Stress tests and bank capital

Just before Christmas the Reserve Bank released a consultative document on the Governor’s idiosyncratic proposal to increase required bank capital ratios to levels unknown anywhere else in the world.    I will have some fairly extensive commentary on aspects of that (unconvincing) document over the next few weeks, but today I wanted to focus in on stress tests –  something the Reserve Bank would prefer you paid little or no attention to in thinking about the appropriateness of their proposal.

Over the last decade or so, bank stress tests have come to play an important role in assessments of the soundness of banks, and banking systems, in many countries.   Devise a sufficiently demanding shock (or set of shocks) and then require banks to test their individual loan portfolios on those assumptions and see what losses would be thrown up.     Sometimes there has been a sense of the system being gamed – the shocks and associated assumptions deliberately set in such a way that banks the supervisors want to protect don’t emerge too badly.  There were suspicions of such issues in the US in 2009, and in the euro-area stress tests more recently (I heard a nice story about the clever way one set of tests were set up to minimise the adverse results for some Greek banks).    When you are in the middle of a crisis, that sort of thing is always a bit of risk: supervisors and their political masters have rather mixed motivations in those circumstances.

But there haven’t any credible suspicions of this sort of “rigging the game” in the stress tests conducted in New Zealand (and Australia) this decade.  That is no real surprise.  Our banking systems have appeared to be in good shape, and it wasn’t obvious that there was anything the supervisors and regulators would want to hide.  If anything, with both APRA and the RBNZ champing at the bit to interfere more in banks’ choices (especially around housing finance), the incentives ran the other way (if you could show more vulnerability, your case for intervention was stronger).  I was still at the Reserve Bank when the first results came in for the stress tests published in late 2014, and I vividly call a seminar in which various sceptics (me included) pushed and prodded, unconvinced that the results could possibly be as good as they appeared to be.  But, various iterations later, the broad picture of the results stood up to scrutiny.

There have been several stress test results published in the last few years (nota bene, however, that unlike the Bank of England, the Reserve Bank has not published results for individual banks.  The Bank of England approach should be adopted here –  publishing individual bank results should be a key component of disclosure and transparency.)  One of those was a dairy-specific stress test, about which I’m not going to say anything more  here (I had a few sceptical comments here).

The other two stress tests  are more useful in thinking about the overall soundness resilience of the banking system, in the face of severe adverse shocks.

The first set was published in late 2014.   This is how they described the main scenario

In scenario A, a sharp slowdown in economic growth in China triggers a severe double-dip recession. Real GDP declines by around 4 percent, and unemployment peaks at just over 13 percent. House prices decline by 40 percent nationally, with a more marked fall in Auckland. The agricultural sector is also impacted by a combination of a 40 percent fall in land prices and a 33 percent fall in commodity prices. The decline in commodity prices results in Fonterra payouts of just over $5 per kilogram of milk solids (kg/MS) throughout the scenario.

Auckland house prices were assumed to fall by 50 or 55 per cent (as large as the biggest falls seen anywhere).   In a 2015 commentary on these stress tests I pointed out just how demanding this stress test was, especially as regards the increase in the unemployment rate (around 8 percentage points).

My point is simply to highlight that the Reserve Bank’s stress tests were very stringent, using an increase in the unemployment rate larger than any seen in any floating exchange rate country in at least 30 years.  It is right that stress tests are stringent (the point is to test whether the system is robust to pretty extreme shocks)  but these ones certainly were.  And yet not a single one of big banks lost money in a single year.  That might seem a bit optimistic –  it did to me when I first saw the results –  but they are the Reserve Bank’s own numbers.

No bank lost money in a single year, and –  this is the Bank’s own chart –  none of them even had to raise any new capital (none would otherwise have fallen below minimum required capital ratios).

box-a-fig-a3-fsr-nov14

This should have been a bit of a problem for the Reserve Bank, as they published these results –  sold at the time as an indication of a sound and resilient system – just a few months before the then-Governor launched a new wave of LVR controls on housing lending.  I wrote various commentaries on this point back in 2015, and occasionally the Governor and his deputy seemed to squirm a little (one example here), but not ones to let rigorously done stress tests get in a way of a favoured intervention, they went on their merry way.   Ever since then, they’ve been trying to convince us that their interventions further reduced the risks associated with the New Zealand financial system.

In 2017, the results of another set of stress tests were published.     Here was how they described the main scenario in that set of stress tests.

The four largest New Zealand banks have recently completed the 2017 stress testing exercise, which featured two scenarios.1 In the first scenario, a sharp slowdown in New Zealand’s major trading partner economies triggered a downturn in the domestic economy. The scenario featured a 35 percent fall in house prices, a 40 percent fall in commercial and rural property prices, an 11 percent peak in the unemployment rate, and a Fonterra payout averaging $4.90 per kgMS. Banks were required to grow their lending book in line with prescribed assumptions, and also faced funding cost pressures associated with a temporary closure of offshore funding markets and a two notch reduction in their credit rating.

(By then, the unemployment rate was starting from a slightly lower level).

If this test was less demanding regarding the fall in house prices, it not only explicitly assumes huge losses in asset values across the full range of types of collateral banks take in their lending, but also imposed material increasses in funding costs (rather than allowing any such pressures to emerge endogenously), and required banks to keep on growing their lending through a savage recession (in which demand for credit is in any case likely to be very subdued).   If there are one or two areas where this stress test could have been made a bit more demanding, overall the test is likely to materially overstate the potential loan losses in an economic downturn of this sort, because large dairy losses and large housing/commercial losses are highly unlikely to occur at the same time.  In any serious adverse economic shock, both the OCR and the New Zealand exchange rate are likely to fall –  typically a long way.   A fall in the exchange rate acts as a huge buffer to the dairy payout, even if global dairy prices fall a long way in an international recession.   These are details –  perhaps important ones –  but they go to the point that overall the 2017 stress test was a pretty demanding one (which is what one wants –  there is no value in soft tests, especially in good times).

And again, no bank made losses, and no bank fell below the minimum capital requirements. Here is some of the Bank’s text.

Credit losses: Due to the deteriorating macroeconomic environment in the scenario, cumulative credit losses associated with defaulting loans were around 5.5 percent of gross loans. Losses were spread across most portfolios, with residential mortgages and farm lending together accounting for 50 percent of total losses. Credit losses reduced CET1 ratios by 600 basis points.

RWA growth: The key driver of RWA outcomes were (i) risk weights increasing in line with deterioration in the average credit quality of nondefaulted customers and (ii) the requirement that banks’ lending grows on average by 6 percent over the course of the scenario. RWA growth reduced CET1 ratios by approximately 160 basis points.

Underlying profit: The banking system’s net interest margin declined by approximately 50 basis points per annum in the scenario. Banks only gradually passed on higher funding costs to customers, reflecting a desire to maintain long-term customer relationships and that some customers are on fixed rates. Underlying profits remained sufficient to provide a substantial buffer of earnings that accumulate to around 550 basis points of additional capital for the average bank.

The banking system survived, quite comfortably, the very demanding test thrown at it, based on bank loan books as they stood in early 2017.  As the Bank goes on to note, the results are sensitive to the assumptions used, but the Reserve Bank had no incentive whatever to understate the potential scale of the losses –  after all, these stress test results were released when they already had their capital review project underway.

Of course, we had one more “stress test”; the actual events of 2008/09.   Going into that recession, the Reserve Bank had been becoming increasingly uneasy about bank balance sheets.  There had been several years of rapid growth in housing lending, but there had also been very rapid growth in commercial property and other business lending, and in farm lending, and a sense that not all of this lending had been done with anything like the discipline that might have been prudent.    The 2008/09 recession was pretty severe, and quite a bit of poor-quality lending was revealed (especially in the dairy sector).  And yet, of course, the banking system came through that shock substantially unscathed.   One could argue that the test really wasn’t that demanding, since asset prices didn’t stay down for long, but in a sense that was the point: even with a severe international recession, and lending standards that did seem to have become quite relaxed, we experienced nothing like the sort of asset price or unemployment adjustments that the stress tests assume.   Capital ratios then were lower than they are now –  the latter now regarded by the Bank as totally inadequate.    Really severe adverse events don’t arise out of the blue, they are typically a reflection (as in Ireland or Iceland) of severe misallocations and reckless lending in the years leading up to the reckoning.   This latter point is one that seems lost on the Reserve Bank.

You’d have thought the Reserve Bank couldn’t have it both ways.  Sure, the most recent stress test results are now two years old, but they’ve spent the last few years telling us that they are pretty comfortable with lending standards (especially after imposing their LVR controls).  What used to be a focus of particular concern –  Auckland housing –  has largely gone sideways since then, and overall credit growth has been pretty subdued.  There is no credible story they can tell (and they haven’t even tried) as to how robust balance sheets in 2017 are now such as to make it imperative –  using the coercive power of the state –  for banks to have much higher capital ratios again.

Stress tests do get a (brief) mention in the capital consultation document.  They acknowledge the results

64. Recent stress tests have found that the banking system can maintain significant capital buffers above current minimum requirements during a severe downturn. During the 2017 stress test, the capital ratios of major banks fell to around 125 basis points above minimum requirements, while earlier tests had a trough buffer ratio of around 200 basis points. However, stress test results are sensitive to assumptions on the scale and timing of credit losses, and on the ability of banks to generate underlying profit under stress.

To which one might reasonably respond with “well, sure, but that is the sort of things you are supposed to test”.

But where they get rather desperate is in the next paragraph.

stress test from consultative doc

And here we have come full circle, back to rather strained reliance on the US, Spain, and Ireland in the 2008/09 crisis.

This chart attempts to imply that there is something wrong with the stress test results, rather than drawing the more obvious conclusion that they say something good about the health of the New Zealand and Australian banking systems, and about the macro environments within which those systems are operating.

Take the first panel of experiences, those from the late 1980s and early 1990s.  All five countries had newly liberalised their financial systems.  Neither banks nor borrowers nor supervisors (to the extent that the latter even existed) new much about lending or borrowing in a market economy.  In New Zealand and Australia there was wild corporate exuberance.  And in the three countries where there were systemic banking crises, all that was compounded by fixed exchange rate regimes –  that misallocated resources during the boom phase and then compounded the adjustment difficulties in the bust.

And what of the second panel?   In both Spain and Ireland there was a fixed exchange rate (membership of a common currency, but it amounted to much the same thing for practical purposes), and in the United States there was a deeply government-distorted housing finance market.   None of those cases bear any resemblance whatever to the situation of the New Zealand economy (and banks) in 2019.   We haven’t had the reckless lending, and although a future severe recession will involve losses, there is no reason to think that the 2017 stress test results materially misrepresent the health of the system.  (As the Bank has noted in the past, research suggests that in most serious banking crisis it isn’t residential lending that is the problem, but corporate and property development lending. The Bank has also previously been on record highlighting the importance of the floating exchange rate in providing a buffer in severe shocks, but now they seem to wilfully downplay or ignore that.)

The consultative document is now out for….consultation (although I think few believe the Governor is serious about taking on board other perspectives, and being open to changing his view).    But a story out the other day suggests they aren’t content to wait calmly for submissions to come in, and that the Governor has returned to the fray already in a letter to a single media outlet

Orr was responding to a BusinessDesk story questioning whether the central bank’s proposed new capital requirements for the major banks amount to gold-plating.

(I’ve asked them for a copy of this letter –  clearly already in the public domain –  but even though the Official Information Act requires them to respond as soon as reasonably practicable, I’m still waiting).

And what does the Governor have to say?

Reserve Bank governor Adrian Orr says stress tests of banks have inherent limitations, suggesting they shouldn’t be relied on.

“We emphasise in our public articles that stress testing results should not be read at face value,” Orr says in a letter.

“Both the significant modelling uncertainties, and the fact that the banks know how/when the stress situation ends, limits the value of stress tests,” Orr says.

“Further, passing a stress test covering only dairy portfolios is not a meaningful indication of overall capital strength, given it is only approximately 10 percent of banks’ exposures.”

As Newsroom notes, the final point is simply irrelevant –  the Governor attempting to play distraction –  when as the Governor and anyone else interested knows the Bank has done economywide stress tests, across the entire loan books of the banks (see above).

And of course stress tests have inherent limitations.   That is one of the reasons to have as much transparency as possible about the tests so that users can evaluate for themselves just how demanding the Reserve Bank has been.   And while the Governor seems to want to imply that the limitation he highlights could understate the potential loan losses etc, there are alternative perspectives.  For example, knowing at the start of the stress test just how severe and lengthy the eventual shakeout (asset price falls, high and enduring unemployment) will prove to be may lead to more loans being called in earlier, perhaps at larger losses.    One thing we saw in the US in 2007/08 was that banks were able to raise fresh capital early on, at a time when few appreciated just how bad things were going to get.

I don’t, for example, recall anyone suggesting (for example) that the stress test results should result in a reduction in minimum capital ratios (despite the ample margins).  They are one input, but they should be something the Governor engages with a great deal more seriously, particularly when he proposes to go out on a limb and adopt capital requirements out of step with those anywhere else in the world.   And if he wants to run these arguments, it might be better form to do so in the published consultative document, than in knee-jerk responses to individual people casting doubt on his preferred option.  I can think of one or two half-decent counter arguments –  and I’ll come back to them in a later post –  but they aren’t ones the Bank has ever advanced.

Reality is that in thinking about the consultative document, on the one hand we have detailed and specific results from repeated stress tests (and the aftermath of a period of rapid lending growth and loose lending standards not many years ago), using the specifics of banks’ loan books as they stand.   A stake in the ground as it were.   And on the other hand, we have numbers that –  despite pages and pages of the document –  are really just plucked out of the air –  both the proposed requirements themselves, and the economic and financial consequences if those whims eventually form policy.

But more on some of those issues over the next few weeks.

 

 

 

 

The tree god again

Some months ago the Governor of the Reserve Bank inaugurated his audacious bid to have his institution –  seen by most as a official agency created by, and accountable to, Parliament –  seen as some sort of local pagan tree god, with him (I assume) as the high priest in the cult of Tane Mahuta.  We’ve been told, by the Governor, that a people –  New Zealanders –  walked in economic darkness until finally the light dawned with the creation of the Reserve Bank.  It is pretty absurd stuff, not even backed by decent history or analysis, and one might be inclined just to ignore it, but the Governor seems serious.  In particular, he keeps returning to his claim. In fact, he was at it again –  claiming the mantle of Tane Mahuta –  yesterday with another little release that poses more questions than it offers answers (and which presumably means we’ll end the year still with no substantive speech from the Governor on anything he actually has statutory responsibility for).

Readers might recall that there was a damning report on the Reserve Bank as financial regulator, drawing on survey results of regulated institutions, released in April by the New Zealand Initiative.    This chart summed it up quite well

partridge 1

It has, presumably, been a priority for the Governor to improve the situation.   After all, even the Bank’s Board –  always reluctant to ever suggest any weaknesses at the Bank, even though their sole role is monitoring and accountability –  was moved to comment on this report, and the issues it raises, in their Annual Report this year.

And thus the Governor begins

In a step toward achieving the best “regulator-regulated” relationships possible, the Reserve Bank (Te Pūtea Matua) has established a Relationship Charter for working effectively with banks. The Charter will also be discussed with insurers and non-bank deposit takers in the near future.

One might question just how “best” is to be defined here –  after all, the public interest is not the same as that of either the Reserve Bank or of the banks, and there have been many examples globally of all too-comfortable relationships between regulators and the regulated.

But it was the next paragraph that started to get interesting.

Reserve Bank Governor Adrian Orr said the Relationship Charter commits the Bank and the financial sector to a mutual understanding of appropriate conduct and culture. “This is underpinned by the principle ‘te hunga tiaki’, the combined stewardship of an efficient system for the benefit of all,” Mr Orr said.

I’m not sure that understanding is necesssarily advanced when an institution operating in English introduces little-known phrases from another language to their press releases.  Here is how Te Ara explains “te hunga tiaki”

Te hunga tiaki

The Te Arawa tribes use the term ‘te hunga tiaki’ instead of kaitiaki, explains Huhana Mihinui.

The prefix ‘hunga’ is more common than ‘kai’ amongst Te Arawa, hence te hunga tiaki rather than kaitiaki. The essence of hunga is a group with common purpose. Hunga may also link with the sense of communal responsibilities. The same meaning is not conveyed with ‘kai’ … te hunga tiaki likewise invokes ideas of obligations to offer hospitality, but also to manage and protect, with the implicit recognition of the group’s mana whenua [customary authority over a traditional territory] role in this respect. 1

Which sounds pretty problematic frankly.  Banks and the Reserve Bank do not have a common purpose or a common set of responsibilities.  The Reserve Bank has legal responsibilities to the people of New Zealand, and the banks have legal responsibilities to their shareholders.  The two won’t always be inconsistent, but at times they will and there is little gained (and some things risked) from trying to pretend otherwise.  In both cases –  but particularly in that of the Reserve Bank –  there are limits on the ability of the principals (citizens and shareholders) to ensure that the boards and/or managers are actually operating according to those responsibilities.   Shareholders can sell.  Citizens are stuck with the Governor.

The statement goes on

“Writing it was the easy part. Operating consistently with the conduct principles is the challenge. We will regularly mutually review behaviours with the industry. Appropriate conduct is critical to the trust and wellbeing of New Zealand’s financial system, and the Reserve Bank – the ‘Tane Mahuta’ of the financial garden,” Mr Orr said. 

It is the tree god again –  a tree god that has some considerable way to go in improving its own conduct, be it around attempting to silence critics or whatever.

But this is also where I started to get puzzled.   In both those last two paragraphs from the statement, there is a suggestion that this document is some sort of agreed position between the banks and the Reserve Bank.   It is there in the charter document itself –  a one pager, complete with cartoonish tree god characters.

RBNZ-Relationships-Charter

(What I didn’t see was, for example, “we will avoid abusing our office and putting pressure on regulated bank CEOs to silence their economists when those economists write things we don’t like”.)

The word “mutual” is there twice, clearly suggesting that the banks have signed on to this.

But, if so, isn’t it a little strange that there are no quotes from any bankers, or the Bankers’ Association, in the press release, just the Governor’s own spin?   And when I checked the Bankers’ Association website, there was no statement from them. In fact, I checked the websites of all the big four banks and there was not a comment or statement from any of them.   Frankly, it doesn’t seem very “mutual”.   It looks a lot like gubernatorial spin.

And, to be frank, I don’t really see any good reason why there should be such mutual commitments.   Regulated entities don’t owe anything to the regulators.  They may often be intimidated by them, (privately) derisive of them, or even respect them.  But the regulated entities are just private bodies trying to go about their business in a competitive market.  By contrast, the Reserve Bank  –  the Governor personally –  carries a great deal of power over those entities, and they have few formal remedies against the abuse of that power.   What might reasonably be expected is unilateral commitments by the Governor as to how his organisations will operate in its dealings with regulated entities, standards (ideally measurable ones) that they and we can use to hold the regulator to account.      But that is different from what purports to be on offer in yesterday’s statement.

Of the brief specifics in the list of commitments, I don’t have too much to say.  There is a big element of “motherhood and apple pie” to them, and a few notable elements missing.  There is nothing about analytical rigour, nothing about transparency, nothing about remembering that the Bank’s responsibility is primarily to the New Zealand public, nothing about maintaining appropriate distance between the regulator and the regulated.  But I guess those would have been inconsistent with the fallacious claims about all being in it together and working for common goals.

It is at about this point that the Bank’s press release changes tone quite noticeably (not quite sure what happened to “one organisation, one message, one tone”).   Deputy Governor Geoff Bascand takes over and claims

Deputy Governor Geoff Bascand said the Reserve Bank’s recent announcement of a consultation with banks about the appropriate level of bank capital highlights the usefulness of the Relationship Charter.

And even in that one sentence he captures some of the mindset risks.  As I read the announcement the other day, it was a public consultation about the appropriate level of bank capital, and yet the Deputy Governor presents it as a “consultation with banks”.  If the Bank is going to run with this “Relationship Charter” notion, perhaps they could consider one for their relationship with the only people who give them legitimacy, Parliament and the public (having said that, perhaps I should be careful what I wish for).

And then weirdly –  in a press release supposed to highlight a new era of comity, open-mindedness etc –  the Deputy Governor launches into an argumentative spiel about the proposed new capital requirements.

“There is a natural conflict of interest. Banks will want to hold lower levels of capital to maximise returns for their shareholders. However, customers and society wear the full economic and social cost of a bank failure. We represent society’s interests and will naturally insist on higher capital holdings than any one individual shareholder,” Mr Bascand said.

Strange use of the phrase “conflict of interest”, which usually relates to a person or an organisation having two competing loyalties (perhaps personal and institutional), but even if one sets that point to one side for now, the rest is all rather one-dimensional and not terribly compelling.  He seems unaware, for example, that banks often hold capital well above regulatory minima –  creditors and rating agencies have perspectives too –  or that in most industries firms happily determine their own levels of capital, and somehow society manages (and prospers).  And, of course, there is not an iota of recognition of the way in which bureaucrats all too often serve bureaucratic interests (rather than societal ones), of the distinction between loan losses and bank failures, or of how the interventions of official and ministers often create the problems in the first place.

And then there is the final paragraph

“Following our Relationship Charter, we long signalled the purpose of our work and shared our analysis and consultation timetable. We have also committed significant time to engage with banks and provide a sensible transition period to make any changes we decide on. The Charter means what we are looking to achieve can be discussed professionally, while we continue to build appropriate working relationships. Outcomes will be superior and better understood and owned by society,” Mr Bascand said.

Of course, for example, whether the proposed transition period is “sensible” is itself a matter for consultation (one would hope –  and not just with banks).  Given the high probability of a recession in the next five years –  and the limited firepower here and abroad to deal with a severe recession –  some might reasonably wonder at just how wise it would be to compel big increases in capital ratios over that five year period, at a time when the Bank’s own analysis repeatedly suggests the banks are sound with current capital levels.   Credit availability might well be more than usually constrained.

One might go on to note that the level of disclosure in the consultative document is seriously inadequate for such a substantial intervention –  one that would take New Zealand further away from the international mainstream not closer to it.   As I noted in a post a few days ago, back in 2012 the Bank published a fuller cost-benefit analysis of the sorts of capital requirements that were then in place.  There is nothing similar in the consultative document issued last week, not even (I gather) any engagement with the previous cost-benefit analysis.  Given the amounts of money involved, that is simply unacceptable.  I’ve lodged an Official Information Act request for the (any) modelling and analysis they’ve done, but I (and others) shouldn’t have needed to; it should have been released as a matter of course.  In fact, even better they should have published a series of technical background papers over the year, held discussions with a range of interested parties (not just banks) before coming to the decisions they chose to formally consult on.      That is what good regulatory process might have looked like.

And then there is that bold final claim

Outcomes will be superior and better understood and owned by society

I’m all for effective and professional relationships between the Reserve Bank and the banks it regulates.  Perhaps that may even lead to better policy outcomes, but there is no guaranteee of that (after all, at the end of it all the law allows the Governor to make policy pretty much on a personal whim –  which is a lot like what the proposed higher capital ratios feel like).  But quite how a better relationship between the Reserve Bank and the banks will make outcomes “better understood and owned by society” is a complete mystery to me.   There are plenty of examples of regulators and the regulated ganging up against the public interest, and others of the regulators ramming through changes that might –  or might not –  be in society’s interest.  There is simply no easy mapping from a better relationship between the Bank and the banks, and good outcomes for society, let alone ones that –  whatever it means –  are “owned by society”.   Good outcomes rely heavily on very good and searching analysis.  And nothing in the Charter commits the Bank to that.

When one reads the argumentative second half of the press release it is little wonder the banks themselves wanted nothing to do with the statement.   I guess there isn’t much chance of the banks and the Reserve Bank getting too close to each other in the coming months as they (and the bank parents and APRA no doubt too) fight over the billions of additional capital Adrian Orr thinks they should have.

Meanwhile, the Governor can play at tree gods.  But it would be much better for everyone, including most notably citizens, if he were to engage openly and (in particular) more substantively on the issues he has legal responsibility for.   Cartoons and glib statements don’t build confidence where it counts.

 

 

 

Bank capital proposals: a few initial comments

I wasn’t planning to write today about the Reserve Bank’s proposed new bank capital requirements, announced yesterday.  I’ll save a substantive treatment of their consultative document until (after I’ve read it and in) the New Year.   But I found myself quoted in an article on the proposals in today’s Dominion-Post, in a way that doesn’t really reflect my views.  Perhaps that is what happens when a journalist rings while you are out Christmas shopping and didn’t even know the document had been released. But I repeatedly pointed out to him that, despite some scepticism upfront, I’d have to look at documents in full and (for example) critically review any cost-benefit analysis the Bank was providing before reaching a firm view.

The gist of the proposal was captured in this quote from Deputy Governor Geoff Bascand

“We are proposing to almost double the required amount of high quality capital that banks will have to hold,” Bascand said.

Or in this chart I found on a quick skim through the document.

capital requirements

These are very big changes the Governor is proposing.   As I understand it, and as reflected in my comments in the article, they would leave capital requirements (capital as a share of risk-weighted assets) in New Zealand higher than almost anywhere else in the advanced world.

These were the other comments I was reported as making

The magnitude of the new capital required by banks surprised former Reserve Bank head of financial markets, Michael Reddell, who now blogs on the central bank.

A policy move of this scale would have an impact on the value of New Zealand banks, though ASB, BNZ, Westpac and ANZ are all owned by Australian companies listed on the ASX sharemarket.

“If these were domestically listed companies, you would see the impact immediately,” Reddell said.

That would be through a fall in the price of their shares.

Many KiwiSaver funds own shares in the Australian banks.

I think the journalist got a bit the wrong end of the stick re the first comments –  perhaps what happens discussing such things, sight unseen, in a carpark.  In many respects the magnitude of the increase isn’t that surprising given that the Governor had already indicated –  a week or so before –  his desire to have banks able to resist sufficiently large shocks that, on specific assumptions, systemic crises would occur no more than once in 200 years.  That is much more demanding than what previous capital requirements have been based on –  the same ones the Reserve Bank produced a cost-benefit analysis in support of only five or so years ago, and which have had them ever since declaring at every FSR  how robust the New Zealand banking system is.

As for the second half of the comments, they were a hypothetical in response to the journalist’s question about whether higher bank capital requirements would be felt in wealth losses by (for example) people with Kiwisaver accounts who might hold bank shares.  He was uneasy about the line the Bank used that the increased capital requirements were equivalent to 70 per cent of estimated/forecast bank profits over the five year transitional period (of itself, this isn’t an additional cost or loss of wealth).  My point was that if the New Zealand banks (subsidiaries of the Australian banks or Kiwibank) were listed companies, such an effect would be visible directly, because (rightly or wrongly) markets tend to treat higher equity capital requirements as an additional cost on the business, and thus we could have expected the share price of the New Zealand companies to fall, at least initially.    As it is, I’d have thought it would be near-impossible to see any material impact on the share price of the parents (or thus on the value of any shares held in Kiwisaver accounts).

My bottom-line view remains the one I expressed here a couple of weeks ago

Time will tell how persuasive their case is, but given the robustness of the banking system in the face of previous demanding stress tests, the marginal benefits (in terms of crisis probability reduction) for an additional dollar of required capital must now be pretty small.

And, thus, I’m looking forward to critically reviewing their analysis, including in the light of that previous cost-benefit analysis.   Is it really worth compelling banks to hold much more capital than the market seems to require (even from institutions small enough no one thinks a government will bail them out)?

In thinking through this issue, there are some other relevant considerations to bear in mind.  The first is to reflect on just how unsatisfactory it is that decisions of this magnitude are left to a single unelected individual who, in this particular case, does not even have any particular specialist expertise in the subject.  And his most senior manager responsible for financial stability only took up his job a year ago, having previously had no professional background in banking, financial stability or financial regulation.   The legislation is crying out for an overhaul –  big policy decisions like these really should be made by those we can hold to account (elected politicians).    And note that banks have no substantive appeal rights in these matters, even though the Governor is, in effect, prosecutor, judge and jury, and (in effect) accountable to no one much.

The other is to note that there is likely to be very considerable pushback from Australia on these proposals –  both the parent banks of the subsidiaries operating here and, quite probably, from the Australian regulator (APRA) itself.   The proposed new capital requirements here are far higher than those required in Australia (and for the banking groups as a whole).  APRA has adopted a standard that Australian banks should be capitalised so that the system is “unquestionably strong”, but their Tier 1 capital requirement is apparently “only” 10.5 per cent.       Of course, subsidiaries operating in New Zealand are New Zealand registered and regulated banks, and our authorities should be expected to regulate primarily in the interests of New Zealand.   We won’t look after Australia, and they are unlikely to look after us, in a crisis (and coping with crises are really what bank capital is about).  But you have to wonder why we should be inclined to place such confidence in our Reserve Bank’s analysis, relative to that of APRA –  an organisation with (especially now) much greater institutional depth and expertise.  Given the legislated trans-Tasman banking commitments, and the common interests of the two sets of authorities in the health of the banking groups, one can’t help thinking that it would have been more reassuring to have seen the two regulators (and the two governments for that matter – limiting fiscal risks in the event of bank failure) reach a rather more in-common view on the appropriate capitalisation of banks in Australasia.

But perhaps the Governor really is leading the way, supported by compelling analysis.  More on that (superficially unlikely) possibility in the New Year.   In the meantime, for anyone interested, there is a non-technical summary of their proposal (although not of any supporting analysis) here.

I didn’t move to Australia; my bank came to me

I was in town for a meeting earlier in the week, and walking along Lambton Quay I noticed this gigantic advertisement adorning the wall of an office building.

TSB photo.jpeg

I’ve always quite admired TSB, as the little bank that could. When I paid more attention to these things, they seemed to have innovative products, good technology, and had to stand on their own feet.  Oh, and there was the feisty CEO who once told visiting central bankers worrying about pandemic risks and bank preparedness that in New Plymouth they had bigger risks to worry about, turning around as he spoke and pointing out the window at Mt Egmont, which will erupt again.

I guess they have always played the “local bank” line in their marketing to some extent, but it was the brazenness of that billboard that astonished me.  Both the message and, even more so, the location.   This is central Wellington, and if there is any sort of “ground zero” for commitment to an open outward-oriented economy surely it must be here.  Much as I dislike the word, New Zealand’s “globalists” disproportionately live and work here.  Within a radius of a couple of hundred metres from this billboard you capture Treasury, MBIE, the Reserve Bank, MFAT, the Ministry for Primary Industry, and the Productivity Commission.  Why, the “right-wing” business think-tank the New Zealand Initiative is just over the road –  Eric Crampton and Oliver Hartwich must just be grateful the billboard faces away from their offices and they don’t have to see this crass effort every time they look out the window.

Perhaps Gabs Makhlouf, Brook Barrington, Adrian Orr et al don’t get out for a lunchtime walk, but their minions do and they must be the target audience for this billboard – Lambton Quay is always at its busiest at lunchtime.

And firms spend money on marketing presumably because they believe it will work –  “work” in this context presumably being drawing in new customers (unless it is just designed to court more Shane Jones Provincial Growth Fund goodies for Taranaki –  TSB being owned by a community trust.)  Are Wellingtonians really going to be swayed by this sort of crude nationalism and economic illiteracy.  It scares me a bit if so.

I didn’t move to Korea and yet the screen I’m typing to was made by a Korean company, and the profits from its design and manufacture presumably accrued to the owners of Samsung.   I didn’t move to the United States, and yet the platform this blog uses is (I think) American, and the profits from what I pay for using it accrue to the owners of that company.   One could go on –  the car, the printer, the TV, the bottle of French wine, or those Californian oranges in the fruit bowl.  The jersey I’m wearing is American and the books on the shelves next to me are from all over the Anglo world –  there will (producers hope) have been profits associated with each of them.  And although there probably isn’t much profit involved, my morning newspaper is produced by an Australian-owned company.  And yet, like 400000+ others I live in Wellington.

It is trade, and it is a good thing –  usually mutually beneficial, and if there are occasional exceptions to that presumption, you wouldn’t expect them to be successfully highlighted down Lambton Quay (even if too many public servants are all too keen on the possibilities of clever government interventions in our lives).   I didn’t move to Australia, and yet the shareholders of ANZ invested some of their savings to provide banking services to New Zealanders like me.  That was good of them –  in fact the earliest progenitors of ANZ were setting banking services here in 1840 (10 years earlier than the founding of what became TSB) when there wasn’t much organised here at all.   The profits from those transactions accrue to the shareholders (many but not all of whom are in Australia), because they provide the risk capital that underpins the business.  And while the TSB talks of the profits “moving to” Australia, in fact successful businesses –  that find willing purchasers of their services –  typically reinvest many of the profits in the business, right here in New Zealand.    Banking is a big business –  some might think too big and views will differ on that, but that isn’t the line TSB is running –  so it takes lots of capital.  That will, often or even typically, mean generating quite large profits –  the returns on that capital.

(Although it is a bit of a distraction, one could note that of the five New Zealand owned banks, four are directly capital-constrained by their ownership structures –  Kiwibank being government-owned, TSB owned by a community trust, and SBS  and Coop being a (modestly-sized) mutuals –  and only one of the NZ-owned banks manages a credit rating better than BBB. Not one of those institutions could even begin to displace the major players, and the risks facing New Zealand would increase if they were to try.)

TSB’s billboard proclaims to sophisticated (as they like to think) Wellingtonians that TSB is “proudly supporting New Zealand”.  This sort of crass attempt to play some sort of crude nationalist card supports no one other than themselves –  and perhaps the Shane Jones-isation of New Zealand politics.  It diminishes, and reflects poorly on, those who commission the advert, who surely know better.  They should stop trying to gull New Zealanders with some weird autarkic vision that, if followed through on, would be bad for a big country, and totally crazy for a small one.

I once worked for someone who told me his maxim was that from choice he would always use an overseas provider if he could (as I recall this was in the Ansett vs Air NZ days) to keep the pressure on the New Zealand providers to work harder and produce excellent products and services.  I never went fully along with him, but having seen that distasteful TSB advert on Tuesday, it actually gave some small pleasure to be in an ANZ branch yesterday and to receive friendly, helpful, accommodating service on the small matter I wanted dealt with. I’d say I’d be happy to have seen the resulting profits accruing to Australian shareholders, but they were so helpful they even waived the small fee on the matter in question –  lifetime customer value and all that I suppose.

As for TSB, they really should do better.  I hope Wellingtonians passing that big advert look on with disdain, grateful instead for the opportunities that foreign trade and investment –  in both directions –  created, and continues to create, for New Zealanders.    Or would we welcome British consumers being regaled with billboards proclaiming “you didn’t move to New Zealand, so why should the profits on that leg of lamb?”.

Local listing for banks: a case for one in particular

There was a very strange article in the Herald yesterday from one Duncan Bridgeman claiming that it was, in the words of the hard copy headline Time to force Aussie banks to list in NZ”.

What wasn’t at all clear was why.

Bank profit announcements seemed to be the prompt for the column

Australian banks reaping huge profits from their New Zealand customers is a perennial scab that gets ripped off every time financial results come in.

I’m not persuaded the banks earn excessive profits here, but I know some other serious people take the opposite view.  But even if they are right, surely that is a competition policy issue –  the case for one of the new market studies perhaps, and any resulting recommendations.  There is nothing in the article explaining how forcing the Australian banks to sell down part of their New Zealand operations would affect, for the better, competition in the New Zealand banking services market.

The other prompt appear to be industry developments in Australia

Meanwhile, Australia’s big banks are starting to move away from vertical integration, partly because of conflicts of interest but also because their financial services model is unlikely to sustain the same profits over the longer term.

Suncorp, ANZ, CBA and NAB have all divested their life insurance operations. The latter two have also announced plans to spin off their wealth management operations. Westpac remains wedded to these areas of business but is expected to follow suit at some point.

And just last week financial services firm AMP, also heavily damaged by the banking royal commission, announced the sale of its wealth protection unit to US firm Resolution Life for A$3.3 billion and divulged plans to offload its New Zealand wealth management and advice businesses through a public offer and NZX listing next year.

But not one of those divestments has anything to do with core banking operations, unlike the approach Bridgeman appears to be proposing for the New Zealand bank subsidiaries.

A not unimportant word that one –   subsidiaries.  Presumably Bridgeman is fully aware, even though his article doesn’t mention, that all four Australian banks do the bulk of their New Zealand business not through branches, but through legally separate New Zealand subsidiary companies, with their own boards of directors (and statutory duties). (New Zealand compels them to do so, at least in respect of the retail business).

But when I read this paragraph I had to wonder if he really did appreciate that.

But if ever there was a time to raise the prospect of some form of domestic ownership and oversight of the banks, it is now.

The problem is it will never happen unless the Aussie banks are forced to by our politicians and regulators. After all, the last thing the banks want right now is another regulator to answer to.

Yet, why should it be accepted that four of this country’s five most profitable companies are effectively regulated in Australia?

The New Zealand subsidiaries are fully subject to New Zealand law: competition law, prudential regulation, financial conduct law, health and safety law.  The lot.  (Even the branches are subject to much New Zealand law, but leave them aside for now.)   The Reserve Bank of New Zealand sets minimum capital standards. minimum liquidity standards, disclosure requirements and so on.

Of course, since the New Zealand subsidiaries are part of much larger Australian-based banking groups, APRA’s regulations and requirements for the group can also be binding  –  not on the New Zealand business itself, but on the group as a whole.   APRA can, in effect, hold the local subsidiaries to higher requirements than those set by our Reserve Bank  (in just the same way that shareholders might voluntarily choose –  perhaps under rating agency pressure – higher standards than a regulator might impose), but it can’t undercut New Zealand standards for New Zealand operations.  Daft as they may be, New Zealand LVR restrictions are binding on banks operating in New Zealand.

Bridgeman goes on

Theoretically an Aussie bank could offload 25 per cent of the institution’s New Zealand assets and list the shares here separately. That would bring tax advantages to New Zealand investors who can’t use Australian franking credits, even though they are dual listed.

I presume he means selling off 25 per cent of the shares in the New Zealand subsidiary (rather than 25 per cent of the assets).  It would, no doubt, have tax advantages for New Zealand investors (and thus, in principle, the shares might command a higher price), and yet the banks haven’t regarded it as worth their while (value-maximising) to do so.    Bridgeman doesn’t look at question of why (presumably something about best capturing value for shareholders by holding all of the operations in both countries, and being able to  –  subject to legal restrictions and duties –  manage them together).

And he also doesn’t note that if, say, ANZ sold down 25 per cent of the shares in its New Zealand operation, the subsidiary will still be regarded by APRA as part of the wider banking group, and prudential standards will still apply to the group as a whole.  As they should –  after all, with a 75 per cent stake there would be a high expectation (from market, regulators and governments) of parental support in the event that something went wrong in New Zealand.

There is a suggestion that the article is a bit an advertorial for NZX

If a quarter of these assets were listed that would bring about $12.5b of capital to the local stock exchange – a badly needed injection at a time when the main market is shrinking.

But even then it isn’t clear what is meant.  It isn’t as if there is a new $12.5 billion (I haven’t checked his numbers) of local savings conjured up.   Buying one lot of shares would, presumably, mean selling some other assets.  In a country with quite low levels of foreign investment, the initial effect of any such floats would be to reduce that level further.  (Of course, in practice quite a few of the shares in any newly floated New Zealand subsidiaries would be picked up by foreign investment funds, leaving the alleged benefits of any compulsory selldowns even more elusive.)

Bridgeman ends with a rallying cry

And right now the Aussie banks are distracted with a battle on their home turf.

It’s the perfect time for some Coalition politicians to show some backbone and make a case for a change in this direction.

It might have appealed to Winston Peters once upon a time, but even if it weren’t a daft policy to start with, Bridgeman may have noticed that business confidence is at rather a low ebb right now.  Arbitrarily interfering in the private property rights of owners of private businesses – even if largely Australian ones –  wouldn’t be likely to do much to instill confidence in the soundness of policymaking.

As it is, they could start closer to home.  If governments really did want to focus on getting some more bank representation on the domestic stock exchange –  and it is not obvious why they would –  perhaps they could look at the New Zealand banks first.  After all, only one of them (Heartland) is sharemarket listed.  And the biggest of those New Zealand owned banks –  Kiwibank – is actually owned by the government itself.    In fact,  by three separate goverment agencies (NZ Post, ACC, and NZSF), none bringing obvious expertise to the business of retail banking, none themselves facing any effective market disciplines.  I’d be all in favour of a well-managed float of Kiwibank  (although once floated it might not last long as an independent entity).  There are good reasons (they’ve been there for years) for the government to consider seriously that option.  But there are no good reasons to force well-functioning locally regulated foreign-owned banks to sell down part of their operations in New Zealand.

 

Voting on monetary reform

This coming Sunday, voters in Switzerland get to vote on the future monetary system.  I don’t share the New Zealand Initiative’s enthusiasm for Switzerland –  the only OECD country since 1970 to have had slower productivity growth even than New Zealand –  but I do like the element of direct democracy in their system: binding referenda on matters initiated by citizens.  No doubt it produces some silly results at times, but that’s part of democracy –  not ideal, just better than the alternatives.    And it isn’t as if our own system is immune to silly policies, unaccountable institutions etc.

I’d forgotten that the Vollgeld referendum was coming up until I saw yesterday that the eminent Financial Times economics columnist Martin Wolf was expressing the hope that the Swiss vote for change this Sunday.  It isn’t clear that he really favours the general adoption of the specific system called for in the Swiss referendum but, in his words,

Finance needs change.  For that, it needs experiments.

Dread word that: experiments.  I remember the efforts we went to one year to get all uses of the word out of the OECD’s review of the New Zealand, in the midst of the reforms of the late 1980s and early 1990s.   For better or worse, one can’t do randomised control trials in macroeconomics and monetary policy: “experiments”, if tried at all, have to be done on entire nations.

What are the Swiss being asked to vote on next week?  The Vollgeld (“full money”) initiative is described by its proponents here, and described/analysed by a couple of independent Swiss economists here.

The key element of the proposal is this

The 100% reserves requirement means that all sight deposits in Swiss Francs (CHF) in Switzerland would have to be entirely kept as reserves in the Swiss National Bank. This implies that commercial banks would not be able anymore to use a fraction of these deposits to finance their lending activities, as they currently do. Swiss money would then entirely become “sovereign money”, controlled by the Swiss National Bank.

Proponents of the Vollgeld approach put a great deal of emphasis on something they label as “money”.   As they note, the issuance of notes and coins is controlled by the state –  even if in practice, supply simply respond to demand –  and argue that the same should apply to other transactions balances (eg a traditional cheque account).    Some seem to argue from a principled position that money creation is a natural business of the state, and thus direct control over the quantity of transactions balances created is simply a logical corollary.   Of course, in New Zealand it was almost 80 years after the establishment of responsible government before the state here issued any payments media (coincidentally, but not inconsistently, we were the highest income country in the world through much of that period).  Personally, I’d continue to mount an argument for removing the current state monopoly on the issue of bank notes.

Others focus on more pragmatic arguments around monetary and financial stability.  If all demand deposits are fully backed by deposits at the central bank – or, at the limit, if all demand deposits were directly claims on the central bank – and were held on a separate balance sheet, there would be no more bank runs on demand deposits.

Ideas of this sort aren’t new.  Proponents often hark back to the so-called Chicago Plan proposed by some prominent US economists in the 1930s, and at one stage in his career as orthodox a figure as Milton Friedman favoured 100 per cent reserve requirements for demand deposits.

But if the broad ideas aren’t new then, as the independent Swiss economists observe, runs on demand deposits also aren’t the main issue in real-world financial fragility.  They put that down to the existence of deposit insurance –  although Vollgeld advocates argue that under their system deposit insurance could be got rid of – but whatever the explanation

…the main source of fragility of modern banks is …..rather the wholesale short term debt issued by banks and held by professional investors, including other banks. These investors, who are not insured, may suddenly stop lending to a bank (this is called a wholesale run) if they suspect that the bank may have solvency problems. This wholesale short term debt is an important source of funding for the banks in the current system, but it is also a source of fragility, as the Global Financial Crisis of 2007-2009 has shown. The 100% reserves requirement would not apply to short term debt.

Wholesale funding markets seizing up was an issue even for Australasian banks in 2008/09.

Vollgeld advocates (at least those looking at the issue in detail) are aware of these other sort of “runs”, or market refusals to rollover funding at maturity, but don’t have a detailed response.

To tackle it, paragraph 2 of article 99a of the VGI mentions that the SNB would have the power to set a minimum duration for the debt issued by commercial banks. The VGI does not give much detail on this question, but it is clear that a new liquidity regulation would have to be introduced as a complement to the 100% reserve requirement. Indeed, financial stability can only be guaranteed in the Vollgeld system if the banks are strictly limited in their ability to issue wholesale short term debt as they do today.

I’ve long argued that the issue goes beyond even that.  One could have all –  or almost all – lending done by closed-end mutual funds (ie no early redemption at all, you just sell your claim on the open market) –  something like the model favoured by prominent US economist Larry Kotlikoff – and there would still be financial crises, they would just take a different form.   The nature of a market economy is that people get optimistic, and then over-optimistic, about particular industries, or the economy more generally.  And then opinion changes –  actual outcomes don’t quite meet expectations or whatever – and the flow of new investment, the flow of finance dries up.  The dot-com boom, and subsequent bust, were good examples of that.  So, in their way, were the Australasian post-deregulation booms and subsequent busts in the 1980s (they involved some bank failures late in the post-bust adjustment, but those failures were incidental).

And nothing in the Vollgeld proposals (or in similar Sovereign Money proposals in other countries, including New Zealand) deals with that.  Nor does it really deal with the fact that many countries –  including New Zealand and Australia and Canada –  have gone for a very long time without bank failures (except in that brief post-deregulation transition period), and yet not been immune to recessions, periods of ill-judged investments, or prolonged booms or prolonged periods of underperformance.

Some advocates of reform put a great deal of emphasis on the alleged problem that lending simultaneously creates deposits, at a systemwide level.  This is a feature not a bug.  Lending transfers claims on resources from one person to another, and both sides of that need to be recorded –  if I borrow to buy a house, the counterpart to that is that the seller of the house collects the proceeds of the sale.    These people tend to confuse the position of an individual bank –  for whom secure access to funding is absolutely critical – from the macroeconomics of the system as a whole.   No (later troubled) New Zealand finance company –  none of whom banked with the Reserve Bank – conjured its deposits out of nowhere: they first persuaded depositors and debenture holders to back their business model, and finance all manner of (often quite bad) projects.   The finance companies didn’t fail because they had on-demand deposits (mostly they didn’t) but because they made really bad loans, and were part of the associated misallocation of real resources.  Nothing in the Vollgeld initiative (or similar Sovereign Money proposals) seems to address that.

So why does someone as eminent as Martin Wolf encourage Swiss voters to vote for the Vollgeld initiative on Sunday?     Mostly, it seems from reading his article, because he grossly exaggerates the real economic cost of financial crises, conflating the headline events (runs on banks, wholesale or otherwise, bailouts etc) with the correction for the misallocation of real resources that occurrred during the boom years and (in the case of 2008/09) treating all the slowdown in productivity growth as a consequence of “the financial crisis” when signs of it were already apparent before the crises. (I dealt with some of these issues in this post some time ago. )   Changing the rules around transactions balances just wouldn’t make that much difference.  And although Martin Wolf and the Vollgeld advocates talk bravely of how such reforms might allow governments to more readily walk away from failing banks (ie the bits not offering transactions balances) at best that is aspirational.   AIG and the federal agencies weren’t offering transactions balances –  and were bailed –  and even in New Zealand one of the key motivations for the OBR model isn’t about transactions balances, but about maintaining the credit process (all the information on firms that enables banks to continue to provide working capital finance with confidence).

Over the years, I’ve spent lots of time looking at various monetary reform proposals.  When I was a young economist, Social Credit was still represented in the New Zealand Parliament, and their acolytes regularly wrote to the Governor and the Minister of Finance.  Their ideas genuinely were wrongheaded and dangerous.  In my experience, though, most such proposed reforms aren’t, and they often capture important elements of truth.  But the proponents typically oversell the likely gains from what they are proposing.  I don’t think the Vollgeld initiative model would be particularly damaging or costly –  although there are a lot of details not spelled out, and the transition could be very unsettling (especially in a world of zero or negative interest rates) – but it just wouldn’t offer the gains the proponents claim.  Monetary matters are rarely quite that important and in a market economy, human nature will have its head, and sometimes things will turn out badly.  More often, of course, real financial crises reflect wrongheaded policy interventions that skewed choices and incentives and made the bad outcomes more likely (I’d include both the US crisis of 2008/09, and the Irish crisis in that category –  and probably the Australasian and Nordic crises of the late 80s and early 90s).

In truth, calls for reform (from people like Wolf) and public support for ideas like the Vollgeld one (apparently perhaps 35 per cent of people may vote for it), probably stem more from some ill-defined sense that something is wrong (with economic and political outcomes).  Banks and monetary systems are a convenient target –  just like the idea here that somehow fixing monetary policy might make a material difference to our economic underperformance – but probably the wrong one.

Readers sometimes suggest that the Reserve Bank is reluctant to ever fully engage with alternative models. I’m not sure what they’ve been doing more recently, but when I was at the Bank I spent quite a bit of time over the years unpicking various proposals and trying to understand their strengths and weaknesses.  It wasn’t always very systematic, and often depended on the interests of individuals, but I’d be surprised if the Bank is that much different now.  We even used to send people along to debate some of those proposing alternative models.  A speech I did along those lines is here.   I’m not sure I’d stand by absolutely everything in it today, but we were an institution willing to engage.

Another Orr interview

The Governor of the Reserve Bank was interviewed over the weekend on Newshub Nation. Perhaps even fewer people than usual watched the programme, since it was  on over a holiday weekend, but I saw a few comments –  public and private –  suggesting it was a rather odd performance so I finally had a look myself.  I had to agree with the commenters.

There were three broad topics covered in the interview:

  • infrastructure finance,
  • bank conduct issues, and
  • mortgage lending.

Of those three topics, only the third is really within the ambit of the Governor’s responsibilities.

On infrastructure finance, you’ll recall that a few weeks ago the Governor weighed in on this issue, claiming to be speaking both in his former capacity of head of the New Zealand Superannuation Fund (NZSF) and in his current role as Governor.  He was venting about his frustration that NZSF had not been able to invest in infrastructure projects in Christchurch after the earthquakes.

“My single biggest frustration when I was at the Super Fund was the inability to be able to invest in New Zealand infrastructure.

“We never got to spend a single penny in Christchurch. I stopped going down. It became too hard,” Orr said.

“I went down, even once CERA [the Canterbury Earthquake Recovery Authority] was formed, and the person said ‘it’s great to see you here, Minister [Gerry] Brownlee is very pleased you’re here. Now, tell me again which KiwiSaver fund you’re from’.”

Understandably, that upset Gerry Brownlee and prompted a rare criticism of a central bank Governor from the Leader of the Opposition and a suggestion that the Governor should stick to his knitting –  the core stuff he now has legal responsibility for.

Orr now claims he wasn’t being specifically critical of the Christchurch situation –  although see the quote – and that he was just making a general point, one he is not defensive about at all.  There isn’t, in his view, enough “outside capital” being brought into infrastructure development, here and abroad.

His mandate, so he claimed in this latest interview, was his obligation to contribute to “maximum sustainable employment” –  the words recently added to the Policy Targets Agreement governing the conduct of monetary policy.   As I’ve pointed out recently, this argument just doesn’t stack up: the words in the PTA are about the conduct of monetary policy (interest rates and all that) not a licence for the Governor to get on his bully pulpit and start lecturing us –  politicians and citizens –  about all manner of other policies he happens to think might be a good idea.   It is a doubly flawed argument because even the new monetary policy mandate is about employment –  not productivity or GDP per capita –  and the Governor will know very well that you can have a poor fully-employed economy or a prosperous fully-employed economy.   Infrastructure finance –  even well done –  has almost nothing to do with sustainable levels of employment.

In the latest interview, he was asked (very first question) about the recent bid by NZSF to invest in light rail in Auckland.  Instead of gently reminding the interviewer that such things aren’t his responsibility any longer, the Governor weighed in.  Any opportunity for outside capital should be welcomed, we were told.  The Governor went on to lament the “hang-ups” people have –  “people”, we were told, were the problem here, “getting in the way” of sensible solutions.  The Governor complained that all this leads to infrastructure being financed by debt or taxes, when it really should –  in his view –  be financed by equity (perhaps he didn’t notice that the NZSF itself was, and is, funded by debt and taxes, or that he has previously called for governments to take on more debt).  The Governor complained about politicians being scared of tolls, and argued that they “need to get over it”.     Challenged as to whether these were not political debates, the Governor argued that he was trying to get these out of the political debate –  as if mere citizens, the dread “people”, might not reasonably have a view not only on what projects should be done, but how they should be owned/financed.   Wrapping up that particular segment of the interview, the Governor opined that the wider economic benefits of light rail were “incredibly important” to maximising sustainable employment”.

It all remains, as I put it some weeks ago, very unwise and quite inappropriate.  Even if his views had merit (which, I would argue, they mostly don’t), these are issues which have nothing to do with the Reserve Bank (where the Governor wields a great deal of barely trammelled power).  As I put it in an earlier post

The Governor holds an important public office, in which he wields (singlehandedly at present) enormous power in a limited range of areas.  It really matters –  if we care at all about avoiding the politicisation of all our institutions –  that officials like the Governor (or the Police Commissioner, the Chief Justice, the Ombudsman or whoever) are regarded as trustworthy, and not believed to be using the specific platform they’ve been afforded to advance personal agendas in areas miles outside the mandate Parliament has given them.   We don’t want a climate in which only partisan hacks have any confidence in officeholders, and only then when their side got to appoint the particular officeholder.  And that is the path Adrian Orr seems –  no doubt unintentionally – to be taking us down. 

The arrogance of it all is pretty breathtaking too –  we “the people” are the problem.  Officials and politicians sometimes say things like that in private (feeling that they really deserve a better class of “people”), but generally not in public.  And the Governor seems to have no conception of the way in which genuine outside capital in a private project in a competitive industry, where all the gains and losses accrue to the private providers, differs from the public-private partnerships he waxes lyrical about (even while championing what would, at best, have been only public-public partnerships, since NZSF is just another pot of government money).    Contracting, in ways that both preserves the public interest and ensures continuity of high quality service, has proved hellishly difficult.   Providers of outside capital in PPPs –  whether state entities of the sort Orr has championed or private ones –  don’t care at all about the fundamental merits of a particular project, so long as they can write a contract that more or less guarantees returns to them.  In such a world, easy access to money can be a recipe for a smoother road to more really bad projects being done –  anyone recall the synthetic petrol plant, as an example of outside capital and guaranteed rates of return?

I’m not suggesting the Governor is totally wrong –  I’m pretty sympathetic to congestion pricing on city roads for example –  but in his official capacity, it is none of his business.    There is a vacancy coming up for Secretary to the Treasury; perhaps could apply for that position?  Or he could run for Parliament –  though probably not with that dismissive attitude to “the people” –  or retire and get a newspaper column.  But it is nothing to do with the Reserve Bank, and he jeopardises the Bank’s position –  both the ability to do its day job with general support, and increasing the chances of future partisan hack appointments –  if he goes on this way.

And what about his claim that infrastructure finance is really core to what the Reserve Bank does?  There was this from his public statement a couple of weeks ago

I have spoken about specific issues recently because increased infrastructure investment opportunities provide sound investment choices, risk diversification for financing goods and services, and improves maximum sustainable employment by relieving capacity constraints.

These are all core components of the Reserve Bank’s role and something we often speak about in our Financial Stability Reports.

In the last month, we’ve had a Monetary Policy Statement and a Financial Stability Report.  There were no mentions at all of infrastructure in the Monetary Policy Statement and, once again, a single mention in the Financial Stability Report –  a brief reference to “market infrastructure”.  The Governor just seems to be making it up on the fly, when these issues are no more part of his official brief than most other areas of government policy are.  

The second strand of the weekend interview had to do the ongoing banking conduct investigation  –  in which the Reserve Bank and the FMA demand banks and insurers prove their innocence, on points which (at least in the Reserve Bank’s case) are really not the government agency’s business.  There wasn’t much new in this part of the interview, apart from the somewhat surprising claim that the Reserve Bank has a very good insight into banks and insurers (which makes you wonder how CBL failed, or Westpac ended up using unapproved capital models for years, or how a few weeks ago the Governor could have been convinced there were no problems here, but now leaves open the possibility that he could recommend a Royal Commission).

As the Governor ran through his checklist of issues, it was more and more clear how little any of this had to do with the Reserve Bank’s statutory responsibilities.  He was concerned, for example, as to whether banks were “customer-focused”.  Personally, I rather hope that, as private businesses, they are shareholder-focused, working first in the interests of the owners.   Now, working in the interests of the owners does not preclude caring a great deal about good customer service (whether in banking or any other sector) but it shouldn’t be the prime goal.  And whether or not banks offer good customer service has very little to do with the Reserve Bank’s statutory focus on the soundness and efficiency of the financial system.    Perhaps we all wish it did, but some friendly customer-focused banks fail, and most flinty hardnosed one don’t, and vice versa.  There is no particular connection.

Similarly, the Governor was concerned about remediation when customers have problems with their banks.  Perhaps there is a role for some agency of government to take an interest (perhaps…..) but there is no obvious connection to the Reserve Bank’s prudential regulatory functions.  Over the years I’ve had plenty more complaints about my supermarket than about my bank, but (fortunately) no one seems to think governments should regulate customer service in supermarkets.

The Governor has found a partial defender in Gareth Vaughan at interest.co.nz.  But as Vaughan notes, it hasn’t typically been the Reserve Bank way

In 2015 when Australian authorities were probing high credit card interest rates, my colleague Jenée Tibshraeny tried to find someone, anyone, in a position of power in New Zealand to take an interest in credit card interest rates here that were at similar levels to Australia. This is what a Reserve Bank spokesman told Jenée;

“The Reserve Bank of New Zealand regulates banks, insurers, and non-bank deposit takers (NBDTs) at a systemic level – i.e. to make sure the financial system remains sound.”

“We don’t regulate from an individual customer protection perspective and don’t have comment to offer about pricing of products and services offered by banks, insurers and NBDTs,” a Reserve Bank spokesman said in 2015.

That stance is entirely consistent with the legislation the Reserve Bank operates under.  Vaughan concludes

Personally I welcome the Reserve Bank thinking of consumers, be they borrowers, savers or insurance policyholders. By taking an interest in consumer outcomes Orr is humanising the Reserve Bank, and making it more relevant to the general public.

However, if this is the path the Reserve Bank wants to go down, and has government support to do so, then perhaps phase 2 of the Government’s Reserve Bank Act review is a good opportunity to enshrine this more consumer outcomes focused role into the Reserve Bank Act. The terms of reference for Phase 2 are due to be published during June.

In a sense, that is the point.   Responsibilities of government agencies are something for Parliament –  the pesky “people” and their representatives again –  to assign, not for individual officials to grab.  I happen to disagree with Vaughan here –  between the FMA and generic consumer protection law, there is no obvious gap for the Reserve Bank –  but it should be a matter for Parliament.

It remains hard not to conclude that Orr is driving this populist bandwagon for two reasons:

  • to avoid letting the FMA take the limelight (the Reserve Bank has never been keen to play second fiddle to the FMA, especially on anything affecting banks) and
  • to distract attention from the Reserve Bank’s own poor performance as a prudential regulator, encapsulated in the recent scathing feedback in the New Zealand Initiative report.

He seems to have been remarkably successful so far – journalists seem to have been so pleasantly surprised by on-the-record media access to the Governor that they don’t bother asking the hard questions, and the Governor gets to portray himself as some sort of tribune of the abused masses (with or without evidence).

Personally, I find the sort of concerns outlined in today’s Australian about the Royal Commission itself , or concerns about the potential for these show trials to reduce access to credit, including (in particular) for small businesses, ones our officials or politicians might take rather more seriously.  But, probably, feel-good rhetoric is more satisfying in the short-term.

The final part of the Governor’s interview was about mortgage lending.  It wasn’t impressive.  The Governor declared that “we’re scared” about the high debt to income ratios evident among households with mortgages, but then in the next breath stressed that banks were very well capitalised and highly liquid etc.     Those two observations are simply inconsistent: if the Reserve Bank really has grounds to be scared (a) bad outcomes should be showing up in their stress tests (which they don’t) and (b) the Bank should be articulating a concern that banks are insufficiently capitalised and raising capital requirements further.  And it isn’t clear how the Governor thinks that, in a regulatory climate in which land prices are driven artificially high, ordinary people would be able to buy a house without a very high initial debt to income ratio.  But this seems to have become an evidence and argument-free zone, in favour of emoting about the “high debt” (not, as I noted last week, much higher relative to income than it was a decade ago).

The final question in the entire interview was about whether loans for Kiwibuild houses should be exempt from the LVR restrictions.  The Governor’s initial response was that he didn’t know, and couldn’t answer.  But then, pushed a little further, he expressed a view that such loans should be exempt……..they were, after all, about adding supply, and doing it quickly, and helping low income people into homes who might not otherwise be able to manage it.

Quite what was going on there wasn’t very clear.  There is already an exemption for people purchasing new houses (and any debt developers take on in the construction phase isn’t covered by LVR restrictions anyway).

The new dwelling construction exemption applies to most residential mortgage lending to finance the construction of a new residential property.

The construction loan should either be
(1) for a property where the borrower has made a financial and legal commitment to buy in the form of a purchase contract with the builder, prior to the property being built or at an early stage in construction. This could be traditional ‘construction lending’ where the loan is disbursed in staged payments, or it could be a loan to finance the purchase of a property, which will be settled (in one payment) once the build is complete.

(2) For a newly-built entire dwelling completed less than six months before the mortgage application. The dwelling must be purchased from the original developer (the contract to buy at completion can be agreed while the building is still being constructed).

This exemption didn’t exist when LVR were first rushed in by the previous Governor, but pretty quickly industry and political pressure built up and the Reserve Bank amended the policy.  In doing so, they revealed the fundamental incoherence of the LVR framework:  the Reserve Bank has always claimed that it is about protecting financial stability and reducing (their view) of excess risk in bank mortgage books.  And yet, lending on new properties –  all else equal – is riskier than lending on existing houses.  Existing houses are, for one thing, finished.  They are also in areas that have been occupied for some time.  By contrast, new houses –  especially in new subdivisions –  can be left high and dry when and if the property turns, or the economy turns down.  Think of the pictures of abandoned subdivisions on the outskirts of Dublin, or of some US cities in the last downturn.

And the Governor’s, apparently off the cuff, suggestion that credit restrictions should be easier for low income people who might not otherwise be able to get into a house, was distressingly reminiscent of the US policies –  political and bureaucratic – in the decade before the US crisis, which ended badly (for banks, and for many borrowers).   It is a recipe for encouraging banks –  supposed to be “customer-focused” in the Governor’s view –  to be more ready to lend to people relatively less able to support debt.  It is, frankly, irresponsible.   (And all this is before one even gets to questions about the extent to which Kiwibuild will simply crowd out other construction –  the Bank’s analysis on which they simply refuse to release, despite having opined on the issue in past MPSs.)

The quality of policymaking – official and political – in New Zealand has fallen away quite sharply in the last 15 or 20 years.  Sadly, Adrian Orr as Governor increasingly seems at risk of averaging it down further.  All while showing no sign of addressing the problems in his own backyard –  whether as regulator, analyst, or as sponsor.