A new BIS paper that undermines the Reserve Bank’s case

At the end of my long post yesterday on the Reserve Bank’s latest efforts to spin the Governor’s plans to increase very markedly minimum capital ratios for locally-incorporated banks, I noted

PS.  As Martien Lubberink at Victoria has pointed out there is another international agency paper out just recently that really doesn’t help the Bank’s case much if at all. I might touch on that tomorrow.

His post is here (complete with the sly –  if obscure, presumably deliberately so –  dig at the Governor in the final paragraph).

The paper he was referring was recently published by the Bank for International Settlements as a Working Paper of the Basel Committee on Banking Supervision, with the title “The costs and benefits of bank capital – a review of the literature”.   The paper was released only a couple of weeks ago, and it should be studied carefully by anyone interested in the issues here in New Zealand, including (one hopes) the Reserve Bank.

The paper begins

In 2010, the Basel Committee on Banking Supervision published an assessment of the long-term economic impact (LEI) of stronger capital and liquidity requirements (BCBS (2010)). This paper considers this assessment in light of estimates from later studies of the macroeconomic benefits and costs of higher capital requirements.

That earlier paper is referenced everywhere the issues are discussed, including in the Reserve Bank’s papers earlier in the decade, and in its consultative document for this review.   It supported –  to some extent made –  the (macro) case for higher capital ratios, in particular higher than had been in place up to that point (shortly after the crisis).  A review and update of the issues, by a group involving officials from the BIS, the Bank of England, the Banque de France, the Fed and Comptroller of Currency (among others) has to be taken seriously, including when the authors highlight the limitations of their own work, and outline areas needing further research.   The paper looks at many of the same studies the Reserve Bank cites but –  in Lubberink’s words –

The conclusions of the Basel Committee study, however, are different. They are much more modest than the findings of the RBNZ.

Before going on, I should say that I have serious problems with elements of the approach taken in the earlier and more recent BCBS papers (various points outlined at greater length in my own submission).   In particular, this work (and the Reserve Bank) treats all output losses in recessions associated with financial crises as being attributable to the financial crisis (bank failures etc) itself.  That is almost certainly wrong, and substantially overestimates the cost of crises themselves –  the loan losses that lead to bank failures arise from misallocations of investment resources (and/or overheated economies) and those misallocations will be corrected anyway (with likely output costs), whether or not any bank fails.   Remarkably –  and this is clearer in the more recent paper –  they also treat output losses in countries that didn’t have domestic financial crises (think Australia or Canada in 2008/09) as costs of financial crises, rather than allowing for the more plausible story that common third factors will have been driving, say, productivity growth slowdowns across the advanced world.  As I’ve argued (and as Cline, in a PIIE paper a few years ago, also made the case), if you want to isolate the output costs of financial crises, a better way is to look at the differential growth performance between (otherwise similar) countries that did and did not experience domestic financial crises.

A great deal turns –  in these sorts of modelling exercises – on how costly the modellers assume crises will be.  Both my points in the previous paragraph suggest the BCBS conclusions –  as to how much capital is likely to be warranted –  are likely to materially overstate the “true” numbers.

There are all sorts of other limitations to the BCBS work. For example, it focuses on “banks”, but doesn’t address the fact that for an individual country – think New Zealand –  a capital requirement on locally-incorporated banks won’t affect branches of foreign banks operating locally, or non-bank lenders.  Disintermediaton costs don’t figure.  It also, more generally, won’t apply to debt capital market funding.   Unlike the Reserve Bank, the BCBS paper does touch on the issue of alternative resolution mechanisms –  the Bank long favoured the OBR approach, but it was never mentioned in the consultative document, even though the more confident you are of OBR (I’m not, but they were) the less capital is required –  but it doesn’t touch on the issue of a banking system in which the large banks all have strong foreign parents.  And it doesn’t take account – in the macro calculations – of the possible income losses to New Zealanders from the higher equity returns to foreign shareholders (much of the overseas modelling seems assume redistribution of income within the country).  This latter point, in particular, has been covered in Ian Harrison’s papers.

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.

And then lets go back to the macroeconomic inputs.    If most of the costs of recessions associated with financial crises would have happened anyway (see above) then the output losses used in these models are substantially overstated.   Higher capital ratios make no difference to whether those losses occur.  Cline (the lower blue line in the chart) uses assumptions more similar to mine: you can see where the crossover point (to net costs) is for him.

Note too that real interest rates and the real cost of capital are higher in New Zealand than in most advanced countries.  The median (real) discount rate used in the studies the BCBS paper looks at is something like 3.5 per cent and none uses a real rate higher than 5 per cent.  A standard New Zealand Treasury guidance for cost-benefit analyses on regulatory proposals is (real) 6 per cent.  Using a higher discount rate materially reduces any benefits from a crisis assumed to arise, probabilistically, decades in the future.   And yet even on the studies reviewed by the BCBS, there is no consensus in favour of anything near as high as the effective capital ratios the Governor is proposing.

And, as I’ve pointed out previously, all this work implicitly assumes that any higher capital ratios can be made binding for decades to come.  Since there is no pre-commitment technology, and actual rules have been changed every few years, there should be a further discounting of any potential gains, particularly in light of the inevitable transition costs from big increases in capital requirements (which are frontloaded, and represents permanent losses, for what may be a temporary policy).

It was also interesting to be reminded, in an annex, of this feature of the earlier (LEI) BCBS modelling

The main results of the LEI appear in Table 8, p 29, of BCBS (2010).  The calibration used is the following:

• the probability of a crisis is 4.6% for a capital ratio of 7%, and declines at a diminishing rate to 0.3% for a capital ratio of 15%.

In other words, a probability of a crisis every 333 years with an (actual) capital ratio –  calculated as more conventionally abroad –  of 15 per cent.  And yet the Reserve Bank’s proposals were supposed to be calibrated to a crisis every 200 years, and yet still somehow generate effective capital ratios of 18 per cent plus for the big banks.

Now in many respects Martien Lubberink’s comment is fair, that for all sorts of reasons

studies on bank capital are more quicksand than a sound foundation for policy recommendations.

And yet, they have been repeatedly invoked by the Reserve Bank, and –  when read carefully – do still provide a commonsense test against which the benchmark the Governor’s ill-considered far-reaching proposals for New Zealand.

The whole exercise really should be suspended.  Come back to it perhaps in a few years’ time when a revised Reserve Bank Act is in place, and when there has been proper parliamentary and public scrutiny of the assignment of powers to the Reserve Bank (which policymaking powers should rest with ministers and which with agencies).  And use the intervening period to undertake some serious local research, working collaboratively with APRA (recognising the common risks, common ownership, likely common resolution) and engaging in workshops and seminars to tests the strengths and weaknesses of staff thinking and research well before decisionmaking authorities reach a provisional view.

And, in meantime, take comfort from the fact that before the IMF suddenly swung in behind the Governor, when there were no institutional pressures at play that international agency only a year ago told us, and told the world, that there were ample capital buffers in the New Zealand banking system.

IMF capital

The risks haven’t changed materially in that time, it is just that the gubernatorial whim has since been revealed.  Such whims are a terrible basis for making serious policy, especially when there are no checks, no appeals, on the Governor’s ability to impose such substantial transitional and ongoing costs on New Zealanders.

 

 

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Reserve Bank still spinning

Earlier this week, the Reserve Bank published (almost all of) the submissions it received on the Governor’s proposal to increase very markedly the share of bank balance sheets that need to be funded by equity.

Welcome as it is to have the submissions –  it is easy to forget that not four years ago the Reserve Bank was still reluctant to publish any submissions it received at all (even though it was the norm for government agencies, parliamentary select committees, and so on) –  the Governor sought to use the occasion for some more spin in support of his proposal (on which he alone will, a few months from now, make the final decisions –  the rest of us, whether Minister of Finance, banks, businesses or citizens will simply be stuck with the results of his whim, with no mechanisms for appeal or review.)

Instead of just releasing the submissions –  which could have been done weeks ago, very shortly after submissions closed –  the Bank chose to release a 22 page document labelled “Summary of Submissions” and a lengthy and argumentative press release in the name of the Deputy Governor.

I haven’t read all the submissions, or even looked at them all, but one reader –  distracting himself from other stuff he should have been doing –  did look at them all, and sent me a spreadsheet with the names of the submitters, the length of each submissions, and broad tenor of any comments.

A good consultative process draws out perspectives or comments or evidence that the consulting agency may not have thought of, may have chosen to ignore, may have interpreted differently, may have missed the point of, or whatever.  Having received that material, the consulting agency would carefully consider those perspectives, (in principle) looking to make the best decision, open to a revised perspective.   Of course, that sort of openness is rare –  it runs against human nature, particularly where the people making the final decision are the people who proposed the scheme in the first place.

And a consultative process shouldn’t be thought of, or presented as akin to, a public opinion poll.   If one wanted to make such decisions by public opinion poll then I guess (a) we wouldn’t delegate them to a specialised agency, and (b) we would commission a properly structured poll.   Apart from anything else, (a) people who are opposed to what is proposed are typically more likely to submit than those in favour, and (on the other hand) (b) especially when the numbers involved are small, it is easy for a handful of low-information submissions to be generated on either side of the issue.

The Reserve Bank, however, has tended to present the submissions as something of an opinion poll.     There was the silly line that “in general, submitters support the Reserve Bank’s objective to ensure that New Zealand’s financial system is safe” –  yes, and we support motherhood and apple pie too.  The issue isn’t whether the system should be “safe”, but how safe, and at what cost, on what assumptions.  And then

There was significant and wide-ranging media and public interest in the How much capital is enough? (PDF 545 KB) paper, with written feedback from 161 submitters.

Yes, 161 submitters is a lot more than the nine submissions they received on the previous paper in the longrunning capital review  but in the grand scheme of things –  considering the scale of the changes the Bank is proposing – it isn’t many.   And more than 20 per cent of the submissions turned out to be six lines or less: whether the submitter was for or against what the Governor was proposing (and in some cases it really isn’t clear) there is no useful information for a proper consultative process in submissions that short (unless perhaps one of the big banks had submitted “Dear Adrian, We agree.  Do start soon.”, which they didn’t).

Thus, when the Deputy Governor says

Many submitters, particularly from the general public, support the proposed higher capital requirements for banks.

He is correct.  Many did.  Very briefly.  Usually without much engagement in the argumentation and issue (although one of the Governor’s mates did write in to offer support and some argumentation, although strangely even he referred to some evidence that capital ratios should be 13-14 per cent, which led him to the view that the Bank’s proposed (minimum) ratio of 16 per cent was “acceptable”.)

And look at this attempt to play the populist card – the public versus the banks – a bit further

Some submitters, in particular banks and business groups, question whether the proposed increases are too large and too costly.

As they know very well, there were a variety of other serious –  more than half a dozen lines long – submissions from people with no vested interests who were very sceptical of the Bank’s proposal, and of the argumentation and evidence in support of it.

You also have to wonder how well the Bank would be able to defend a claim (perhaps in a judicial review) that the consultative process was a sham.  The Deputy Governor again

Increasing the amount and quality of capital can be reasonably expected to mean that banks can survive all but the most exceptional shocks, Mr Bascand says. “We think the costs of doing so are outweighed by the benefits – someone’s cost is for society’s broader benefit.”

(do note the attempt to play vested interests again: “someone’s cost”).  Isn’t it still months until the final decision is supposed to be made?  And yet the Deputy Governor can confidently declare not just ‘in putting out the consultative document we thought it likely benefits would exceed costs”, but (present tense) “we think the costs…are outweighed by the benefits”.  And if the Deputy Governor already knows perhaps he could release that cost-benefit analysis that so many submitters and other commentators have been calling for.  I guess they haven’t yet back-fitted the numbers to suit the Governor’s conclusion yet.

Continuing with the spin, the Deputy Governor moved on to invoke support from the International Monetary Fund and the OECD, both of whom released comments on the New Zealand economy last week.

Following its recent mission to New Zealand, the International Monetary Fund has released a Concluding Statement that highlights the need for strengthening bank capital levels and that the proposals appear commensurate with the systemic financial risks facing New Zealand. The Organisation for Economic Co-operation and Development’s latest Economic Survey of New Zealand expects increases in capital will likely have net benefits for New Zealand.

It is hard to make much of the IMF comments at this stage.  They are not much more than a couple of sentences in a press release, with no published supporting analysis.  And the Fund almost always backs the authorities – who are the people they talk to most  –  especially when central banks and regulators want to put more restrictions on banks. Why wouldn’t they?  Any economic costs don’t sheet home to them.  But the IMF’s support isn’t without its problem for the Reserve Bank.     Here is what they said

The new requirements would increase bank capital to levels that are commensurate with the systemic financial risks emanating from the dominance of the four large banks with similar concentrated exposure to mortgages, business models and funding structures.

Which, by logical deduction, appears to be saying that current levels of capital are grossly inadequate to the risks the New Zealand banking system faces. But there was no hint of these serious risks in past Financial Stability Report from the Reserve Bank (although they amped up the rhetoric in the latest one), and –  perhaps more to the point –  no hint of that in past IMF Article IV staff reviews or Executive Board discussions.  This snippet is from last year’s Article IV report, published as recently as June last year.

IMF capital

Not a word from staff, from the Board –  or, indeed, fron the New Zealand authorities in their published comments –  of a pressing need for a huge increase in minimum capital ratios.

The Deputy Governor also attempts to deploy the OECD in support.  They typically aren’t particularly expert in such matters, but here is what they actually said:

The Reserve Bank has proposed large hikes in bank capital requirements. High bank capital requirements reduce the cost from financial crises, but might also dampen economic activity through higher lending rates. On balance and nothwithstanding considerable uncertainty, increases in bank capital are likely to have net benefits, but the impacts should be carefully monitored.

Take it from me – I negotiated line by line wording on numerous OECD reports –  that is about as tepid as it gets.  It doesn’t even endorse the huge increases in minimum capital the Governor is proposing –  the comment is simply about “increases”, and there is a long way from current levels to what the Governor has planned.

And if you doubt my take on the OECD, here is their own slide from the presentation when they released the report in Wellington last week.

OECD capital.png

And these comparisons are just of headline required ratios (triangles are actuals I presume), while part of the Reserve Bank proposal is to materially increase the calculation of risk-weighted assets for the big 4 banks, to an extent that would, in effect, add another three percentage points or so to those New Zealand numbers, which already –  in the OECD’s words – “exceed those in other OECD countries”.

So, spin all the way down.    Complete with the observation about their continuing consultation –  fishing around to find some supporters perhaps

It is continuing its stakeholder outreach programme, which includes conducting focus groups to understand the public’s risk appetite, and engagement with iwi, social sector and industry groups, financial institutions and investors. It has also engaged three external experts for an independent review of its proposals.

They elaborate a little in the document that supposedly summarises the submissions.  On the iwi point “a workshop with Maori service providers” –  but why, what specific issues might there be for “Maori service providers” (whatever they are) from any others –  Catholic, Pacific, or whatever?   And the workshop they plan with “social service providers and NGOs” really looks like an attempt to drum up support for the shonky “social costs of crises” material they’ve run previously, and which Ian Harrison (in particular) has comprehensively demolished.  I will be lodging an Official Information Act request for the reports etc from any focus groups –  again it looks a lot like an attempt at distraction, a populist Governor trying to summon a mandate from “the people”, rather than from Parliament.

Also from that Summary of Submissions, this attempt to spin the issue (wasn’t this supposed to be a summary of submitters’ view and analysis?)

It’s about keeping New Zealanders, their investments, and the economy safe from the disastrous impacts of financial instability and the failure of a registered bank, which historical evidence suggests can be very long-lasting and go beyond just the financial costs for people.

Loaded language (and not even particularly well written).  Nothing like a bogeyman to scare people with I suppose, but surely only fairly geeky people even read a document like this.  Who is the Governor hoping to impress?  Not much sign of calm, balanced, detached and objective consideration, that’s for sure.

(Having said that, it was noticeable reading through the Summary itself how few arguments staff managed to find from the submissions in support of what the Governor was proposing.)

The other person who has weighed in this week is the Minister of Finance, with a rather plaintive appeal to everyone to get on and talk nicely, as if he was a harried parent pleading with children to just play nicely (“pleeeeeeease”) at the end of a long tiring day.   The Minister is reported to have called for a “mature debate”, observing

“I want to remind all parties that we are still in a consultation process. I am calling on all interested participants to listen to and work with each other constructively as this work is carried out.”

It wasn’t exactly authoritative.

Perhaps he might address his concerns specifically to the Governor, including via the Acting Secretary to the Treasury and the Bank’s Board (whose job to work for the Minister and the public to monitor and hold to account the Governor).   And perhaps he needs to wake up to the power asymmetries here: we have a single unelected official (largely appointed by some other unelected board members, all appointed by the previous government), championing huge increases in minimum capital requirements, having made no effort to socialise thinking or test reasoning before settling on a view, and is now judge and jury in a case he himself is prosecuting.  And the “defendants” –  not just banks, but the wider economy –  have no rights of appeal.  And the way the Governor has conducted himself –  dismissive of sceptical comments, strong elements of pre-meditation, no cost-benefit analysis, no serious analysis of the transition, no serious engagement with the Bank’s preferred resolutiuon tool (the OBR), “independent” experts handpicked by him to review the proposal (but barred from talking to anyone else without his permission) and so on –  doesn’t exactly inspire confidence.  He talks a lot about “making banks safer”, but all independent analysis  –  and their history –  suggests the banks are fairly safe already: we could reduce lots of risks in society to near-zero (the road toll for example) but the costs just aren’t worth it. He simply hasn’t made the case that this proposal –  which he cannot commit would even endure beyond his governorship – is worth the risks and costs.

The Minister of Finance does not have formal powers to stop the Reserve Bank.  It is right and proper that the Minister should not be able to interfere with supervisory decisions or judgements involving individual institutions, but what is going on here is probably the largest policy initiative (bigger than, eg, outsourcing/local incorporation) around bank regulation in many decades.  Big policy calls –  in areas where there is huge uncertainty (as the OECD, among others, says there is here) – really should be a matter for politicians.  At very least, they shouldn’t be a call for a one-man band with a bee in his bonnet (and without even any particular specialist technical expertise).

If the Minister really wanted to display some leadership he would call in the Governor (in consultation with the Secretary to the Treasury) and strongly urge that the entire review be put on hold.   There are several and sufficient reasons to do so:

  • the government has made provisional decisions around deposit insurance, but there has been no attempt to link that initiative and the bank capital proposal,
  • Phase 2 of the review of the Reserve Bank Act is well underway, and the provisional intention is that the Governor should no longer be the sole decisionmaker on matters of prudential policy, and that in future Treasury should play a stronger review role,
  • there is absolutely no urgency about doing anything about bank capital now (as every one recognises banks are strongly capitalised and have strongly capitalised parents, and it is only a few years since capital ratios were increased),
  • if anything, there is a strong case for doing nothing right now: the looming economic slowdown and diminished inflation pressures that are leading to OCR cuts remind us again of the approaching limits of conventional monetary policy.  The last thing we should be doing in that climate –  when stress tests etc show that bank balance sheets are sound –  is throwing more sand in wheels, potentially impeding credit availability over the next few years.

Of course, the Governor could refuse such a request, but he would be very unwise to do so.   The Governor has no public mandate, no independent source of legitimacy, and this is not an issue about the supervision of an individual institution –  it is about overall economic management, where the big parameters (eg inflation targets, debt targets……and financial stability goals, which are harder to pin down) should be made by those we elect, and can toss out again.   It should hardly be controversial if the Minister were to suggest to the Governor that he would be prepared to legislate so that in future changes in bank conditions of registration –  the lever the Bank uses –  could only be done by Order-in-Council, not simply on the Bank’s whim.  After all, that is how the prudential regime works for non-banks (and you’ll note there is no proposal in front of us to markedly increase capital requirements for non-bank deposit takers).

We need expert advice from the central bank – something we aren’t getting at present –  and expert independent adminstration of the rules, but the big policy calls (which involve significant risks, which no one can determine definitively) need to be the responsibility of the elected government.

For anyone interested, my own submission is here.

PS.  As Martien Lubberink at Victoria has pointed out there is another international agency paper out just recently that really doesn’t help the Bank’s case much if at all. I might touch on that tomorrow.

 

 

Not tenable in a crisis

On a quick read through the Executive Summary of the latest consultation document from the review of the Reserve Bank Act, there look to have been a range of not-entirely-unreasonable in-principle decisions made by the Minister of Finance.   Some even look thoroughly welcome, if long overdue, including the in-principle decision to end the charade that the Board of the Reserve Bank could or would adequately do the job of holding the Governor to account.  In turn, the decision to stop the Governor being the sole decisionmaker on banking regulatory policy can’t be implemented soon enough.

The other major change that I welcome, and have championed for some years inside and outside the Reserve Bank, is the decision to introduce a deposit insurance system.   Among advanced countries, New Zealand has been increasingly unusual in not having such a system.  The discussion of deposit insurance issues is from page 85 onwards in this document.

There are lots of details still to be sorted out, but the headline-grabber in the announcement yesterday was the aspect of what is proposed that I have most problem with.

The Minister has also made an in-principle decision that the scheme will protect eligible depositors’ savings up to an insured limit, proposed to be in the range of $30,000-$50,000 per depositor.

This has the feel of a bureaucratic compromise, including with the staff at the Reserve Bank who have consistently opposed deposit insurance.    More importantly, it is a ridiculously low limit which would almost certainly prove untenable, unsustainable, in an actual crisis.  David Tripe, at Massey University, calls it “a joke”, but it is (of course) more serious than that.

I favour deposit insurance mostly for second-best reasons.   You can advance various arguments for why deposits should, in principle, be specially favoured and protected.  I’m not really convinced by any of them.  If people really wanted rock-solid assets, and were willing to pay for them, the market could and would provide.  The evidence is, quite strongly, that people don’t (look, for example, at the tiny number of people holding government retail Kiwi Bonds, in contrast to the amount in bank term deposits etc).  And that isn’t surprising. Not only are banking crises rare, in countries where markets are allowed to work –  how much different the literature and mindset in this area might be if for 150 years Canada had had US banking etc laws, and the US had had Canadian ones –  but in the course of our lives many of us are much more likely to have serious  –  larger –  unexpected losses (financial or otherwise) from other sources.  A leaky home, a lost job, a serious relationship break-up, health problems, a business plan that just didn’t work out, an unexpected change in government policy,  living in a town that economic activity moved away from, and so on.

I’m not even persuaded by arguments about bank runs, that seem to have appealed to the authors of the consultation document (and the IMF and OECD).  There is little evidence of irrational runs and –  as we saw globally in 2008/09 –  wholesale creditors are at least as capable of running for their money, rationally or otherwise, as small depositors.

No, I support a credible deposit insurance system because governments –  abroad, and here –  have a demonstrated track record of bailing out depositors, and whole banks, when faced with a crisis, and political incentives that mean it would be difficult to change that track record –  perhaps especially in a political system such as our own, where so much power is bested in the executive, and the executive governs by commanding a majority (at least on supply issues) of Parliament.    If we believe in the importance of market discipline (beyond simply shareholders) – and I do –  then we need to do what we can to identify and recognise the pressure points and to internalise the costs of the protection they result in.   In this case, it is a concentration of (likely) voters, facing (potentially) large and visible immediate losses.

I’ve run through the likely political calculus in earlier posts (eg here), but suffice to say that I just do not believe that a plausible New Zealand government, faced with a plausible failure scenario for a major New Zealand bank, would let a bank fail, and use the OBR tool on all creditors, with protection only (via a deposit insurance scheme) for $30000 to $50000 per depositor.

The government has sought to argue that the proposed cap on coverage is somehow internationally mainstream, but I don’t know who they are trying to fool (themselves apart?).   This chart is from the official document.

dep insurance

You can ignore the strained attempt to split OECD countries into two separate classes and just focus on the data.  Whether you look at the limit in simple dollar terms, or as a ratio to GDP per capita, the range of coverage the government proposes here would be lower than in all but two OECD countries.   And perhaps the thing that stands out to me most starkly from the chart is how many of those red dots (the other country limits in NZD terms) are at or near $150000.

Not unimportantly, the limit in Australia is A$250000 (just a bit more than that in NZD terms).  The government has probably noticed that the big banks in New Zealand are all subsidiaries of Australian banks.  It is probably aware that if a big New Zealand bank ever gets to the point of failure, it is highly likely to be a situation in which the parent is also on the brink of failure.  And anyone who has ever thought about the issue recognises the high likelihood that the resolution of a failed Australian banking group, with major operations in New Zealand, is likely to be handled at a trans-Tasman political level (including because of pressure from the Australian government to keep the banking groups together, which might well be the best way to realise value for creditors).  Most likely, the big banks would simply be bailed out completely.  But if they weren’t, how credible do you suppose it is that a New Zealand government will simply walk away from depositors with amounts in excess of, say, $50000 –  left to the tender mercies of OBR –  while their Australian siblings (in a bank with the same brand) are protected to A$250000?  Not very, would be my answer.     (And bear in mind the complication that it is generally recognised that if OBR is ever used, the non haircut deposits in any failed bank will need to be government guaranteed, and that such a guarantee may even need to be extended to other banks, to avoid a big loss of funds to the failed bank.)

I’m not arguing that we need the same limit as Australia –  apart from anything else, New Zealanders are poorer on average (but would it have hurt to have looked at common model?) –  but a $30000 to $50000 limit will simply strike people as so low that it won’t be persisted with if and when a crisis hits.  Deposit insurance limits get changed on the fly –  it happened all over the advanced world in 2008/09 –  and when they are, those who get the protection won’t have paid for it.    Failing to get this right, ex ante, simply increases the risk that when the crisis comes we’ll end up bailing out wholesale creditors (including foreign ones) too.

Much better to put in place a credible limit (indexed to inflation or nominal per capita, to remain sensible) –  perhaps $150000 per depositor – and charge depositors directly for the protection the Crown is proposing to offer.  Don’t –  as the discussion document talks of –  build up a modest fund and then stop charging the levy.  Remember that major bank failures are (and are supposed to be) very rare events: a levy of 15 basis points per annum on insured deposits for 150 years, would cover losses of (say) 20 per cent of all insured deposits (an extraordinarily large loss).   But just like your house insurance, the best outcome is if you pay your premium all your life and never need to make a claim.

The consultation document discussion on deposit insurance is itself something of a mixed bag.  At a technical level, some of its seems solid enough, but then they attempt to buttress it with overwrought claims.  There was this, for example

The GFC showed that a loss of confidence in one bank can rapidly spread throughout the financial system through ‘contagion’ that causes instability and destroys financial and social capital.

“One bank”????     And, even more far-fetched

The OECD (2013) and IMF (2017) have both warned that, without depositor protection, New Zealand is particularly vulnerable to contagious bank runs that can escalate into banking crises that destroy social and financial capital. The financial costs alone could be profound and long-lasting: experience overseas suggests that in a bank crisis GDP might fall 20 percent below trend, and the Government debt-to-GDP ratio might increase by 30 percentage points for a decade.

As we have seen, in analysing the Reserve Bank’s claims around bank capital, most of those “cost of crises” analyses simply don’t withstand serious scrutiny.  But, even if they did, no serious observer would claim that the presence or absence of deposit insurance in the difference sparing us staggering GDP losses.  Here, officials and the governments are attempted to sell us a model in which financial crises arise out of nowhere, and they know –  even the Minister really should –  that that is simply not so.

But I was left wondering quite how much the Minister of Finance understands when I saw him reported as suggesting that

A bank deposit protection scheme may help defuse the battle between the Reserve Bank and the country’s biggest trading banks over how much extra capital they should have to hold on their balance sheets, Finance Minister Grant Robertson indicated today.

It is a lot more likely to amp up the tensions I’d have thought.  From a fiscal perspective –  the Crown as underwriter of a deposit insurance scheme –  deposit insurance increases your interest in having bank capital ratios as high as possible (and the discussion document talks of funding deposit insurance with a levy on bank profits, rather than directly on insured deposits). But it was noticeable that there was no discussion at all of the interaction between the two: in principle, the higher your minimum capital ratios, the cheaper the deposit insurance should be.  I guess we will know the Governor’s final decision on capital before the Minister tries to legislate deposit insurance, but you would hope for some more joined-up discussion at some stage.

On which note, on the Radio New Zealand news last night, I heard the Prime Minister quoted as saying (apparently at her post-Cabinet press conference)

“Our banking system is one of the strongest and most resilient in the world”

I suspect she is probably right about that (floating exchange rate, vanilla loan books, little or no government interference in housing finance markets, no history of recent financial crises, banks part of much bigger overseas groups (from a similarly governed country).

But, if she is right, if that is what she has picked up from her briefings, from Grant Robertson, and perhaps even from the Governor, what possible grounds are there for requiring the huge increases in minimum bank capital ratios that the Governor is currently proposing?  We’ve not seen a cost-benefit analysis (but, who knows, perhaps she has).  On the face of it, let alone digging more deeply, there is no such case.   She is content, it appears, to let an unelected bureaucrat impose potentially large costs on the New Zealand economy  –  over a period (next few years) when things are likely to be difficult anyway –  for little or no gain (given the strength and resilience of the banking system, of which she spoke, and the inability to commit to such capital standards for more than a few years ahead).

 

 

Bank capital requirements: playing defence

Liam Dann, apparently the Reserve Bank’s favoured journalist, has a column on the Herald website on the Governor’s proposal to increase substantially the minimum core capital ratios for locally-incorporated banks.  No doubt it will warm the Governor’s heart, if perhaps not the more rigorous of his staff.  Dann’s column runs under the rather populist heading “Don’t let Aussie shareholders hijack our banking debate”.

And yet, here’s the thing.  Dann advances not a shred of evidence in support of his  suggestion.    He writes

I also know the Reserve Bank’s new capital ratio proposal is an important topic for national debate.

And it is becoming one-sided.

The sheer weight of PR power pushing for the status quo – ultimately the interests of Australian bank shareholders – is what leaps out at me in this debate.

We’re seeing the screws turned on the Reserve Bank by numerous financial institutions, lobby groups and even opposition politicians, in a way that undermines the process.

“Becoming one-sided” when a well-resourced major economic regulator, able to act as prosecutor, judge and jury in its own case, with no rights of appeals –  and able to get media coverage whenever he wants it – proposes very major changes in the operating environment for a core part of our financial system, without robust supporting analysis or a proper cost-benefit assessment, and a wide range of parties push back?

Perhaps Dann didn’t notice that the Bankers’ Association put in a unified submission.  Sure, the Australian-owned banks are the biggest members of the Association, but the small New Zealand banks are also members.  The Bankers’ Association submission draws on work led by former Secretary of the (New Zealand) Treasury, former (New Zealand) Productivity Commission member, Graham Scott, supported by other analysis undertaken by Glenn Boyle (New Zealand) academic at Canterbury University, Martien Lubberink (a Dutch academic, and former bank regulator, at Victoria University, and one other New Zealand economist.    As a reminder, all the bank members of the association (New Zealand, Australian, Chinese, Dutch, British, American) signed on.

What of other economists?  I’ve been fairly vocal on the subject, speaking only for myself  (and I may be the last native New Zealanders who has no family connections to Australia at all, let alone any connections to Australian-owned banks and their shareholders).  My former colleague Ian Harrison has gone into some of the issues in much greater depth.  He’s a New Zealander too –  driven by his reading of the evidence, argumentation, and the public interest – and didn’t do any of his work with Australian bank shareholders as his focus.    I guess we’ll have to wait until the Reserve Bank finally publishes all the submissions to see the full range, but I’ve read several other unpublished submissions by New Zealanders, working for New Zealand firms, that were far from convinced that what the Governor is proposing would be in the New Zealand public interest.

If anything, I have been a little surprised at how quiet the Australian banks have been, at least in public.  Presumably there is intense lobbying going on behind the scenes –  on both sides of Tasman – but isn’t that entirely appropriate, and what one should expect (and welcome)?     Perhaps it would be better still if the debates were played out more openly….but that might require the Governor to actually engage, not to play his “politics of slur” card, that anyone disagreeing with him is simply serving vested interests, in the pocket of Australian banks.

And what of that bizarre suggestion that somehow the “screws are being turned….by Opposition politicians”…. “in a way that undermines the process”.  The Opposition must be flattered that anyone thinks they have that much power.  But quite what bothers Dann about the Opposition (or the wider opposition) isn’t clear….except perhaps that it has upset that nice Governor, who only has in mind –  and is clearly gifted with unique insights on – the wider public interest.  Contest and scrutiny and challenge are part of how policy is, and should be, developed and tested.

Anyway, you rather get the gist of the Dann column with this quote

To me, Orr and his predecessor Graeme Wheeler both seem to be intelligent, philosophical thinkers of a kind that is sadly all too rare in the upper levels of the New Zealand political sphere.

or

Neither this Governor nor the last has been troubled by differing views on where interest rates should be or what inflation is doing.

That would be same Governor (Wheeler) who marshalled his entire senior management team to complain formally to one of the banks (he regulated) when that bank’s chief economist criticised Wheeler on monetary policy?

or (of Wheeler)

For some reason many local commentators made assumptions about the Governor being the prickly one.

“For some reason”!    Very good, very visible, reasons –  whether one was inside or outside the Bank at the time.

In Dann’s world, Wheeler and Orr have been something akin to perfect hero knights, to whom the rest of us should defer in some mix of wonder and gratitude.  In the real world, both were pretty deeply flawed, with increasing questions about whether Orr is equipped (eg temperamentally) for the role (it became clear that Wheeler wasn’t).

When half-baked and costly proposals emerge from very poor policy processes –  and when there are no appeals against Orr’s unilateral exercise of statutory power –  those proposals need to be robustly scrutinised and challenged, by entities directly affected (whichever country they come from), and by those with a concern for the wider health and economic wellbeing of New Zealand.    Good proposals always benefit from robust scrutiny (even just enhancing confidence that what looks good actually is) and bad, poorly supported, proposals put forward by the confident and powerful badly need that scrutiny and challenge, in the public interest.   There are plenty of serious questions journalists could put to Orr – if he’d give them access to ask them –  and, on some at least there might be convincing and robust responses.  We’d all be better for hearing how the Governor deals with the substance of disagreement.   At present, reliance on slurs raises further questions as to whether the Bank has good answers, and whether it (and the Governor) have thought broadly and deeply enough.

A few weeks ago we learned that the Governor was planning to have some independent experts rather belatedly involved in what has, to now, been a very poor policy process.

The Reserve Bank is also in the process of appointing external experts to independently review the analysis and advice underpinning the proposals.

On the surface that sounded better than nothing, although as I noted in a post just before the FSR

And who are they going to find to serve as “external experts” this late in the piece, when most of those who think about the issues domestically have already either expressed their views and been involved as consultants in preparing submissions by others.  There can be a role for overseas experts, but knowledge of the New Zealand system and New Zealand experience should not be irrelevant.  And quite what is the selection process the Governor is going to use at this late stage –  the suspicion will inevitably be that he will be aiming for people just credible enough to look serious, but emollient enough not to want to make difficulties.

That same day the Bank quietly posted on its website –  where no one would find it who wasn’t looking –  the terms of reference for these external experts, together with the names/background of the people the Governor had appointed.   All three are from overseas, none (it would appear) with much/any background in banking regulation and none with any substantial background in New Zealand economics or banking (one spent a few weeks here in 2014).  At least two seem to have publications which suggest they will be very sympathetic to the Governor, and one other has published an entire book on protecting bank supervison from regulatory capture (good book).

You will recall the report last week that at FEC the Governor had gone further and (slanderously) claimed that anyone local had already been “bought” by the banks.   Which left me puzzling again at the way the Bank has apparently overlooked Professor Prasanna Gai, at the University of Auckland,  of whom we learn.

Professor Gai is currently serving a four-year term on the Advisory Scientific Committee of the European Systemic Risk Board

He might be presumed to have some relevant perspectives and experience, and I hadn’t seem his name associated in public with any other submissions/views on the current capital proposals.  I have no idea what his views on bank capital might be, but I suspect he isn’t flavour of the month at 2 The Terrace for some of his other views on the governance of financial stability etc.  And, unlike the foreign experts, he would have been somewhat attuned to the local debate.

As it is, in addition to having been carefully selected by the Governor himself –  at a late stage in the process, when he already has his stake in the ground –  the role of the “independent experts” has been drawn very narrowly.  One could even say, generously, surprisingly so.

First, there is the framing in the terms of reference. Thus (emphasis added)

The Capital Review has been carried out within the context of New Zealand as a small open economy, with external imbalances and an economic and financial system that is disproportionately subject to external economic and financial shocks and changes in offshore sentiment

This claim pops up quite regularly from the Bank, but there is no empirical or analytical support offered for it all at all.   Then we are told

Much of New Zealand’s private debt is concentrated in the household and agricultural sectors, and has been steadily climbing over recent decades.

That second half of that is simply wrong.  There were big run-ups in debt (to income or GDP) in the 90s and 00s, but the ratio of private debt to GDP or income is little different now than it was prior to the last recession.

The risk appetite framework is centred on the concept of ensuring that systemically important banks can survive large unexpected losses – i.e. losses that have a likelihood of occurring only once in every 200 years. This is a higher degree of risk aversion than is implicitly built into the New Zealand system at the moment, reflecting the Reserve Bank’s judgement that the economic and social impacts of financial crises are large and more wideranging than previously realised.

And yet have outlined nothing (here or in the fuller documents) in support of the claims in the final sentence, nor do they note –  these are overseas experts recall –  that New Zealand itself, like Australia, has not had a systemic financial crisis in well over 100 years.

And they repeat one of their starting stipulations

Capital requirements of New Zealand banks should be conservative relative to those of international peers, reflecting the risks inherent in the New Zealand financial system and the Reserve Bank’s regulatory approach.

But it is all castles in the air stuff, because they never seek to demonstrate that the risks around the New Zealand financial system (floating exchange rate, vanilla loan books) are even as high, let alone higher, than those of a typical advanced country.

What also wasn’t clear from the initial Reserve Bank reference is that the focus of the independent experts is not to be on the decision still to be made.  Instead, they are invited to review all the papers the Bank has released in its (multi-year) capital review.   This is the Scope of Work

The External Experts Report will cover: 

  • Is the problem that the Capital Review seeking to address well specified? 
  • Has the Reserve Bank adopted an appropriate approach to evaluate and address the problem? For example, is the range of information considered, and the analytical approach appropriate? 
  • Do the inputs and cited pieces of evidence used by the Reserve Bank in its approach appropriately capture the relationship between bank capital and financial system soundness and efficiency? 
  • Has the analysis and advice taken into account all relevant matters, including the costs and benefits of the different options?   
  • Have the issues raised in submissions been assessed fairly and adequately? The External Experts will only consider the Reserve Bank’s assessment of issues raised in the submissions on the first three consultation papers.
  • Have the key risks been adequately considered across the proposals in the Capital Review?  Was the advice and analysis underpinning the Capital Review reasonable in the New Zealand-specific context?

The Capital Review has generated internal analysis covering a wide range of issues. This analysis has formed the basis of four public consultation papers and a much larger number of internal reports. This analysis has covered all aspects of the capital requirements, including the definition of capital (“the numerator”), the calculation of risk-weighted assets (“the denominator”) and the capital ratio itself.

Thus, the independent experts are not asked to look at the submissions on the latest (most controversial document).  They are invited to consider whether the “advice and analysis” was ‘reasonable in the New Zealand-specific context”, and yet there is almost nothing about the New Zealand specific context in the “how much capital is enough” consultation papers, none of the experts has any material New Zealand specific knowledge, and they are not supposed to engage with or review the submissions.   And

It is not expected that the External Experts will carry out extensive consultation as part of their work. Any external consultation should be agreed in advance with the Reserve Bank.

If, for example, one of the experts was somehow to become aware of (say) Ian Harrison’s specific critiques of some of the modelling, they would be prohibited from engaging with Ian without the prior permission of the Reserve Bank.

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 alll be very abstract, ungrounded in the specifics of New Zealand, and the value of their report 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 flawed process highlights just what is wrong with the governance of banking regulation and related issues in New Zealand.  We need an expert bank supervisory body, but that body shouldn’t be able to set big-picture policy all by itself (one unelected individual, to whom all the rest work).   Those calls should be made by the Minister of Finance –  who, in any case, should be playing a more active and public role on this specific proposals in front of us –  advised by both the Reserve Bank and The Treasury, and drawing on whatever independent perspectives the Minister would be useful to the process.   The current system would be flawed even if we had a superlative Governor –  expert, judicious, rigorous, open-minded, self-critical etc etc –  but it is performing particularly poorly under the leadership the Reserve Bank has had for most of this decade, as the Bank has chosen to take to itself bigger and bigger interventionist policy calls.

Twenty questions

I wasn’t planning to write anything today, but in the Herald this morning there was an “interview” with Reserve Bank Governor Adrian Orr around the bank capital proposals. I put the word in quote marks, because it was more of a platform for the Governor to articulate his views and frustrations, than any searching or penetrating scrutiny.  I tweeted out a link which attracted a response from Newsroom’s Bernard Hickey

Twitter isn’t really conducive to a long list of possible questions (240 characters and all that) and I have more readers here than there, so I thought I’d jot down a few suggestions, a non-exhaustive list of possibilities, here.

  1.  Given that proposals of this sort were always going to be controversial, why didn’t you adopt a more robust process from the start (eg technical workshops, green papers etc before the Governor signed up formally to a specific option)?
  2. Especially so given that in this area you (single decisionmaker) can be seen as prosecutor, judge, and jury in your own case, without any rights of appeal?
  3. Why did you not publish all the relevant documents when the consultation paper itself was released, rather than drip-feeding them out over months?
  4. Why was there no proper cost-benefit analysis, with assumptions and senstivities clearly stated, published with the consultative document?
  5. Why have you not published (or prepared?) a robust comparative assessment of your proposals relative to the capital rules proposed/in place in Australia, enabling submitters to see clearly the similarities/differences?
  6. Why have you repeatedly attempted to slur all critics of your proposals as representing “vested interests”, rather than engaging with the substance of the arguments critics have made?
  7. Wouldn’t your position, and preferences, appear more robust to disinterested parties if they could see you engaging with, and specifically responding to, alternative perspectives?
  8. Are you willing to revisit the Bank’s previous decision on the inadmissibility of CoCos?  Given the relatively high level of CET1 capital, what grounds do you have not allowing (eg) CoCos issued to wholesale investors to meet any additional capital requirements the Bank considers warranted?
  9. Wouldn’t the ability to issue CoCos to meet any additional capital requirements be particularly valuable to the (capital-constraind) New Zealand banks?
  10. Why was there no discussion of OBR in the consultation document?  A credible OBR system appears to greatly reduce the need for any capital requirements (let alone very high ones), so does this absence suggest the Bank was walking back its support for OBR?
  11. Where is the evidence for the claim, made several times in the recent Bank FSR, of evidence that the costs of financial crises are much higher than previously realised?  Realised by who, and when? (Bearing in mind that current capital requirements post-date 2008/09.)
  12. You have taken to suggesting that the 2008/09 episode in New Zealand supports the need for further increases in bank capital.  GIven the very low level of loan losses and NPLs through that period –  a severe recession, after a dramatic run-up in credit to GDP – can you elaborate on your view?
  13. Why was there no discussion/analysis of the probable transitional effects in the consultative document?
  14. Why are you not proposing to impose the same higher capital requirements on NBDTs?  Won’t this further un-level the playing field?
  15. What sort of disintermediation from the balance sheets of the big 4 locally incorporated banks do you expect to see, bearing in mind that the requirements don’t apply to (a) other non-bank lenders in New Zealand, (b) banks operating here that are not locally incorporated, (c) foreign banks not operating here, but lending to major New Zealand borrowers, or (d) to the domestic securities market?
  16. How does this disintermediation square with the efficiency constraint that appear prominently in your Act (didn’t we experience lots of disintermediation in the 70s and early 80s?)
  17. Do you agree that any costs of the higher capital requirements are likely to fall most severely on borrowers (and depositors) with the fewest alternative options?  Under that heading, is it likely modestly-sized borrowers with idiosnycratic needs (including farmers) will be among the harder hit?  If not, why not?
  18. In your documents you do not seem to have engaged with the evidence that floating exchange rate countries that did not have a financial crisis in 2008/09 did not perform much differently than floating exchange rate countries that had a financial crisis?  Why not?  Doesn’t this suggest your “cost of crisis” assumptions are substantially overstated?
  19. How, if at all, do you distinguish between the economic costs of a misallocation of resources during a credit boom (which higher capital requirements are unlikely to stop) –  but which only crystallise (and become apparent) in the bust – and those arising from the banking crisis itself?   There is no sign that you attempted to draw this distinction in any of your documents?
  20. Why are you so reluctant to pay heed to repeated waves of Reserve Bank stress tests which suggest that very severe (appropriately so) adverse shocks would not severely impair the health of the New Zealand financial system, based on the lending standards adopted in the last decade or more?

And that was a list straight from the top of my head, without even pausing to check my submission on the proposals.  It wouldn’t be hard to come up with at least another twenty questions that journalists seriously interested in holding the Governor to account might reasonably ask.

An embattled Orr

Still catching up, but noticing some concerning newspaper stories about how the Governor was handling things, yesterday I finally got round to reading the Reserve Bank’s Financial Stability Report and watching the Governor’s press conference.

Of the former, probably the less said the better.  It is a disappointingly lightweight effort, clearly designed to sound a bit more worried about New Zealand financial system risks – to support (belatedly) the Governor’s capital proposals – even while offering no evidence to suggest that such risks were (a) significant, or (b) worsening.       There were statements of the blindingly obvious –  “some” households and farms are overindebted, as if that has not always been the case –  and alarmist conclusions (about the threat banks could face if lots of borrowers default) made without any reference to the Bank’s own repeated stress tests.

And then there was the press conference.   I’ve seen some pretty poor performances from Governors over the years –  early ones by Alan Bollard were often awkward, and as Graeme Wheeler became more embattled the defensive introvert, never comfortable with the media, took over.     But this one was the worst I’ve seen, and from someone who has many talents in communications.  But just not, so it is confirmed again, in coping with challenge, disagreement, or finding himself on the back foot.  I doubt a senior politician would have got away with it, and it isn’t obvious why an unelected bureaucrat, uncomfortable at facing serious scrutiny, should do so.

The Governor and Deputy Governor faced several questions about the possible impact of the Bank’s capital proposals on farm lending –  various commentators have suggested such borrowers will be among the hardest hit.  The Bank attempted to push back claiming that any sectoral impacts were nothing to do with them, and all about banks’ own choices.  But they seemed blind to the fact that banks will have more ability to pass on the additional costs of the higher capital requirements to some sectors, some borrowers, than others.  And that is because of a point the Bank never addresses: their capital requirements don’t apply to all lenders.

They don’t apply to banks operating here that aren’t locally incorporated, they don’t apply to banks operating abroad in respect of loans to New Zealand entities, they don’t apply to local non-bank institutional lenders (deposit-takers, who have their own capital regime, or others), and they don’t apply to bond markets.   So some borrowers (think large corporates in particular) have a variety of alternative options and others don’t.  Almost inevitably the costs of the Bank’s capital proposals would bear most heavily on those with the fewest options, and farm borrowers are foremost among that group (there isn’t a big appetite from new entrants to build farm loan books, and farm lending is information-intensive and quite property-specific).   The Reserve Bank’s failure to openly and honestly address these sorts of issues –  none of them have been touched on in any of the consultative documents –  reflects poorly on them.   Whether it is because they simply never recognised the issue, or are trying to play blame games and shift responsibility etc, isn’t clear, but since the issues have been raised here (and elsewhere) for months, there is an increasingly likelihood that they know exactly what they are doing, not playing straight with the New Zealand public.

The Governor came across as embattled from start to finish –  embattled at best, at times prickly, rude, and behaving in a manner quite inappropriate for a senior unelected public official exercising a great deal of discretionary power, with few formal checks and balances.   BusinessDesk’s Jenny Ruth – who often asks particularly pointed questions about the exercise of the Bank’s regulatory powers, and the lack of transparency around its use of those powers – was the particular target of his ire, and at one point he tried to refuse to take further questions from her.

It isn’t always clear that the Governor hears the way he sounds: he goes out of his way to state that it is a genuine and open consultation, only to then conclude “but we are going to have more and better capital” –  in other words, no true consultation at all, as he has already made up his mind on the big picture.  Asked by another journalist what had changed in recent years that made further big increases in capital requirements warranted now, he fell back on spin –  no substantive answer, but “not enough has changed since 2008”, which isn’t a serious answer at all, especially in view of (a) the resilience of Australasian bank loan books in 2008/09, (b) repeated stress tests since, and (c) that aggregagate debt to income ratios are little different now than they were 10 years ago.   At one point, he actively misrepresented a prominent submitter’s submission.

Not all the awkward questioning was about the new capital proposals.  Some was about the recently-discovered failure of ANZ to use approved models in calculating capital requirements for operational risk, in the course of which it was revealed –  belatedly –  that the  Reserve Bank had told banks  (but not the public) that it is no longer approving any changes they would like to make to their internal models.    Under pressure –  this is after all the Reserve Bank’s day job –  the Governor moaned that the Bank hadn’t been adequately funded and that they had to prioritise. It was a shame no one asked about why the $1 million on the Governor’s Maori strategy, his tree god spin, and the endless talk about climate change –  at best peripheral to the Bank’s responsibilities – is being prioritised over proper adminstration of the bank capital regime.  Someone still should (after all, recently they had the money to send two staff to Paris for a climate change shindig).

The press conference deterioriated further as it got towards the end.  Without specific further prompting, the Governor noted a certain frostiness in the room, and then launched off again in his own defence.  The Bank was very transparent –  he asserted, even though it took months to get the full capital proposal documentation out, and we still have no cost-benefit analysis –  and it was very open-minded (except that, as he told us, he was closed minded on the needed for more and better capital).  He went on to note that he needed to rely on facts, and he would welcome decent questionings but (and I paraphrase) “I will be short with people when I see continuous mis-statements from journalists and others with vested interests”, all while – he told us –  he was trying to serve the interests of the people of New Zealand.

It should become a case-study for official agencies in how not to do things.

But it appears that Orr wasn’t finished, and didn’t go back to his office, reflect that that hadn’t gone well, listen to some sage counsel from his senior managers or Board, and re-engage in that sunny upbeat way the Governor at his best can manage much better than most.

A couple of articles in the Herald in recent days tells us some more of the story.   The first was from Liam Dann, who has in the past provided a trusty outlet for the views of successive Governors, and the second was a column from Pattrick Smellie, under the heading “Bunker mentality returns to the RBNZ?”, evoking unwelcome memories of the Wheeler governorship.

Dann’s article draws from a media lunch at which Orr had apparently been speaking.  There was, it appears, no hint of emollience, no suggestion of welcoming all the thoughtful work and analysis that had gone into the many submissions the Bank had received.  That is what a normal person would do and say (whatever they felt privately).  But not Orr.  He’s all in.  People either don’t understand, or they choose not to understand because –  on the Governor’s telling – they are all self-interested, part of the financial sector, while he –  and he alone it appears –  is looking out for the future of New Zealand.   If you think I’m caricaturing, read the article for yourself (I’m reluctant to excerpt extensively something behind a paywall).   But here are two extracts.

Orr said he had expected the strong critical response from the banks because he was aware of “the capability and resource” within the industry to lobby for the status quo.

“It is a very, very powerful industry.”

But he said he had been surprised by the personal attacks and “the underlying venom” that had come from the broader financial sector – including bloggers, think tanks and some sections of the media.

The noble Governor –  alone equipped to assess the public interest –  as the Three Hundred at Thermopylae facing down the amassed hordes of bankers (and “bloggers, think tanks and some sections of the media”).

Not only is there nothing about the substance of the arguments and evidence submitters and commenters have made (at length over many months) but note the attempt to imply that anyone criticising his proposals (and the very weak process around them) was part of the “financial sector”.   No doubt my views don’t count for much, but I’ve articulated numerous questions and criticisms here (and in my submission), and have never once taken a cent from the “financial sector”.  My former colleague Ian Harrison has extensively critiqued the Bank’s proposals and supporting documents, and I know for a fact it was entirely a labour of love (well, voluntary and unremunerated anyway).  And even if affected industries have made submissions –  shouldn’t we want them to? –  the onus should still be on the Governor and his staff to address issues and criticisms in a constructive way, not to engage in some sort of Trumpy politics of slur (no need to engage, because you are  – great evil –  banks).  It actually got worse at FEC (at least according to the Smellie column): questioned about why his “independent experts” (appointed belatedly) were all from abroad, he couldn’t stick to a moderate line that (say) most New Zealand residents who knew much about the issue had already weighed in in one form or another, but had to resort to the (frankly slanderous) suggestions that any New Zealand experts “had already been ‘bought’ by the trading banks”.

In the Dann article there was further illustration of how the Governor plays politics and spin, rather than engaging on substance.    We get this

Orr described the notion that the major banks “sailed through the GFC” as a popular myth that had taken hold with the general public.

In fact sailing through had involved a $133 billion overnight guarantee, an $8b direct asset purchase by the Reserve Bank to provide liquidity, a $10b wholesale underwrite and a drop of the OCR by 5.75 per cent.

I know Orr was not in the core public sector at the time (he was trading the markets at NZSF), but this is a highly misleading attempt to play distraction.   First, as the Governor very well knows, the big banks did not want to participate in the retail deposit guarantee scheme (the Minister of Finance compelled them to, as a condition of the limited wholesale guarantees).  Second, as the Governor equally well knows, every wholesale funding market in the world dried up for a time (and for reasons –  as all the contemporary documentation makes clear –  that had nothing to do with the specifics of Australasian banks).  Third, it is a core role of the Reserve Bank to provide liquidity support when demand for liquidity rises.  Fourth, as regards banks, all those operations were profitable for the Crown.    Fifth, the scale of the OCR adjustment is totally irrelevant to questions of bank soundness or otherwise –  there was a severe recession, partly domestic, partly foreign –  and adjusting the OCR as it did was just the Reserve Bank doing its day job (a little slowly as it happens).  And finally –  and really the only point of relevance to the capital debate  – bank losses (and NPLs) remained impressively moderate through that nasty recession and slow recovery.  Capital was never impaired.

On my reading, even Pattrick Smellie’s column is too willing to defend Orr’s conduct –  last week, and more generally.    He sticks up for his use of the Bank to pursue climate change agendas that have no grounding in statute (translations of the Bank’s self-chosen Maori name signify precisely nothing), of the tree god nonsense and the costly Maori strategy (even defending Orr’s claim that criticism of him on this is somehow “racist”).  And he buys into the Orr propaganda line that the Bank is “now more open and transparent” (it just isn’t so –  the capital review is only the latest example, but nothing material has changed about monetary policy, we’ve had no serious speeeches from the Governor on his core responsibilities, and they play OIA games just as much as ever), but this really should worry the Board (albeit they are usually in the Governor’s pocket), The Treasury (other distractions I suppose), and the Minister of Finance.

Ebullient, rambunctious, prone to Shane Jones-ian turns of phrase, Orr is the antithesis of his prickly predecessor, Graeme Wheeler. The RBNZ is now more open and transparent.

However, Orr and members of his senior team are starting to exhibit some of the same bunker mentality as beset Wheeler,

Orr very much needs to be pulled into line, for his own sake and that of the country (as single decisionmaker he still wields huge untrammelled power).  At present, he is displaying none of the qualities that we should expect to find in powerful unelected official –  nothing calm, nothing judicious, nothing open and engaging, just embattled, defensive, aggressive, playing the man rather than the ball, all around troubles of his own making (poor process around radical proposals made without any robust shared analysis, all while he is prosecutor, judge, and jury in his own case).

It is a sad week for New Zealand when the heads of our two main economic agencies –  The Treasury and the Reserve Bank –  are so much, and so deservedly, under intense scrutiny, and when we have no idea who will even be Secretary to the Treasury –  lead economic adviser to the government –  three weeks from now.

 

 

Poor policy processes and bank capital

The Reserve Bank’s Financial Stability Review is out tomorrow.  The last such document came out in late November, when we got a lot on the non-issue (from a New Zealand banking system systemic risk perspective) of climate change and almost nothing on bank capital.   There was a double-page spread on the former –  which the Governor has next to no responsibility for –  and on the latter only this

A consultation paper on the minimum capital ratios is due to be released in December. Our preliminary view is that higher capital requirements are necessary, so that the banking system can be sufficiently resilient whilst remaining efficient. The Reserve Bank’s aim is to announce final decisions on all key components of the capital framework in the second quarter of 2019.

The actual announcement of a huge proposed increase in minimum capital ratios was a mere two weeks away –  decisions must already have been made –  and there was not even a hint of the magnitude of what the Governor was about to hit the economy with.  And do note that strong sense of pre-determination: they thought they could announce proposals on the eve of Christmas and have everything finalised by June.  Their latest plan, announced last week, is for a final decision in November.   Even then, there is a strong hint of pre-determination, with comments as recent as the last day or two stating that “we will lift capital levels”, even if they now seem to want to sound more open about the extent.

I don’t suppose the Governor will be saying much tomorrow about the substance of the bank capital proposals.  Submissions have now closed, and it would be unwise for him to weigh in further now, at least if he hopes to be able to defend himself against charges that the consultation wasn’t for real.     But I hope there are serious questions –  both at the Governor’s press conference, and from the Finance and Expenditure Committee –  about the process.    It has been poor from the beginning, built on a weak and inappropriate governance framework, and if the latest announcement is a little more encouraging there are still significant unanswered questions.

Under the terms of the Reserve Bank Act, the Governor can unilaterally vary conditions of registration for banks.  That includes their minimum capital requirements.  This isn’t a conventional regulatory model: no ministers are involved, no decisionmaking board is involved, Parliament’s regulations review committee can’t disallow such rules.   And, of course, the Governor is not elected, is not even appointed by people who are elected, and neither he nor those who appoint him face any serious or effective accountability.  The only thing he has to do is to make sure that he jumps through the process hoops around “consultation”, and even then it is a very weak test given the deference courts tend to pay to agencies, and the extreme reluctance of banks to ever openly challenge their regulator in court (the Bank has lots of other discretion it can wield to disadvantage awkward banks).  It is a bad case of the adminstrative state run rampant, neither accountable nor particularly expert.

The Governor himself can’t change the statute he operates under (although the government does have underway at present a review of the Reserve Bank Act).  But a good Governor can recognise the limitations of that legislation, and choose to operate in ways that minimise the risks and disadvantages of a framework put in place decades ago, when the designers did not envisage the Bank exercising major regulatory discretion.  As it is, the Governor is effectively prosecutor, judge, and jury in his own case, and there are no rights of appeal.  Anyone with the slightest sense of history and human nature would recognise certain risks in such a model.   Checks and balances not.

The Reserve Bank’s overall capital review has been running for several years, dating back to Graeme Wheeler’s time.   There has never been strong grounds for urgency around the review, capital requirements having been lifted last only a few years ago.  Of course, regulated entities (banks, in this case) want certainty, but I’m pretty sure even they want robustly developed and scrutinised rules.

How much better if, having got their internal staff work to a certain point, the Reserve Bank had engaged in some proper, open-minded, consultation before the Governor ever signed on to a particular proposal.   Perhaps there could have been a series of Analytical Notes, Bulletin articles, and other background papers, reviewing relevant literature, reviewing the New Zealand experience, comparing and contrasting New Zealand’s situation with those in other countries (including identifying how and in what ways specific countries were relevant comparators, and rigorously reviewing arguments and evidence around possible medium-term transitional effects.  It might have all come together in something like, in older parlance, a Green Paper: not formal proposals, but a canvassing of issues, possibilities, risks, costs, benefits and so on.  A series of workshops and/or conferences could have been held over several months, open to interested parties (including invited local and international experts), to help test the Bank’s preliminary thinking. scrutinise the evidence etc etc, and all without the eventual decisionmaker having committed himself.  Such a process wouldn’t simply have been about picking holes, but might have highlighted new evidence (for or against) the Bank wasn’t aware of, or identified a list of important further questions needing more analysis or research.

It could have been a genuinely constructive process –  the path to better policy, as well as to a better reputation for the Bank (recall that stakeholder survey from a year or so ago).  At very least, it would have helped alert senior management (the Governor particularly) to the potential weaknesses in the Bank’s own analysis, major areas of concerned that commenters might raise if the matter went to formal consultation, and thus should have helped his own preliminary decisionmaking process.

And having done all that over a period of several months, the Governor might then have taken a preliminary view and moved to the next phase of consultation, but have done so with all his ducks in a line:

  • all the relevant papers would be released at the same time (not continue to be written over several months) including the pro-active release of background internal material,
  • there would be a proper rigorous cost-benefit analysis, with appropriate key sensitivities and asssumptions clearly highlighted,
  • there would be a regulatory impact assessment, not just done by those championing the reform, but independently reviewed and scrutinised,
  • and recognising that, unlike when a minister initiates legislative proposals (which have to get through Cabinet, select committee, and Parliament), the Governor is the sole decisionmaker on his own proposal, it would have been appropriate for the Governor to have announced the appointment –  at the start of the process –  of a small independent panel of credible experts to assist him in his later deliberations.  The Governor can’t delegate his statutory decisionmaking powers to expert advisers, but he can commit to have serious regard to the analysis and advice of such a panel, and to publish their advice before his own final decision was taken.

But we’ve had none of this.  Instead, the Governor charged ahead on what was evidently little more than a whim and a personal preference, and has been rushing to try to backfill his case ever since.  Having run into what appears to have been unexpectedly strong resistance to his plans –  and not just from the directly affected banks themselves, but from plenty of people with no vested interests –  we are now finally promised a proper cost-benefit analysis, and some “external experts”, but it is now so late in the piece that whatever and whoever they come up with is going to be greeted with a considerable measure of scepticism.  Anyone can produce a cost-benefit analysis to meet his or her boss’s preferences, and there will inevitably be a sense that whatever is finally produced –  how many more months away? –  it was generated to support the boss rather than to illuminate the issues.  And who are they going to find to serve as “external experts” this late in the piece, when most of those who think about the issues domestically have already either expressed their views and been involved as consultants in preparing submissions by others.  There can be a role for overseas experts, but knowledge of the New Zealand system and New Zealand experience should not be irrelevant.  And quite what is the selection process the Governor is going to use at this late stage –  the suspicion will inevitably be that he will be aiming for people just credible enough to look serious, but emollient enough not to want to make difficulties.

In a better world, having got this far, the Bank would now commit to publishing the cost-benefit analysis, the regulatory impact assessment, and the advice of the (as yet unknown) external experts and then reopening the consultation process for a short period (say 4-6 weeks), and only after any new submissions had been received, analysed, and seriously considered would the Governor make his final decision.   These are very big issues, with potentially major economic consequences, and no urgency (no doubt the Bank will tomorrow repeat its longrunning assurance that the financial system is sound).  We need to see much better policy processes used than have been on display so far –  all the more so when a single non-expert unelected official is making the proposals and the final decisions, and when his final decisions cannot be appealed.