Exporting to a large communist state

One of the things that seems to worry establishment people in New Zealand is a belief that our economy is somehow very vulnerable to anything that disrupts the trade of New Zealand firms with China.  It is a more-than-slightly puzzling concern, since only around 20 per cent of our exports go to China, and exports themselves aren’t an overly large share of GDP in New Zealand.   For the firms involved –  even if not the wider economy –  there are clearly somewhat greater risks, since China has a demonstrated track record of being willing to use targeted trade sanctions for “punishment”.   Those are the risks you take, as a private company, when you choose to play in that particular sandpit.

For the world economy, of course, any serious dislocation of China’s economy is a significant risk.  With interest rates in most of the world not much above zero, any serious downturn in one of the world’s two largest economies could be quite problematic (as the US recession/financial crisis in 2008/09 was).      But such downturns generally do even more damage to the economy at the centre of the problems than to everyone else.  We all have a stake in a better-managed Chinese economy, even if the Chinese authorities are showing increasingly autarckic tendencies, and even if China isn’t anywhere near as internationally connected as the major Western economies are.  But that interest isn’t a good reason to orient foreign policy around deference to China, or to refuse to have an open debate about Chinese government interference in the domestic affairs of other countries.

One case study that sometimes get mentioned when people talk about the vulnerabilities of trade with China is Finland.   After a rather difficult time in World War Two –  gallantly losing to the Soviet Union in 1939/40, and then ending up on Germany’s side –  Finland spent the post-war decades in an awkward position.  A new word was added to the international vocabulary: Finlandization

the process by which one powerful country makes a smaller neighboring country abide by the former’s foreign policy rules, while allowing it to keep its nominal independence and its own political system.  The term literally means “to become like Finland” referring to the influence of the Soviet Union on Finland’s policies during the Cold War.

And largely, no doubt, just because of geography, much of Finland’s foreign trade was with the Soviet Union during those decades (it was a highly managed and regulated trade).  Eyeballing a long-term chart, over the post-war decades to 1990 around 20 per cent of Finland’s exports were to the Soviet Union. And in the 1970s and 1980s, total exports as a share of GDP averaged just over 25 per cent in Finland.   In other words, exports to the Soviet Union were averaging about 5 per cent of Finland’s GDP, pretty similar to New Zealand exports to China today.  (A century ago, by contrast, New Zealand exports to the United Kingdom in the 1920s were 20-25 per cent of our GDP.)

The Soviet Union ended messily, at least in economic terms.   Here is a chart, using Maddison data, of real per capita GDP in the (once and former) Soviet Union.


In the slump, and associated disarray, imports plummeted, including those from Finland. In fact, in 1992 Finnish exports to Russia (the largest chunk of the former Soviet Union) were less than 1 per cent of Finnish GDP.

At the time, Finland itself was going through one of more wrenching recessions seen until then in post-war advanced economies.  The unemployment rate rose from 3 per cent to over 17 per cent in just three years, and real per capita GDP fell by 11 per cent from 1990 to 1993.

The collapse of the Soviet Union wasn’t the only thing going on at the time.  There were recessions in many western economies (including New Zealand and Australia) around 1991, but Finland’s experience was particularly savage (and also worse than the experiences around the same time of other Nordic countries).

One distinctive was house prices.

finland real house prices

Real house prices rose by about two thirds (across the country) in just a couple of years, and then more than fully reversed the increase.  The 50 per cent fall in real house prices involved a very sharp fall in nominal house prices, only matched in recent times in Ireland.

To some New Zealand readers it will all seem like just the sort of stuff they worry about.  Isn’t our economy heavily dependent on trade with China, which could easily but cut off or otherwise implode, and aren’t house prices extraordinarily high?  Isn’t the great Finnish recession exactly the sort of thing Graeme Wheeler and the Reserve Bank were warning of?

No doubt there are some similarities in what they were warning about.  But if Finland offers lessons for us, they aren’t about who our firms trade with, nor even really about house prices and housing lending exposures.  Instead, they are the (now) age-old lesson about the risks of severely overvalued exchange rates, with an overlay of a warning about the transitional risks of financial liberalisation (readers will recall that New Zealand and Australia also had a tough time in that transition in the late 1980s).

Finland had had quite high inflation even by the standards of many other European countries during the great inflation of the 1970s.    Persistently high inflation, in a fixed exchange rate system, is typically accompanied by a succession of devaluations.  We went through almost 20 years of something similar in New Zealand.   But in Finland in the 1980s they decided to break the cycle, and set out to maintain a “hard markka” –  the fixed exchange rate holding down imported inflation and, supposedly, imposing domestic disciplines that would lower domestically-sourced inflation.    Much of the advanced world was disinflating at the same time, and so for a while the approach looked pretty successful.  Core inflation was 12 per cent in 1980, and not much above 3 per cent by 1986.

But the Nordic economies, including Finland, were also liberalising their domestic financial systems in the 1980s.  And a necessary corollary of a fixed exchange rate system is that, with an open capital accounts, your country’s interest rates are heavily influenced by those abroad.   And German interest rates, which had been 7.5 per cent in 1980, just kept on falling –  the Bundesbank’s discount rate was 2.5 per cent by 1988.

In process –  fixed exchange rate, falling global interest rates – what followed was a massive speculative credit and investment boom in Finland. Lending and asset prices surged.  Inflation picked up, and Finnish industry became increasingly uncompetitive internationally.  That in turn created doubts about the stability of the exchange rate peg, prompting increases in domestic interest rates.

Here is what happened to the real exchange rate

fin rer

And a measure of real short-term interest rates

fin int rates

Real interest rates didn’t peak until well into 1992, two years after the recession began.  Why? Not because inflation was a particular problem –  it was back down to not much above 3 per cent in 1992 and falling fast –  but because of the extreme reluctance of the authorities to float the exchange rate.   There had been grudging periodic adjustments under pressure, but it wasn’t until September 1992 that the markka was finally allowed to float.

In the process –  the boom over the late 80s and the subsequent bust, both heavily linked to the fixed exchange rate  –  the Finns managed to bring on themselves a very severe domestic financial crisis.   And there had been huge shifts in the shares of various components of the economy.  Here was the export share of GDP.

exports finland

Investment as a share of GDP fell from around 30 per cent at the end of the boom, to around 19 per cent at the trough.

Floating exchange rates can be messy, but unless you economy is very closely aligned to –  and integrated with –  the currency of some other country, they are usually better than the alternative.  That was certainly Finland’s experience over the crisis of the early 1990s.

And what of the financial crisis?  Surely with house prices falling by that much, residential mortage losses must have been a big part of the story?  In fact, the overwhelming bulk of the problem loans were to businesses and although many residential borrowers did get into trouble –  rapid increases in unemployment and rising real interest rates in combination can be a toxic brew –   in the end only 1 per cent of household loans were written off.   That isn’t particularly surprising, is a point made in numerous studies, and is consistent with a survey of financial crises done a few years ago by the Norwegian central bank.  As they put it

We look at a wide range of national and international crises to identify banks’ exposures to losses during banking crises. We find that banks generally sustain greater losses on corporate loans than on household loans. Even after sharp falls in house prices, losses on household loans were often moderate. The most prominent exception is the losses incurred in US banks during the 2008 financial crisis . In most of the crises we study, the main cause of bank losses appears to have been propertyrelated corporate lending, particularly commercial property loans.

And thus it was in Finland (and neighbouring Sweden for that matter).  It is a point I’ve been making about New Zealand: when severe adverse shocks hit, provided your exchange rate is floating, not only does the exchange rate fall, but interest rates typically do too.  Those are typically very powerful buffers, especially in the case of an adverse shock that isn’t global in nature.

And what of the role of the collapse in Finnish exports to the (now) former Soviet Union.  I found various books and articles on my shelves about the Finnish experience –  it was one of the handful of defining post-war crises.  None of them regard that sudden drop as a particularly important part in the Finnish recessionary story.  For anyone interested, there is an interesting recent paper by a couple of Finnish researchers.  Their summary is as follows

It is shown that empirically, the strong credit expansion resulting from the simultaneous liberalization of the domestic financial markets and international capital movements has played the most important role in explaining the changes in real economic activity in Finland during the time period analyzed. In fact, over a longer time period (1980-2005) exports to Russia emerge as a countercyclical variable: slightly contractionary after the crazy years, and expansionary during the following depression [exports to Russia recovered somewhat after the first chaotic year or two].

Exporters were fairly soon able to find alternative markets for their products, helped –  after 1992 –  by the much lower real exchange rate.

And what of the overall Finnish economy itself?  After freeing the exchange rate and allowing real interest rates to drop sharply, the economy itself rebounded quite rapidly.  By 1997, real per capita GDP was already 4 per cent above somewhat flattering boom-exaggerated 1990 levels.

finland real pc GDP  And consistent with a story I’ve run here in various posts over the years, through all that disruption and dislocation, here is the path of Finnish real labour productivity (real GDP per hour worked).

fin real gdp phw

As was the case with the numerous US financial crises in the 19th and early 20th centuries, there isn’t much sign of any enduring damage to productivity (levels or growth) from the Finnish crisis.  That’s reassuring, if not terribly surprising.

(Finland’s economic performance in the last decade has been pretty shockingly bad, including a productivity performance that –  like the UK’s –  is even worse than New Zealand’s over that period.  But that is a story for another day.)


Submission on the DTI proposals

Submissions close today on the Reserve Bank’s consultation on its proposal to add a debt to income limit tool to the approved list of possible direct controls on bank housing lending.

Despite the Prime Minister’s comments the other day, I don’t regard this as a “dead duck” at all.  The Reserve Bank won’t be coming back to the Minister of Finance with its recommendation, in light of the consultation, until after the election, and who knows what the political or housing market climate will be like by then.  Graeme Wheeler will be gone by then, and so the Reserve Bank’s decision will be in the hands of the (illegally appointed) acting Governor, Grant Spencer, and new Head of Financial Stability (and presumed Governor-aspirant) Geoff Bascand.  Perhaps they will have less appetite for controls than Wheeler has had –  both come from backgrounds that were not particularly keen on direct interventions –  but for now we have to assume that the proposal will continue to move ahead.

As I noted earlier in the week, there is a lot of useful and detailed material in Ian Harrison’s paper on the DTIs, which I gather he is putting in as a submission.

I ummed and aahed about whether to make a submission.  In one sense, it is a pure waste of time, since the Bank is unlikely to grapple very seriously with any points I make.  But, on other hand, it is good to have alternative perspectives, and questions, on the issue out there, and just possibly it might provide some angles for people with a bit more influence than I have.

So I did write a fairly brief submission.  My overview and summary is here


I am firmly against adding any sort of serviceability restriction (henceforward “DTI”) to the list of possible controls.  The Reserve Bank has failed to mount a convincing case, and has not demonstrated that it (or anyone) has the level of knowledge required for such restrictions to operate in a way likely to make New Zealanders as a whole better off.  Such restrictions would appear to go well beyond the Reserve Bank’s statutory mandate (contributing little or nothing to soundness and eroding the efficiency of the financial system), and a better cost-benefit analysis would in any case suggest that such controls would probably be welfare-detracting.   Other instruments (such as capital requirements and associated risk weights) that do not impinge directly on the borrowing and lending options open to individuals and firms remain a superior way to manage any future risks to the soundness of the financial system.  Serious microeconomic reform remains the best route to fix the serious housing affordability/land price problems.

As a reminder, the Reserve Bank has no statutory mandate to target house prices or the level (or growth rates) of credit in the New Zealand economy.   It also has no “house purchaser or borrower protection” mandate.  Restrictions of the sort proposed in the consultative document would represent serious regulatory over-reach.

The fact that a handful of advanced economies have deployed somewhat similar tools is little comfort or basis for support for the Reserve Bank’s own proposals.  Bad policy elsewhere isn’t a good reason to adopt bad policy here.  But more specifically, the interests of regulators themselves and of citizens are not necessarily, or naturally, well-aligned, a point that Reserve Bank material rarely if ever addresses.  For example, the Reserve Bank makes much of the British and Irish DTI limits (which do not apply to investment properties, where the consultative document says the Reserve Bank would want to focus), but never addresses the institutional incentives facing regulators in those countries following the financial crises each experienced in 2008/09 (the typical regulator incentive in the wake of a crisis to overdo caution –  and “to be seen to be doing something”, in the regulator’s own bureau-protection interests).     On the flip side, neither in the current consultative document nor in past Reserve Bank material has the Bank seriously engaged with the experience of housing loan portfolios in floating exchange rate countries during the 2008/09 crisis.  In countries like ours –  including Australia, Canada, the UK, Norway, Sweden, as well as New Zealand –  residential loan books emerged largely unscathed, despite big credit and housing booms in the prior years, and the subsequent nasty recession and, in most of these countries, a sustained period of surprisingly low income growth.

There has also been no evidence presented that banks have been systematically poor at making and managing portfolios of loans secured by residential mortgage, let alone that citizens should have any confidence in the ability of (and incentives on) regulators to do the job better.    Anyone can suppress overall credit creation with tough enough controls, but to what end, at what cost, to whom?     Controls of the sort now proposed, and the sorts of LVR restrictions already extensively used, seem to represent ill-targeted measures, based on an inadequate model of house and land prices.  They temporarily paper over symptoms –  house prices driven high by the failures of regulation elsewhere require high levels of credit – rather than address the structural causes of the housing market problems.     And because they seem to be premised on a model that wrongly treats credit as a leading factor in the housing market problems, they also do little to address any (limited) financial stability risks.  And in the process, they systematically favour some groups in society over others –  the sorts of distributional choices that, if made at all, should be made only by elected politicians, not by an unelected official.

A reasonable starting proposition would be that in the 25 years prior to the imposition of LVR restrictions the New Zealand housing finance market had been efficient and well-functioning.  Lenders lost little money, more borrowers could get better access to credit than in the earlier regulated decades, borrowers had no need to concern themselves with the changing details of Reserve Bank regulatory restrictions, there were no rewards to special interest group lobbying and rent-seeking, and competitive neutrality among different classes of lending institutions prevailed.  Perhaps the Reserve Bank would disagree with that characterisation of the market, but if so then, in proposing still further extensions of its regulatory intervention powers, surely the onus should be on you to make your case, not simply to ignore the past, apparently successful, experience?

Anyone interested can read the whole document here

Submission to RBNZ consultation on DTI proposal Aug 2017

The DTI proposal is a tool to address, inefficiently, a problem that isn’t there (threats to the soundness of the financial system), while appearing to try to do something about an actual serious problem (house and urban land prices), of successive governments’ making, about which the DTI tool can do little or nothing useful.  It won’t help, and if anything it distracts attention from the real issues, and from those really responsible, for the disaster that is the New Zealand housing “market”.

LVR restrictions

The successive waves of LVR controls that the Reserve Bank Governor has imposed on banks’ housing lending in recent years are back in the headlines, with comments from both the Prime Minister and the Leader of the Opposition (here and here).

As readers know, I’m no defender of LVR restrictions.  The other day I summarised my position this way

I never favoured putting the successive waves of LVR restrictions on in the first place.  They are discrimatory –  across classes of borrowers, classes of borrowing, and classes of lending institutions –  they aren’t based on any robust analysis, as a tool to protect the financial system they are inferior to higher capital requirements, they penalise the marginal in favour of the established (or lucky), and generally undermine an efficient and well-functioning housing finance market, for little evident end.  Oh, and among types of housing lending, they deliberately carve-out an unrestricted space for the most risky class of housing lending –  that on new builds.

You’d never know, from listening to the Governor or reading the Bank’s material, that New Zealand banks – like those in most other floating exchange rate countries –  appear to have done quite a good job over the decades in providing housing finance and managing the associated credit risks.   We had a huge credit boom last decade, followed by a nasty recession, and our banks’ housing loan book –  and those in other similar countries –  came through just fine.

The Bank’s statutory mandate is to promote the soundness and efficiency of the financial system.  On soundness, successive (very demanding) stress tests suggest that there is no credible threat to soundness, while the efficiency of the system is compromised at almost every turn by these controls.

At a more micro level, this comment (from my post yesterday) about the Bank’s debt to income limit proposals is just as relevant to the actual LVR controls they’ve put on in successive waves.

Much of the case the Reserve Bank seeks to make for having the ability to use a debt to income limit rests on the assumption that banks don’t do risk management and credit assessment well and that, inevitably crude, central bank interventions will do better.  The Bank’s consultation paper makes little or no effort to engage on that point at all.  It provides no evidence, for example, that the Reserve Bank has looked carefully at banks’ loan origination and management standards, and identified specific –  empirically validated –  failings in those standards.  Neither has it attempted to demonstrate that over time it and its staff have an –  empirically validated –  superior ability to identify and manage risks appropriately.

For all that, in partial defence of the LVR controls right now, many of those who are calling for the controls to be lifted or eased seem to be giving all the credit (or blame) for the current pause in housing market activity to the LVR controls.   That seems unlikely.  Other factors that are probably relevant include rising interest rates, self-chosen tightening in banks’ credit standards, pressure from Australian regulators on the Australian banking groups’ housing lending, a marked slowdown in Chinese capital outflows, and perhaps some election uncertainty (Labour is proposing various tax changes affecting housing).  I don’t know how much of the current slowdown is explained by each factor, but then neither do those focusing on the LVR controls.   Neither does the Reserve Bank.

And the backdrop remains one in which house price problems haven’t been caused mostly by credit conditions, but by the toxic brew of continuing tight land use restrictions (and associated infrastructure issues) and continuing rapid population growth.     Those two factors haven’t changed, so neither has the medium-term outlook for house and land prices.  Political parties talk about improving affordability, but neither main party leader will openly commit to a goal of falling house prices, and neither main party’s policies will make much sustained difference to the population pressures.   A brave person might bet on  some combination of (a) a recovering Australian economy easing population pressure, and (b) talk of abolishing limits around Auckland actually translating into action and much more readily useable land.  It’s a possibility, but so is the alternative –  continued cyclical swings around a persistently uptrend in the price of an artificially scarce asset.

And thus, in a sense, the Reserve Bank has a tiger by the tail.  House prices are primarily a reflection of serious structural and regulatory failures, and the problem won’t just be fixed by cutting off access to credit for some, or even by just buying a few months breathing space until a few more houses are built (before even more people need even more houses).   This isn’t a “bubble”, it is a regulatorily-induced severely distorted market.

So I strongly agree with the Prime Minister that, having repeatedly sold the LVR controls as temporary, the Reserve Bank Governor really needs to lay down clear and explicit markers that would see the controls be wound back and, eventually, removed completely.     And yet how can the Governor do that in any sensible way?   After all, the underlying problem wasn’t credit standards, or even overall credit growth.  It appeared to be simply that the Governor thought that he should “do something” to try and have some influence on house prices, even though he (a) had no good model of house prices in the first place, and (b) his tool didn’t address causes at all, and bore no relationship to those causes –  it was simply a rather arbitrary symptom-suppression tool.  And the Reserve Bank knew that all along –  they never claimed LVR controls would do much to house prices for long.

Because the interventions weren’t well-designed, any easing or removal of the controls will inevitably be rather arbitrary, with a considerable element of luck around how the removal would go.   What sort of criteria might they lay out?

  • a pause in house prices for a couple of years?  Well, perhaps, but as everyone knows no one is good at forecasting cyclical fluctuations in immigration.  Take off the LVR controls and, for unrelated reasons, house price pressures could still return very quickly,
  • housing credit growth down to, say, the rate of growth of nominal GDP for a couple of years.  But there isn’t much information in such a measure, as the stock of housing credit is mostly endogenous to house prices (high house prices require a higher stock of credit).

The latest set of restrictions seemed to be motivated as much by a distaste for investor buyers as by any sort of credit or systemic risk analysis, so it isn’t clear what indicators they could use to provide markers for winding back the investor-lending controls.  And since the Bank has never documented the specific concerns about banks’ lending standards that might have motivated the controls in the first place, it isn’t obvious that they could easily lay out markers in that area either.  Since the controls were never well-aligned with the underlying issues or risks, it seems likely that any easing won’t be able to be much better grounded –  almost inevitably it will be as much about “whim” and “taste” as anything robust.  Unless, that is, the incoming Governor simply decides they are the wrong tool for the job, and decides to (gradually) lift them as a matter of policy.   Doing so would put the responsibility for the house price debacle where it belongs: with politicians and bureaucrats who keep land artificially scarce, and at the same time keep driving up the population.

Some have also taken the Prime Minister’s comments as ruling out any chance of the Reserve Bank’s debt to income tool getting approval from the government.  I didn’t read it that way at all.

But he [English] explicitly ruled out giving the bank the added tool of DTIs, which it had requested earlier in the year.

“We don’t see the need for the further tools, Those are being examined. If there was a need for it then we’re open to it, but we don’t see the need at the moment. We won’t be looking at it before the election.”

As even the Governor isn’t seeking to use a DTI limit at present (only add it to the approved tool kit), and as submissions on the Bank’s proposal haven’t yet closed, of course the government won’t be looking at it before the election (little more than a month away).  It will take at least that long for the Reserve Bank to review submissions and go through its own internal processes.  In fact, at his press conference last week Graeme Wheeler was explicitly asked about the DTI proposal, and responded that it would be a matter for his (acting) successor and the new Minister of Finance to look at after the election.    Perhaps the Prime Minister isn’t keen, but his actual comments yesterday were much less clear cut on the DTI proposal than they might have looked.

In many ways, the thing that interested me most in yesterday’s comments was the way both the Prime Minister and the Leader of the Opposition seemed to treat decisions on direct interventions like LVR or DTI controls as naturally a matter for the Reserve Bank to decide.

The Prime Minister’s stance was described by interest.co.nz as

However, he again reiterated that relaxing LVR restrictions was a matter for the Reserve Bank. “I’m not here to tell them what to do.” English said government was not going to make the decision for them and that he did not want to give the public the impression that politicians could decide to remove them. “The Reserve Bank decides that.”

The Leader of Opposition similarly

“But we’ve not proposed removing their ability to set those…use those tools,” Ardern said. “We’re not taking away their discretion and independence.”

Both of them accurately describe the law as it stands.  The Reserve Bank –  well, the Governor personally –  has the power to impose such controls.    But there isn’t any particularly good reason why the Reserve Bank Act should be written that way.

The case for central bank independence mostly relates to monetary policy.  In monetary policy, there is a pretty clearly specified objective set by the politicians, for which (at least in principle) the Governor can be held to account.  In our legislation, the Governor can only use indirect instruments (eg the OCR) to influence things –  he has not direct regulatory powers that he is able to use.

Banking regulation and supervision are quite different matters.  I think there is a clear-cut argument for keeping politicians out of banking supervision as it relates to any individual bank –  we don’t want politicians favouring one bank over another, and we want whatever rules are in place applied without fear and favour.  In the same way, we don’t want politicians making decisions that person x gets a welfare benefit and person y doesn’t.  But the rules of the welfare system itself are rightly a matter for Parliamant and for ministers.

There isn’t compelling reason why things should be different for banking controls (and, in fact, things aren’t different for non-bank controls, where the Governor does not have the same freedom).  As my former colleague Kirdan Lees pointed out on Morning Report this morning, when it comes to financial stability and efficiency, there are no well-articulated specific statutory goals the Reserve Bank Governor is charged with pursuing.  That gives the holder of that office a huge amount of policy discretion –  a lot more so than is typical for public sector agencies and their chief executives – and very little effective accountability.    So when Ms Ardern says that she doesn’t propose to take away the Bank’s discretion or independence, the appropriate response really should be “why not?”.

We need expert advisers in these areas, and we need expert people implementing the controls and ensuring that different banks are treated equitably, but policy is (or should be) a matter for politicians.  It is why we have elections.  We get to choose, and toss out, those who make the rules.  It is how the system is supposed to work –  just not, apparently, when it comes to the housing finance market.

I’ve welcomed the broad direction of the Labour Party’s proposal to shift to a committee-based decisionmaking model for monetary policy.   But, as I noted at the time of the release, their proposals were too timid, involved too much deference to the Governor (whoever he or she may be), and simply didn’t even address this financial stability and regulatory aspects of the Bank’s powers.      There is a useful place for experts but –  especially where the goals are vague, and the associated controls bear heavily on ordinary citizens –  it should be in advising and implementing, not in making policy.   Decisions to impose, or lift, LVR controls or DTI controls should –  if we must have them at all – be made by politicians whom we’ve elected, not by a single official who faces almost no effective accountability.



Doomed to repeat history…..or not

Last week marked 10 years since the pressures that were to culminate in the so-called “global financial crisis” burst into the headlines .

Local economist Shamubeel Eaqub marked the anniversary in his Sunday Star-Times column yesterday.  It grabbed my attention with the headlines Ten years on from the GFC” and “We appear dooomed to repeat history” .  

Frankly, it all seemed a bit overwrought.

It seems inevitable that there will be yet another crisis in the global financial system in the coming decade.

There have been few lessons from the GFC. There is more debt now than ever before and asset prices are super expensive. The next crisis will hopefully lead to much tighter regulation of the financial sector, that will force it to change from its current cancerous form, to one that does what it’s meant to.

The first half of the column is about the rest of the world.  But what really caught my attention was the second half, where he excoriates both the Reserve Bank and the government for their handling of the last decade or so.    This time, I’m defending both institutions.

There are some weird claims.

We were well into a recession when the GFC hit. So, when global money supplies dried up, it didn’t matter too much, because there was so little demand to borrow money in New Zealand anyway.

Here he can’t make his mind as to whether he wants to date the crisis to, say, August 2007 (10 years ago, when liquidity pressures started to flare up) or to the really intense phase from, say, September 2008 to early 2009.

Our recession dates from the March quarter of 2008 (while the US recession is dated from December 2007), but quite where he gets the idea that when funding markets froze it didn’t matter here, I do not know.  Banks had big balance sheets that needed to be continuously funded, whether or not they were still expecting any growth in those balance sheets. And they had a great deal of short-term foreign funding.  Frozen foreign funding markets, which made it difficult for banks to rollover any such funding for more than extremely short terms, made a huge impression on local banks.  For months I was in the thick of our (Treasury and Reserve Bank) efforts to use Crown guarantees to enable banks to re-enter term wholesale funding markets.  Banks were telling us that their boards wouldn’t allow them to maintain outstanding credit if they were simply reliant on temporary Reserve Bank liquidity as a form of life support.

Despite what he says I doubt Eaqub really believes the global liquidity crunch was irrelevant to New Zealand, because his next argument is that the Reserve Bank mishandled the crisis.

The GFC highlighted that our central bank is slow to recognise big international challenges. They were too slow to cut rates aggressively. They were not part of the large economies that clubbed together to co-ordinate rate cuts and share understanding of the crisis.

I have a little bit of sympathy here –  but only a little.  I well remember through late 2007 and the first half of 2008 our international economics people patting me on the head and telling me to go away whenever I suggested that perhaps events in the US might lead to something very bad (and I’m not claiming any great foresight into just how bad things would actually get).  And I still have a copy of an email from (incoming acting Governor) Grant Spencer in August 2007 suggesting that it was very unlikely the international events would come to much and that contingency planning wasn’t worth investing in.

And, with hindsight, of course every central bank should have cut harder and earlier.  I recall going to an international central banking meeting in June 2007 when a very senior Fed official commented along the lines of “some in the market are talking about the prospect of rate cuts, but if anything we are thinking we might have to tighten again”.

As for international coordination, well the Reserve Bank was part of the BIS –  something initiated in Alan Bollard’s term.  Then again, we were tiny.   So it was hardly likely than when various central banks did coordinate a cut in October 2008 they would invite New Zealand to join in.  Of its own accord, the Reserve Bank of New Zealand cut by 100 basis points only two weeks later (having already cut a few weeks earlier).

But what did the Reserve Bank of New Zealand actually do, and how did it compare with other advanced country central banks?

The OECD has data on (a proxy for) policy rates for 19 OECD countries/regions with their own currencies, and a few other major emerging markets.   Here is the change in the policy rates between August 2007 (when the liquidity pressures first became very evident) and August 2008, just before the Lehmans/AIG/ agencies dramatic intensification of the crisis.

policy rate to aug 08

The Reserve Bank had cut only once by this time.  But most of these countries had done nothing to ease monetary policy.  It wasn’t enough, but it wasn’t exactly at the back of the field, especially when one recalls that at the time core inflation was outside the top of the target range, and oil prices had recently been hitting new record highs.

That was the record to the brink of the intense phase of the crisis.  Here is the same chart showing the total interest rate adjustment between August 2007 and August 2009 –  a few months after the crisis phase had ended.

policy rate to aug 09

Only Iceland (having had its own crisis, and increased interest rates, in the midst of this all) and Turkey cut policy rates more than our Reserve Bank did.   In many cases, the other central banks might like to have cut by more but they got to around the zero bound.  Nonetheless, the Reserve Bank cut very aggressively, to the credit of the then Governor.  It was hardly as if by then the Reserve Bank was sitting to one side oblivious.

Obviously I’m not going to defend the Reserve Bank when, as Eaqub does, he criticises them for the mistaken 2010 and 2014 tightening cycles.  And the overall Reserve Bank record over several decades isn’t that good (as I touched on in a post on Friday), but their monetary policy performance during the crisis itself doesn’t look out of the international mainstream.   Neither, for that matter, did their handling of domestic liquidity issues during that period.

Eaqub also takes the government to task

The government bizarrely embarked on two terms of fiscal contraction. This contraction was at a time of historically low cost of money, and a long list of worthy infrastructure projects in housing and transport.

Projects that would have created long term economic growth and made our future economy much more productive, tax revenue higher, and debt position better.

Our fiscal policy is economically illiterate: choosing fiscal tightening at a time when the economy needed spending and that spending made financially made sense.

To which I’d make several points in response:

  • our interest rates, while historically low, remain very high relative to those in other countries,
  • in fact, our real interest rates remain materially higher than our rate of productivity growth (ie no productivity growth in the last four or five years),
  • we had a very large fiscal stimulus in place at the time the 2008/09 recession hit, and
  • we had another material fiscal stimulus resulting from the Canterbury earthquakes.

Actually, I’d agree with Eaqub that the economy needed more spending (per capita) over most of the last decade –  the best indicator of that is the lingering high unemployment rate – but monetary policy is the natural, and typical, tool for cyclical management.

And, in any case, here is what has happened to gross government debt as a share of GDP over the last 20 years.

gross govt debt

Not a trivial increase in the government’s debt.   Not necessarily an inappropriate response either, given the combination of shocks, but it is a bit hard to see why it counts as “economically illiterate”.  Much appears to rest on Eaqub’s confidence that there are lots of thing governments could have spent money on that would have returned more than the cost of government capital.  In some respects I’d like to share his confidence.  But I don’t.   Not far from here, for example, one of the bigger infrastructure projects is being built –  Transmission Gully –  for which the expected returns are very poor.

Eaqub isn’t just concerned about how the Reserve Bank handled the crisis period.

Our central bank needs to own up to regulate our banks much better: they have allowed mortgage borrowing to reach new and more dangerous highs.

I’d certainly agree they could do better –  taking off LVR controls for a start.  But bank capital requirements, and liquidity requirements, are materially more onerous than they were a decade ago.  And our banking system came through the last global crisis largely unscathed –  a serious liquidity scare, but no material or system-threatening credit losses.  Their own stress tests suggest the system is resilient today.  If Eaqub disagrees, that is fine but surely there is some onus on him to advance some arguments or evidence as to why our system is now in such a perilous position.

Macro-based crisis prediction models seem to have gone rather out of fashion since the last crisis.  In a way, that isn’t so surprising as those models didn’t do very well.     Countries with big increases in credit (as a share of GDP), big increases in asset prices, and big increases in the real exchange rate were supposed to be particularly vulnerable.  Countries like New Zealand.   The intuitive logic behind those models remained sound, but many countries had those sorts of experiences and had banks that proved able to make decent credit decisions.  And we know that historically loan losses on housing mortgage books have rarely been a key part in any subsequent crisis.     Thus, the domestic loan books of countries like New Zealand, Australia, Canada, the UK, Norway and Sweden all came through the last boom, and subsequent recession, pretty much unscathed.

One of the key indicators that used to worry people (it was the centrepiece of BIS concerns) was the ratio of credit to GDP.  Here is private sector credit as a per cent of GDP, annually, back to when the Reserve Bank data start in 1988.

psc to gdp

Private sector credit to GDP was trending up over the two decades leading up to the 2008/09 recession.   There was a particularly sharp increase from around 2002 to 2008 –  I recall once getting someone to dig out the numbers suggesting that over this period credit to GDP had increased more in New Zealand than it had increased in the late 1980s in Japan.  It wasn’t just housing credit.  Dairy debt was increasing even more rapidly, and business credit was also growing strongly.   There was good reason for analysts and central bankers to be a bit concerned during that period.  But what actually happened?  Loan losses picked up, especially in dairy, but despite this huge increase in credit –  to levels not seen as a share of GDP since the 1920s and 30s – there was nothing that represented a systemic threat.

And what has happened since?  Private sector credit to GDP has barely changed from the 2008 peak.  In other words, overall credit to the private sector has increased at around the same rate as nominal GDP itself.  It doesn’t look very concerning on the face of it.  Of course, total credit in the economy has increased as a share of GDP, but that reflects the growth in government debt (see earlier chart), and Eaqub apparently thinks that debt stock should have been increased even more rapidly.

It is certainly true that household debt, taken in isolation, has increased a little relative to household income.  But even there (a) the increase has been mild compared to the run-up in the years prior to 2008, and (b) higher house prices –  driven by the interaction of population pressure and regulatory land scarcity – typically require more gross credit (if “young” people are to purchase houses from “old” people).

If anything, what is striking is how little new net indebtedness there has been in the New Zealand economy in recent years.  Despite unexpectedly rapid population growth and despite big earthquake shocks, our net indebtedness to the rest of the world has been shrinking (as a share of GDP) not increasing.  Again, big increases in the adverse NIIP position has often been associated with the build up of risks that culminated in a crisis –  see Spain, Ireland, Greece, and to some extent even the US.   I can’t readily think of cases where crisis risk has been associated with flat or falling net indebtedness to the rest of the world.

There is plenty wrong with the performance of the New Zealand economy, issues that warrant debate and intense scrutiny leading up to next month’s election.  In his previous week’s column, Eaqub foreshadowed the possibility of a domestic recession here in the next year or two: that seems a real possibility and our policymakers don’t seem remotely well-positioned to cope with such a downturn.     But there seems little basis for “GFC redux” concerns, especially here:

  • for a start, we didn’t have a domestic financial crisis last time round, even at the culmination of two decades of rapid credit expansion,
  • private sector credit as a share of GDP has been roughly flat for a decade,
  • our net indebtedness to the rest of the world has been flat or falling for a decade,
  • there is little sign of much domestic financial innovation such that risks are ending up in strange and unrecognised places, and
  • whereas misplaced and over-optimistic investment plans are often at the heart of brutal economic and financial adjustments, investment here has been pretty subdued (especially once one looks at capital stock growth per capita).

In other words, we have almost none of the makings of any sort of financial crisis, “GFC” like, or otherwise.

House prices are a disgrace. We seem to have no politicians willing to call for, or commit to, seeking lower house prices.  But markets distorted by flawed regulation can stay out of line with more structural fundamentals for decades.  If house prices are distorted that way, it means a need for lots of gross credit.  But it tells you nothing about the risks of financial crisis, or the ability of banks to manage and price the associated risks.

Bank capital: some thoughts

Six months or so ago the Reserve Bank announced that it would be conducting a review of capital requirements for banks.  At the start of last month, they released an Issues Paper, inviting submissions by today (rather a short period of time, for an issue which has major implications for banks’ financing structures and, potentially, costs).   I’m not going to make a formal submission, but thought I might outline a few thoughts on some of the issues that are raised in (or omitted from) the paper.

I’d also note that it is a curious time to be undertaking the review.  Background work and supporting analysis is always welcome, but here is how the Reserve Bank summarises things.

Detailed consultation documents on policy proposals and options for each of the three components will be released later in 2017, with a view to concluding the review by the first quarter of 2018.

But the Reserve Bank is now well into a lame-duck phase.  Graeme Wheeler –  currently the sole formal decisionmaker at the Bank –  leaves office on 26 September, and then we have an acting Governor (lawfully or not) for six months.  Spencer’s temporary appointment expires (and he leaves the Bank) on 26 March 2018, which is presumably when a new permanent Governor will be expected to take office.   The incentives look all wrong for getting good decisions made, for which the decisionmakers will be able to be held accountable.     Big decisions in this area –  and the Bank is raising the possibility of big increases in capital requirements –  are something the new Governor should be fully coomfortable with (and, especially if an outsider is appointed, that shouldn’t just mean some pro forma tick granted in his or her first days in office.)    We have constitutional conventions limiting what governments can do immediately prior to elections.  It isn’t obvious why something similar shouldn’t govern the way unelected decisionmakers behave in lame-duck, or explicitly caretaker, periods.  Some decisions simply have to be made and can’t wait.   These sorts of ones aren’t in that category.

(In passing, and still on capital, I’d also note that there is something that seems not quite right about the Reserve Bank’s refusal to comment on why a couple of Kiwibank instruments have not been allowed to count as capital.   The capital rules should be clear and transparent.  The terms of the relevant instruments are also presumably not secret.  Perhaps Kiwibank has been told why their instruments missed out, but it seems unsatisfactory that everyone else is left guessing, or reliant on things like the deductions and speculations of an academic who was once a regulatory policy adviser (eg here and here).    I have no particular reason to question the Reserve Bank’s substantive decision, but these are matters of more than just private interest.  It is an old line, but no less true, that in matters where government agencies are exercising discretion sunlight is the best disinfectant.)

High levels of bank capital appeal to government officials.   To the extent that more of a bank’s assets are funded by shareholders rather than depositors then, all else equal, the less chance of a bank failing.  And if avoiding bank failure itself isn’t a public policy interest –  after all the Reserve Bank regularly reminds us that the supervisory regime isn’t supposed to produce zero failures –  minimising the cost of government bailouts is.   There might be various ways to do that –  the Open Bank Resolution model is designed to be one, but high levels of capital are another.

High levels of capital should also appeal to depositors and other creditors.  Your chances of getting your money back in full are increased the more the bank’s assets are funded by shareholdes, who bear the losses until their capital is exhausted.   Of course, that argument is weakened if you think that the government will bail out anyway, but that is just another reason for governments to err towards high levels of capital.

Capital typically costs more than deposits (or wholesale debt funding).  That isn’t surprising –  the shareholders are taking on more risk.  But, of course, the larger the share of equity funding then the lower the level of risk per unit of equity.  In principle, higher capital requirements lower the cost of capital.  Very low capital levels should tend to raise the cost of debt (debt-holders recognise an increased chance that they will be the ones who bear any losses).  Modigliani and Miller posited that, on certain assumptions, the value of a firm was unaffected by its financing structure –  to the extent that is true, higher capital requirements don’t affect the economics of (in this case) banking.

It won’t hold in some circumstances.  For example, if creditors are all sure a government will bail them out, a bank is much more profitable the lower the capital it can get away with.  In the presence of that sort of perceived or actual bailout risk, there is little doubt that increasing capital requirements is a real cost to the banks.  But it is almost certainly worth doing: it helps ensure that the risks are borne by the people responsible for the decisions of the bank (shareholders, and their representatives –  directors and management).

Taxes also complicate things.  If the tax system has an entrenched bias in favour of debt, then increased capital requirements will also represent a real cost to the banking system.  Many –  most –  tax systems do have such a bias.  For domestic shareholders, and to a first approximation, neither our tax system nor that of Australia have that bias.  That is because of the system of dividend imputation, which is designed to avoid the double-taxation of business profits (returns to equity).    Unfortunately, there is no mutual recognition of trans-Tasman imputation credits, and most of our banking system is made up of Australian banks with (mostly) Australian shareholders.   For most, but not all, of our banks increasing capital requirements is likely to represent some increase in effective cost.  And the resulting revenue gains are mostly likely to be collected by the Australian Tax Office.

An open question –  and one not really touched on in the Bank’s issues paper –  is to what extent our bank regulators should take account of these features of the tax system.  For most companies, capital structure is a choice shareholders and management make, weighing all the costs, benefits, opportunities and distortions themselves.  But in banking, for better or worse, regulators decide how much capital banks have to raise to support any given set of assets.   One could argue that tax is simply someone else’s problem:  if higher required capital ratios increased costs, the Australian banks could simply redouble their lobbying efforts in Canberra to get mutual recognition of imputation credits, and if that didn’t work, there would simply be a competitiveness advantage to New Zealand banks.   Perhaps that solution looks good on paper, but I think it is less compelling than it might seem. First, banks can and do lobby here too.  The Reserve Bank might get to set capital ratios at present, but that law could be changed.  And second, we benefit from having foreign banks, with risks spread across more than one economy.

Even if all the tax issues could be eliminated here –  and they won’t be in time for this review, if ever –  there is still the possibility that the market will trade on the basis that additional capital requirements will increase overall funding costs for banks, even if there is little rational long-term reason for them to do so.   One reason that problem could exist is because the tax biases are pervasive globally, and it is therefore a reasonable rule of thumb for investors to treat higher capital requirements as an expected cost.

Over the years, I’ve tended to have a bias towards higher capital requirements.  I’ve read and imbibed Admati’s book (for example).  As recently as late last year I wrote here

My own, provisional, view is that for banks operating in New Zealand somewhat higher capital requirements would probably be beneficial, and that there would be few or no welfare costs involved in imposing such a standard.  My focus is not on avoiding the possible wider economic costs of banking crises (which I think are typically modest –  if there are major issues, they are about the misallocation of capital in booms), but on minimising the expected fiscal cost of government bailouts.  As I’ve explained previously, I do not think the OBR tool is a credible or time-consistent policy.

But I have been rethinking that position to some extent.   The Reserve Bank talks in its Issues Paper of the possibility of an “optimal” capital ratio (from the academic literature) of perhaps 14 per cent (with estimates that range even higher), well above the minimum ratios that are in place today.

But if there are additional costs from raising capital requirements –  which seems likely, at least to an extent –  we need some pretty hard-headed assessments of the real gains that might accrue to society as a whole to warrant those increased costs.  And those gains are hard to find:

  • for over 100 years our banking system has been impressively stable.  If that was in jeopardy in the late 1980s, that was in unrepeatable circumstances in which a huge range of controls had been removed in short order (and when there were no effective minimum capital requirements at all).
  • repeated stress tests, whether by the Reserve Bank, APRA, or the IMF all struggle to generate credible extreme scenarios in which the health of an indvidual bank, let alone the system, could be seriously impaired.  In most of those scenarios, the existing stock of capital hasn’t been impaired at all, let alone being at risk of being exhausted.
  • we have a banking system where most of the main players are owned by major larger overseas banking groups with a strong interest in the survival of the domestic operation, and the ability to provide any required capital support (the New Zealand regulated entities aren’t widely-held listed companies).

I’m still not sure what to make of the role of the OBR mechanism.  As I noted earlier, I’ve never been convinced that it is a credible or time-consistent option, but our officials appear to, and even ministers talk up the option.  If they really believe that they (and their successors) will be willing and able to impose material losses on bank creditors and depositors in the event of a future failure, there can’t be any strong case for higher capital requirements (indeed, arguably a very credible OBR eliminates the basis for capital requirements at all).  Even if officials and ministers aren’t 100 per cent sure about OBR, any material probability of it being able to be used in future crises needs to be weighed into the calculations when a proper cost-benefit assessment of proposals for higher capital requirements is being done.  At present, there is little or sustained discussion of the OBR issues in the Issues Paper.  I look forward to the inclusion of OBR considerations in a proper cost-benefit analysis if the Bank does end up proposing to raise capital ratios.

My other reason for unease is that in the Issues Paper the Reserve Bank does not engage at all with, for example, the past stress test results.  There is nothing in the paper to suggest that current capital ratios don’t more than adequately cover risks.  Instead, they fall back on generalised results from an offshore literature, and arguments about why New Zealand capital ratios should be higher than those abroad.  Those simply fail to convince.

Here is the gist of their argument

One of the principles of the capital review is that the regulatory capital ratios of New Zealand banks should be seen as conservative relative to those of their international peers, to reflect New Zealand’s current reliance on bank-intermediated funding, New Zealand’s exposure to international shocks, the concentration of our banking sector, the concentration of banks’ portfolios, and a regulatory approach that puts less weight on active supervision and relatively more weight on high level safety buffers such as regulatory capital.

I’m not sure what weight should rest on that “be seen as” in the second line.  I presume not that much, as these seem to be presented as arguments that would warrant genuinely higher capital ratios than in other countries, not just something about appearances.  But in substance they don’t amount to much:

  • “New Zealand’s current reliance on bank-intermediated funding”.  I’m not quite sure what point they are trying to make here.  Does the Reserve Bank regard bank-based intermediation as a bad thing?  If so why?  I presume the logic of the point is something about it being more important than in most places to avoid bank failures, but that simply isn’t made clear, or justifed with data.  Payments systems –  a big focus of Bank concern around the point of a bank failure –  tend to be based through the banking system everywhere.  It is not even as if our corporate bond market –  while modestly-sized –  is unusually small by international standards.   (Incidentally, it is also worth noting that there appears to be nothing in the Issues Paper about non-banks, some of whom the Reserve Bank also regulates.  Making bank-based intermediation relatively more expensive –  which higher capital requirements could do –  would tend to lead to disintermediation.)
  • “New Zealand’s exposure to international shocks”.   Again, it isn’t obvious what this point amounts to.  Presumably the sorts of shocks New Zealand is exposed to are reflected in the scenarios used in the stress tests the Bank and others have run?  And it isn’t obvious that New Zealand’s economy is more exposed to international shocks than many other advanced economies –  there was nothing very unusual for example about our experience of the crisis of 2008/09.   I suspect that lurking behind these words is some reference to the old bugbear, the relatively high level of net international indebtedness –  a point the Bank and the IMF often like to make.   But this simply isn’t an additional threat to the soundness of the financial system.  Rollover risks can be real, but they aren’t primarily dealt with by capital requirements (but by liquidity requirements) and as we saw in 2008/09 the Reserve Bank can easily temporarily replace offshore liquidity.  Funding cost shocks also aren’t a systemic threat because, with a floating exchange rate, the Reserve Bank is able to offset the effects through lowering the OCR and allowing the exchange rate to fall.  The difference between a fixed exchange rate country and a floating exchange rate one, in which the bank system’s assets are all in local currency, seems to be glossed over too easily.
  • “the concentration of our banking sector”    Is this really much different from the situation in most smaller advanced economies (or even than Australia and Canada)?
  • “the concentration of banks’ portfolios”.  This seems a very questionable point.  Banks’ exposure in New Zealand are largely to labour income (the largest component of GDP, and the most stable) –  that is really what a housing loan portfolio is about – and to the export receipts of one of our largest export industries.  That is very different from, say, being heavily exposed to property development loans, to financing corporate takeovers, or other flavours of the day.   The effective diversification is very substantial, including the fact that in any scenario in which labour income is severely impaired (large increases in unemployment) it is all but certain the exchange rate will be falling (boosting dairy returns).  The two biggest components of the banks’ books themselves thus provide additional diversification.
  • “a regulatory approach that puts less weight on active supervision and relatively more weight on high level safety buffers such as regulatory capital.”     Is the Reserve Bank really saying they believe that on-site supervision would produce better financial stability outcomes?  I’m sceptical, but if they are saying that, surely the case would be strong to change the regulatory philosophy.  It would, almost certainly, be cheaper than a large increase in capital requirements.  At very least, if they want to rely on this argument, it would need to be carefully evaluated in any cost-benefit analysis.

It all leaves me a bit uneasy as to whether there is really the strong case for higher capital ratios that the Bank might like us to believe.  They’ll need to provide much more robust analysis if they really choose to pursue such an option.

And a final thought.  The Bank devotes some space in their Issues Paper to considering the role of convertible capital instruments  –  issued as debt but converting to equity under certain (more or less well-defined) adverse event circumstances.  In doing so, they provide vital loss-absorbing capacity, providing a buffer for depositors and other non-equity creditors.  There are some practical problems with these instruments –  the Bank touches on many of them –  and they probably shouldn’t be marketed to retail investors (at least without very explicit warnings) lest the pressures mount for holders of these instruments also be to bailed out in a crisis.     Nonetheless, in the presence of the tax issues discussed earlier, convertible instruments look like a generally attractive option for supporting the robustness of banks in a cost-efficient way.

Given that I was interested in this paragraph  on convertible instruments from the Bank.

In New Zealand there has been no conversion at all of Basel-compliant AT1 and Tier 2 instruments, because banks have not been in financial difficulty, so there is even less certainty about the practical effects of conversion in New Zealand’s particular legal and institutional environments. In the Reserve Bank’s view these instruments should be regarded as essentially untested in the New Zealand environment.

Of course, the same can be said for OBR, and indeed for almost all the crisis-management provisions of New Zealand bank supervisory legislation.

The Bank does draw attention to the risk of bailouts of holders of convertible capital (co-co) instruments.  On the other hand, they can work when banks fail.  Earlier this week, Banco Popular in Spain “failed”.  It was taken over, for 1 euro, by Banco Santander, which will inject a lot of new equity into Popular.   Popular had co-co instruments on issue.  Here is what happened to the price of those bonds.

popular co-co

Banks can fail, banks should fail from time to time (as businesses in other sectors should), and when they do it should be clearly established who is likely to lose money.  This looks like a good example, where the shareholders and the holders of the co-cos will have lost everything they had invested in these instruments.

To revert briefly to our own Reserve Bank’s review, perhaps there is a case for higher capital ratios.  But, if they want to pursue that option, it isn’t likely to be cost-free, and any such proposal will need to be backed by a robust and detailed cost-benefit analysis. For now, it isn’t clear that the reasons they have suggested why capital ratios here should be higher than those in other advanced countries really stand up to scrutiny.


The Financial Stability Report: falling short again

The Reserve Bank yesterday released its six-monthly Financial Stability Report.   With (fortunately) no new direct controls to announce, the latest FSR didn’t get a great deal of coverage, and I won’t be writing about it at great length either.  But there were a few points that I thought it was worth making.

First, I thought it was a little surprising that the Bank did not have a bit more discussion of euro (and EU) break-up risk.  It has been a slow-burn process (materially slower than pessimists like me had expected) but none of the underlying stresses seem to be going away.  This weekend alone we have the Italian referendum, which could see the fall of the mainstream Italian government, and the rerun of the Austrian presidential election.  In the first half of next year, there are elections in France and the Netherlands, and in both countries anti-euro parties are polling very strongly.  The Reserve Bank does note problems in the banking systems of various European countries, but these are symptoms of some of the underlying problems not the source of the main risk.  As with all tail-risks, it is impossible to get the timing right, but to me these euro/EU risks remain by far the largest visible disruptive threat to the world economy and world markets over the next decade (China, by contrast, is more closed to the world, and has a strong (grossly over-strong) central government).  Perhaps the Reserve Bank feels uncomfortable writing about these euro/EU risks –  it might make for awkward conversations for the Governor the next time he goes to BIS meetings –  but these reports are for New Zealand citizens, not for the international fraternity of central bankers.  If it is too awkward to reflect on real and substantial risks, one has to ask how much value there is in FSRs more generally.  Conventional, and anodyne, references to Brexit and/or the US election don’t really cut it.

Second, it was a bit disappointing that even in a financial system piece like the FSR, the Bank still couldn’t help itself, and insists on running the line that

“New Zealand’s economy is strong relative to other advanced economies, growing 2.8 per cent in the year to 2016”.

And our population grew by 2.1 per cent in that year.  Per capita GDP growth is weak, and has been over the last few years taken together. I illustrated a while ago that relative to other advanced countries, growth in real GDP per capita since 2013 has been around the median.  And there has been no labour productivity growth here at all.

At one level when the Bank writes misleading things like this it doesn’t matter very much.  But at another level it does. Society has delegated an enormous amount of power to the Governor, including the resources to produce major reports like the FSR. We should expect them to avoid rose-tinted political perspectives.  If they don’t on small issues like this, how can we have much confidence in their willingness to accurately represent things in conditions of much greater stress or risk?

In the FSR the Bank puts quite a bit of weight on the increased use banks have been making of offshore wholesale funding.  I was a bit puzzled by this increased use, since there has been no sign of the current account deficit widening notably (and bank offshore borrowing tends to grow most notably when the current account deficit is large –  it was the main channel through which the larger deficits were financed).  I was interested in this chart, drawing on data from the Reserve Bank website.  It shows annual growth in Private Sector Credit to resident, and a broad measure of the money supply (M3, from residents), both adjusted for repo transactions.

psc and m3.png

The deposit side of the financial system balance sheet is growing at around the same rate as the credit side, hardly suggestive of any particular problems.  If anything, it looks as though banks’ increased reliance on foreign wholesale funding markets isn’t reflecting some deteriorating domestic macroeconomic imbalances, so much as the specification of the Reserve Bank’s core funding requirement (CFR) which, somewhat arbitrarily, distinguishes between some types of domestic deposits and others.  I don’t have a strong view on how the CFR is set up, and I believe some funding restrictions are necessary –  to internalise what would otherwise be a willingness of banks to simply rely on the central bank in times of stress.  But no such rule is perfect, and it would be good if the Bank were a bit more explicit about where the pressure for more (more expensive) foreign wholesale funding seems to be coming from.

One of my longstanding criticisms of FSRs over the years (including when I sat on the editorial committee reviewing them internally) is the weak treatment of the efficiency side of the Bank’s statutory responsibilities.  The Bank is required to use its statutory bank regulation powers to “promote the maintenance of a sound and efficient financial system”.  There is an almost inevitable tension between those two strands –  something I believe that Parliament recognised in phrasing things the way it did –  and the Act also requires the Bank to write FSRs in ways that allow the conduct of policy to be evaluated against the statutory criteria.

In yesterday’s FSR there is one paragraph (and one table) on the efficiency side of the Bank’s responsibility, under the somewhat ambiguous heading “Some indicators suggest New Zealand’s banking system is operating efficiently”.  Am I meant to take from that that other indicators, not reported, suggest otherwise?  I’m also a bit genuinely puzzled why the Reserve Bank considers that a low ratio of NPLs is an indicator of system efficiency.  In credit booms there are typically very few NPLs –  they come after the boom has bust.  In very risk averse systems there are typically very few NPLs.  In isolation, it simply doesn’t look like an efficiency indicator.      And the Bank simply does not address the inevitable adverse efficiency implictions of its increasing reliance on direct controls on specific classes of lending by specific types of institutions.   There has never been a proper cost-benefit analysis on the repeated waves of new controls.  Perhaps it is hard to do one formally, but the FSR should be an opportunity for some more considered analysis exploring some of these issues. As it is, it risks veering towards being a propaganda sheet for the Governor’s chosen policies.  Perhaps it is hard for it to be otherwise, especially under the current governance model –  the Governor signing off on a report on his own policy –  which simply highlights against the desirability of structural governance reform.

The FSR reports no reason to doubt the ability of the insurance sector to cope with the recent severe earthquake.  Perhaps the event was too recent to allow them to deal with the issue in any greater depth, but for the next FSR it might be worth posing the question as to what might threaten the ability of New Zealand insurers to keep getting reinsurance in large volumes for earthquake risk.    The NOAA database suggests that of the 33 earthquakes of 6.5 magnitude or greater to have hit New Zealand since 1840, 10 –  or almost a third –  have hit in the last 10 years (and the very destructive February 2011 aftershock was less than 6.5).    Is there a risk that a continuation of that sort of higher quake frequency could serously impair the ability to insure earthquake risk in New Zealand?  As we know that the Reserve Bank solvency standards for insurers were not set to cope with a repetition of the Christchurch quakes, what sort of tail risk concerns might this raise –   not just for the insurers, at least for the wider (currently) insured population?

The Reserve Bank has underway a review of the capital requirements for banks. on which they expect to consult next year.  As they note at present

The Reserve Bank will also look at international norms when considering calibration of New Zealand’s capital requirements. In raw international comparisons, the current capital ratio of New Zealand banks is relatively low. But a simple comparison is potentially misleading as the risk weights that New Zealand banks must apply to certain asset classes are set conservatively. This means New Zealand banks’ capital ratios appear lower than foreign banks’ ratios for the same underlying portfolios.

After adjusting for the conservative approach New Zealand takes, the Reserve Bank’s preliminary assessment is that New Zealand banks’ riskweighted capital ratios have been near or above international norms.

Looking ahead  (emphasis added)

As part of the review, the Reserve Bank will consider the appropriate amount and quality of capital New Zealand banks should be required to maintain. This will involve a survey of recent academic and central bank studies on optimal capital ratios. Care will be taken when interpreting these studies as they tend to be sensitive to assumptions about the effect of capital on banks’ funding costs and the scale of GDP losses that are directly attributable to banking crises.  It is also unclear how the inclusion of different types of capital affects the results of these studies.

I found those comments encouraging.  While I would hope that the Bank always interprets literature carefully, there are particular issues in this area.

Thus, those arguing for much higher bank capital ratios often suggest (for example) that all or most of the underperformance in economies since 2008 can be ascribed to the banking crises. If one assumes that, it is worth society spending almost any amount of money to avoid a repeat.  A more plausible story is that the banking crises themselves explain only a rather small amount of a structural global slowdown in productivity growth (that was already underway well before the crisis).  On other hand, those opposed to higher capital requirements often argue that having to fund a larger proportion of loans from equity would materially increase the cost of funding.  That approach tends to ignore both the potential for the Reserve Bank to cut the OCR, to offset any incipient rise in interest rates, and –  more importantly –  ignores the extent to which a higher reliance on equity reduces the riskiness of the institutions, and should reduce the required rate of return on equity.  Tax systems can complicate that story, but the New Zealand (and Australian) tax systems, with dividend imputation, tend to treat debt and equity more or less equally.

My own, provisional, view is that for banks operating in New Zealand somewhat higher capital requirements would probably be beneficial, and that there would be few or no welfare costs involved in imposing such a standard.  My focus is not on avoiding the possible wider economic costs of banking crises (which I think are typically modest –  if there are major issues, they are about the misallocation of capital in booms), but on minimising the expected fiscal cost of government bailouts.  As I’ve explained previously, I do not think the OBR tool is a credible or time-consistent policy.

Many of these have been relatively small points, at least for now.

I am more uneasy about two aspects of the report, one of which is missing completely.

There is simply no discussion at all –  and has been none in past reports –  of what the implications of drifting ever closer to the near-zero lower bound on nominal interest rates might be for financial system resilience in a further severe recession.  One of the great merits of a floating exchange rate system has been the flexibility it provides to national central banks to adjust policy interest rates, more or less without limit, as domestic conditions require. But the limits are now becoming increasingly visible.  It is remiss of the Bank – both in its MPS, its FSR, and its more corporate documents such as its Statement of Intent, or governors’ speeches – not to even begin to address these issues openly.  Simply ignoring them doesn’t make them go away, and there will no acceptable excuse if we find ourselves in the same position many other advanced countries found themselves in after 2008, having been given a decade’s sharp-focus notice of the potential problem.

And my final source of unease is around the Reserve Bank’s analysis of the housing market.  The Bank puts a great deal of importance on developments in the housing market, and the market for housing credit.  It is has imposed successive rafts of direct controls, of the sort never seen before in post-liberalisation New Zealand, all on the basis of little or no research.  And in the latest FSR, there is no fresh analysis, just the looming threat of debt to income restrictions –  if the market takes off again –  so long as the Governor can persuade the Minister of Finance to give him political cover (and of course he will, or otherwise the Opposition will attack the Minister for standing in the way of the Reserve Bank).

I’ve noted in the past that we’ve seen no analysis from the Bank on, for examples, countries that have had large increases in house prices and where there has been no subsequent financial crisis, or even collapse in house prices.  New Zealand, Australia, the United Kingdom and Canada in the 2000s are just some of the examples that spring to mind.  And although the Bank keeps talking about the problems in housing supply, they show no sign of having really thought deeply, or researched, the role of land market restrictions.  The New Zealand housing market is unlikely to be sorted out by simply building enough houses to keep the occupancy rate stable – or even a few more.  There is a much more structural issue around restrictions on land use (accentuated by the heavy regulatory costs imposed on building new houses).  I’m not aware of countries with floating exchange rates and tight land use restrictions where urban house and land prices have sustainably come down again.  Perhaps the Bank is, but if so surely the onus is on them to disseminate the research, rather than continuing to hand-wave and treat all house price increases as more or less equally risky.  When house prices are bid up on the back of congressional and executive pressure on lenders to lower lending standards, on pain of potentially losing favour with the regulators, that is a very different issue than when the combination of population pressures and land use restrictions drive prices up. But the Reserve Bank has never articulated that sort of distinction.

It is more than three years now since the Reserve Bank set off down the path of increasing direct controls (with no end in sight, let alone the prospect of removing the controls).  I went through the list of their Analytical Notes, Discussion Papers,  and  Bulletins over the last three years or so, and was struck by how little housing-market research they have published.  For an organisation with so much discretionary power, and a substantial publicly-funded research capability, it really isn’t good enough.

I could repeat a variety of points from previous commentaries –  including questions about what other risks banks are assuming if they are prevented from taking on as many high LVR housing loans as they would like –  but will leave it at that for now.



LVR controls, regulatory philosophy (and the OIA)

I’ve had a bit of a relapse in my recovery and seem set to spend much of this week doing little more than lying on the sofa reading something not too taxing.  There are plenty of things I’d like to comment on substantively, but for now it won’t happen.

The Reserve Bank released its (latest –  third in three years) final LVR decision on Monday.  To no one’s surprise, after a sham consultation, they confirmed the Governor’s original plans, albeit with some curious refinements to the exemptions –  curious, that is, if one thinks that decisions on such things should be based on considerations – the statutory ones – around the soundness and efficiency of the financial system.

And although the lawgiver has now descended from the mountain and issued his unilateral decrees, which have the force of law, there is still no sign of a regulatory impact assessment.  There is talk in the summary of submissions that one is forthcoming, but really……when the regulatory impact assessment is published only some time after all the decisions have been made, it reveals quite how little weight the Governor seems to put on good processes.  And it is not as if the initial consultation document was sufficiently extensive and robust to cover the ground –  recall the “cost-benefit” analysis that consisted of a questionable list of pros and cons with no attempts to quantify any of them.

One of the other things I had hoped to comment on in more depth was a speech given last week by Toby Fiennes, the Reserve Bank’s Head of Prudential Supervision. on the Bank’s regulatory philosophy and supervisory practices.    It included this nice chart, outlining various aspects of financial institutions’ operations and how much, in the Bank’s judgement, they mattered to the “RBNZ and society” (as if these were the same thing) and how much they mattered to the institutions themselves.

Figure 1: Selected interests of the RBNZ, society and financial institutions


Fiennes went on to note that the blue areas aren’t of much interest to the Bank (and don’t therefore attract much regulatory interest), while the red area are typically quite heavily and directly regulated.

But in this context, it was the comments on the green areas that caught my eye

Some things – like risk management and underwriting standards (in green) – are of strong interest to both the Reserve Bank and firms. Here we tend to use market and self-discipline. Examples of some of our supervisory practices in this area are:

  • Disclosure of credit risks;
  • Mandatory credit ratings;
  • Governance requirements; and
  • Publicly disclosed attestations by the board that key risks are being managed.

Now I know that the Bank’s prudential supervisors have never been keen on LVR restrictions, and that they are devised in a different department, but……..all controls are imposed under the same legislation –  indeed the same part of the legislation –  and by the same Governor.  And when housing loans are the biggest single component of banks’ credit exposure –  and banks have most to lose if things go wrong – and yet when the Bank has imposed three sets of direct controls on housing LVRs in three years, imposing its own judgements on underwriting standards, you might have hoped that practice and “philosophy” might have been better reconciled, or the gaps smoothed over in a speech by the Head of Prudential Supervision.

As regular readers know, I’ve been pushing to get submissions on Reserve Bank regulatory proposals routinely published.  Such publication is common practice in other areas of government, including submissions to parliamentary select committees.  If you make a submission seeking to influence public policy, that submission should generally be public as matter of course –  it should be one of the hallmarks of an open society.

Some progress has been made with the Reserve Bank.  If someone asks, they will now typically release submissions made by anyone who isn’t a regulated institution.  I asked for all the submissions on the latest LVR “proposal” to be released, and  –  as expected –  the Bank has released all those not made by banks (the regulated institutions in this proposal).  Anyone interested can find those submissions here. I have three remaining areas of concern.

The first is that release of submissions should be a routine part of the process for all consultations, not just when someone makes the effort (remembers) to ask.  The second is that on this occasion they have withheld the names of four private submitters.  As I noted, if you want to influence lawmaking, you should be prepared to have your name disclosed.  How can citizens have confidence in the integrity of lawmaking processes if they don’t know who the Bank is receiving submissions from, and what interests they may represent?  (Of course, since one of the anonymous submitters appears to have views very similar to my own, we can safely assume that that person’s views will have had no influence on the Bank.)

And the third concern is that the Reserve Bank is still consistently keeping secret the views of regulated entities (the banks in this case).  When the regulated lobby the regulator it is particularly important that citizens are able to see what arguments are being made, to ensure that the process remains robust and that the regulators are not being “captured” by their closeness to the regulated –  bearing in mind that the Bank is supposed to be regulating in the public interest, not that of banks.   As I’ve noted before, the Bank justifies withholding bank submissions on the grounds of section 105 of the Reserve Bank Act –  which they argue compels them to withhold such material.  In fact, that section of the Act gives no hint of a distinction between material received from banks and that from other parties,  If section 105 applies to submissions on proposed regulatory changes, the Bank is obliged to keep secret all submissions, not just those from banks.  As I’ve noted before, there is a good case for a small amendment to the Reserve Bank Act to make it clear that the section 105 protections do not apply to submissions on regulatory proposals and hence that banks should expect their submissions to the Reserve Bank on regulatory initiatives to be published, in just the same way that bank submissions to parliamentary select committees will generally be published.

I have appealed to the Ombudsman the Bank’s decision to withhold the bank submissions, in effect seeking greater legal clarity on what the section 105 restrictions actually apply to.  In the meantime, of course, if the banks have nothing to hide –  and I don’t imagine they really do –  they could chose to publish their submissions.  According to the Summary of Submissions “a few respondents urged tighter LVR restrictions on investors than proposed”, so perhaps the ANZ really did follow up on their CEO’s newspaper op-ed and advocate more far-reaching restrictions.  If so, citizens should have the right to know (customers might be interested to, but that is their affair).