Bouquets and brickbats for the ANZ

In July last year, while the Reserve Bank was consulting on the latest extension in its (seemingly) ever-widening web of controls –  this one, restricting mortgages for residential investment properties to 60 per cent LVRs –  David Hisco, the chief executive of the local arm of the ANZ bank, went very public arguing that the Reserve Bank wasn’t going far enough.

Heavily increase LVR limits for property investors. The Reserve Bank wants most property investors around the country to have 40 percent deposits in future. We think they should go harder and ask for 60 percent. Almost half of house sales in Auckland are to property investors. Taking them out of the market will be unpopular amongst investors but it may end up doing them a favour. Of course this would mean less business for us banks but right now the solution calls for everyone to adjust.

It was an interesting stance.  As I noted at the time (a) there was nothing at all to stop the ANZ tightening up its lending conditions along those lines if they thought such restriction was prudent, but (b) the ANZ’s own economics team, in a piece issued the very same week, had been less than convinced of the case for even the Reserve Bank’s own more-modest proposed restrictions.

To us, the case for requiring investors to have a 40% deposit is not overly
strong. This is particularly considering the RBNZ’s own stress tests and the fact that most investor lending was already done at sub-70 LVRs anyway.

I noted then that

There must be some interesting conversations going on at the ANZ.  It would be very interesting to see the ANZ submission on the Reserve Bank’s proposals, and if the Reserve Bank won’t release it, there is nothing to stop ANZ itself doing so.  I’ll be surprised if they do, and even more surprised if the submission recommends limiting all investors throughout the country to LVRs not in excess of 40 per cent.

The Reserve Bank has long been quite resistant to releasing submissions made on regulatory proposals –  even though if, say, you make a submission to a select committee on a proposed new law that submission will routinely, and quite quickly, be published.  Under pressure, the Reserve Bank has slowly been backing away. First, they agreed to release submissions from entities they didn’t regulate, while refusing to release anything from regulated entities (banks in this case).  They rely in their defence on a provision of the Reserve Bank Act which, even if it legally means what the Bank has claimed it does, was never intended to enable permanent secrecy for submissions on general policy proposals.  The Bank has now reviewed its stance again, and has now agreed to release/publish submissions made by regulated entities but only if those entities themselves consent (and subject to normal provisions allowing commercially sensitive information to be withheld).  Partly presumably because I had appealed to the Ombudsman over the withholding of bank submissions on last year’s extension of the LVR controls, they have now decided to apply this new stance retrospectively.

Yesterday I received a letter from the Reserve Bank

The Reserve Bank has sought the consent of the registered banks to provide to you their submissions from the consultation on adjustments to restrictions on high-LVR residential mortgage lending. We have obtained consent from ANZ Bank to release its submission to the consultation. Accordingly, the submission from ANZ Bank is being provided to you under the provisions of section 105(2)(a) of the Reserve Bank of New Zealand Act 1989.  Some parts of the submission have been redacted by ANZ Bank as a condition of its consent.

Other registered banks have not provided consent and submissions provided by other registered banks continue to be withheld

Of course, ANZ could have released the submission itself months ago, but they still deserve credit for agreeing to the release even at this late date.   I hope this move foreshadows routine willingness to allow ANZ submissions to the Reserve Bank to be published.

The ANZ stance contrasts very favourably with that of the other banks.    Given the risks of regulators and the regulated getting too close to each other, at risk to the public interest, getting the submissions of regulated entities published should be a basic feature of open government, and the continued reluctance doesn’t reflect well on either the Reserve Bank or the other commercial banks.  What do they have to hide?

Apparently the Reserve Bank will be putting a link to the ANZ submission (as redacted) on their website shortly [now there, together with all the other LVR submissions and material they’ve released over the years] but for now here it is.

anz-response-to-lvr-consultation

Perhaps to no one’s surprise, there is nothing in the submission suggesting that ANZ would have favoured a more restrictive approach (of the sort outlined by the chief executive a few weeks earlier).

anz-on-lvr

It wouldn’t have cost them anything to have advocated the chief executive’s preferred position –  after all, it wasn’t likely that the Reserve Bank would adopt it anyway –  but there is no suggestion, not even a hint, that our largest commercial bank thought the Reserve Bank wasn’t going far enough.

I noted at the time

But I don’t suppose we will actually see ANZ move to ban all mortgages for residential investors with LVRs in excess of 40 per cent.  Instead, Hisco wants the Reserve Bank to do it for him.    That would enable him to tell his Board that he simply had no choice, and provide cover when profits fell below shareholder expectations.  That should be no way to run a business in a market economy –  although sadly too often it is.

Reality seems to be even worse, in some respects.   Not only did ANZ not pull its own LVR limits back to 40 per cent, they didn’t even take the opportunity of a (then) private submission to the regulator to make their case for a tougher policy.  Instead, it looks a lot like they were just going for the free publicity of a call for bold action, while never having had any intention of doing anything about it.   It isn’t exactly straightforward.  Of course, they are free to do it if they can get away with it, but it doesn’t look like the sort of ethical behaviour we might hope for from senior figures in major financial institutions.

Although the Reserve Bank was consulting on extending LVR restrictions, quite a lot of the ANZ’s submission is devoted to what appear to be mostly sensible concerns about the possible extension of the regulatory net to include debt to income limits.  The Reserve Bank is apparently about to launch a consultation on the possible addition of debt to income limits to its “approved” tool-kit (technically it doesn’t need anyone’s approval to use them).  I hope that the forthcoming consultative document takes seriously the practical problems various people, including the ANZ, have already raised.

I welcomed the recent decision of the Minister of Finance to require the Reserve Bank to undertake public consultation now, not just at the point they want to use DTIs.  Perhaps his motivations were somewhat mixed –  there is after all an election only a few months away –  but there is probably a better chance of the Governor taking submissions seriously now than at a point when the Governor has already decided he wants to use the tool, perhaps as a matter of urgency.    Having said all that, I was a little bemused at the suggestion from the Minister that the Reserve Bank should now do a cost-benefit analysis on the use of DTIs. I’m all in favour of such analysis, and am concerned that too often there is no attempt to quantify the costs and benefits of proposed interventions, but……it isn’t clear how one can do a cost-benefit analysis on an intervention except in the specific circumstances that might arguably warrant the deployment of the instrument.  One surely needs to know the specific threat to be able to evaluate the chance that a proposed intervention might mitigate the risks?

Deposit insurance

Late on Friday afternoon, Stuff posted an op-ed piece calling for the introduction of a (funded) deposit insurance scheme in New Zealand.  It was written by Geof Mortlock, a former colleague of mine at the Reserve Bank, who has spent most of his career on banking risk issues, including having been heavily involved in the handling of the failure, and resulting statutory management, of DFC.

As the IMF recently reported, all European countries (advanced or emerging) and all advanced economies have deposit insurance, with the exception of San Marino, Israel and New Zealand.   An increasing number of people have been calling for our politicians to rethink New Zealand’s stance in opposition to deposit insurance.   I wrote about the issue myself just a couple of months ago, in response to some new material from the Reserve Bank which continues to oppose deposit insurance.

Different people emphasise different arguments in making the case for New Zealand to adopt a deposit insurance scheme.  Geof lists four arguments in his article

  • providing small depositors with certainty that they are protected from losses up to a clearly defined amount;
  • providing depositors with prompt access to their protected deposits in a bank failure;
  • reducing the risk of depositor runs and resultant instability in the banking system;
  • reducing the political pressure on government to bail-out banks in distress – deposit insurance would actually make Open Bank Resolution more politically realistic.

Of these, I emphasise the fourth.  I’m not convinced that there is a compelling public policy interest in protecting depositors, small or otherwise (many schemes cover deposits of $250000, sometimes per depositor per bank).   There are plenty of other bad things in life that we don’t protect people from (the economic consequences of) –  job losses, fluctuating house values, road accidents, bad marriages and so on.  The ultimate state safety net is the welfare system, which provides baseline levels of income support.  Should “deposits” or “money” be different?  I’m not sure I can see good economic arguments why (although there are good reasons why in the market debt and equity instruments co-exist, and debt instruments generally require less day-to-day monitoring by the holders of those instruments).

And there is a  variety of ways of providing depositors with prompt access to funds following a bank failure.  A bailout is one of them.  OBR is another.  And deposit insurance, in and of itself, doesn’t ensure prompt access to funds; it just ensures that the insured amount is fully protected (minus any co-payment, or deductible).

I’m also not persuaded that deposit insurance reduces instability in the banking system.  International historical evidence has been that in many or most cases,  depositors can distinguish, broadly speaking, the weaker banks from the stronger banks in deciding whether to run (I would argue that the UK experience with Northern Rock is one recent observation in support of that proposition).  And anything that weakens, albeit marginally, market discipline (in this case, by reducing the incentive on deposits to monitor risk and respond accordingly) can’t be likely to contribute to greater stability in banking systems.  Deposit guarantees for South Canterbury Finance only postponed, and probably worsened, the eventual day of reckoning.

But I find the political economy arguments for deposit insurance (at least in respect of large banks) compelling.  I outlined the case more fully in my earlier post.  If we don’t want governments bailing out all the creditors of a failing bank (large and small, domestic and foreign), we need to build institutions that recognize the pressures that drive bailouts and take account of that political economy.  It is futile –  and probably costly in the long run  –  to simply pretend that those pressures don’t exist.  In its recent published material, the Reserve Bank again just ignores these arguments, but they know them.  In fact, I found a quote from Toby Fiennes, their head of banking supervision, who correctly observed a few years ago that

some form of depositor protection arrangement may make it easier for the government of the day to impose a resolution such as OBR that does not involve taxpayer support – in effect the political “noise” from depositor voters is dealt with,” said Fiennes

As I’ve noted previously, in the last thirty years:

  • The BNZ was bailed out by the government
  • Finance company (and bank) deposits were guaranteed by the government
  • AMI was bailed out by the government
And each of those bailouts/protections was done on the advice of the Reserve Bank and Treasury.  Two were put in place by National governments and the other (the 2008 deposit guarantee scheme) was done with the support of the then National Opposition.
We have let other institutions fail, and creditors lose their money.  Wholesale creditors of DFC lost material amounts of money in that failure (the few retail creditors were protected, mostly for convenience in dealing with the main creditors), various finance companies failed before the guarantees were put in place, and one other insurance company failed after the Christchurch earthquakes and was not bailed out.   So our governments have a track record of being willing to allow people to lose their money when financial institutions fail, if the number of people involved is quite small, or the creditors are foreign. But they have no track record of being willing to allow large numbers of domestic depositors/policyholders to lose money in the event of a financial institution failing –  and it is not as if these examples are all ancient history; two were resolved under the current government.

And it is not as if governments in other advanced countries have been any more willing to allow retail depositors to lose money.  Most of our major banks are Australian-owned, and Australia has relatively recently adopted a deposit insurance scheme, reinforcing the longstanding statutory preferential claim Australian depositors have over the assets of Australian banks.  In the event of the failure of an Australian-owned banking group, why should we suppose voters here will tolerate losing large proportions of their deposits when they see their counterparts in Australia –  in the same banking group –  protected?    The Australian government  –  in the lead in resolving such a failure – is unlikely to be receptive to such a stance either, and if they can’t force us to protect our depositors, there are lots of strands to the trans-Tasman relationship, and ways of exerting pressure if our government did choose to make a stand.

A deposit insurance scheme heightens the chances of being able to use OBR, and thus to impose losses on wholesale creditors, many of whom will be foreign.

But it doesn’t guarantee it.   I noticed that Geof’s article included this paragraph

Since the global financial crisis, many countries, including New Zealand, have developed policies that enable even large bank failures to be handled in ways that minimise the prospect of a taxpayer bail-out, by forcing shareholders, then creditors (including depositors), to absorb losses.

I am less optimistic than Geof here.  Countries have been moving in the right direction, of trying to establish resolution mechanisms that would enable bank failures to occur without taxpayer bailouts, and in which large and wholesale creditors would face direct losses.  But none of these mechanisms has really been tested yet.  I’m yet to be convinced that the authorities in Britain or the US would be any more ready to let one of their major banks fail, with creditors bearing losses, than they were in 2008.

I’m reminded of a story Alan Bollard once told us about his time as Secretary to the Treasury. Faced with the prospect of Air New Zealand failing, the Prime Minister of the time asked if Treasury could guarantee that if Air New Zealand failed the koru would be still be flying the following week.  Unable to offer any such assurance, the government decided on a bailout.  Faced with the prospect of the failure of one of our larger banks, the Prime Minister might reasonably ask the Reserve Bank and Treasury whether they could assure him that, if he went ahead and allowed OBR to be imposed, other New Zealand banks and borrowers would still be able to tap the international markets the next week.  At best, officials could surely only offer an equivocal answer.  Bailouts remain likely for any major institution (especially as, in our case, resolution of any major bank involves two governments).

I hope I am too pessimistic in respect of wholesale creditors.  And we shouldn’t simply give up because there is a risk that governments might blanch and bail out the entire institution.  But the best chance of governments being willing to impose losses on larger creditors in the event of failure, is to recognize that the pressures to bailout retail depositors will be overwhelming, and to establish institutions that internalize the cost of that (overwhelmingly probable) choice.  A moderately well-run deposit insurance scheme does that, by imposing a levy on banks for the insurance offered to their depositors.

As Geof notes, he has changed his stance on deposit insurance.   Looking around the web, I stumbled on  “Deposit insurance: Should New Zealand adopt it and what role does it play in a bank failure” a 2005 paper, by Geof and one of his colleagues (now a senior manager at TSB) on deposit insurance, which has been released under the OIA.   It is a useful summary of some of the counter-arguments.

One of the issues it covers is the question  of whether, instead of adopting deposit insurance, we could achieve much the same outcome by using the de minimis provisions in the OBR scheme.  Under those provisions (built into the prepositioned software) deposits up to a certain designated amount can be fully protected, and not subject to the haircut.

As I’ve noted previously, this provision might be useful if it was only a few hundred dollars –  effectively, say, protecting the modest bank balance of a very low income earner or superannuitant, who needed each dollar of a week’s income to survive.  It might be tidier to have all these small balances protected than to have all these people turning to food banks. It might also keep down the ongoing administrative costs of the statutory management, by keeping many very small depositors out of the net   But the de minimis provisions are not a serious substitute for deposit insurance, on the sort of scale that it is typically offered at.  Any preference for very small depositors comes at the expense of the rest of the creditors.  That might be tolerable for small balances in a large institutions with lots of funding streams.    It is much less so in a bank that is largely retail funded, and quickly becomes impossible in such banks once the level of protection rises above basic weekly subsistence levels.  And, of course, no one knows what the de minimis level is, so the risk (facing other creditors) cannot be properly priced.  By contrast, a deposit insurance scheme can be set, at priced, at pre-specified credible levels.

If we were to establish a deposit insurance scheme in New Zealand, there are many operational details to work through.  One, of course, is the pricing regime.   In his article, Geof notes that

‘the cost is small –  no more than a small fraction of a percentage point per annum on each dollar of bank deposit”

I’m less convinced that that is the correct answer.  There is a market price for insuring against the risk of bank failure, and associated losses on debt instrument.  That is what credit default swaps are for.  Historically, in the decade or so prior to the crisis, premia on Australian bank CDSs were very low.  We used them in setting the price for the deposit guarantee scheme in 2008, and from memory they had averaged under 10 basis points.  That isn’t so any longer,  and for the last few years the average premium has been more like 100 basis points (fluctuating with global risk sentiment) –  nicely illustrated here. Bank supervisors would, no doubt, tell us that these premia far overstate the risk of loss –  and I would probably agree with them (and certainly did in 2008, when we used historical pricing) –  but it is the market price of insurance.  Is there a good reason why government deposit insurance funds should charge less?

It is time to adopt a deposit insurance scheme in New Zealand –  not, in my view, because people necessarily should be insulated against losses, but because governments will do so anyway.  In the face of such overwhelming pressures (and track record here and abroad) we are best to build institutions that help limit and manage that risk, and which charge people for the protection that governments are offering them, while making it clearer and more credible that others –  outside that net –  will be expected to bear losses in the event of a bank failure.

Kiwibank: a retrograde step

I wrote about Kiwibank last week, noting that there had never been a good economic reason for the Crown to have established it, and that there was not a good economic reason for the Crown to continue to own it.   Doing so undermines (modestly) the efficiency of the financial system, and poses unnecessary risks for taxpayers.

I take it that the Minister of Finance agrees.  Listening to him on Morning Report, unable to give any reason why the government should own a bank other than “it is government policy that we do so”, one almost felt a little sorry for him.  Then again, he is the Deputy Prime Minister.

What to make of yesterday’s announcement from New Zealand Post?  The plan is that NZ Post will sell 45 per cent of its stake in Kiwi Group Holdings (KGH) to ACC (20 per cent) and the New Zealand Superannuation Fund (25 per cent), at a price which values KGH at $1.1 billion.

In some ways, the price tells us what we need to know about Kiwibank.  The book value of shareholders’ equity in KGH as at 31 December 2015 was $1.304 billion, and yet the sale is going to go through at the equivalent of $1.1 billion (or perhaps lower if due diligence shows up some problems).   That is around 85 per cent of book value.

When I checked yesterday, the four Australian banks appeared to be trading on the stock exchange at anything from 1.2 to 2.1 times book value.  And the Reserve Bank of Australia ran this nice chart in their last Financial Stability Review

graph-1.17

Note where the Australian and Canadian banks have been trading.  By contrast, banks in much of the rest of the world, where there have been real doubts about asset quality or earnings potential have been trading at or below book value since the 2008/09 recession.

The deal also values KGH at eight times last year’s earnings ($137 million).  A quick check suggests that five listed Australian banks (the four operating here and the Bank of Queensland) are trading, on average, at prices around 11.5 times last year’s earnings.

Kiwibank just isn’t a very profitable bank.  Last week I showed this slightly-dated Treasury chart:

bank roa

But, of course, there are other reasons for a fairly low price:

  • Given the government’s determination not to privatize Kiwibank (even partially), there were no other possible takers.  ACC and NZSF no doubt knew that.
  • ACC and NZSF will, apparently, be locked in for the first five years (beyond the next two elections), unable to sell out, and yet without effective control (individually or jointly).  Some finance guru could no doubt value that (loss of) option, but I wouldn’t have thought it would be a trivial amount.

As Michael Cullen noted yesterday, if there had been a sale into private ownership it would have “almost certainly led to a higher price” for NZ Post.

At one level, the price of the transaction does not matter unduly, as all the buyers and sellers are ultimately owned by the New Zealand government.  In fact, the price should probably be the least of the worries.

The cleaner alternative approach to deal with Kiwibank (KGH) would have been for the government itself to have simply purchased KGH from NZ Post, and established KGH as a proper SOE, subject to proper SOE monitoring and accountability arrangements.  In the short-term, it would have made little or no difference to Kiwibank which option was chosen.  And it would have had the advantage of totally and immediately separating NZ Post and Kiwibank, enabling the directors and managers of NZ Post to focus solely on their troubled business.   But, of course, doing so would have involved immediate Crown cash outlays (to NZ Post, even if much of it came back shortly thereafter as a special dividend), while yesterday’s clever wheeze involves cash flowing into the Crown accounts (from those other government entities, ACC and NZSF) via the special dividend NZ Post will pay.  The cash flows don’t change the economic value to the overall Crown balance sheet.

Although the deal has been presented as making it easier for the owners to provide any future capital injections to Kiwibank that might be thought warranted (beyond what retained earnings –  the way most banks grow –  would allow), that isn’t an argument for the particular form of yesterday’s deal, as opposed to simply taking KGH directly into Crown ownership as an SOE.    After all, central government has considerably deeper pockets than either ACC or the NZSF.   At least on the basis of last year’s Annual Report, the proposed KGH investment (at $210m) will already be ACC’s largest single equity investment.

acc

It would also appear to be the largest equity holding for NZSF.  These don’t seem like organisations with sufficiently deep pockets that they would (or should anyway) be wanting much more exposure to a single entity, a minor (not overly financially successful) player in its own sector, than they will already have if this deal is completed.

I’m extremely wary of the state owning a bank, but if we are going to own it, I’d rather the question of any additional capital was being decided by the elected representatives of the owners, who we can kick out.

The deal has been presented by NZ Post as offering benefits to Kiwibank through the “long-term investment horizons” and “expertise” of ACC and NZSF investment managers.  For better or worse, the central government has actually tended to have a longer-term investment horizon than either institution (NZ Post in its current form was set up almost thirty years ago, the predecessor Post Office based bank ran under central government for well over 100 years).   And as for investment expertise, well, yes no doubt.  But Kiwibank is a retail bank, and neither ACC nor NZSF has any particular expertise in retail banking –  and nor would one expect, or want, them to (after all, as NZSF’s head of investment’s noted in last year’s Annual Report, NZSF is statutorily prohibited from having control of operational businesses).  Both ACC and NZSF are funds managers.  They seem to do that job moderately well (I’m much more skeptical of NZSF, but that is a topic for another day), through some mix of strategic asset allocation and tactical stock selection, but that isn’t the sort of expertise that helps generate a strong profitable retail bank.

Curiously, the sorts of expertise ACC or NZSF might have already seem rather well represented on the Kiwibank board, not one of whom has retail banking experience or apparent expertise.  Perhaps the Board will change under the new ownership, but why should we suppose that government funds such as ACC or NZSF will be better able to nominate suitable directors than NZ Post was (and in any case, for now NZ Post will retain the majority shareholding).

The paper-shuffling doesn’t have the feel of a long-term arrangement.  ACC, in particular, seems unlikely to be a natural holder of a 20 per cent stake in any company, and NZSF probably shouldn’t be.  A constant risk around NZSF has been that it would be used for political purposes: a large pool of money just waiting for people with “good ideas”  –  and a major ownership stake in a politically totemic, modestly performing,  bank is just an example of that sort of risk.

And so this deal has the feel of short-term opportunism.  Immediate cash inflows for the government rather than immediate cash outflows (with no difference in economic value between the two), and a way of making it perhaps just a little easier to privatize the bank if political conditions were to change.  No doubt for now, if ACC and NZSF wanted out, the Crown would repurchase the shares.  But if the political winds change a little, then, for example, the five year minimum holding periods could be waived if it suited the Crown to do so, and it might be rather easier for NZSF and ACC to dribble their shares out into private institutional hands gradually, at one remove from the decisions of politicians, than for politicians to choose a trade sale, or even a modest IPO.

I favour privatization, but also favour good government, and clear transparent lines of accountability.  This deal doesn’t look the way we should be running things.  We have a fairly good framework for Crown-owned operating businesses, the State-Owned Enterprises Act.  It should be used for Kiwibank (and KGH) and when the time comes the debate around privatization, partial or full, should be had directly and openly, between politicians, and citizens (as was done with the power companies, and all past privatisations), not by reshuffling holdings of major Crown assets into arms-lengths agencies that can offer little or nothing new to Kiwibank, and face neither market discipline, or effective public accountability themselves (indeed, in the case of NZSF, that lack of effective political accountability was the whole point of the governance structure).

Having said that the SOE Act has been a pretty good framework over 30 years for governing Crown-owned operating businesses, I was somewhat disconcerted to note yesterday how politicized the NZ Post press statement was.    The statement from Bill English and Todd McLay headed “Kiwibank to remain 100 per cent Govt owned” was fairly factual and descriptive in nature.   Michael Cullen’s statement, by contrast, was considerably more rhetorical: “Stronger circle of Crown owners proposed for Kiwibank”,  “these two Crown investors –  both essential parts of the New Zealand fabric”, “time to broaden the bank’s support base within the wider public sector”, “a rare opportunity”.      (Mind you, where the NZ Post statement really overstepped the mark for me was when they compared assets under management at ACC ($32bn) and NZSF ($28bn) with the sum of assets and liabilities of Kiwibank ($38 billion).  I’ve never heard anyone previously refer to the size of a bank by adding together than assets and liabilities.)

Overall, it seems like an unstable model (perhaps deliberately so).  We have a small underperforming bank that will be owned by three government owners, instead of one, none with any great expertise in the business the bank is actually undertaking.  One will still have effective control, but less so than previously.  And if things go wrong, no one of the direct shareholding parties will be able to call the shots to sort things out, and the risks are likely to fall back on central government anyway.

UPDATE: My unease has just been increased reading these comments from Bill English on the ending of the NZ Post guarantee.

“It wasn’t really an effective guarantee, but now that’s been replaced by an arrangement where the Government underwrites any capital requirements related to the bank coming under pressure,” he said.

“That’s yet to be finalised in detail, but there’ll be a capital facility there so that depositors know that if anything went wrong with Kiwibank then the Government is able to stand behind it,” he said.

“It’s a capital facility. It’s not like a deposit guarantee because in New Zealand we don’t have deposit guarantees, but it is a facility that Kiwibank can call on if in extreme circumstances it needed to repair its capitalisation,” he said.

Perhaps it just makes explicit the reality, and we will need to see the details (will this facility be priced?).  Better to have a properly priced deposit insurance scheme across the entire system, and get the state out of owning –  or underwriting the equity of – banks.

 

Big banking systems and house prices

On Saturday afternoon I found myself in an email exchange with a couple of people about how the composition of bank lending had changed since 1984.  I wasn’t quite sure where the table I was responding to had come from, but when I eventually got to the business section of Saturday’s Herald I found the answer.  Brian Gaynor had devoted his column to a discussion of the changing significance of banks in recent decades, portentously headed  “Banks’ long shadow over New Zealand economy”.   I found myself agreeing with almost none of his interpretation.

My alternative story has two key strands:

  • the institutions we label “banks’ have become more important in the financial system as the incredible morass of restrictions built up since the days of Walter Nash were removed, first (too) slowly, and then in a great rush over 1984/85.  That has allowed the financial system to become much more efficient.  Financial intermediation is now undertaken mostly by those best placed to do it, rather than increasingly by those either subsidized by the government to do it, or just outside the network of controls and so still free to do it.
  • total credit to GDP (and especially the housing component) has risen mostly because of regulatory restrictions on building and, in particular, on urban land use. Higher housing credit is mostly an endogenous response to this policy-created scarcity.

There are all sorts of caveats to the story.  In some respects, banks are much more heavily and directly regulated now than they have ever been (and that burden is only getting heavier with LVR controls which threaten a new wave of disintermediation).  The “too big to fail” problem probably skews things a little too far towards banks (but adequately price deposit insurance and banks will still remain dominant), and at times banks get over-enthusiastic about increasing lending to particular sector and sub-sectors.  But, fundamentally, the rising importance of banks (relative to other intermediaries) has been a good thing not a bad one, and if one might reasonably be ambivalent or even concerned about the rise in household credit, that has been an almost inevitable consequence of artificial shortages created by central and local government.  Given the determination of our leaders to mess up urban land supply, in a country with a fast rising population, it would have happened in one form or another, and it is better that it has been done by efficient intermediaries.  Concerns should be addressed to central and local government politicians who keep the housing supply market dysfunctional, not to bankers.

At this remove, it is probably hard for many to appreciate quite what the New Zealand financial system was like in the heavily regulated decades.  Old New Zealand Official Yearbooks will give a good flavour, and the Reserve Bank published in 1983 a 2nd edition of its Monetary Policy and the New Zealand Financial System, which has lots of detail (the 3rd edition is a quite different book –  a weird confusion, which I take responsibility for).

In addition to the Reserve Bank  –  which lent, not just to its staff, but also to the major agricultural marketing bodies –  we had:

  • trading banks (each established by statute, with no new entrants for many decades)
  • private savings banks (savings banks subsidiaries of the trading banks, introduced in the early days of deregulation in the 1960s)
  • trustee savings banks (a different one in each region, some large and strong, some tiny)
  • the Post Office Savings Bank
  • the Housing Corporation (government mortgage finance)
  • the Rural Banking and Finance Corporation (govt rural finance)
  • the short-term official money market
  • finance companies
  • the PSIS
  • building societies (terminating and permanent)
  • life insurance and pension funds (large and fast-growing supported by a tax regime, and fairly large lenders)
  • the Development Finance Corporation
  • stock and station agents

And that was just the institutional entities –  almost all with different statutory and regulatory powers and restrictions.  And there was a very large non-institutional market in finance –  notably, the role of solicitors’ nominee companies in mortgage finance.

Trading banks had never been dominant providers of finance in New Zealand –  since they had not historically provided mortgage finance, whether to farmers or for households –  but even in their role as providers of, typically, short-term finance to business, they had been withering (under the burden of regulatory restrictions) for decades. As the Reserve Bank noted in its 1983 book, “trading bank loans and investments have fallen from being around 50 per cent of GNP in 1930 to around 25 per cent of GNP in 1981”.    As far as I can tell –  it was my impression back then, when writing an honours thesis on the disintermediation process, and it is my impression now –  that the only people who benefited from this state of affairs were the people running the entities subject to a lighter burden of regulation.  My schooling was mercifully free of so-called “financial literacy” education, but the one message I recall being drummed in repeatedly (reinforcing the one from my father) was that it was very difficult to get a mortgage, and one had to spend years building a track record that might allow one to go, on bended knee, to a lender, seeking as a special favour access to such credit.  But if you were on a lower income, the state would provide.  Alternatively, coming from a well-off family, or getting a job in an organization with concessional staff mortgages, was the way to go.  (Reserve Bank concessional loans were very good, although in the end I had one for only 2 months.)

Gaynor quotes statistics showing that trading bank housing lending was 14 per cent of total lending in 1984 and is 52 per cent now.  But look who did housing lending back then.  This chart is drawn from the 1984 New Zealand Official Yearbook, and shows the flow of new mortgages (on properties less than 2 hectares, so largely excluding farm mortgages) in the year to 31 March 1983.

mortgages 1983

Trading banks barely figure at all (and this includes their private savings bank loans, and loans to staff).  Most mortgages by then were being made through the Housing Corporation, within families, or through solicitors’ nominee companies.  Neither of the latter two offered much diversification, a key way of making available affordable finance.  Call me a relic of the 1980s if you like, but I count it as huge step forward that large and efficient private sector entities are now the main vehicle for residential mortgage finance.

I mostly want to focus on housing lending, but Gaynor also notes in support of his case

The first point to note is the huge fall in lending to the manufacturing sector, from 24.5 per cent of total bank lending 30 years ago to only 2.8 per cent at present. This reflects the deregulation and demise of manufacturing, which was also the result of policy initiatives by Sir Roger Douglas and the fourth Labour Government.

Yes, the relative importance of the manufacturing sector in the economy has shrunk –  perhaps more than it would have in a better-performing economy  –  but by my calculations drawn from Gaynor’s table, trading bank lending to manufacturing ($1.6 bn) was around 3.5 per cent of GDP in 1984 and at $11.4 bn is around 5 per cent of GDP now.  Across all the financial intermediaries that existed in 1984, the share would have been higher, but the overall picture is a quite different one from that Gaynor paints.

But what about housing lending?   Gaynor asserts that

The clear conclusion from this is that anyone who bought a house in the early 1980s has been extremely fortunate because aggressive bank lending has been a major contributor to the sustained rise in house prices over the past few decades.

Since 1980/81 was the trough of a very deep fall in real house prices, there is no doubt that it was an ideal time to have bought.  And there is also no doubt that there has been an aggressive (and almost entirely desirable) process of re-intermediation.  Some entities that weren’t trading banks became trading banks (or ‘registered banks’ as we now know them) – think of Heartland, SBS, ASB, PSIS –  or were directly purchased by banks (think of the United or Countrywide building societies, or Trustbank or Postbank), and in other cases banks just won market share away from other participants in the market (no need for a solicitor’s second or third flat (short-term interest only) mortgage when you could get a 80 per cent table first mortgage at the local bank branch).

But is there any evidence that “aggressive lending” by the financial sector (now mostly ‘banks’) has been a “major contributor” to the huge rise in real house prices in recent decades?    I think the evidence is against that claim.  Why?

First, “aggressive lending” usually ends badly.  It did for the banks when they lent on the massive commercial property and equity boom post-1984.   It did for the finance companies with aggressive property development lending in the years up to 2007.  It did for the banks with dairy lending (both in 2008/09 with a surge in NPLs and perhaps again now –  going even by the Reserve Bank’s own stress test).  Housing lending, by contrast, has not ended badly, even though the push by banks into housing lending has been going on now for more than 25 years, through several economic cycles and one very nasty recession.  It is easy to say “just wait”, but history is strongly against that proposition.  Inappropriately aggressive lending goes wrong much faster than that.

Second, while the lending terms of banks have become easier than they were 25 years ago –  when banks were just finding their way in this new market for them, and nominal interest rates were still extraordinarily high – they are not noticeably looser (at least in asset-based terms) than the terms applied by other housing lenders in earlier decades. 80 or 90 per cent 30 year mortgages from the Housing Corporation weren’t uncommon (or inappropriate for a young couple with decades of servicing capacity ahead).  Banks, including the Reserve Bank, had long lent those sort of proportions to their own staff.  And, on the other hand, we have not had any material amount of mortgage business written with LVRs above 100 per cent, or with terms of 100 years or beyond (things seen in various European markets at times).  Overall, credit conditions are probably easier than they were, but not in way that is self-evidently inappropriate or overly risky for either borrowers or lenders.  The Reserve Bank’s housing stress test backs that conclusion  – taking account of the joint risk of losses in asset values, and losses in servinig capacity (if unemployment were to rise sharply).

Third, there is a simpler explanation for high house and urban land prices.  Regulatory land use restrictions combined with population pressures (including policy-driven immigration ones) are a more persuasive story, including in explaining why house prices in Auckland have increased so much more than those elsewhere.  In New Zealand we have only one fairly large city, but think of the situation in the United States: there is a fairly unified financial system (albeit with some state level differentiation in restrictions) and yet we find huge increases in house prices in places like San Francisco (with tight land use and building restrictions) and very modest real increases in large and growing places such as Houston, Atlanta, Nashville and so on.  High house prices, and high house price to income ratios, are not an inevitable feature of a liberalized financial system.  They aren’t an inevitable feature of tight land use restrictions either, but the correlation across cities is pretty good.

demogrpahia 2016And if finance were primarily responsible, finance would also have brought forth lots of new supply.  That is way markets work –  it is part of the reason why credit-driven booms don’t last that long.  Instead, prices have been bid up largely as a result of regulatory constraints: there are not consistently excess profits lying around that developers can readily take advantage of.

Of course, higher house prices typically mean that buyers of houses need more credit than they otherwise did.  If house prices suddenly double because some regulatory change makes land scarcer, then with incomes unchanged either people can wait (much) longer to buy, saving a larger deposit, or they can borrow more to complete the purchase.  If the people who wanted to buy, but are reluctant to take on more debt, do hold back, someone else will buy the property.  And that person will need finance –  either debt or equity.  If banks are reluctant to lend on houses, then houses will tend to be owned by people who are least dependent on debt: those with large amounts of established wealth already.  All else equal, since few people get into the owner-occupied housing market without debt, that would be a recipe for even larger falls in owner-occupation rates than we have already seen.

Much of the overall increase in housing debt in New Zealand (and other similar countries) in recent decades has been the endogenous response to the higher house prices, rather than some independent factor driving up prices.  And these forces take a long time to play out.

In the chart below I’ve done a very simple exercise.  I’ve assumed that at the start of the exercise, housing debt is 50 per cent of income, house prices and incomes are flat, and people repay mortgages evenly over 25 years.  Only a minority of houses is traded each year, but each year the new purchasers take on new debt just enough to balance the repayments across the entire mortgage book.

And then a shock happens –  call it tighter land use regulation –  the impact of which is instantly recognized, and house prices double as a result.  Following that shock, house purchasers also double the amount of debt they take on with each purchase, while the (now rising) stock of debt continues to be repaid in equal installments over 25 years.

In this scenario remember, house prices rose only in year 1.  There is no subsequent increase in house prices or incomes.  But this is what happens to the debt to income ratio:

debt to income scenario

In this particular scenario, 100 years after the initial doubling in house prices, the debt to income ratio is still rising, solely as a result of the initial shock, converging (ever so slowly by then) to the new steady-state level of 1.  One could play around with the parameters, but a permanently higher level of real house prices will, in almost any of them, produce a permanently higher level of gross housing debt, and it will take many years to get to that new level.  The flipside, which I could also show, is the deposit balances of the other parts of the household sectors – the young who have to save for a higher deposit (even for a constant LVR) and the older cohorts who extract more money from the housing market when they downsize or exit the market.  Higher house prices do not, of themselves, require banks to raise more funding offshore.

This is deliberately highly-stylized, but it is designed to illustrate just two main points: higher debt ratios can be primarily a symptom of higher house prices (rather than any sort of cause) and the adjustment upwards in debt levels following an upward house price movement can take many years to work through.    And there is one more important point: this a process that mostly reallocates deposits and credit among participants in the housing market: it needn’t materially affect the availability of credit, or economic opportunities, in the rest of the economy.

None of which is to suggest that higher house prices, as a result of some combination of regulatory measures (eg land use restrictions and high non-citizen immigration), are matters of indifference.    They have appalling distributional consequences, and prevent the housing supply market working remotely efficiently.   But the banks aren’t the people to blame: that blame should be sheeted home, constantly, to the politicians responsible for the regulatory distortions.   We get bigger banks as a result –  more gross credit has to be distributed from one group in society to another –  but if we are going to mess up the housing and land supply markets, bigger banks are almost an inevitable, perhaps even second-best desirable, outcome. The alternative would be whole new waves of disintermediation, and a housing stock ending up (even more) increasingly owned by those not dependent on debt.

The preferable path would be one in which land use restrictions were substantially removed, and house and urban land prices once again reflected market economic factors rather than regulatory impositions.  That would be a path towards smaller banks –  but just as in my chart above, the adjustment would take many years.

Kiwibank

I’m still puzzling over the academic who told Radio New Zealand’s listeners yesterday that he didn’t agree with me that New Zealand was remote: “we are, after all, in the middle of this great ocean, the Pacific”.    I keep looking at the globe, conscious that perhaps I have a eurocentric view of the world, but….we still look about as remote as they come.  And it is a sort of remoteness which, historically, hasn’t been conducive to really high levels of economic performance for lots of people (see Tristan de Cunha, St Helena, Bouvet, and even Samoa, Kiribati, or Fiji).  Henry Kissinger is reported to have described Chile as “a dagger pointed at the heart of Antarctica”.  Much the same could be said of New Zealand, one of the Antarctic Rim countries.

But, on another topic, I noticed that Kiwibank and NZ Post were in the news this morning.

Late last week, Radio Live was reporting a story that Kiwibank was being prepared for sale, and they asked for my thoughts on that.  That interview is here.

There was never a good economic case for setting up Kiwibank.  Our banking market was, and is, pretty competitive, and there were few material regulatory barriers to new entrants.  And the historical track record, here and abroad, is that government-owned banks are more prone to getting into costly trouble than private-owned banks (and some of them cause quite enough trouble).  In a modern New Zealand context, think of the Bank of New Zealand, DFC, and the (different sort of case of the) Rural Bank.  Overseas, examples abound.

But, of course, the case for Kiwibank was never mostly about economics.  It was mostly about nationalism, and some mix of political product differentiation and the political circle turning. Jim Anderton has resigned from the Labour Party in 1989, having been suspended from Labour’s caucus when he refused to vote for the sale of the Bank of New Zealand (then still predominantly government-owned).   And now Jim Anderton was back, as Deputy Prime Minister in a Labour-Alliance government.  Not only could the government own businesses, but it could –  so it was claimed –  build good new ones.  This speech by Jim Anderton captures the flavour.  This centre-left government would be different from its predecessor, and the establishment of Kiwibank would be one important marker of that difference.

The Reserve Bank and (more importantly) Treasury opposed the establishment of Kiwibank.   There weren’t obvious gaps in the market that other new entrants couldn’t fill, and establishing any new business is risky.

The National Party opposed the establishment of Kiwibank, but has never been willing to commit to selling it (in full or in part), even when Don Brash was leader in the 2005 election.

The actual track record of Kiwibank has been less bad than many of the opponents feared.  NZ Post was able to recruit some capable people who have built a reasonably substantial bank, that now has around $19 billion of assets.  Kiwibank grew very rapidly in its early years, and when institutions –  especially new entrants –  grow rapidly, it is wise to worry about the credit standards: it is most easy to write loans to people whom other lenders are reluctant to lend to.  Kiwibank had a few ill-judged forays into particular market segments, but appears to have built a reasonably self-sustaining bank, which came through the recession of 2008/09 with little more damage than the larger banks sustained.   My own reaction to that record was that, as taxpayers, we should be thankful for small mercies, and take the opportunity to sell before something went wrong.

But it has never been quite clear how much money Kiwibank has really made, and in particular whether it has ever sustainably succeeded in covering the cost of the taxpayers’ capital invested (and reinvested) in the bank.  Banking is a highly leveraged business, and since the government’s finances are already heavily directly exposed to the overall health of the New Zealand economy, there were no obvious diversification gains for it in establishing a bank in New Zealand.  We needed a good rate of return to justify the risk.

One of the reasons it has never been clear just how profitable Kiwibank has been is that Kiwibank and its parent NZ Post were intertwined, operating (most obviously) from the same physical locations.  During the early years in particular, there was a lot of incentive for NZ Post (with its government appointed Board) to help ensure that Kiwibank was a success, and to err in favour of Kiwibank in any allocation of costs or charging for shared services.  I got involved with these issues briefly in my time at Treasury and even then it seemed impossible for outsiders to know whether costs were being allocated appropriately.  Several years on one might have hoped all these issues were adequately resolved, so I was a little surprised to see this comment from Bill English in the Herald this morning.

He said there had been discussions over whether NZ Post was subsidising Kiwibank.

“Certainly through the start-up phase it has been but NZ Post can’t afford to keep cross-subsidising the bank,” he said.

Which doesn’t give one a great deal of confidence that, even over the last few years, the Kiwibank accounts give a full representation of the returns from a standalone banking business.  I don’t read the literature as suggesting that the economies of scale in retail banking are huge (so a small bank could be profitable) –  and we have both big and small banks co-existing in the New Zealand market –  but I doubt it could be shown that Kiwibank had been a good investment for the taxpayer.  Fortunately, it hasn’t been a disastrous one.

So I’d be all in favour of Kiwibank being sold.  There is just no good reason for the government to be involved in the business of retail banking.  Even today, the barriers to new private sector entrants are quite low, and even if there is some independent concern  about New Zealand-owned banks, then we have SBS, TSB, Co-op, and Heartland.

One key strand in New Zealand’s approach to banking is the idea that no institution, and no depositor/creditor, is totally immune from failure and the risk of losing one’s money.  I don’t think that is a politically tenable stance, and am among those who favour New Zealand adopting some form of deposit insurance (as most other countries have done).  But it is a particularly difficult model to sustain in respect of a government-owned bank.

Yes, governments have been willing to allow creditors of SOEs to lose money –  the banks who had lent to Solid Energy most notably among them –  but a handful of banks, mostly foreign, is a rather different matter than hundreds of thousands  (800000 apparently) of retail depositors (and voters).   Governments can say all they like that no one is guaranteed, but it isn’t obvious why anyone would –  or should –  believe them.  After all, a standard element in the Reserve Bank’s approach is that if a bank gets into difficulties, the Reserve Bank will look to its shareholders to recapitalize the bank concerned.  The  New Zealand government owns all the shares in NZ Post, the immediate (struggling) parent of Kiwibank.   The credit rating agencies also take that view: S&P, for example, noted last year that

we consider that Kiwibank has a “high” likelihood of receiving extraordinary support from the New Zealand government, reflecting the bank’s “very strong” link and “important” role to the government.

The unpriced implicit support Kiwibank has from the government skews the domestic banking market and undermines the efficiency of the financial system, all while continuing to pose material financial risks for the New Zealand taxpayer.

And it is not as if the governance of Kiwibank looks particularly strong either.  I was quite surprised to find, looking through the list of directors, that not a single one of them has a background in retail banking.

At very least I think it would make sense to restructure the NZ Post group, removing Kiwibank and making it a standalone SOE in its own right.  Going by the comments from the Minister, if the story Radio Live ran had anything behind it, that was the mostly likely form.

A sale would also make sense, but I don’t see any chance of it happening under the current government.  One could conjure up all sorts of imaginative options that might mitigate the political uproar –  recall the size of the petition around the partial sales of the government stake in three power companies –  but I can’t see why this government would regard it as worth the political risk.  And no potential coalition partner really cares enough to want to make a sale a “bottom line” in any deal –  while NZ First might well care enough on the opposite side.

Kiwibank shares could, for example, be distributed to all adults –  on current book value that might be around $300 each –  so that it was truly the “people’s bank”.  But then there would no single dominant shareholder, and the rating agencies would get nervous, and so would the Reserve Bank.  It would have quite high direct costs, and the opposition parties would no doubt sell it (accurately) as prelude to those individual parcels being bought up by one or another of the other banks.

I’ve seen suggestions that perhaps the New Zealand Superannuation Fund should become a key shareholder in Kiwibank.  I reckon that would be even worse than direct state ownership, since the NZSF faces neither market nor political disciplines.

I don’t really like the idea of a partial privatization, with the government retaining the majority shareholding.  It still has most of the moral hazard/bailout risks associated with the current ownership model, with more risk that the private shareholders would seek to aggressively (and quite rationally) exploit such advantages.  It was, more or less exactly, the model used with the Bank of New Zealand in the late 1980s.

In truth, the best value for the taxpayer probably lies in what is the least politically attractive option: a straight trade sale, probably to one of the existing large participants in the market. That was how the previous Postbank was sold, back in 1988.  It is what happened to Trustbank in 1996, and to Countrywide a couple of years later.  And, of course, Lloyds concluded that the best value from the National Bank was through a trade sale to ANZ.  The government might get a price well above book value in such a sale, even recognizing that banks are less inclined to aggressive expansion than they were a decade ago, and that some of the Australian banks might be uneasy about overweighting their exposure to New Zealand.  But even to propose such a sale would surely be seen by the government’s political advisers as an unadulterated gift to the Opposition.

And so it seems likely that, for the foreseeable future, the government will not just be the largest owner in New Zealand of dairy farms, funds managers, trains and planes, power companies, and legal firms, but will remain the owner of a modest-sized, not outstandingly successful, retail bank.

UPDATE:  In casting around for any summary analysis that has been done/released on Kiwibank’s long-term performance, I found this chart of return on assets (not equity) in a Treasury report from a couple of years back.

bank roa.png

The results shouldn’t be very surprising, but they do reinforce the point that even if Kiwibank is currently earning reasonable rates of returns (eg in the most recent year), it has a long way to go to deliver the sorts of cumulative returns to taxpayers that private sector shareholders might have expected (especially as none of the private comparators were start-ups).