – that there would be no “knee-jerk reactions”, that we were in “a good space” and  –  perhaps most incredibly of all –  that “confidence and cashflow will win the day”.  Confidence that had tanked, cashflow that was rapidly becoming a problem for many.  It was –  or one really wished it was –  unreal.

But Orr and Hawkesby –  both statutory officeholders charged with the stabilisation role of monetary policy –  were back at it yesterday.  Clearly, the Governor’s voice is most important –  especially with no deep or authoritative figures elsewhere on the MPC –  so we’ll take his new comments first.

Not all of it was silly.  There was the standard advice to firms to talk to their banks early (I imagine that, where they still can, firms might be well advised to draw down any credit lines early too).  But then we get lines like this

Reserve Bank governor Adrian Orr has advised businesses to focus on things they can influence and banks to consider their “social licence” and play a long game to bridge the gap in activity created by the coronavirus pandemic.

“That is it all it is, just a gap,” he said.

Talk about minimisation.  If a firm takes a deep hit to its revenue for six or nine months, and has fixed commitments it can’t get out of at all, and other semi-fixed commitments, what was a viable business can quickly run through any remaining collateral and not be viable at all (the underlying business might be, but not the existing owners).  So sure it is a “gap”, but it could be a mighty big one, with quite uncertain horizons for anything like normality returning.

Most especially because the Governor –  like the Minister of Finance – gives no hint of recognising that the worst  (probably a lot worse) is yet to come.

(And what about that strange suggestion that firms should focus on what they can influence?    What they can’t, really at all, influence is what is likely to be worrying most, more so by the day.)

But the interview goes on

He said he did not believe there was a perception that the bank had been slow to respond to date.

Instead, there were benefits in the central bank getting more information about how consumer and investor behaviour was unfolding and the response of global governments, he said.

“While some talk about ‘what is your interest rate response?’, at times like this central banks have a much broader and important role which is around financial-market functioning and financial institution stability,” he said.

“There, we certainly aren’t sitting on our hands, watching, worrying and waiting.

“We are on high alert around how the financial markets are operating and our role in the provision of liquidity.”

I guess he isn’t reading much of anything –  unless he now has his media clippings selected only for their favourability to him –  if he really believes that first sentence.  Perhaps the case for an OCR cut at the MPS was borderline, but there were plenty of sceptics even then as to whether their talk was taking things seriously enough.  And I haven’t seen many people who thought has remarks on Tuesday were appropriate, responsible, timely, or whatever.  In the meantime, central banks in Australia, the US, Canada and now the UK have acted.

But it was the rest of that quote that really staggered me –  the claim that the Bank had a “much broader and more important role” in this situation around market functioning and financial institution soundness.  Again, what planet is he on?   No one, but no one, believes the coronavirus shock’s economic effects are primarily a financial stability issue.  Really severe recessions could in time generate significant credit losses, but that is well down the track (for banks of our sort).  In things to do with the Bank this is primarily a severe adverse shock to demand (almost wholly a demand shock for New Zealand so far, something neither Orr nor Hawkesby seem to grasp).  These are the guys who go on and on about their new employment-supporting mandate.  Lots of jobs are being lost right now, and will be over the coming weeks and months.   There may be other things governments can/should do, there may be other stuff other wings of the central bank need to focus on, but monetary policy is their macroeconomic business, the tool that can be deployed quickly and flexibly, and which has been in every past crisis.  But Orr and Hawkesby seem to prefer to sit on their hands and gather more information (of the gathering of information in fast-moving, exponential, crises there is no end).

Before coming back to Orr’s final comments, I add some remarks on Hawkesby’s interview.

Assistant Reserve Bank Governor Christian Hawkesby says the RBNZ’s main focus at this point of the coronavirus crisis is making sure the banking system remains strong.

Echoing comments Governor Adrian Orr made on Tuesday around confidence and cashflow being key, Hawkesby said the RBNZ is looking at how funding markets and banks’ relationships with their coronavirus-affected clients are holding up.

“That’s really our first point of call and our main focus – at least in these initial stages,” he told interest.co.nz.

Much the same themes, but how utterly irresponsible.  No sense of his responsibility as a (statutory) monetary policymaker, explicitly charged with a macrostabilisation role.  Doubly so because, as he goes on to acknowledge (and unlike, say, Italy)

“We have a well-capitalised banking system and a well-funded banking system.”

So try looking under the right lamp-post for issues that need to be addressed.

Hawkesby, like Orr on Tuesday, hosed down expectations of large, if not emergency, Official Cash Rate (OCR) cuts in the immediate future.

He said the government could move with more haste than the RBNZ, targeting those most affected by coronavirus.

He also claimed it was “early days”: early days was a month or six weeks ago, when the Bank was doing its MPS forecasts.  This is now a full-throated downturn –  where even the local banks are now talking, belatedly, of recession.

And what of that nonsense about the government being able to move faster.  Not only is it generally not true –  OCR decisions can be taken and implemented almost instantly –  but on this occasion neither party has actually done anything yet.   In  fairness to Hawkesby when I listened to the interview he seemed to be trying to make a point that sectoral issues are better targeted with sectoral policies, but that doesn’t really help him this time, as he went on to say

Hawkesby said: “What we need to think through is, to what extent is it [coronavirus] a supply-side issue around supply chains; around specific sectors being affected – in which case monetary policy can’t provide direct help.”

He said monetary policy would be useful if there is a spill-over effect and a lack of demand and confidence across the economy.

Perhaps he missed the data release on Tuesday showing that business confidence had fallen to levels last seen in 2009.  And when you are talking about the temporary collapse of one of our largest economic sectors –  overseas tourism –  you are dealing with pervasive effects that really only macro policy can do much to lean against.

It is almost as if these guys think they are running some sort of academic seminar, rather than being alert to real world developments –  here and abroad, including monetary policy responses abroad.  Whatever the explanation –  and no one seems to have a good one, they are just failing to do the basics of their job.  In none of any of that was there any mention of the idea that (at least temporarily) neutral interest rates will have plummeted –  the fall in very long-term bond yields is probably a bare-minimum estimate of how much –  and that much of the job of monetary policy is keeping actual short-term rates in line with shifts in neutral.  These guys would appear to prefer to do nothing, even as real retail interest rates are rising. (I’m sure they will move, perhaps quite a lot, as spiralling global crisis will produce a lot of reality to mug them with in the next couple of weeks.)

Oh, and as in the Governor’s remarks on Tuesday, there was nothing in either interview about the threat to inflation expectations. They are falling around the world, and in New Zealand –  seen in the bond market and in the ANZ business survey.  As I noted towards the end of yesterday’s post, it is a strange omission, because only a few months ago both Orr and Hawkesby were dead-keen on emphasising downside risks to inflation expectations and making the case for pro-active least-regrets monetary policy adjustments.  Good and sensible quotes from both of them are included in this post from late last year.    Not sure what happened to those central bankers.  The threats/risks must be much greater now.  But it all fuels a sense that these guys are just out of their depth, with no consistent mental models or sense of the world (or this event) found especially wanting by a crisis.

By contrast there was good workmanlike speech on coronavirus economic issues yesterday by Guy Debelle, Deputy Governor of the Reserve Bank of Australia, Hawkesby’s direct counterpart.  It was what serious normal central banking looks like.

But I wanted to come back to Orr’s final comment in his Stuff interview.

The coronavirus was a reminder of why policies such as the Reserve Bank’s decision to increase the capital requirements of the major banks and to ensure they could operate on a standalone basis had been pursued, Orr said.

“We try to implement them in peace time, because it is hard to implement them in war time – not that I am saying we are in war time.”   

He probably should get his lines sorted out with his deputy: you’ll recall that Hawkesby quote that, at current levels before any of the increased capital requirements take effect, we have a “well-capitalised” banking system.   Which is what the Bank’s demanding stress tests have always shown, and what numerous serious critics pointed out in the consultation process last year.

But even if we take Orr’s comment in isolation, he seems not to recognise at all that whether his announced higher capital requirements made sense in some long-run steady-state, they will have some adverse effects on the availability of credit, rates of investment etc through the transition period.  Orr confirmed that capital requirements in December and they are to be phased in over seven years.   Unfortunately, the beginning of that transition period – when bank behaviour is already being affected (and we saw this in the last credit conditions survye months ago – the next one, presumably taken this month, will be fascinating) – happens to coincide with the nastiest economic shock we’ve had in a long time.   But, at present, no bank’s capital ratios will be any higher now than they would have been if Orr had seen sense and not proceeded (so there is none of the additional buffer he is implying).   As it happens, reported capital ratios  –  though not of course actual dollar capital – would drop before long, because the change to the rules around aligning minimum risks weights for iRB banks with the standardised rules is being frontloaded.

And while no one could foresee that we’d have a severe pandemic shock this year, Orr was warned of exactly this sort of issue: in a climate with little conventional monetary policy capacity, sharply increasing capital requirements over a period when a new recession was fairly probable at some point would simply compound the real economic and economic policymaking challenges.  This was from my submission

Finally, in this section, 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 tradeoff that appears to be worth making – at least not without much more supporting analysis than we have had to date.

I’ve seen no sign Orr or his colleagues ever engaged with this point.

And before passing on, don’t overlook this bit from Orr

“not that I am saying we are in war time”

Relentlessly determined to minimise just what is going on and the extremely challenging period –  of indeterminate length –  we are now entering.

But whatever should have been, the new capital requirements are what they are.

There is some discussion as to whether it might make sense to suspend implementation of the new requirements.  In the UK, the Bank of England last night released their Countercyclical Capital Buffer (an element of their capital requirements).  More generally, people are looking at the merits of some regulatory accommodation.

For now at least, I have to say I’m quite sceptical, at least in New Zealand (and I noticed Hawkesby suggested these were conversations for well down the track).  Sure, capital is there to be used as loan losses mount (which, of course, they haven’t yet).  But it is always worth remembering how important expectations are to behaviour –  for bank/bankers as much as anyone else.  So, sure, Adrian Orr could suspend the implementation of the higher requirements, but why would that materially alter the attitude of banks to taking on additional risk?  After all, the Governor tells us this is just “a gap”, but even when reality finally mugs him, the banks –  and their parents in Australia –  will know that the Governor is still sitting there waiting to resume the steady escalation in capital requirements as soon as some modicum of normality returns.   I’m not going to oppose suggestions of a temporary suspensionm but I doubt there would be much bang for the buck in doing so, at least while Orr is still Governor.

It really has been a reprehensibly bad performance so far in this crisis from the Governor, his monetary policy deputy, and the Monetary Policy Committee as a whole (all of whom must, for now, be presumed to be on board – although will the next OCR decision be the first time someone on MPC is willing to record a dissent?).  Looking to the statutue books, you might have been hoping that the chair of the Bank’s board and/or the Minister of Finance –  both responsible for the Governor and the MPC –  would be demanding something better, but I’m not holding my breath about either of them.

There are, of course, more ultimate statutory provisions.  They won’t be used.  But the case is mounting that the Governor, the Bank, Hawkesby, and (as far we can tell) the external ciphers on the MPC simply are not doing their monetary policy job.  It is an utter failure of leadership, something we are now seeing far too much of at the top levels of government as this crisis deepens.  We are paying for unserious appointments, weakening public institutions, in the quiet times.



What does bank capital do?

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.

If you assume policy is powerful, you can justify almost anything

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.

summary CBA.png

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 gubernatoral 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.)



As we await the Governor’s final decision

At midday the Governor of the Reserve Bank will descend from the mountain-top, having communed with himself for some months, and tell us how much more capital locally-incorporated banks will have to hold for each dollar of (risk-weighted) assets.

It is one of the more stark of the democratic deficits in the current Reserve Bank law –  which grew like topsy over the years –  that a single unelected official, largely appointed by more unelected part-timers,  has the unchallengeable power to make such far-reaching decisions, when there is no shared agreement about the appropriate goal policy should be set to meet, no shared agreement on the relevant models of the economy and financial system, and no ongoing accountability for whether this single individual’s choices end up effectively serving the public interest.  Instead, we are left with one individual’s whims – in this case, an individual without even much in-depth expertise or long well-regarded professional experience – and one individual’s personal views of “the public interest”.    Usually, that is the sort of thing we hire/elect politicians for, including because we have recourse –  we can toss them, and their party, out again.

With a better Governor and a better institution beneath/behind him, the legislative framework would still be deeply flawed in principle.  In practice, it might matter rather less.    But instead we have a relatively inexperienced Governor, a similarly inexperienced (in banking, financial stability and associated regulation) Deputy Governor and a fairly weak bench as well.  Search the Reserve Bank’s publications and you will find precisely no serious research or analysis on issues relevant to financial stability or bank regulation.  That isn’t the fault of individual staff, but of choices of successive waves of senior management.  Key management figures are widely known for their aggressive, but insular, approach, and it is only a couple of years since the independent stakeholder survey of the Reserve Bank as regulator produced damning results.   Regulatory capture is often a big concern the public should have about regulatory agencies, and that seems unlikely to be the Reserve Bank’s particular problem.   But analytical excellence, an open and consultative approach, willingness to engage, listen, and reflect, willingness to work effectively with others, are the sorts of areas where the Reserve Bank falls well short.  A system where the Governor is prosecutor, judge and jury in his own case, with no feasible rights of appeal, doesn’t conduce to things being better than they are.

And thus we come back to the Governor’s proposals for markedly increasing bank capital.   These were launched a few days short of a year ago.  There had been no working level technical consultation or wider socialisation of analysis and research on any dimension of the issues.  There was no cost-benefit analysis –  in fact, there still isn’t, we only finally get to see one today and can be sure that will have been artfully constructed to support the Governor’s decision.  As the background papers finally came out it emerged that the 1 in 200 year framework had been chosen at the very last minute.  There was no evidence of close engagement with APRA, despite (a) most of the major banks being subsidiaries of Australian banks, (b) economic and financial risks being similar, and (c) APRA having greater depth and expertise.   To this day we’ve had no serious analysis comparing and contrasting effective capital requirements here and in Australia.

And so it has gone on.  The Bank did publish a few more papers designed to support their case.  They very belatedly hired some hand-picked chosen overseas experts to give the Governor’s plans a tick –  people with no expertise specific to New Zealand.  And even then the ticks weren’t exactly ringing endorsements –  recall David Miles noting that one could grosly over-specify a bridge, or employ engineeers to do regular inspections and assessments.   We’ve had the odd speech –  although never once a serious effort from the Governor, the sole decisionmaker –  including, most recently, the half-hearted ill-supported attempt by the Deputy Governor to claim that New Zealand was much riskier than Australia.  But no indications of any serious engagement with people who had lodged submissions raising technical points of one sort or another on the proposal.

And then, of course, there was the Governor’s style.    There were the attempts –  open and public –  by the Governor to suggest that anyone who disagreed with him was “bought and paid for”, in league with the banks.   Even if it were true –  which it demonstrably wasn’t –  isn’t the onus on a decent policymaker, particular such a powerful one, to engage on the substance and to show where and why someone with an alternative perspective might be wrong.

And then you might recall the succession of Stuff articles on other aspects of how the Governor has been operating this year.

The video of the conference remains on the Reserve Bank’s website. Some reporters said they were stunned Orr would air his anger so publicly and called it bullying.

But other observers were not surprised. Details of Lubberink’s experience were already circulating in Wellington and industry sources say they match a pattern of hectoring by Orr of those who question the Reserve Bank’s plan.

“There is a pattern of [Orr] publicly belittling and berating people who disagree with him, at conferences, on the sidelines of financial industry events,” said one source who’s been involved in making submissions to the Reserve Bank on the capital proposal.

There have also been angry weekend phone calls made by Orr to submitters he doesn’t agree with.

“I’m worried about what he’s doing.”

The source said some companies have “withheld submissions,” for fear of being targeted by Orr.

“They’re absolutely scared of repercussions. It’s genuinely disturbing,” he said.


In the cut and thrust of the debate, Orr’s jokey style and everyman charisma fell away. In recent months he’s dogmatically insisted the cost of his plan would be minimal and has picked personally at critics in the media, academia, and the financial services industry.

He’s been variously described as defensive, bullying, and perilously close to abusing his power.

“He’s in danger of bringing scorn on his office,” said long-time industry watcher David Tripe, professor of banking at Massey University. “I used to know him well. I no longer feel so confident.”

Or the strange statement the Governor corralled his entire senior management to sign, rejecting attacks on Bank staff –  and thus attempting to play distraction, since most of the concerns were about the Governor himself and his (now) handpicked senior management.

(As I’ve noted previously, I don’t have a personal dog in this fight.  If he has been abusing me –  which wouldn’t surprise me – I don’t know of it, and fortunately wasn’t one of the submitters subject to one of those “angry weekend phone calls”.   But New Zealand deserves a lot better from such a powerful public figure.)

The Reserve Bank’s Board and the Minister of Finance are jointly and individually responsible for the Governor.  I wrote to both a couple of months ago expressing my concern, partly because the chair of the Board tried to bat away the issues by suggesting that he had had “no formal complaints” (as if that was the appropriate threshold for concern, in an industry where the Governor has great power to make things difficult for at least soe troublemakers).  My letter to the Board was here.   I also knew that I wasn’t the only person writing to the Board.

I lodged a request under the Privacy Act for (basically) any Reserve Bank senior management mentions of me during October (the time of the Stuff articles and the letters to the Board).  I was mostly after the flavour of the period.

For anyone interested the response (not particularly long) is here

Reddell Personal Information 281119 (1)

It includes the letter, Geof Mortlock, former Reserve Bank (and APRA) official, wrote to the Board chair Neil Quigley (because he referenced something I’d written), quite critical of both the Governor and the Board.

Here was how one of Orr’s deputy chief executives responds when Neil Quigley forwarded the letter on.

robbers 1.png

I thought that “Sigh” was pretty telling.  The SLT statement to which she refers was that extraordinary to suggest that it wasn’t fair that people were beating up on their staff when…..no one was.  Play distraction rather than addresss any issues about policy or the Governor.

I sent my letter later the same day.  This was the Robbers unguarded response

robbers 2

(I have never met her, but I can assure her (and her bosses) that I’m not “bitter” –  I’m not sure what I’m supposed to be “bitter” about, but it is clearly a theme that makes Bank management feel better –  and if they looked at all carefully they would find I typically express my concerns more moderately than some others commmentators on the Bank –  see eg some of the Mortlock articles and, indeed, letter to the Board.  Never mind though, she is “calm and serene”).

Having received my letter, Quigley contacted Orr.  An excerpt

quigley 1

Actually, I didn’t ask for it to be discussed at the Board (although I appreciate the fact that it was so discussed – see below).  More importantly, perhaps, I had not talked to Kate MacNamara for the articles, and have never had any contact with her.

Orr responds a few minutes later, not at this stage having seen the letter

orr letter

One has to chuckle at the lack of any apparent self-awareness in that second paragraph, written just days after the Governor had had his SLT put out that unsolicited statement attempting to distract from real concerns.  I guess it wasn’t the Governor who was making those “angry phone calls”, or engaging as he did with Jenny Ruth, and so on.

A few minutes later Quigley responds, rather characteristically it would seem (one of the consistent criticisms of the Board is that they repeatedly acts as if their role is to cover for the Governor, not –  as the law provides –  to hold the Governor to account on behalf of the public and the Minister.

quigley 3

This is, presumably, a reference to the episode in which Graeme Wheeler used public resources and his official position to attack me as “irresponsible” for bringing to light what proved to have been a leak of the OCR and associated systemic failures, and when I expressed concerns to the Board –  on which Quigley was then a member (generally one rather sceptical of Wheeler) –  they all circled the wagons to defend the Governor.

The Board met a few days later.  A few days later Quigley confirmed to me that the non-executive directors (Orr is also a director) had discussed my letter.  The Board’s minutes confirm this.


We don’t know what was said (and even if it were recorded, it would –  rightly –  not have been disclosed), although there are rumours –  heard from several sources –  that the subsequent meeting between Quigley and Orr was a fiery one, suggesting that the Board may actually have taken seriously some of the concerns raised.   There were signs in the Governor’s demeanour at the last two press conference that he may have been counselled to rein himself in and act with a bit more gravitas and dignity.

As it happened, I had lodged a parallel Official Information Act request in which I asked for

·         all communications received from outside the Bank by Board members (including the Governor) during October 2019 regarding the Governor’s performance or conduct, including (but not limited to) issues raised in recent articles by Stuff’s Kate MacNamara

·         any comments on those communications made by the Governor

·         details of any external speaking engagements, or contributions to written publications, where the Bank had initially indicated that the Governor would speak but which, during October 2019, were either rescheduled, cancelled, or assigned to some other Bank staffer.

The response was due last Friday.  It wasn’t an onerous request.  There can’t have been many such communications to Board members, nor (presumably) many written comments by the Governor.  The third strand was to attempt to find out whether the reported story was correct, that the Governor had chosen or being prevailed on to pull out of some engagements after the criticism.

Anyway, the Bank has extended the deadline for this request by another 2.5 weeks, claiming the need for “consultations”.   But I guess it also conveniently pushes any release beyond today and close to the Christmas break.   Perhaps there is more there than I assumed.  More probably they are just being deliberately obstructive.

As I noted, I also wrote to the Minister of Finance about these issues, mostly to reinforce the point that the Governor was his responsibility, and he couldn’t just fob things off to the Board.  The Minister’s stance right through this year has been to distance himself from the proposed major new regulatory initiative, claiming it is just up to the Governor, and refusing to exercise any of the powers he does have.    Here is that letter.

Letter to MOF re Orr Oct 2019

I didn’t really expect to get more than a one sentence reply, but a fuller response turned up in the post the other day.  Here is the heart of it


I thought there were two interesting statements in this letter, neither of which he was compelled to make:

  •  first, the statement of “complete confidence” in the Board, even though almost non one shares that view, and his own consultative documents as part of the Phase 2 Reserve Bank Act review recognised the serious weaknesses of the current model and proposed scrapping it, and
  • second, the line that “I have been satisfied with the Governor’s work so far”.  I guess “satisfied” isn’t a terribly strong endorsement, and arguably “work” might not include style, but it clearly sees the Minister of Finance line up behind the Governor including around the Bank capital proposals and decisions (almost certainly the Minister would have been informed of the final decision by last week when the letter was dated).  That is a brave choice, given the serious pitfalls in the Bank’s work in this area that I and various others have highlighted.

Before long we will have the Governor’s final decision.  Perhaps after a year and more of weak performance, his presentation (there is apparently a press conference) will be marked by grace, insight, rigour, and gravitas, and the documents will be penetrating, complete and convincing, addressing comprehensively, whether directly or by implications, many of major concerns that have been raised.  Perhaps, but it seems unlikely.   If it so, I hope I will one of those saying tomorrow how pleasantly surprised I was.

We need a high-performing Governor, a robust and rigorous Bank, and the sort of openness that really should characterise a strongly-performing powerful institution in a free society.  On each count, they’ve been a long way short this year, covered for by both the Bank’s Board (in pretty predictable fashion) and now by a Minister of Finance who refused to take any responsibility –  including when questioned on the issue in Parliament –  and now seems happy to line up behind the flawed Governor he is responsible for –  but, no doubt, a Governor whose personal politics and championing of issues well outside his lane warms the hearts of MPs on the government benches.

New Zealanders deserve better –  behaviour and substance – than we’ve had this year.  As I noted just last week, even at this late date the groundwork the Governor was laying for this decision was shaky and incomplete at best.



Shaky groundwork

The Reserve Bank released its six-monthly Financial Stability Report this morning, followed a bit later by the Governor’s press conference.  The FSR seemed to be mostly about laying the defensive groundwork for next Thursday’s announcement of the Governor’s final decision on minimum bank capital requirements.  And the press conference was mostly pretty tame, the Governor having announced that he wouldn’t answer any questions on bank capital issues, and the assembled journalists having come quietly and not asked any.  The Governor himself was mostly on his best behaviour again.    It is to be hoped that the journalists get an opportunity to question the Governor seriously, and in an informed and open way, when the capital decisions have been announced and the year-overdue cost-benefit analysis has finally been released.

There was some discussion at the press conference about the Bank’s staffing for supervision.  We were told that they now have 38 staff in that area, up by five, although they avoided answering the question of how many people they have assigned to each main bank.   Asked about plans for further staffing increases, the Governor indicated they were planning on 30 more people, but he had to be hauled into line by his deputy who stressed that it was all contingent on how much the government agrees to allow them to spend in the forthcoming Funding Agreement.  Count me just a little sceptical that there would be much marginal value, in terms of system soundness gains, from the 30th additional person, especially if (as we must) we assume the Governor is pushing ahead undaunted with his capital plans.    It was one of the Governor’s own vaunted “independent experts” who wrote recently.

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.

“Belt and braces” springs to mind.

The Governor told us he hadn’t been “particularly close” to easing the LVR limits, those restrictions first put in place –  as avowedly “temporary” – more than six years ago.  Now that the central bank has been delivered into the hands of enthusiasts for direct controls, facilitated by a government with not much belief in indirect instruments or markets, we must assume it would take something really rather severe to see the LVR controls lifted again.  It has always reminded me of exchange controls –  imposed in a hurry in 1938, finally fully lifted in 1984.   But again, no one seems to have thought to ask whether there would not be an element of “belt and braces” about having binding LVR controls in place at the same time as – the already resilient (Governor’s words) banking system is facing a near-doubling of its minimum capital requirements.    I guess enthusiasm for regulation begets enthusiasm for yet more regulation.

Remarkably, in the FSR the Bank claimed that there had been a “gradual reduction in housing market imbalances”.    It wasn’t fully clear what they had in mind, but since those words appeared in the same (short) paragraph that featured a link to this chart, it appeared to be something about price to income ratios.


The price to income ratio might have fallen back in Auckland, but it has been continuing to increase in the rest of the country (taken together) and for the country as a whole a current ratio (estimated) of 6.64 is immaterially different from the peak of 6.78.    Whether these are really “imbalances” –  as distinct from equilibrium outcomes given land use restrictions –  is another question.

The Bank itself persists in minimising the importance of these fundamental regulatory distortions.  In the FSR there is a box which attempts to address the question “How have lower long-term interest rates affected housing valuations?”    It is an attempt to argue that low(er) interest rates themselves are a big part of what has gone on.

This is their main chart (in which it is a little puzzling why they start from 2009 –  the depths of the recession/crisis –  rather than, say, take a peak to peak approach).

house prices FSR

Focus on the left-hand panel, for the entire country.   (In these charts, blue bars are positive contributions and red bars negative ones.)   It isn’t very satisfactory that they appear to have modelled nominal house prices rather than real house prices. It isn’t clear why they have done so, but (at very least) it appears to be convenient for them, enabling them to (claim to) show that lower interest rates are a big part of what explains house prices rises, when lower inflation expectations –  an offsetting factor (in red) –  would be expected to be fully reflected in lower nominal interest rates over a 10 year horizon.  Taken together, the effect of real interest rates looks quite small.

Similarly, this highly reduced-form approach tends to imply that rents are an exogenous explanatory factor in house prices, and using nominal (rather than real) rents only compounds the problem.  As I’ve pointed out here on various occasions, the sharp fall in real long-term interest rates should have been markedly lowering real rents over the decade –  real rents should be more affordable than ever.  Almost certainly it is the supply restrictions, interacting with unexpected population surges, that has driven up house prices, in turn driving up rents.    Interest rates are, at most, a second order issue: had the OCR not been lowered in line with the fall in neutral rates then –  all else equal – house/land prices would be lower, and the entire economy weaker.

Perhaps an easier way to see the point is this chart, showing the BIS measure of real house prices for the advanced economies in aggregate.

real house prices BIS 19.png

Real and nominal interest rates have fallen a lot almost everywhere in the advanced world since 2007 (Japan excepted) and yet real house prices are barely higher now than they were in 2007.    Lower interest rates do not explain high house prices, rising rents certainly don’t.  The culprit here (and in Australia) is tight planning restrictions, the effects of which are exacerbated by rapid population growth.

There were a couple of other significant points in the document that caught my eye, consistent with my description of the document earlier as laying the defences for the capital requirement increases next week.

The first related to credit conditions.    You will recall that the Bank recently released the results of its credit conditions survey. I wrote about them here.   Across the various classes of business lending, actual credit conditions were reported to have tightened quite a bit, and conditions were expected to tighten further over the coming six months.  And why?   Well, this was the chart –  from their own data.

credit 4

“Regulatory changes” is explicitly identified as the biggest single factor –  surely mostly the bank capital proposals –  closely followed by “balance sheet constraints” and “your bank’s risk tolerance”, both which one would expect to be directly influenced by the expected change in capital requirements.  And yet not a word of this made it into today’s FSR, presumably because it would have been a bit awkward or uncomfortable to have confronted it directly.    (There were a couple of mentions of credit conditions, but none of the role their own policy proposals appear to have played.)

And then there were stress tests.  One of the highly unsatisfactory elements of the way the Bank has tried to spin the case for much higher capital requirements is their reluctance to engage seriously with the results of various stress tests done this decade, all of which – no matter the shock – suggest that the banks come through in pretty good shape, in turn suggesting that (a) banks have plenty of capital and (b) bank lending standards in recent years haven’t been that bad at all.  Typically the Bank waves its hands, suggests the stress tests might not capture things perfectly, and hurries on to another issue.   But in this FSR they’ve come up with a new argument –  not previously seen, at least as I recall it, in a year of consultation.

While the stress tests are calibrated to a severe downturn event, the Reserve Bank is seeking to ensure that the system will be resilient to even larger shocks.

Well perhaps, but the scenarios they’ve already tested seemed plenty demanding (and appropriately so).  For example, a 4 per cent fall in GDP, a 40 per cent fall in house prices (and a 50-55 per cent in Auckland house prices) and an increase in the unemployment rate to 13 per cent.  It is the interaction between lower house prices and higher unemployment rates that creates large mortgage losses.

There are few examples anywhere of house prices falling more than that (including in the crises –  typically in fixed exchange rate countries –  people like to quote), and as for the unemployment rate, I devoted a whole post to that a few years back, where I concluded that there was not a single example, across the entire OECD, where a floating exchange rate advanced economy had experienced an increase in its unemployment rate as large as was implied by the Bank’s stress test in the entire post-war era (now 75 years, across perhaps 25 market-based countries).   The Bank seems to be wanting to prepare for a Greek crisis, or for a rerun of the Great Depression, without taking account of the stabilisation role monetary policy and a floating exchange rate now play in countries like New Zealand.   Without a lot more open engagement on the sorts of risks they see, it is pretty tawdry stuff.

In the course of his press conference, the Governor took the opportunity to wrap himself around the recent reports of the foreign academics he’d hired to provide some comments on the Bank’s capital proposals, lamenting only that these “excellent”, “very positive”, “wholly independent of us” reports hadn’t had much local media attention “unlike some other views” (it wasn’t quite clear who he was having a dig at there, but perhaps Kate McNamara’s stories are still leaving a sting).   Victoria University academic, and bank capital expert, Martien Lubberink was live-tweeting the Governor’s press conference and was moved to observe of these reports

I wrote about those reports in a post a few weeks ago, summarising

As I said at the start, for handpicked reviewers, chosen at a time when the Governor had already put his stake in the ground, the reports were much what one should have expected.   The Bank seems to have taken the reports as reassuring support –  but that is why they hired these particular people, known for particular predispositions –  but I suggest you don’t.  Many of the bigger picture questions simply haven’t been engaged with, adequately or at all.

(many of those bigger picture questions were rehearsed in the post)

and went on to conclude that there was a surprising absence from the reports (and from any Reserve Bank papers on the issue)

And, somewhat to my surprise, I didn’t see any mention at all of the paper that came out three months ago, from a working group of major central banks, looking at issues around appropriate minimum capital requirements, working within the academic framework these reviewers are comfortable with.   I discussed that paper here and  highlighted this chart and these issues

On my reading, this is the bottom line chart in the BCBS paper.

bcbs chart.png

They report the net marginal economic benefit (slightly lower GDP each year, offset against savings from a less serious crisis decades hence) from higher bank capital ratios, drawn from a series of studies.    On these models there were really big gains in lifting capital ratios, up to around to around 9-10 per cent.  If there are gains at all –  and they don’t report margins of error around these estimates –  they are looking extremely small beyond about 13 per cent.    Perhaps that doesn’t sound too far from the 16 per cent number the Reserve Bank is proposing for the big banks but (among other limitations, many made inevitable by data limitations):

  • this modelling is done on actual capital ratios, not regulatory minima (a 16 per cent minimum ratio is likely to see banks aim for something between 17 and 18 per cent actual ratio), and
  • none of this modelling takes account of differences in accounting and regulatory treatment across countries: conventional wisdom, (backed by estimates done by PWC) suggest that effective capital ratios in New Zealand (and Australia) would be far higher if things were measured the same way they were done in various other advanced countries, and
  • none of it takes account of the regulatory floor in how risk-weighted assets are calculated.  As the Bank is quite open about, a significant part of what is proposing is that in calculating risk-weighted assets, the big banks will have a floor of 90 per cent of what the standardised rules would generate (the more normal floor is, as I understand it, about 72 per cent).  A 17.5 per cent headline actual capital ratio would, on RB proposed rules, be akin to something like 20 per cent in the sort of framework the BCBS authors are looking at.

Nothing in this paper suggests any reason for confidence that effective capital ratios of, say, 20 per cent of risk-weighted assets would be generating net economic benefits, even on the (overly pessimistic) macro assumptions the authors are using.  But that is what the Reserve Bank claims to believe.  The onus, surely, is on them to show us, and to engage on their assumptions and analysis – in open dialogue – well before decisions are made.

Neither in todays report nor in the press conference was a rigorous, open, accountable, excellent central bank of the sort we should expect on display.     Perhaps it is too easy to become accustomed to this mediocrity.  Perhaps that accounts for the not-very-searching questions at the press conference –  nothing at all for example about the recent very public concerns about the Governor’s conduct over the bank capital proposals.

Next week all will be revealed. No one seems to expect any material departure from the initial proposal, even if there are a few cosmetic modifications, or adjustments to the transitional arrangements.  Perhaps then we will get all the answers: really good and convincing cost-benefit (and associated sensitivity) analysis, serious engagement with the serious analytical points raised in submissions (rather than attempts to treat submissions as akin to a public opinion poll), a sustained narrative around transitional paths and risks in allowing material tightening in credit conditions when conventional monetary policy is almost exhausted, and so on.


Credit conditions

Back in mid-2009, just as the first glimmers of recovery  from the severe recession were emerging, the Reserve Bank launched a credit conditions survey (of lending institutions).  It was a sensible enough initiative but, to be honest, I never paid much attention to it.  We knew conditions had got very tight during the recession and (at least in my remaining time at the Bank) the data weren’t that interesting –  of course credit conditions were easier than they’d been in the midst of that financial scare, and when there were changes shown they were for pretty obvious reasons (eg access to housing credit was reported as tightening when the Governor imposed LVR restrictions).   Also, the number of institutions covered was quite small, and one had to worry that results could be affected by who happened to fill out the form in a particular institution on a particular occasion (plus, when reporting to your prudential regulator incentives aren’t entirely straightforward).

There is a series of questions about:

  • observed loan demand (by class of loan),
  • expected loan demand,
  • observed credit availability,
  • expected credit availability, and (since early last year)
  • a series of factors potentially affecting the availability of credit.

That makes for lots of series.  I’m less interested in the demand side, which is largely going to reflect stuff we see captured in other data (eg housing turnover, business surveys etc).  But demand for new business loans does seem to have fallen away somewhat in recent years.

But what about the supply side?

Here is observed credit availability over the last six months (the survey is six monthly) for the four business sectors (there was no particular change in availability to households).

credit 1

And here is what respondents expect (presumably from a position of knowledge, responsible for something around overall credit within their own institution).

credit 2.png

Yes, there is some idiosyncratic variability in the response at times, but in the ten year history of the series we’ve seen nothing like the tightening in expected conditions observed in the last few quarters, now across all the business classes (there is little movement on the mortgage and personal household lending categories).

It isn’t easy to know quite how much weight to put on these responses –  for a start, with only one incomplete cycle of observations, we have little idea of “normal” variability as economic conditions turn down.  But as the recent downturn is larger than the post-2009 upturn (coming off a pretty savage tightening in conditions) it doesn’t have the look of something that should be quickly glossed over.   It looks to represent a potentially quite material tightening in monetary and financial conditions.

The other question they have about actual credit availability might also tend to confirm that unease.  Respondents are asked about how credit availability is now compared to the past three years (I guess to smooth through idiosyncratic influences on the past six months).  Here are the responses for the business sector loans (household was directly and materially affected by the waxing and waning of LVR restrictions, a policy intervention).

credit 3.png

Again interesting that there had been little movement re SMEs, but for the other three business categories the scores are getting back towards levels we saw just after the last recession.

Early last year the Reserve Bank did a welcome extension to the survey and started asking respondents about the influence of various specific factors that could reasonably influence credit availability.  Here are answers.

credit 4

Cost of funds hasn’t been an issue in changing credit availability (nor would you really expect it to be –  should affect price rather than availability), and neither has competitive pressure, but look at those four striking negative yellow bars.    Risk appetite among the lenders, risk capacity, and (distinctively) regulatory changes have all worked to (apparently materially) tightened credit conditions.

Sadly, here we reach the limits of the survey. It would be fascinating to be able to disentangle quite what is going on.  There is a quite plausible story that all three of the other negative yellow bars are primarily a reflection of the fourth, regulatory change (presumably the Governor’s capital whims).  Perhaps it isn’t so, and there are independent reassessments of risk and willingness to bear risk going on in head offices, whether here or in Australia, but whatever the precise combination of factors it is pretty likely that regulation is already weighing fairly heavily on credit availability in New Zealand. (I only qualify that claim a little because banks perhaps have an incentive to play up the issue, knowing that the Governor is about to make his final capital decisions, but I doubt that is more than a marginal factor here, given the small number of respondents and the ability of the Bank to query each).

You may recall the consultation document the Bank published almost a year ago on the Governor’s proposals to greatly increase capital requirements for locally-incorporated lenders.  You may not recall the discusssion of these sorts of effects, let alone the apparent differential sectoral effects.  That isn’t the fault of your memory.  There just was no discussion of those issues in the document.  Which seemed odd at the time, and even more extraordinary now.  It will be interesting to see how the Governor responds to these data in his two scheduled press conferences in the next few weeks (MPS and FSR).

While these data are clearly of some relevance to the bank capital debate, my main interest in them was in the more immediate issues around the appropriate stance of monetary policy and the setting of the OCR.   There appears to have been quite a sharp change in market sentiment/pricing and the views of some market economists this week on the chances of the Bank cutting the OCR on 13 November (the reasons for that change still aren’t fully clear, and one is left wondering if the Bank has been signalling –  by accident or design –  some change in its own view).

My interest is much less in what the Bank will do in the short-term, but in what they should do (which should, of course, make my commentary of interest to the Bank, given the Assistant Governor’s speech the other day, but…..).  “Will” and “should” eventually tend to converge, but it can take some considerable time for them to do so.

But if we grant that this credit conditions data is material the MPC did not have when they did their August forecasts, or made their slightly panicked last minute decision on a 50 basis point cut, and did not even have at the last OCR review, it really should be  colouring the projections they finalise next week (even if the variable might not feature in their formal models).  Add in own-activity business survey data that has shown no signs of rebounding since August, inflation expectations that have either fallen further (surveys) or remained very low (inflation bond breakevens), and a core inflation rate that remains consistently materially below the (focal) midpoint of the inflation target, the case for not cutting the OCR in November seems weak at best.  There isn’t another review opportunity until February, the world situation (if not one of sentiment spiralling downwards) seems no stronger substantively, and for a committee that was sufficiently rattled to do a 50 point cut only three months ago –  and not to have seen anything much improve since then –  to do nothing now would only further muddy the communications waters, leaving people even less clear about how the MPC thinks, or that there is a consistent and disciplined process at work, secreted away from the public/market spotlight.

(Bearing in mind that there is still some material local data to be released before 13 November) the risks around a further OCR cut in November at present look quite asymmetric.  As we drift closer to the next recession, and to the limits of conventional monetary policy, the very best thing that could possibly happen would be positive surprises on core inflation, spilling over into somewhat higher inflation expectations.  People are no longer convinced inflation will settle at 2 per cent or above. It would be better, for almost everyone (certainly for the management of the next downturn) if they were.   When credit conditions appear to be tightening quite materially –  and that even before the final decisions are announced –  getting that sort of outcome will be made harder than necessary if the Bank ends up setting on its hands, confusing messaging, all for what?  So that the Governor can get some perverse psychic satisfaction from surprising people again?   Unpredictability is not a desirable feature of public policy.


Productivity (lack of it) and other things

When I was writing some comments last week on Reserve Bank Deputy Governor Geoff Bascand’s speech in Australia I was playing round with some comparative data and stumbled on this chart.

nzau 1

Over the entire period (since 1991) real GDP per capita has grown at exactly the same rate in Australia and New Zealand.   And I haven’t even cherrypicked the starting point: my chart starts when the SNZ quarterly GDP per capita series starts.

Of course, even in 1991 we were materially less well off than Australians, but should we take some comfort from having kept pace over now almost 30 years?  I’d say not.

Here’s why.   Look at the employment rates in the two countries


You might be among those who think the more employment the better but (a) working is a cost (an input) to the employee and (b) wouldn’t it have been much preferable, even if you think higher employment rates are some great thing, for it to have resulted in more growth in average per capita income than in the country where employment rates didn’t increase as much?   Australia’s unemployment rate is a bit higher than ours, and that is a mark against them, but it is only a small part of the difference in the employment rates.

And here is a chart that is perhaps even more stark.


Across the whole population, the average Australian is now working 5 per cent more hours than in 1991, while the average New Zealander is working 22 per cent more hours.

And yet the bottom line, growth in average real output per capita, is the same.

The difference is productivity – or, more specifically, in our case the lack of anywhere near enough productivity growth.

I’ve got other things on today, so that is it for original content.  But earlier this morning I was rereading my submission to the Reserve Bank consultation on the Governor’s plans to require large increases in bank capital.   There wasn’t anything in it I would now resile from.  I also skimmed through former colleague, and expert in bank capital modelling, Ian Harrison’s papers (here and here) and I doubt he would resile from anything in there.

But what remains striking is how little engagement there has been from the Governor on his proposals.    He has only given four on-the-record speeches this year, not one of which has involved a serious sustained attempt to make his case, let alone engage with alternative perspectives.  The only attempts I’ve seen to respond to alternative perspectives seem to simply involve suggesting that anyone who disagrees with him is somehow bought and paid for, and therefore their views aren’t worthy of serious notice or scrutiny.

At one level, it shouldn’t be surprising, given Orr’s personality and intolerance of challenge or disagreement –  and the fact that, formally at least, he doesn’t have to convince anyone but himself (since he is prosecutor, judge, and jury in his own case, and there are no rights of appeal). But as matter of good governance, in a democratic society, it reflects very poorly on him, on his handpicked senior managers, and on the Bank’s Board and Minister of Finance who are paid to hold the Governor to account but in fact act as if there role is to simply get out of the way and let the Governor get on with it, poor as the process and substance have been, poor as Governor’s conduct increasingly seems to have been.

And so I’ll leave you with some of the unanswered points from my submission

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.


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.

I ended

New Zealanders deserve better than they have had in the poor process and weak substance that together made up this consultation.

To which one can only add that the repeated reports  –  some of things in public, others less so –  of the way the Governor has handled himself, his own conduct, through this episode are deeply disquieting.  There is little sign of the sort of character and temperament we should expect from a senior public servant exercise so much barely-trammelled power.  The Minister of Finance may declare that he has full confidence in the Governor.  The public should not, and if the Minister continues to sit on the sidelines doing nothing but expressing full confidence that should probably raise more questions about the Minister himself.

Meanwhile, one wonders what our new Australian Secretary to the Treasury makes of her first encounters with national policymaking and advice.

The Governor’s “independent experts”

Several months after going public with his plan for really large increases in capital requirements for locally-incorporated banks, and apparently feeling under a bit of pressure, the Governor of the Reserve Bank selected some foreign academics –  anyone local, he claimed, had been bought and paid for – to each write a report on aspects of the multi-year bank capital review.  I wrote here about the appointments, the terms of references the three selected people were working to, and what we might reasonably expect from them.

Their role was tightly-drawn, wasn’t primarily focused on the current (most contentious consultation), and they were only supposed to talk to anyone outside the Bank with the advance approval of the Reserve Bank.  Their focus was supposed to be on the Bank’s documents, not on (for example) the submissions the Bank had received in response.   And while there was talk of looking at the New Zealand specific context, none of the invited academics had any particular knowledge or, or background in, New Zealand.

This is what I wrote about what we might expect

I’m not impugning the integrity of the independent experts.   But they have been chosen by the Governor, having regard to their backgrounds, dispositions, and past research –  a different group, with different backgrounds etc, would reach different conclusions – and the Governor is well-known for not encouraging or welcoming debate, challenge or dissent.  Quite probably the experts, each working individually, will identify a few things the Bank could have done better, but it will all be very abstract, ungrounded in the specifics of New Zealand, and the value of their reports is seriously undermined in advanced because of who made the appointment, and the point in the process where the appointment was made.  This is the sort of panel that, at very least, should have been appointed a year ago.  Better still, it would not have been appointed by the Governor.

The three reports were released a few weeks ago and the visitors pretty much delivered for the Bank –  as, no doubt, having carefully selected them, the Bank was pretty sure they would.   There were, as I suggested, a few apt suggestions and questions but very little sustained engagement with the deeper issues, with the New Zealand context, or with the process.   The experts appear to have been let out to talk to a few (commercial bank) people outside the Reserve Bank but –  as per their terms of reference – there is no sign of systematic engagement with the range of expert submissions or submitters.  One declared himself comfortable that the Bank had answers to all the points raised by submitters, which may have been comforting for him but –  and this report was written months ago –  not so much for New Zealanders who’ve had no engagement from the Bank.

A Bank summary of the three report is here.  The Bank has claimed full-throated endorsement from the experts they selected.  Personally, I was a bit surprised how limited the reports were: offering more support (from people already strongly disposed to think more capital “a good thing”) than illumination.

I’m going to step through the reports one by one but I’m only going to talk about their comments on the current consultation on the minimum level of bank capital (for some –  and reasonably enough given the terms of reference –  that makes up only a fairly small portion of the report).

The first of three was by James Cummings, now of Macquarie University and formerly a researcher at APRA.    His report was quite long, but there wasn’t much insight offered relevant to the current consultation. There is a lot of reportage. For example, he simply channels –  without examining – the Reserve Bank’s claim about the greater vulnerability of New Zealand.  And despite being (a) Australian, and (b) previously from APRA he offers no thoughts on how robust the case might be for minimum core capital ratios here being material higher than those in Australia.  Then again, neither has the Reserve Bank.  There is no discussion about the trans-Tasman nature of the big four banks and the possible implications for the design of a sensible capital regime.  He mentions the Bank’s stress tests but – again simply, and briefly, channelling the Bank – to downplay them.

Cummings makes what appears to be a reasonable point that the Bank may have over-estimated the cost of equity in the Australasian banking sector (I presume that is one of the points the Bank will be having a look at).  But that is really about all the value he adds on the current consultation.  He is clearly highly sympathetic to the idea of the Australian banks listing their New Zealand subsidiaries locally and reducing their 100 per cent ownership of the subsidiaries. That will have been music to the ears of Messrs Orr and Bascand –  Orr in particular appears to have been pursuing that outcome as some sort of “New Zealand nationalist” goal, quite unrelated to his statutory mandate.  Cummings is correct that issuing equity locally could get round the fact that the imputation regime, although operating domestically in both New Zealand and Australia, doesn’t operate trans-Tasman.  But he doesn’t engage at all with the likely costs to selling down ownership and local listing (if they were non-existent, for example, the tax argument might already have led to partial local floats of the subsidiaries).  Those costs might well include a less strong ability to rely on the parent in the event of a crisis.  You’ll recall that really serious crises are supposed to be the focus of the capital review.

The second report is by David Miles of Imperial College, London (who spent a term on the Bank of England’s Monetary Policy Committee).  Miles has published some past research (unsurprisingly, given his selection) pretty sympathetic to higher capital ratios.  His (shorter) report is almost entirely focused on the current consultation.

He appears keen to be supportive of the Bank, and he begins his report by pushing back against the claim –  made by various critics –  that the Governor’s 1 in 200 year risk appetite stake in the ground was really just plucked out of the air.    And yet the Bank itself released a paper –  dated a mere six weeks before the release of the Bank’s proposals –  written by one of their internal experts, which adds the 1 in 200 year risk appetite possibility  (ie a 0.5 per cent annual probability of crisis) almost as an afterthought.


Presumably the Governor latched onto 1 in 200 and they were off.  Much of the subsequent supporting analysis and modelling was only done, and released, after the Governor had already nailed his colours to the mast and published his radical plans.

Miles is actually somewhat sceptical about several of the assumptions the Bank has made in its modelling, and Ian Harrison – expert submitter on the modelling etc who neither Miles nor the others show any sign of having engaged with –  plausibly argues that Miles show signs of not fully understanding the modelling framework and thus being less critical than he should be.   One of the parameters (R, around correlations) was based on a particularly shoddy piece of “analysis” –  Miles, being more diplomatic, observes simply “but this evidence is quite weak and not a firm basis to be confident that a higher value of R [than used conventionally] is justified.”.

By background, Miles is a macroeconomist and you might therefore have supposed that he would something insightful to offer around the scale (in GDP terms) of the sort of severe crisis the Governor’s plans are designed to avoid.  The Bank uses quite a high number – 63 per cent of GDP –  in turn based on remarkably little analysis (several sentences in this paper).  Miles reckons this is quite possibly a “serious underestimate” and “seems optimistic”.   His argument for this appear to rest on nothing more (you can check –  page 14 of his paper) than a thought experiment in which he posits the possibility that the entire extent to which UK GDP now is below the pre-2008 trend is a) all due to a financial crisis, and (b) permanent then the cost of crisis might be 330 per cent of GDP.    As indeed it might, but Miles provides no discussion for why we should interpret even UK GDP that way, no mechanism for how these huge effects (more costly than World War Two?) might arise, no distinction between GDP lost because of poor lending and borrowing in the boom (costs which crystallise later) and those actually related to the banking crisis itself, and no engagement with (for example) comparisons between the output paths of countries which had financial crises with those that did not.  I’ve argued – it was in my submission –  that something more like 10-20 per cent of GDP might well be more reasonable.

You might also have supposed that the macroeconomist among the experts might also thought about discount rates.    As we typically have the highest real long-term interest rates among advanced countries, the appropriate long-term discount rate here should also be higher (making taking insurance against even a costly future crisis rather less valuable than it might be in some other countries).  Even the Reserve Bank noted that point (even if it changed nothing in their analysis) but not the Bank’s macroeconomic expert adviser.

Miles’s offering is pretty abstract and doesn’t engage with the specifics of New Zealand (or the trans-Tasman nature of our large banks) much at all (although he does note the difficulty the Governor’s proposal may pose for our capital-constrained local banks).  Given his background, that isn’t really surprising –  and is more a reflection on the Bank than on him.

But a couple of his concluding remarks are worth highlighting.   He is quite dismissive of the issue that I and others have raised as to whether there is a robust case for setting New Zealand core capital requirements so much higher than those in Australia or than in most other advanced countries.    There is, in his view, no information value whatever in such judgements by other authorities, when set against a “careful” Reserve Bank of New Zealand analysis.  That analysis really should pose questions not for New Zealand citizens etc but for other countries, who perhaps just haven’t done enough of the Bank’s sort of analysis.  He makes a fair point that we don’t want the same speed limits on all roads –  it depends on the risk –  but offers not a scintilla of reason to suppose that macroeconomic risks, and exposure to severe shocks, is more severe in New Zealand than elsewhere.

And then there is his final, distinctly two-handed, defence of the Bank’s stance.  As far as I’ve seen, his final –  perhaps delicately worded –  swipe at the New Zealand regime has had no coverage.  Here is what he has to say.

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.

Ouch.  On the Reserve Bank’s own numbers, the Governor’s capital proposals involve an annual loss of GDP of $750 million.  You could buy a really large (by New Zealand standards) number of new bank supervisors and regulators for even a 10th of that amount.  I’m sceptical there even is much of that sort of trade-off in New Zealand, at least for the big 4 banks, given that they are, in effect, subject to APRA’s own more hands-on supervision.  But 30 more supervisors might be cheap compared to the costs and distortions of the Governor’s current proposal –  even allowing for the old maxim, about the devil making work for idle hands.

It was striking that neither Miles nor Cummings devoted any space at all to the sectoral and distributional effects of what the Governor is proposing –  and thus did not point out that the Bank’s consultation papers have not done so either.     Thus, no mention of the fact that the rules would apply to locally-incorporated banks, but not to (a) other banks, (b) non-banks, whether deposit-takers or otherwise, or (c) to market-based funding mechanisms (eg securitisations or bond finance directly).    Or, thus, that the burden of the policy will fall very unevenly –  those with easy access to alternative sources of finance will face no material impact at all, and those without could be hit quite severely (whether in terms of cost, credit standards, or competition among credit providers).

The third of the experts, Ross Levine, a US academic –  with no particular background in policymaking or bank regulation, but with an impressive publications record across a range of areas –  does touch on alternative sources of finance.  Indeed, it is one of the main themes of what is really an essay on incentives, risk-taking and so.  It is quite a thoughtful essay  – with some suggestions of issues the Bank might have discussed but didn’t – but it isn’t really clear what bearing it has on the merits of the Governor’s proposals or the quality of the analysis and argumentation supporting them.

Levine’s deep conviction is that banks are heavily subsidised, prone to recklessness, and that anything that reins them in, reducing their relative importance, is prima facie a good thing.    Those aren’t his exact words, but a paraphrase they seem to capture his view pretty well.   Well, fine, but some evidence would be nice, perhaps especially when you are dealing with (a) a pretty vanilla banking system, (b) in a country largely free of a track record of serious systemic financial crises, and (c) where the country’s vanilla banking system is owned by banks based in, supervised in, another country with a similarly strong track record of financial stability.   Remarkably, despite the focus on issues around incentives, Levine does not discuss at all how his thinking about the issues facing New Zealand might be affected by the fact that the big 4 banks are themselves owned by other (foreign) banks, subject to group capital requirements.  He suggests the Bank should assess some of these issues –  and it is a fair enough criticism that it hasn’t –  but offers no perspectives of his own. If the New Zealand subs remain wholly owned by the parents, for example, it is unlikely that any New Zealand capital requirement policies will affect the incentives on managers of the New Zealand operations, who operate largely as part of wider banking groups.

Because Levine is keen on a reduced reliance on banks, he thinks the Reserve Bank should have put more weight on how non-banks might respond.   He is keen that they should do so but it isn’t clear if he is aware that (a) the last (small) financial crisis in New Zealand was among non-banks or (b) that non-banks are subject to a lighter (materially so if the Orr proposal proceeds) regulatory regime than banks. Nor, it seems, has he given much thought to the implications of potential bank lenders not covered by the proposed new requirements.

His conviction is that banks are heavily subsidised and thus that capital requirements are generally too low. But he shows no sign of having engaged with, for example, indications regarding the sort of capital ratios found to work (for shareholders and creditors) in financial intermediaries where there is no credible prospect of a government bailout.  I touched on this in a post earlier in the year: as yet, we have no deposit insurance, and yet TSB, Heartland, and SBS each operate with actual risk-weighted total capital ratios of around 14 per cent. while the Governor wants to insist on 16 per cent minimum core capital ratios for the big 4 banks.  But I guess that sort of perspective would muddy the rhetorical story.

Levine doesn’t get into at all the issues around the actual economic cost of crises, the marginal reductions in those costs from the last few percentage points of capital requirements, discount rates or the myriad of other relevant angles. In fairness, he claims not to be taking a strong view on whether what the Governor is proposing is too high or too low, but his priors pervade his paper –  priors the Bank knew very well when they hired him.

The reviewers reports are generally pretty positive on the Reserve Bank analytical staff involved in the technical aspects of this project.  That is good, but not particularly surprising or new.  The issues here are more about senior management –  the Governor in particular –  and reluctance to engage more broadly or on a wide range of angles and perspectives.  The Governor has recently been attempting to deflect criticism of him by suggesting it is all about his staff –  “you are all beating up on my wonderful staff”  –  when no one is criticising them much if at all.  Staff have to deliver for senior management, and the Bank’s technical staff seem to have done the best they could to provide support for the Governor’s whims and priors.    It is the Governor and senior management colleagues who refuse to engage, refuse to look wider, and fail to provide any sort of robust defence of a proposal to impose much higher core capital requirements here than in most other places and, in particular than in Australia.

As I said at the start, for handpicked reviewers, chosen at a time when the Governor had already put his stake in the ground, the reports were much what one should have expected.   The Bank seems to have taken the reports as reassuring support –  but that is why they hired these particular people, known for particular predispositions –  but I suggest you don’t.  Many of the bigger picture questions simply haven’t been engaged with, adequately or at all.

And, somewhat to my surprise, I didn’t see any mention at all of the paper that came out three months ago, from a working group of major central banks, looking at issues around appropriate minimum capital requirements, working within the academic framework these reviewers are comfortable with.   I discussed that paper here and  highlighted this chart and these issues

On my reading, this is the bottom line chart in the BCBS paper.

bcbs chart.png

They report the net marginal economic benefit (slightly lower GDP each year, offset against savings from a less serious crisis decades hence) from higher bank capital ratios, drawn from a series of studies.    On these models there were really big gains in lifting capital ratios, up to around to around 9-10 per cent.  If there are gains at all –  and they don’t report margins of error around these estimates –  they are looking extremely small beyond about 13 per cent.    Perhaps that doesn’t sound too far from the 16 per cent number the Reserve Bank is proposing for the big banks but (among other limitations, many made inevitable by data limitations):

  • this modelling is done on actual capital ratios, not regulatory minima (a 16 per cent minimum ratio is likely to see banks aim for something between 17 and 18 per cent actual ratio), and
  • none of this modelling takes account of differences in accounting and regulatory treatment across countries: conventional wisdom, (backed by estimates done by PWC) suggest that effective capital ratios in New Zealand (and Australia) would be far higher if things were measured the same way they were done in various other advanced countries, and
  • none of it takes account of the regulatory floor in how risk-weighted assets are calculated.  As the Bank is quite open about, a significant part of what is proposing is that in calculating risk-weighted assets, the big banks will have a floor of 90 per cent of what the standardised rules would generate (the more normal floor is, as I understand it, about 72 per cent).  A 17.5 per cent headline actual capital ratio would, on RB proposed rules, be akin to something like 20 per cent in the sort of framework the BCBS authors are looking at.

Nothing in this paper suggests any reason for confidence that effective capital ratios of, say, 20 per cent of risk-weighted assets would be generating net economic benefits, even on the (overly pessimistic) macro assumptions the authors are using.  But that is what the Reserve Bank claims to believe.  The onus, surely, is on them to show us, and to engage on their assumptions and analysis – in open dialogue – well before decisions are made.

There were other problems in this paper – for example, to my reading of the experiences of other countries they use too-high estimates of the cost of crises –  but those will do to be going on with.  Neither the Bank nor their independent reviewers have engaged with the challenges this paper –  not by some lone academic or iconoclast, but from within the hallowed halls of central bankers and supervisors –  poses to the Governor’s plans.