Critics of the Governor

There have been a couple of media stories this week that were less than flattering about the Governor of the Reserve Bank, Adrian Orr.  I was going to say “new Governor”, but checking the calendar I see that in another month or so he will be a quarter of the way through his first term.

The first story was by Stuff’s Hamish Rutherford, and centred on the Governor’s plan to require banks to greatly increase the share of their assets funded by equity rather than debt.   In the on-line version of the story, Orr is labelled “Mr Congeniality”.  The story begins this way

Since Adrian Orr became Governor of the Reserve Bank of New Zealand he has built a reputation of being someone who likes to be liked.

Charming and jocular, but possibly sensitive to criticism.

But Orr is now in a battle with the bulk of New Zealand’s banking sector in a way which could see him demonised, probably with the focus on lending to farmers.

He knows it. Recent days have seen Orr on a campaign to explain itself.

I’m not sure he seems any different as Governor than he ever was before –  his well-known strengths and weaknesses have continued to be on display.

I’ve written quite a lot here about the substance and process around the Bank’s capital proposals – starting with the apparent lack of consultation and coordination with APRA, through to the weaknesses of many of the arguments the Bank advances, the lack of apparent understanding of how financial crises come to occur, the grudging and gradual release of further supporting material, and (presumably partly as a result) two extensions to the deadline for submissions.

In the article Orr is quoted thus, in perhaps the understatement of the week

The consultation process, in Orr’s words “could have been tidier”.

Done properly there would have been extensive workshopping of the technical material over months before the Governor ever put his name to a specific proposal.   As it is, we have a half-baked proposals, not benefiting from any prior scrutiny, and yet the same Governor who put the proposal forward is now judge and jury in his own case, with no effective rights of appeal for anyone.    And there is big money involved –  not just the additional capital that might need to be raised, but probable losses in economic output that will affect us all to a greater or lesser extent.

Presumably no one in the industry would go on record for Rutherford’s article.  Not upsetting prickly Governors is an art the banks have sought to master (even when it involved pandering to an earlier Governor who wanted a senior bank economist censored), although presumably the banks’ submissions will be fairly forthright.  (But will the public ever see those submissions?)

But some of the tone of the off-the-record concern is there in the article

Sources across several of the major banks are warning that if the bank pushes ahead with its plan it could act as a significant constraint on lending to farmers and small businesses,  sectors which are as economically important as they are politically sensitive

Both sectors are considered risky and when capital requirements go up the impact will be magnified.

Why those sectors?  Well, the “big end of town” (Fonterra, Air New Zealand or whoever) will have no difficulty raising debt either directly (bond market) or from banks that aren’t subject to the Reserve Bank’s capital requirements (which means every other bank in the world not operating here, as well as the parents of the locally-incorporated banks operating here).  And the residential mortgage market is both pretty competitive (including from some local institutional players that are less badly hit by the Governor’s proposals than the big banks), and more open to the possibilities of securitisation (which would then avoid the capital requirements too).   Idiosyncratic small and medium loans (including farm loans) aren’t, and farm loans in particular require a level of industry knowledge that newcomers won’t acquire easily (and offshore parents often won’t have).

Perhaps these effects will be large, perhaps they will be quite moderate in the end. But the point Rutherford didn’t make, but could have, is that none of this was analysed in the Bank’s consultative document.   When a really major change is proposed we should surely expect a serious analysis of transitional paths (not just for the banks, but for customers and the economy) as well as the long run.  But there was almost nothing, and nothing in any more depth has emerged in subsequent material that has seeped out.

It simply isn’t a good policy process, and that should concern both the Minister of Finance (and his advisers at The Treasury) and the Bank’s board.   The Governor simply isn’t doing a good job on this front.  If there is a compelling case for what he proposes, he hasn’t made it.  And that is almost as bad –  in a serious independent regulator –  as not having a good case in the first place.

The second article was by the news agency Reuters.   The focus in that article is Orr’s conduct of monetary policy, and particular his policy communications (which many had expected to be one of his strengths).

There are at least two strands to the article.  There are criticisms of Orr for not yet having given a single substantive on-the-record speech on either of his main areas of policy responsibility (monetary policy and financial regulation).  I’m among those quoted

Michael Reddell, an ex-RBNZ official who served with Orr on its monetary policy committee in the 1990s and 2000s, is critical of Orr for not giving a “substantive” speech on monetary policy in the past year.

“It would be unthinkable in Australia or the United States or even under previous governors here.”

I’ve been more and more surprised at the omission as time went on.  And in respect of monetary policy it is not as if there has been much from his offsiders either.  Sure, we get the rather formulaic paint-by-numbers Monetary Policy Statement every few months, but it simply isn’t the same as a thoughtful carefully-developed speech –  which shows more of how the individual/institution is thinking, and the omission has been particularly significant given that we had a new Governor and a refined mandate.

Orr’s response to this criticism is reportedly that it is “thin”.   Whatever that means, the fact remains that in other countries top central bankers talk, quite frequently, about their thinking in on-the-record speeches.  I’ve suggested, speculatively, that perhaps he doesn’t do serious speeches on core areas of responsibility because he just isn’t that interested (saving his passion for infrastructure, climate change, diversity, and all manner of other stuff he has little or no responsibility for).  I’d  like to be wrong on that, but nothing in this article provides any countervailing evidence.

But the bigger criticism in the Reuters article appears to come from financial market participants, concerned that they aren’t able to read the Governor’s policy intentions well.

Many traders who spoke to Reuters in the past two weeks blame Orr for confusing the message, and some have even been critical of frequent references to legends of the indigenous Maori people in his speeches, saying they served little purpose for financial markets eager for more policy clues.
“I am extremely frustrated at the lack of communications for global market participants,” said Annette Beacher, Singapore-based macro-strategist for TD Securities.
“Since Adrian Orr has assumed the role, he’s managed to surprise the market every six weeks. We don’t hear anything from him in between policy decisions,” Beacher said, echoing similar complaints from others.
“So what do I recommend to my trading desk? I’m saying trade the data but we’re not quite sure what is going to happen at the next meeting. It’s not meant to be this way.”

Here, to be honest, I’m not sure quite what to make of the criticism (I mostly don’t hang out with international markets people).   I’m sure there is a great deal of eye-rolling at the tree god nonsense that Orr continues to champion, but perhaps here the longstanding central banker in me comes out and I wonder if the offshore market people aren’t being a little precious.    Markets should not need their hands held to anything like the extent some of the comments in the article suggest, and if there is a little noise in market prices as a result that isn’t necessarily a bad thing.

It seems that quite a few people the journalists talked to were grumpy about the move to an explicit easing bias at the last OCR review, I couldn’t help wondering how much of that was a disagreement with the Governor’s stance (market economists on average have been more hawkish than the Bank for years, and have been more wrong) and how much a sense that a forthcoming change hadn’t been signalled.  I was bit (pleasantly) surprised myself by the move to an easing bias, but mostly because I thought the Governor wouldn’t want to launch a change of direction days before the new MPC took over.  Perhaps that is one of the circumstances in which advance signalling  might have been appropriate?    And perhaps the two strands of concern come together here: we shouldn’t have the Governor or senior staff giving private previews to select contacts about their evolving thinking.  So it has to be serious interviews or serious speeches –  and, as Annette Beacher notes, we haven’t really had either.

The Bank has probably also suffered somewhat from being in transition. At the start of last year, they lost the ultimate safe pair of hands, longserving Deputy Governor Grant Spencer.  A new top-team took over, and within a few months Orr was restructuring, which included demoting longserving chief economist John McDermott.  He lingered for a few months before leaving entirely, but can’t have been entirely engaged.  The head of financial markets was also ousted, and it was only in late March that the new recruits started to take office.  As I’ve noted previously, on the monetary policy side of the Bank it is very much a case now of a Second XI at play (internals and externals) and there is now quite a challenge in getting communications onto a steady, sustainable, and functional path.   The goal shouldn’t be keeping overseas economists happy, but it is perhaps telling that Reuters couldn’t find a domestic one willing to go on the record defending the Orr approach.

What of the Governor’s response to all this?  I’ve already recorded his response to the concern about speeches.  Here is some of the rest of what he told Reuters

In an interview with Reuters earlier on Tuesday, Orr said he wants to reach out to a wider audience than just currency traders, analysts and bloggers.

“The broad audience for this bank is the public of New Zealand. We are seen as a trusted institution but they don’t know what we do. So that is my communication challenge,” he said.

Orr also defended the Maori references in his speeches as part of the bank’s efforts to reach out to wider groups.

“Metaphors have their limits and metaphors can be over used. I get all that, but metaphors need to be introduced and created sometimes.”

I quite get that he wants to communicate to people beyond just the likes of Annette Beacher or me.    But it is not much short of populism to pretend that the audience of people who do pay close attention to the Bank, and know something about it and other central banks (and can even think through the aptness or otherwise of his metaphors), don’t matter.  He can try to appeal over the head of the relatively knowledgable all he likes, but I suspect he won’t find many listening.  Most people have better –  more interesting and important to them –  things to do with their lives.  As it happens, the Governor released a while ago a record of which audiences he delivered speeches to last year, and despite all the rhetoric –  tree god and all –   I was a bit surprised by how relatively few and conventional the audiences were.  The only novelty seemed to be a lot of mention of the tree god – cue to eyes rolling from many of the audiences no doubt.   How many more readers, I wonder, have the cartoon versions of the MPS and FSRs won?  How many have tried twice?

There is a “retail communication” dimension to the Reserve Bank’s role –  when you are driving interest rate up (or down) and affecting people’s employment prospects, business profitability etc, you have to explain yourself.  Over 30 years of an independent Reserve Bank, successive Governors have done a great deal of it –  Don Brash almost to the point of exhaustion, in his nationwide roadshows.  But the core of the job is actually rather more “wholesale” in nature.  And the Governor doesn’t seem to have been getting that right –  at all re bank capital, and in some dimensions re monetary policy (I’m probably closer to his bottom line on the OCR than many other commentators).  All this should be a concern for the Minister of Finance, and for the Bank’s Board.

There is still time for the Governor to right the ship –  and perhaps the new MPC will end up helping –  but the signs aren’t good. Only this morning, a press release emerged from the Bank championing the cause of climate change.  Action may well be really important, but it just isn’t the core business –  or really any business at all in a New Zealand context, with the sort of loan book New Zealand banks have –  of the Reserve Bank.  It is what we have an elected government for.

Sadly, we can expect to hear more from the Governor on climate change and his tree god (flawed) metaphor, and there is no sign of any contrition around the lack of serious communication from him on monetary policy or (where he is still sole decisionmaker) financial sector regulation.

 

Reading the RBA FSR on bank capital

One of the frustrating things about the Reserve Bank’s consultation on its proposal to greatly increase the amount of capital (locally incorporated) banks have to have to conduct their current level of business in New Zealand, is its utter refusal to produce any serious analysis comparing and contrasting their proposals to the rules (actual and prospective) in Australia.   The larger New Zealand banks are, after all, quite substantial subsidiaries of the very same Australian banking groups.    If there is a case to be made either that the New Zealand proposals are not more materially demanding than those in Australia, or that, if they are, there is a sound economic case for our regulators to take a materially more demanding stance than their Australian counterparts, surely you would expect that a regulator serious about consultation, allegedly open to persuasion (and working for a government that once boasted that it would be the “most open and transparent”) would make such a case.   But months have gone on and there has been nothing.

It is striking that over the entire period when the consultation has been open we have not had a Financial Stability Report from the Reserve Bank (I guess it is just the way the timing worked, but still…).      With proposals out for consultation that would force banks to have much higher risk-weighted capital ratios, working to the statutory goal focused on the soundness of the financial system, you’d have to assume that any FSR would conclude that the financial system at present was really quite rickety.   Perhaps they will when the next FSR comes out late next month, but (a) it would be a very big change of message from past FSRs, and thus (b) I’m not expecting anything of the sort.

A reader pointed out that the Reserve Bank of Australia released its latest Financial Stability Review last week.   The RBA isn’t the regulator of the financial system, but works closely with APRA, and has some systemic responsibilities (including the analysis and reporting ones reflected in the FSRs).   Capital requirements (on both sides of the Tasman) feature in the chapter on the Australian financial system.

The discussion starts this way (ADI = Australian deposit-taking institution).

RBA 1

You’ll recall that the Reserve Bank of New Zealand’s proposal would (a) require major banks to have a minimum CET1 ratio of 16 per cent of risk-weighted assets, and (b) would measure risk-weighted assets in a more demanding way than Australia does.

Here is graph 3.6 –  a really nice chart with lots of information in a small space.

RBA 2

The first panel is the one of most relevance here, relating as it does to the four banks that have major operations in New Zealand.   The regulatory minima are shown in the two shades of purple, and the additional capital held above those regulatory minima is in blue.   Three of the four banks are already at the “unquestionably strong” benchmark level.

I also found the the second panel (other listed deposit-taking entities) interesting.  In a post earlier in the year, I suggested that too-big-to-fail arguments weren’t a compelling reason for higher minimum regulatory capital requirements, as there wasn’t obvious evidence that entities that no one regarded as too-big-to-fail were required by market pressures to have capital ratios materially above those prevailing at larger institutions.   This chart may suggest this point holds in Australia too (deposit insurance muddies the water, but does not apply to wholesale creditors).

The RBA discussion goes on

rba 3.png

with a footnote elaborating the point

RBA 4

Unlike the Reserve Bank of New Zealand, they don’t just claim it is hard to do international comparisons, and then blame copyright to defend not presenting any analysis.    And APRA has actually published its analysis comparing  the way risk weights etc are applied in Australia and other countries.

So the Reserve Bank of Australia (and, presumably, APRA) claims that the capital ratios applying to the major Australian banking groups are in the upper quartile internationally, based on actual CET1 ratios of “only” around 10.5 per cent.   The Reserve Bank of New Zealand, by contrast, has tried to claim –  with no real analysis, just a bit of gubernatorial arm-waving –  that its proposed CET1 minima of 16 per cent (measured materially more conservatively again) would also be inside the range of requirements in other advanced countries, probably also in the upper quartile.

At a substantive level, the two claims are just not consistent.    Perhaps the Australian authorities are wrong in their claims, but I doubt it.  I could advance several reasons to have more confidence in the Australia regulators’ claims:

  • they have a much deeper pool of expertise than the Reserve Bank of New Zealand, and two agencies (RBA and APRA) able to peer review work in the area before it is published,
  • the Australian parent banking groups are all listed companies and there is considerable broker analytical resource devoted to monitoring and making sense of the performance of those banks and the constraints on them,
  • for what they are worth, the credit ratings of the Australian banking groups are consistent with them having capital ratios and risk profiles in the upper (safer) part of the distribution of advanced country banks,
  • the Reserve Bank of New Zealand has simply avoided the Australian comparisons in all the material it has released (so far).

Whatever the absolute position, we can be totally confident that the Reserve Bank of New Zealand’s CET1 minima are far more demanding than those APRA applies to the Australian banking groups  (16 per cent minimum –  perhaps 17-18 per cent actual –  vs the benchmark actual of 10.5 per cent in Australia, where the New Zealand requirements will be measured in a more conservative way.  Not one shred of argumentation has been advanced by the Reserve Bank of New Zealand to explain why they, in their wisdom, think New Zealand banks need so much higher risk-weighted capital ratios.   There might be a case to be made –  something about risk profiles, or reckless Australian regulators perhaps –  but they just haven’t made it  (and it would have to be a pretty compelling case given that the major New Zealand banks have large parents –  to whom the regulator might expect to look in a crisis –  whereas the Australian banking groups don’t).   That simply isn’t good enough.

The RBA goes on to discuss the Reserve Bank of New Zealand’s proposals.

rba 5

That text correctly notes not suggest that the headline CET1 ratios required here would be much larger than those applying to the Australian banking groups, but would be measured in a more conservative way than has been the case hitherto (and more conservatively than APRA will be allowing Australian banks to do).

The rest of the paragraph interested me, especially that final sentence.  It appears to suggest that the rules would apply differently depending whether the capital of the New Zealand subsidiaries was increased through retained earnings or through a direct subscription of new equity by the parent.  In economic substance the two are the same, and regulatory provisions should be drawn in a way that reflects the substance.  But the paragraph is perhaps a reminder that one possibility open to the Australian parents, if the Reserve Bank persists with its proposals, is a divestment in full or in part.  Comments from the Reserve Bank Governor and Deputy Governor have suggested that they would not be averse to such an outcome, and might even welcome it.  I think a much less cavalier approach is warranted and that the New Zealand generally benefits from having banks which are part of much larger groups.

The RBA discussion also has a chart show bank profits in Australia since 2006 (I truncated a bigger chart so the dates aren’t showing).

rba 6

As they note, return on equity is less than it was in the mid-2000s, not inconsistent with the higher capital ratios (reduced variance of earnings) in place now.     The (simple) chart is perhaps consistent with the Reserve Bank of New Zealand’s story that banks will come to accept lower ROEs on their New Zealand operations over time if higher capital ratios are imposed, but (a) the transition may still be difficult (especially for sectors with few competing lenders), and (b) there is no guarantee, since shareholders will focus on overall group risk/return, not the standalone characteristics of one individual unlisted subsidiary.

Part of the Reserve Bank of New Zealand’s attempt to obfuscate the Australian comparisons is to muddy the waters by suggesting something along the lines of ‘total capital requirements will end up being much the same, but our banks will have much better quality capital’.

As you can see from their own text, the Australian authorities put much more weight on the core (CET1) ratios, where Australia’s (quite demanding by international standards) expectations will be a lot less than those proposed for New Zealand.  But the Reserve Bank of Australia text touches on the additional loss-absorbing capital as well.

RBA 7

RBA 8

Here is the summary of the APRA proposals.  These additional requirements, if confirmed, would be able to be met with ‘any form of capital’, including (for example) the contingent-convertible bonds (typically hold by wholesale investors, and which convert to equity in certain pre-specificed distress conditions) which the Reserve Bank of New Zealand has taken such a dim view of (to disallow for capital purposes).  This additional loss-absorbing capacity is typically regarded as much cheaper than CET1 capital, and (coming on top of upper quartile CET1 funding) serves just as well in protecting the interests of creditors in the event of a failure of a major financial institution.   For any banking regulator interested at all in efficiency that should count strongly in its favour, but even more so in New Zealand where the big banks are subsidiaries of the Australian banking groups, failures will inevitably (and rightly) be handled on a trans-Tasman basis, and where most of what matters is securing a substantial share of residual assets for New Zealand depositors and creditors.

But even allowing for all that, look at the nice summary chart from APRA of their proposals

APRA 1

If fully implemented:

  • the APRA proposal for Australian banking groups would amount to a 16 per cent total capital ratio requirement, with risk-weighted assets measured the Australian way, while
  • by contrast, the Reserve Bank of New Zealand proposal would involve a 16 per cent CET1 capital ratio minimum requirement (8 per cent in Australia – the CET1 and CCB components), with risk-weighted assets measured the New Zealand way, and
  • the Reserve Bank proposal include a plan to raise the minimum risk-weights (in a not unsensible way, considered in isolation) that would mean a 16 per cent CET1 requirement in New Zealand might be equivalent to something like 19 per cent range in Australia.  The proposed floor –  risk-weighted assets calculated using internal models, relative to the standardised approach –  in Australia is, in line with Basle III. 72.5 per cent, and the RBNZ is proposing a 90 per cent floor: apply a ratio of 90/72.5 to give an indication of the scale of the possible effect).

The simple summary is that (even if the Reserve Bank of New Zealand ends up scrapping any Tier 2 capital requirements, and it seems quite ambivalent about them in the consultation document) its capital requirements will be (a) materially higher than those applied to Australia to the parent banking groups, (b) materially more costly, because of a largely-irrational aversion to forms of capital other than CET1, even though we have good reason to take seriously the claims of the Australian authorities (and the sense of the rating agencies) that Australian banks are already among the better-capitalised in the world.

In hundreds of pages of material, slowly released over several months, the Reserve Bank of New Zealand has not provided a shred of evidence, or even argumentation, for why locally-incorporated banks operating here should face such an additional regulatory burden, with the attendant economic risks and costs.  Add in the refusal of the Bank to provide a decent cost-benefit analysis as part of the consultation (they promise only at the end of it all, when there is no further chance for public input, and no appeals), and there are few grounds to have confidence in what the Governor (prosecutor, judge, and jury –  with no appeal court) in his own case is suggesting.   We should expect better. The Minister of Finance (and the supine Board) should be demanding more.

For anyone in Wellington next week and interested, Ian Harrison (who used to do a lot of the Reserve Bank modelling work around bank capital) is doing a lunchtime lecture/seminar on the Reserve Bank proposals next Wednesday.   You might think I’m fairly critical of the Reserve Bank. Ian is more so, and tells me he has chased every reference in every document the Bank has published in support of its case, and still isn’t remotely persuaded of the merits of the Governor’s claims.

The Emperor’s clothes are threadbare

When you worked for an organisation for 30+ years you really do try to look for the best in it. Perhaps it is just me, but I tend towards optimism (notwithstanding Cassandra) and so have had trouble appropriately calibrating my expectations of the Reserve Bank.  They keep surprising me on the downside.  It isn’t so much the specific policy choices themselves (reasonable people might differ) as the too-often threadbare cases they mount in support of interventions which have taken the fancy of successive Governors, or causes Governors (especially the current one) have used their official bully-pulpit to champion.

I had another example yesterday when I opened a (very belated) response from the Bank to an Official Information Act request I’d lodged a couple of months ago.

You’ll recall that last December the Governor launched a consultative document in which he proposed to massively increase the amount of capital banks have to hold to conduct their current level of business. There had been no prior socialisation of this work, testing the analysis in expert fora etc.  Just a (very far-reaching) proposal.  A month or so later, in response to various OIA requests, they finally released some of the relevant background papers (one of which they had only written after the consultative document was released).  (In fact, four months into the consultation there was another big new supporting document released last week, although those who’ve looked at it closely say it doesn’t really shed any fresh light on the issues.)

By February, the Bank’s Monetary Policy Statement was due.  To their credit, the Bank devoted a box (Box E),  a couple of pages in length, to the proposal, under the heading “Monetary policy implications of higher bank capital requirements” (pages 35 and 36).

They make a number of claims in the box.  They correctly note the need to distinguish between the transition and the long-run (itself something of a concession, since there was no discussion of the transition at all in the consultative document itself).

Of interest rate effects they note

All other things unchanged, bank funding costs would rise as a result of their higher capital requirements, because the cost of equity (in terms of investors’ required rate of return) is usually higher than debt. This could lead banks to increase lending rates, lower deposit rates, and/or tighten credit standards in order to retain their expected return on equity.

However, in reality, the impact on the lending and deposit rates will be affected by a range of offsetting forces.

The extent that banks will be able to pass on their potentially higher funding costs – in the form of higher lending rates and lower deposit rates – will be constrained by:
• competition from both within the banking sector and alternative
sources of funding (for example, capital markets); and
• other interest rates in the economy being broadly unchanged, or
lower, as risk premia in New Zealand decline.

Hard to argue with most of that (I would make an exception for the second bullet).

They went on to elaborate that particular point (a little)

The increased stability of the banking system should reduce the risk premium associated with investing in New Zealand. This results in a reduction in the expected frequency and severity of economic disruption associated with systemic financial crises.

Summing up

In the long run, bank lending rates are likely to be slightly higher. How much higher depends on a range of factors, such as how much the cost of equity and debt for banks declines, the degree to which risk premia in New Zealand fall, and how competitive pressures affect banks’ ability to pass on costs to customers in the form of higher lending rates or lower deposit rates. The Bank expects that the spread of banks’ lending rates to the rates at which they borrow will settle in the range of around 20 to 40 basis points higher as a result of the proposed changes, although the exact effect is uncertain.

And then there is a further claim

Higher bank capital requirements could also improve the government’s fiscal position. A higher share of bank equity funding would likely increase tax revenue from the banking sector since debt funding is tax-deductible while equity funding is not. The value of any perceived implicit public guarantee of the banking system would also be reduced as the system becomes safer, improving the government’s credit profile.

And there was a final interesting observation

If implemented, changes to bank capital requirements are likely to affect economic conditions through a number of channels.

At his press conference that day, the Governor was also quizzed extensively about the capital proposals.  In the course of that press conference the Governor told the assembled media that the proposed capital requirements would be well within the range of norms” seen in other countries.

All of which was interesting, but supported (on the day) by no further analysis.  And so I lodged an official information act request

I am writing to request copies of any analysis undertaken by or for the Bank in support of Box E in today’s Monetary Policy Statement, including (but not limited to) the numerical estimate of the impact on the banks’ lending margins.

I am also requesting any material/analysis used to support the Governor’s claim (at the press conference) that the proposed capital requirements will be “well within the range of norms” seen in other countries.  I would note that there was no such supporting material in the Bank’s consultative document.

And finally on Monday, having had the request extended for a month to allow for, as they put it, “ongoing consultations” I had my answer.

I have tended all along to assume that the Bank would have done extensive and detailed analysis, and would have been keen to get that analysis out into the public domain to, as they would see it, strengthen the case for the proposals they clearly believe to be in the public interest.

But the evidence is increasingly against that presumption.  The response from the Bank is here.    There was only six pages of it.   There is, apparently, one (possibly substantive) paper

Paper 1.6: What might higher bank capital requirements mean for monetary policy?

But they simply refuse to release any of that, on principle.

The second document is a single page exercise in arithmetic, described as

Table: Stylised example of the pricing impact of different required returns on equity

I did not check every calculation but I have no reason to doubt the numbers are what they say they are. It is the sort of exercise a new graduate should have been able to churn out in a couple of hours.  It appears to be the source of the suggestion that bank lending margins might widen by 20 to 40 basis points.    But –  being a stylised example in a simple table –  there is no discussion or analysis about whether the scenarios are the correct ones, no engagement with estimates other analysts have come up with, no discussion of (for example) whether for the wholly-owned Australian banks (which dominate the market) group earnings variability etc might not be a relevant metric (shareholders in ANZ Banking Group probably do not great care whether the profits –  mean and variance –  come from the New Zealand operations, the Australian operations, or anywhere else in the world).  Just nothing.

There is no discussion or analysis of those (entirely reasonable) points in the MPS about the extent of competition from entities not subject to the capital requirements, possibilities of disintermediation and so on.  Nothing.

There was also, apparently, nothing to support the claim made by the Bank that overall New Zealand interest rates would fall if the capital proposals were adopted, and nothing to support (or quantify) the suggestion that the capital proposals might be fiscally positive (recall that in his speech a few weeks later, Geoff Bascand suggested that the proposals would permanently reduce the level of GDP by up to 0.3 per cent, which would surely also have some fiscal consequences).

And that was that on the material in the two page box: one page of arithmetic.  Breathtaking really.

The rest of the release was devoted to material to support the Governor’s claim that the Bank’s proposed capital requirements would be, in the words of the Governor, ‘”well within the range of norms” in other advanced countries.

One piece they released was this slide they had used in a presentation to the Minister of Finance on the day the Governor made his public comments.

MOF slide.png

The comparisons with Australia –  surely the most relevant? –  are simply asserted, with no supporting evidence or analysis (nothing that, for example, recognises that the Reserve Bank is proposing to pull up the floor (on the weights used in calculating risk-weighted assets in the first place) much further than Australia has done).  Nor do they acknowledge to the Minister that the sorts of capital they propose to rule out not only does the job in the event of a bank failure (and bank failures of trans-Tasman banks are inevitably going to be handled in a trans-Tasman way), but is much less expensive than what they are proposing to require.

In any case, this slide is not analysis, and we do not gain any insight from being told that the Governor told the Minister the same as he told the journalists.  In reality, it seems to be enough for the Bank to say it is “hard to do” the comparisons, so do not expect us to do them.

You will have noticed a couple of other comparisons on the slide. They are covered a bit more extensively in a document described as

Media resource: international comparisons of bank capital ratios, 12 December 2018

That was the day before the consultative document was released.  Presumably some people have had this document for months, and yet the Bank took two months to release it under an OIA.

Among the shonkiest bits of the document is a comparison (using World Bank data) of the unweighted 2017 ratio of total capital to total assets.  Of the seven other countries they choose to cite, New Zealand conveniently would sit almost bang on the median  But so what?  First, these proposals are to markedly increase the amount of capital banks in New Zealand have to hold: in fact on the numbers the Bank uses in that stylised table (see above) total capital to total asset after these changes were implemented would be above those of any of the seven other countries the Bank sought to compare us with.  And second, and perhaps more importantly, the reason why capital frameworks focus on risk-weighted assets is that not all assets have similar risk characteristics: the balance sheets of New Zealand banks, for example, look very different to those of US banks.

But I suspect the Bank itself doesn’t really regard that data as relevant.  They seem to put most weight on the S&P framework, and some on the BIS comparisons.   I dealt with both of those at some length in my post on Geoff Bascand’s February speech.   Of the BIS comparisons I noted then

All else equal, a 16 per cent capital ratio calculated on Reserve Bank rules could easily be equivalent to something like 19 per cent in many other countries’ systems.   And not even the 95th percentile of G-SIB banks will –  according to the BCBS table –  have a Tier 1 capital ratio of 19 per cent.

But here is the rather plaintive tone of the Bank’s comments in the 12 December document, finally released now.

S&P RB

“We acknowledge that there is a genuine interest…..which cannot easily be met”.    Give us strength.  Well, give us a rigorous and robust official agency, because on this sort of evidence we certainly don’t have one at present.

Here is some of what I wrote about the S&P numbers in February

The rating agency S&P engages in its own attempt to calculate risk-weighted capital ratios for a large number of banks, using its own risk-weighting framework.   But a great deal depends on the “economic country risk score” the S&P analysts assign.    And they take a dim view of New Zealand, assigning us a score of 4 (on a 10 point scale).  Here is what that means for housing risk weights

S&P risk weights

And there are similarly large differences for the corporate risk weights.

As I said, S&P gives New Zealand a 4.   But Sweden, Norway, Belgium, Switzerland, and Canada all get a 2.    You might think there are such large systematic economic risk differences between New Zealand and those countries, but I doubt the Bank really does, and I certainly doubt. I wrote about this a few years ago where I noted

The S&P model appears to put quite a lot of weight on New Zealand’s relatively high negative NIIP position. But I think they are largely wrong on that score too. First, the NIIP/GDP ratio has been fluctuating around a stable average for 25 years now. That is very different from the explosive run-up in international debt in countries such as Spain and Greece prior to 2008/09. But also the debt is largely taken on by the government (issuing New Zealand dollar bonds) and the banks. No one seriously questions the strength of the government’s balance sheet, or servicing capacity, even after years of deficits. And the ability of banks to borrow abroad largely depends on the quality of their assets and the size of their capital buffers. If asset quality really is much poorer than most have recognised, rollover risk could become a real problem, but it isn’t really an independent source of vulnerability.

Score us as a 3 or even a 2 and suddenly the Deputy Governor’s chart will have the implied capital ratios for New Zealand banks a lot higher.

The Bank knows all this, but despite attempting to rely on these numbers they make no effort to highlight the limitations (and there are others with the S&P methodology).

As I noted in that earlier post

There aren’t easy right or wrong answers to some of these issues, but the uncertainties just highlight how much better it would have been if the Reserve Bank had engaged in an open consultative process at a working technical level, before pinning their colours to the mast with ambitious far-reaching proposals.

(Incidentally, I see that I also made this point in February.

As another marker of what is wrong with the process, the Deputy Governor told us yesterday that the Bank will be releasing an Analytical Note on the Bank’s estimates of the costs of their proposals: it will, we were told, be out in a “couple of weeks”, by when two-thirds of the (extended) consultative period will have passed.

That Analytical Note still hasn’t been published.)

In truth, despite the Governor airily declaiming that his proposals are nothing to worry about, and comfortably within the range of international requirements, so far they have produced no evidence or analysis that could lead reasonable observers to share his confidence.  That simply isn’t good enough.

There is no sign, for example, that the Bank has ever seriously engaged with APRA and in a mutual process sought to robustly assess how each regulator’s proposals would apply to the same portfolio of assets.    If the two agencies both agreed on the results, I’d probably be persuaded (not necessarily that we need such high ratios, but on the relative demandingness of the two sets of rules themselves).   Similarly, they have made no effort to sit down with the regulators in the countries with the (apparently) most demanding capital rules (Sweden?) and look at how their rules and those the Reserve Bank are proposing might work out (in terms of required capital) for the same portfolio of assets.  It might not be easy to do, but….that is what we fund the Reserve Bank and pay Reserve Bank staff for.  There are huge amounts of money involved here  (my former colleague Ian Harrison called it The 30 billion dollar whim and, on a quite different approach I suggested that the Bank’s own guesstimates of the real economic costs could easily capitalise to $15 billion).

With no sign that the New Zealand financial system is imperilled –  recall that the Bank itself tells us every six months that it is strong and stable –  there is no obvious a priori case for much higher capital requirements: any such case needs to be made rigorously, in detail, with lots of careful scrutiny.  In other words, in ways quite unlike how the current ambitious proposal has been done.   It may have been the outcome of a meandering multi-year process (on lots of things other than the minimum ratio), but in the end it looks a lot like the fruit of a gubernatorial whim, without even the decency of constructing a robust ex post rationalisation that would withstand serious scrutiny.

That simply isn’t how policy in a serious country should be made.   And the frightening thing about the New Zealand system is that if the initial proposal was one man’s whim, the same one man is the final decision maker: prosecutor, judge and jury in his own case, with no subsequent rights of appeal.  There is no decisionmaking board, no separation of management from final decisionmakers, no powers for the Minister of Finance to have any say.  Just one unelected man pursuing a whim.

(If you still happened to think that policy advice in New Zealand was that of a serious country –  actual whether you do or don’t –  don’t miss checking out Eric Crampton’s post yesterday on a new adventure and enthusiasm for The Treasury.   As a flavour

Imagine surprising Aotearoa with a strain of compassion so delightful that it re-wires our collective consciousness!

Don’t miss clicking through to the feelings game.  You too might want to spend $113.85 on a set of feelings cards, devised by a business set up by a former Treasury staffer who

She saw an opportunity for her and other people within the Ministries to more deeply, creatively and energetically serve New Zealanders by bringing more of their hearts to work and being able to more empathetically connect with colleagues, staff and service end users.

Spare us.   As one of New Zealand most eminent economists, now resident in Canada, put it “if I were dead, I’d be rolling in my grave”  )

 

 

An unserious organisation, with serious consequences

I wasn’t planning to write anything more today, but then I got an email from the Reserve Bank.

You’ll be aware that almost three months ago the Reserve Bank released a consultative document, in which the Governor proposed to massively increase the amount of equity capital banks have to have just to keep on doing the business they are doing now.

As this was, apparently, the culmination of a multi-year review (in fact, the final numbers seem to have been very much a last-minute affair) you might have supposed that a serious central bank would have all its arguments straight and evidence (or at least sustained reasoning, engaging alternative perspectives) at hand in accessible form to support all their claims.  They’d probably have anticipated all the plausible area of disagreement or challenge, and had good responses readily to hand.

Whether they supposed, for some reason, that everyone would embrace their schemes with open arms and uncritical spirit, or what, actual experience has been anything but that.  When they finally responded to OIAs and released the background papers, it turned out that one of them had only been written several weeks after the consultation paper was released.  And in his speech a couple of weeks ago, the Deputy Governor was promising that they would soon publish an Analytical Note explaining their estimates of the likely impact on interest rates (which still hasn’t seen the light of day).

At the Monetary Policy Statement in February, there was a considerable attention on the proposed capital changes.  In fact, the Bank even proactively included a box in the text (page 35).   There were various claims, some numerical and some not.  These were a couple of examples

The Bank expects that the spread of banks’ lending rates to the rates at which they borrow will settle in the range of around 20 to 40 basis points higher as a result of the proposed changes, although the exact effect is uncertain.

Higher bank capital requirements could also improve the government’s fiscal position. A higher share of bank equity funding would likely increase tax revenue from the banking sector since debt funding is tax-deductible while equity funding is not.

There were lots of questions at the Governor’s press conference as well, including his claim (not made in the text) that the Bank’s proposed new capital ratios would be “well within the range of norms” seen in other countries.

That was all very interesting, but I wanted to know a bit more, and assumed they would simply have material to hand to support their claims.  It would, you’d have thought, have been in their interests to do so –  after all, they obviously believe in what they are proposing, and would presumably want to carry us with them, supported by robust evidence and analysis.  Or so you’d have thought.

And so I lodged a fairly simple Official Information Act request, for the material supporting those claims.   That was on 13 February.  This afternoon –  the day before the last date by when a response was due – I got this letter.

OIA barclay

In which they take to themselves a whole another 20 working days.    Not because whatever they have needs to be collated or compiled, but allegedly because of “ongoing consultations”.  One can only assume that is a shorthand for “there wasn’t much, if anything, there, but give us time and we’ll see what we can drum up”.

It is both so ludicrous and so telling that I’m not going to waste the time of the Ombudsman’s office complaining.  I’ll just let it stand –  a powerful public figure makes claims in support of a far-reaching proposal on which he is prosecutor, judge, and jury –  and can’t, or won’t, produce any evidence or analysis to support his specific claims.   Sadly, it isn’t the first time.

If you want sceptical analysis and argument:

  • Ian Harrison’s substantive document, “The 30 billion dollar whim” is here, and
  • my succession of posts on unanswered questions and unconvincing analysis are here.

As for the Governor, he seems to have time to play tree gods, and for spending other people’s money on Maori cultural advice (recall, that this was going to improve the quality of monetary policy and financial regulatory policy decisions), just not for the serious stuff.

The Bank is at growing risk of becoming a profoundly unserious organisation, but one whose whims have serious consequences for the rest of us.

It isn’t good enough.  The Bank’s board is charged with protecting us from Governors not doing their job properly. It is about time they took some responsibility.

“The 30 billion dollar whim”

A week or two back I foreshadowed a forthcoming paper by my former colleague Ian Harrison reviewing the Reserve Bank’s proposals under which the banks would have to greatly increase the volume of capital simply to carry on doing the business they are doing now.

Like me, Ian spent decades at the Reserve Bank.  But much of his time was spent specifically in the area of banking regulation and bank supervision, including leading much of the modelling work done a few years ago as part of the Basle III process, which resulted in something like the current bank capital requirements.   He knows the detail in this area, has consulted on this sort of stuff since leaving the Bank, and has invested a great deal of time and effort over the last couple of months in getting to grips with the Bank’s proposals, reviewing the various papers they’ve published, and going back and reviewing the papers the Bank has cited in support of their case.   The result is his (50 page) review document.   Here are his key conclusions (overlapping in various places with points I’ve made in post here). Ian does not pull his punches.

Part two: Key conclusions

1. The ‘risk tolerance’ approach is a backward step that ignores a consideration of both the costs and benefits of the policy. The soundness test is based on an arbitrarily chosen probability of bank failure that ignores the cost of meeting the target. The Bank has ignored its own cost benefit model which did take the probability of bank failure, the costs of a failure, the interest rate costs of higher capital and societal risk aversion into account.

2. Bank decision based on fabricated evidence. The Banks’s decision to pursue a 1:200 failure target was purportedly based on evidence from a version of the Basel advanced model. It was manipulated to produce the right answer. Initially, a 1:100 target was proposed, but when this couldn’t generate a capital increase, the target was switched to 1:200 at the last minute.

The Bank’s model inputs were not credible. It was assumed that all loans were higher risk business loans and that the probability of loan default, a key model input, was more than two and a half times the estimates the Reserve Bank has approved banks to use in their capital modelling.

The Bank’s analysis was embarrassingly bad, so it attempted to cover this up with a subsequent information paper that was written after the decision was made, and after the Consultation paper was released. It reached the same conclusion on the required level of capital, but only by assuming a 1:333 failure probability, and by using model inputs that were still not credible.

3. A 1:200 target can be met with a capital ratio of around 8 percent. If the Basel model were rerun using credible inputs if would probably show that a 1:200 failure rate can be met with a capital ratio of around 8 percent.

4. The policy will be costly. The Bank has down played the interest rate impact of the policy, saying any increases will be ‘minimal’. Based on its own assessment of the interest rate impact, the annual cost will be about $1.5-2 billion a year. The present value of the cost of the policy could be in excess of $30 billion.

A homeowner with a $400,000 mortgage could be paying an additional $1,000 a year. A business with a $5 million loan could be paying an additional $50,000.

5. The Bank’s assessment that the banking system is currently unsound is at odds with rating agency assessments and borders on the irresponsible. The rating agancies’ assessment of the four major banks is AA-, suggesting a failure rate of 1:1250. The Bank is now saying that, at current capital ratios, the banking system is ‘unsound’ because the failure rate is worse than 1:200. Or in other words the New Zealand banking system is not too far from ‘junk’ status. The international evidence does not support the Bank’s contention that the probability of a crisis is worse than 1:200. The Bank has ignored the fact that banks will need to hold an operating margin over the regulatory minimum, and has not adjusted New Zealand capital ratios to international standards to make a fair like-for-like comparison.

6. The Bank‘s analysis ignores the fact that the banking system is mostly foreign owned. Foreign ownership increases the cost of higher capital because the borrowing cost increases flow to foreign owners. Foreign owners will support their subsidiaries in certain circumstances, which reduces the probability of a bank failure. There is little point in having a higher CET1 ratio than Australia, because if a parent fails then it is highly likely that the subsidiary will also fail, because of the contagion effect. A New Zealand subsidiary might still appear to have plenty capital, but depositors will run and the Reserve Bank and government will have to intervene.

7. The Australian option of increasing tier two capital has been ignored. APRA is proposing to increase bank capital by five percentage points, but will allow banks to use tier two capital to meet the higher target. This provides the same benefits, in a crisis, as CET1 capital, but at about one fifth of the cost. New Zealanders will be required to spend an additional $1.2 billion a year in interest costs for almost no benefit in terms of more resilience to a severe crisis.

8. The benefits of higher capital are modest. Most of the costs of a banking failure are due to borrowing decisions made before the downturn. This will impose costs regardless of the amount of capital held. With current levels of bank capital failures will be rare, with the main cost likely to be a government capital injection. The experience with most banking crises, in countries most like New Zealand, is that governments have recovered most of their costs when the bank shares are subsequently sold.

9. The Bank is mis-selling insurance. The Bank is selling a form of insurance to the New Zealand public, but it vague about the premium costs and has exaggerated the benefits. The premium is the $1.5-2 billion. The benefit would be around a 10 percent reduction in the economic cost of a financial crisis, with an expected return of a few tens of millions.

An informed, rational public would not buy this policy.

10. New Zealand banks already well capitalised compared to international norms. A recent PricewaterhouseCoopers report argued that if New Zealand bank capital ratios were calculated using international measurement standards they would be 6 percentage points higher, placing New Zealand in the upper ranks of well capitalised banking systems. The Reserve Bank critised some details in the report, but has not produced is own assessment as Australia’s APRA has done.

11. The Bank has forgotten about the OBR.   The Open Bank Resolution (OBR) bank failure mechanism, was originally conceived as a substitute for higher capital to reduce fiscal risk, and to reduce the costs of a bank failure. While banks are been required to spend almost $1 billion on outsourcing policies to supportthe OBR, it does not appear in the capital review at all – despite the Governor’s arguments that the main justification for capital increases is to reduce fiscal risk.

The bottom line?

An informed, rational public would not buy this policy.

But, as it happens, an informed rational public won’t get a say. The Governor proposes and (under New Zealand law) disposes: prosecutor, judge, jury, and appellate court in his own case.

Partly, I gather, for his own amusement, and partly to help respond accessibly to some specific assertions/arguments in the more accessible material the Bank has put out to support the Governor’s case, Ian has a separate document, the Pinocchio awards.

pinocchio 2pinocchio 1

The Governor is a great deal smarter and more analytically capable than Donald Trump, but on Ian’s reading, he is resorting to the financial regulator’s equivalent of questionable Trumpian rhetoric to champion the indefensible.  Against Trump there are the courts and Congress.  Against a Governor with a whim and the bit between his teeth……well, nothing really.

It would be interesting to see what the Reserve Bank makes of Ian’s arguments and evidence.

UPDATE: A fairly accessible summary of some of Ian Harrison’s key argument in this article by veteran journalist Jenny Ruth.

 

Unelected officials wielding too much power

The Governor of the Reserve Bank is currently consulting on his own proposal that would markedly increase the share of their balance sheets New Zealand registered and incorporated banks have to fund from equity.     Whatever the possible merits of this proposal –  saving some possible, but highly uncertain, costs in several decades’ time – it is an expensive proposition.   From the economy’s perspective, if his deputy is to be believed, we’ll all be poorer (level of annual GDP permanently lower) by about 0.25 per cent.  In present value terms, that is a cost in the range of $15 to $20 billion.    As for the owners of the banks themselves, they will have to stump up billions in new capital just to keep doing the business they are doing now.  Among other options, the Deputy Governor cavalierly observes, they could simply sell off part or all of their business (which seems to be one of the possible outcomes the Governor would quite like –  with no statutory authoritiy – to see).

All on a whim, supported by flimsy analysis at best.  And with few or no protections for citizens or for the owners of the directly affected private businesses.  Government in a free society shouldn’t be done this way.   And mostly it isn’t.   Mostly there are a lot more checks and balances.   But not when it comes to the Governor of the Reserve Bank exercising his extensive regulatory powers over banks.

Typically, if a bureaucrat has a bright idea about a new rule or law, he or she first has to persuade the bosses of their own agency.    Even if they are persuaded, the boss then has to persuade the relevant minister.  The minister might have to persuade his or her Cabinet colleagues (at which point other relevant government agencies will have input to the Cabinet paper).  And Cabinet may even need to persuade Parliament, a process which involves select committee submissions (which are public), deliberations and reports back, sometimes through a committee chaired by an opposition party MP.   Even if it is the minister who has the bright idea –  and ministers are actually elected, and can be tossed out again (either by the PM instantly or at the next election) –  it will still typically have to go through much the same sort of process –  referred to the relevant agency/department for advice, and so on as above.    Heads of agencies/departments don’t set out to gratuitously upset ministers, but they do have an degree of independent status and authority and can, and sometimes do, offer free and frank advice on a minister’s bright ideas.

Contrast that with what happens when the Reserve Bank has a bright idea around the regulation of banks (“hey, how about we double the amount of capital banks have to have?”).  If there are any formal checks and balances, they are about process only.  I’m sure staff still come up with ideas –  good ones and daft ones –  and not all of them are accepted by management.

But if an idea comes from the Governor, or is once accepted by the Governor, things quickly become all-but-unstoppable.   After all, all the power (around the regulation of banks) rests with the Governor personally.     Someone who wasn’t elected, and wasn’t even directly appointed by someone who was elected –  rather he was chosen by half a dozen faceless company director types who themselves have no accountability and little or no subject expertise.     All the executive power with in the Bank also rests with the Governor personally (not necessarily a problem in itself, except in conjunction with that extensive policymaking power).   If we blessed with a highly competent saint as Governor –  of equable temper, open mind, encouraging dissent etc etc –  none of this might matter much.    But such people will be (exceedingly) rare: we need to build institutional arrangements around the crooked timber of humanity; people with all their flaws, biases etc.   Few of us are as ready to acknowledge the weaknesses in cases we are advancing, championing, as might objectively be warranted.  That is human nature, not something to specific to central bank governors.  It becomes harder to change our minds the more we’ve nailed our personal colours to the mast.   Everyone recognises that, which is why most serious decisions involve multi-stage processes, appeal or review rights etc.  In the criminal system, you can’t be prosecutor, judge, jury, and appellate court in the same case –  even in places like the PRC, in the deference vice pays to virtue, they observe the form of distinctions like this, although not the substance.

And yet that is exactly how the bank capital proposals are handled.    It is not even as if there was any socialisation of the ideas, testing of the argumentation, with interested and/or expert parties in advance of the Governor’s proposal being announced.  Instead, with little or no preparation of the ground, the person who will be the final decisionmaker launched his radical proposal.   Understandably, he and staff now champion that proposal in public fora (interviews, speeches etc).  But how then do we suppose that the Governor will be able to bring the requisite degree of objectivity and detachment to the submissions that come in.       No doubt, he will do enough to get through the legal hoop of “having regard to” the material in the submissions, but that is much much too weak a standard when he is prosecuting a case in which he will also be judge.  Imagine a criminal case in which the prosecutor was also judge (and there were no substantive appeal rights): the prosecutor/judge might swear black and blue that they would take seriously defence evidence/arguments, but no one –  no one –  would regard that as a credible or appropriate model.   It isn’t either when it comes to multi-billion dollar regulatory decisions.

The problems are compounded when the people most directly affected by the Governor’s regulatory whims have to keep on his good side because the Governor wields a great deal of discretion around other things that matter to individual banks (approval of models, approval of instrument, approval of individuals).  That has typically left banks very reluctant to say anything much in public about what the Governor might be proposing, no matter how potentially costly or troublesome those proposals might be.  From their own perspective, that might be the best course open to them.  It isn’t a pathway to good policymaking, or robust decisionmaking around bank regulatory matters.

There is no need for things to be done this way.   A more-normal process would involve major policy decisions being made by the Minister of Finance, or preferably Cabinet.  The Minister would want to take expert advice from the Reserve Bank and from the Treasury, and it might even open to those agencies to champion their preferences in a consultative document.   But when unelected people are championing change, they shouldn’t also be the ones making final decisions, with no appeal or review rights.  (All the more so in a structure like the current Reserve Bank one in which all power rests with a single individual –  a highly unconventional, inappropriate, governance structure for major regulatory powers.)

The specific issues are totally unrelated, but I had much the same thoughts –  too much power resting with unelected unaccountable bureaucrats –  when I listened to the Police Commissioner on Morning Report yesterday asserting his absolute right to decide whether or not Police routinely carry guns.   (This is the same Police Commissioner who thought it appropriate to give the eulogy, praising the man’s integrity, at the funeral of a former policeman found to have planted evidence.)  The mantra of “operational independence” was chanted, in ways reminiscent of the Reserve Bank.

I’m not clear whether the Polce Commissioner really has the power he claims (although successive ministers seem to have been willing to defer to that view), but when I looked up the Policing Act it contained a high-level distinction between matters for the minister and matters for the Commissioner that seemed appropriate.

police

The items under 16(2) seem like exactly the sort of areas we don’t ministers involved in: the Minister of Police should never be able to tell Police to arrest, or not arrest, a friend or enemy  (any more than the Minister of Finance should be able to tell the Governor to go easy on bank x and hard on bank y, where cronies might be involved) or interfere in individual personnel decisions

But applying the law to all people without fear, favour or political interference is very different than a general policy question as to whether, say, Police should routinely carry guns.  That is the sort of choice (including about what sort of society we want to be, what risks we will accept, or not) that only elected politicians – directly accountable to us –  should be making.    The incentives are all wrong otherwise.  I’m strongly opposed to routinely arming Police, but I’m even more opposed to letting the Police Commissioner get away with assertions that it is a decision for him alone to make.  If that really is the law, it should be changed.    No matter how much Police Commissioners like to tell you they serve the public, historically they (and probably any bureaucracy) will tend to serve its own interests more.  Thus, I noticed an article in which the southern police commander, asked what kept him awake at night, replied that it was safety of his officers.  That is natural, and not even necessarily inappropriate (and health and safety laws apply to Police management too) but against that has to be weighed other interests – for example, the rights of law-abiding citizens not to live in fear of Police, the rights of innocent people not to be deprived of life by a Police officer acting rashly (it happens) and so on.  It is simply unreasonable and inappropriate to allow Police themselves to make such policy decisions.

Democracy isn’t perfect by any means, just less bad than the alternatives.  And one of those alternatives involves delegating a great deal of power to unelected unaccountable bureaucrats.   When big policy decisions –  whether about capital structures of banks, or routinely arming the Police force –  are involved, only those who are elected –  and thus able to be unelected – should be making the decisions.  And when officials are championing any particular cause, they shouldn’t be the ones making the final decisions, the more so when there are no appeal rights.  Too often, of course, it suits politicians to opt out –  not just here, it has been a huge problem in the US Congress for decades –  but if they aren’t willing to make and defend hard decisions themselves perhaps they should consider another occupation.   We want and need experts for (a) advice, and (b) implementation.  But the big choices should be made only be those whom we elect, and can toss out again.   Neither Adrian Orr nor Mike Bush has got themselves elected.

 

 

Banking crises are not bolts from the blue

The Herald’s economics columnist Brian Fallow devoted his column last Friday to the Reserve Bank’s proposal to massively increase the proportion of their balance sheets banks would have to fund by equity.  He ended on what seemed to be a moderately sceptical note.

So we are left trying to weigh a highly debatable but significant cost against an incalculable benefit.

As I’ve noted here, the sort of cost-benefit calculus we can glean from various Reserve Bank publications just doesn’t stack up at all.    In his speech the other day (which a couple of readers have suggested I was too generous towards), the Deputy Governor indicated that the level of GDP might be up to 0.3 per cent lower (permanently) as a result of these changes.    Call it an annual insurance premium of 0.25 per cent of GDP (and bear in mind that the estimates Bascand is using don’t take account of the implications of most of our banks being foreign-owned, which raises the cost to New Zealand).

If we knew with certainty that:

(a) adopting these much higher capital ratios would prevent a crisis in 75 years time that would have otherwise cost 40 per cent of GDP (recall that the proposals aren’t supposed to prevent 1 in 200 year crises, but are presumably supposed to prevent 1 in 150 years crises, and 75 years is halfway through 150 years –  the crisis could happen next year, or in year 149), and

(b) that the new higher capital ratios would be applied consistently for the next 75 years

that might be a borderline reasonable bet –  the benefits might roughly match the costs.

If you thought instead there was no more than a 50 per cent chance that the new policy would be applied consistently for 75 years  (and given how politics, personalities, and conventional policy wisdom has changed quite a bit, to and fro, since 1944 that seems generous) , you’d need to be preventing a crises twice as large for the insurance policy to be worthwhile.

As a benchmark for how serious these events can be, you could think about the United States since 2008.   Over 2008/09, the United States experienced the most severe banking crisis of (at least) the modern era, since (say) the creation of the Federal Reserve.   (The Great Depression itself was, of course, worse, but it was mostly a failure of monetary policy management and institutional design rather than a banking crisis).

I’ve shown this chart previously.  Real GDP per capita for the US and New Zealand from 2007q4.

crisis costs 2019

The United States was the epicentre of the systemic banking and financial crisis.  New Zealand did not experience a systemic banking crisis at all.  At least on the OECD’s estimates, the output gaps of the two countries were pretty similar in 2007.   And there is no just credible way you can come up with estimates that have the United States doing (cumulatively, in present value terms) 40 per cent of GDP worse than New Zealand.   Do the comparisons of the US with other OECD countries that didn’t run into serious banking problems –  eg Australia, Canada, Norway, Israel, Japan –  and you still won’t find cumulative output losses sufficient to justify the sort of tax the Reserve Bank of New Zealand wants to lump on our economy.

In fact, for what it is worth, here is the cumulative labour productivity (real GDP per hour worked) growth of the United States and those non-crisis countries for the period 2007 to 2017 (from the OECD databases).

United States 10.6
Australia 14.0
Canada 9.6
Israel 10.1
Japan 8.3
Norway 3.0
New Zealand 4.4

Sure, there are all sorts of other things going on in each of these countries.   But bad as the 2008/09 banking crisis was in the United States, it is all but impossible to come up cumulative cost estimates that would reach even 20 per cent of GDP (crisis country experience over the experience of non-crisis countries).

And if the Reserve Bank continues to believe otherwise, the onus should be on them to make the case, to set out their arguments, assumptions, and evidence.

(Note, that none of this is to suggest that the 2008/09 recessions were anything other than undesirable and costly.  Recessions generally are.  But there are lots of low probability bad things in our world, and not all of them are worth paying the price to try to prevent.)

But even having come this far, I’ve risked conceding too much to the Reserve Bank ‘s story.  In part, that is because the storytelling implicitly treats higher capital ratios as sufficient to spare an economy all the costs associated with a banking and financial crisis.  And in part (but not unrelated to the previous point) because it tends to treat systemic banking crises as bolts from the blue –  unlucky bad draws imposed on a country when the Lotto balls are selected.   Neither is true.

Unfortunately, Brian Fallow seemed to buy into some of this sort of implicit reasoning in his column.

But in a complicated and perilous world it is idle to suggest that stress tests or banks’ internal modelling can accurately quantify the probability and magnitude of a major economic shock that could threaten the solvency of banks. Or even forecast the nature of the shock: another global financial crisis, perhaps?

The last one inflicted the deepest recession New Zealand had suffered since the 1970s.

A pandemic against which we are pharmacologically defenceless? It’s 100 years since the Spanish flu killed more people than WWI.

International hostilities breaking out in some surreptitiously weaponised but systemically vital realm of cyberspace?

Or a more conventional geopolitical conflict? The current crop of world leaders do not inspire confidence.

One might note first that the stress tests the Reserve Bank requires banks to undertake have deliberately used highly adverse combinations of shocks (rising unemployment, falls in house prices etc).  They are deliberately designed to look at really adverse events.

One might also note that –  contrary to the implication here and in Geoff Bascand’s speech –  the banking crisis (failure of DFC, need to recapitalise BNZ) did not “inflict the deepest recession New Zealand has suffered since the 1970s”, rather it was one (probably rather modest) factor in a range of contributors (disinflation, structural reform, fiscal adjustment, downturns in other countries etc).

But what I really wanted to focus on were the final three paragraphs in that extract, which imply that banking crises arise out of the blue.  And they just don’t.  They never (or almost never) have.  Might they in future?  Well, I suppose anything is possible, but we can’t sensibly take precautions against everything.

The prospect of a serious pandemic is pretty frightening.  But awful as the episode 100 years ago was, it didn’t result in systemic banking crises.    Cyber-warfare sounds pretty scary as well, but it isn’t remotely clear how higher bank capital requirements protect us against that.   World War Two was dreadful, but it didn’t result in systemic banking crises either.    There was a serious financial crisis at the start of World War One, but it was a liquidity crisis not a solvency one, and capital requirements (then, or in some future unexpected outbreak of hostilities) are pretty irrelevant in a crisis of that sort.    Do the leaders of the world as individuals or a group command much confidence?  Well, no, but then in the last 100 years or so periods when it was otherwise seem rare enough  (the PRC and USSR border war of 1969 anyone)?  I suppose if we go back far enough a repeat of the Black Death –  wiping out a third of the population –  wouldn’t be great for the value of bank collateral, but (a) capital proposals aren’t supposed to counter 1 in a 1000 year shocks, and (b) you might think there would be bigger things to worry about then (and a high likelihood of statutory interventions to redistribute gains and losses anyway).

Systemic banking crises –  one where banks and borrowers lose lots and lots of money and 5 per cent, 10 per cent or more of bank loans are simply written off in a short space of time –  simply do not arise out of the blue, as decent well-managed banks and universally responsible borrowers are suddenly hit by some totally unforeseeable event.  Rather they are –  always and everywhere – the outcomes of choices made over the years (typically only a handful) previously.    Lenders and borrowers make bad –  wildly overoptimistic  –  choices, some just going along for ride, others actively pushing the envelope.  In the process, real resources in the economy in question are misallocated, perhaps quite badly, but that cost is something that is really only apparent (only crystallises) when the boom comes to end, whether it ends in a whimper or a bang.   Sometimes government policies can play a direct part in helping to generate the mess.  In the United States, for example, the heavy state involvement in the housing finance sector greatly exacerbated the imbalances that crystallised in 2008/09.  In Ireland, for example, entering the euro and taking on the interest rate fit for Germany and France when Ireland might have been better with New Zealand interest rates, was a big part of the story.  Fixed exchange rates have often been a significant factor, both giving rise to initial imbalances, and aggravating the difficult resolution afterwards).  Transitions out of periods of heavy regulation can play a role too: in New Zealand (and various other countries) in the late 80s, neither lenders nor borrowers really had much idea of operating in a liberalised financial system.  You can go through every modern financial crisis –  and probably plenty of the older ones too – and point to the excesses, the over-optimistic lending and borrowing that accumulated in the preceding years.  Japan –  crisis of the 1990s – was yet another prominent example (Zambia in 1995, a crisis I was quite involved in, was the same).

Would higher required capital ratios have prevented any (many) of these episodes?  One can’t answer with certainty.  They might have prevented some bank failures themselves, but that isn’t the issue I’m focused on here (which is about the bad lending/borrowing in the first place).    Perhaps a few banking systems really went crazy because creditors thought they could offlay all the risks on the state, but that isn’t a compelling story more generally.  After all, shareholders still stood to lose everything.   A more plausible interpretation (to my mind) of those periods of undisciplined lending/borrowing is that people simply misjudged the opportunities, and got carried away by excess optimism, in ways that meant they just pay much less attention to the potential downsides.  The world was different (so people were being told, or they told themselves).  If so, most of the misallocations of real resources would happen quite independently of the levels of bank capital requirements that were imposed.  And you can mount an argument that high capital requirements may tend to encourage banks to seek out more risks than they would otherwise take, especially in buoyant times, concerned to keep up rates of return on equity.    Even if that doesn’t happen, disintermediation would see more risks to be taken on in the shadows –  no less resource misallocation in the process, but rather less visibility to the authorities and resolution agencies.

Perhaps good and active bank supervision can prevent those excesses, and misallocations, building up.  But that is a (very) different case from one in which ever-more-demanding capital buffers  supposedly eliminate (or reduce to minimal levels) the costs when the bad lending crystallises.  It isn’t a case the Reserve Bank has made –  and they probably wouldn’t, as historically they have been (rightly) fairly sceptical about the value hands-on supervision can add.  And it is a case I am pretty sceptical of.   And for which there is not much evidence (even allowing for the fact that crises avoided tend to be not very visible).   Much as APRA likes to suggest it is an example (in the 2000s) I don’t think they were really tested.

Bank supervisors –  and their bosses in particular –  breath the same air as everyone else in a society, and when lending and borrowing in a particular country is going badly off course, it is unlikely that the bank supervisory agency will be taking (for long) a very different stance from those around them, and those who appoint them.   This isn’t an argument about corruption –  although regulators perceived to be realistic and responsive will no doubt attract a better class of well-remunerated job offer –  but about political and economic realism.  But even if better Irish regulators (say) could really have made a difference in the 2000s, what was really needed were different lending/borrowing practices, not just more capital.  More capital wouldn’t have avoided a nasty aftermath (even if it would have reduced some fiscal costs) –  and at the peaks of self-confident booms, capital is cheap and easy to raise.

And so we are brought back to the specifics of New Zealand where:

  • repeated stress tests conclude that our banking system is resilient to very very nasty shocks,
  • the Reserve Bank tells us at every FSR that the financial system is strong and sound,
  • we have control of our own monetary policy, including a floating exchange rate (34 years today),
  • we have healthy public finances,
  • we have little active involvement of the government is directing finance

Against that backdrop, and against the experience in which it is hard to conclude that banking crises themselves (as distinct from the bad lending that later gave rise to them) are worth more than a few percentage points of GDP, in a country not prone to systemic financial crises (the episode doesn’t even meet the test in many collections of crises), with our banks owned mostly from a country also with no track record of frequent serious financial crises, the case just hasn’t been at all convincingly for compelling banks to fund so much more of their balance sheets with equity.  Doing so will, on the Reserve Bank’s own telling, involve real economic costs.  For benefits that are, at best, tiny and far-distant.

It is disconcerting that in none of the Reserve Bank’s material do they ever show signs of engaging with any of this sort of analysis.  Instead, they have a policy preference and prefer assertions and flimsy analysis to any serious engagement with the issues and experience.

My former colleague Geof Mortlock has another piece on interest.co.nz making the case for splitting up the Reserve Bank and creating a separate Prudential Regulatory Agency.  I strongly agree with him on that –  and have argued the case here last year.  Geof is probably more optimistic than I would be about what bank regulators can add, but on this particular item we seem to be as one.   Among his long list of what is wrong with the Bank’s conduct of its financial regulatory functions, introduced thus

Geof Mortlock argues the Reserve Bank is about as much use as a financial regulator as is a cricket umpire who is nearly blind and who understands little about the game

is this:

the recent release of bank capital regulation proposals that would see banks in New Zealand being required to hold a very high level of capital compared to other countries, with potentially adverse consequences for borrowers’ access to credit, an increase in interest rates and adverse impacts on the economy – and all on the basis of shockingly flimsy analysis by the Reserve Bank.

Quite.