Governing financial stability policy

On Monday afternoon, The Treasury hosted Professor Prasanna Gai of Auckland University, who gave a guest lecture on the topic “Resilience and reform –  towards a financial stability framework for New Zealand”.     The timing of this event, put on at quite short notice, is presumably not unrelated to the current review of the Reserve Bank Act.

Prasanna Gai is well-qualified to talk about such issues.  He was formerly a professor at ANU, and prior to that worked at both the Bank of Canada and the Bank of England.  These days –  even from the ends of the earth –  he is an adviser to the European Systemic Risk Board.  A few years ago he served as an external academic adviser to the Reserve Bank of New Zealand, and did one of the periodic visitor reviews of our forecasting and monetary policy processes, based on his observation of one Monetary Policy Statement round.

In his presentation the other day, he appeared to set out to be “politely provocative” in pushing for reform, including greater transparency and accountability.   There was a fairly large number of Reserve Bank people at the lecture, and I suspect Prasanna’s calls won’t have gone down that well with them.

He began by noting that even now, 10 years after the last international financial crisis, there is very little academic analysis of the political economy of financial stability policy/regulation.  As he noted, in monetary policy there were key defining papers that laid the groundwork for monetary policy operational independence to become the norm internationally.    There is still really nothing comparable in respect of financial stability –  and certainly nothing robust that would justify delegating a very high degree of autonomy (arounds goals, instruments, and intermediate targets) to unelected officials (especially a single such official).

As he notes, in most countries –  though not the US or the euro-area –  politicians (as representatives of societies) play the lead role in setting/approving the inflation target.   Things aren’t just mechanical from there –  there can be, and are, real debates about how aggressively to respond to deviations from target and the like –  but at least there is some benchmark to measure performance against.    There is nothing comparable for financial stability, and Prasanna Gai argues  –  and I strongly agree with him –  that politicians need to “own” financial stability policy, including taking a view (implicit or explicit) on things like the probability of a crisis that society is willing to tolerate (it is the implicit metric behind much of what systemic financial regulators do).

Gai’s focus in his talk was on what he –  and the literature –  likes to call “macroprudential policy”.     He draws a distinction between the supervision of individual banks and the supervision/regulation of the system as a whole.  I’ve never been convinced that it is a particularly robust distinction, at least in the New Zealand context, where a key defining characteristic of our banking system is four big banks, all with offshore parents from a single overseas countries, all with relatively similar credit exposures (and funding mixes).   Gai –  and others (including the Reserve Bank when it suits them) –  argue that each bank might manage its own risks relatively prudently, but has no incentive to take adequate account of the impact of its choices on other banks.  Again, in a concentrated system like our own, I’m not sure that is really true, at least in a way that has much substantive content.   Anyone lending on dairy farms (for example) will know that the market in such collateral gets extremely illiquid whenever times turn tough (as they did after 2007).  You’d be a fool, in managing your own bank’s risks, not to recognise that other people might be trying to liquidate collateral at the same time as you.   Much the same goes for housing loans –  and even if you didn’t directly take account of other banks’ exposures, if your bank has a quarter of the market, you can’t just assume your actions will have no impact on the value of the overall collateral stock (whereas, say, a 1 per cent player might be able to).   It doesn’t mean that banks don’t get carried away at times, and excessively ease credit standards, but I doubt the big 4 are ever not aware they are big fish in a small pond.  Banks were all very consious of firesale risks in managing dairy exposures in 2009/10.

And if the banks themselves forget it, I don’t think the Reserve Bank ever has.   As regular readers know, I don’t feel a need to defend the Reserve Bank on every count, but……I sat on the Financial System Oversight Committee for the best part of 20 years, and was involved in putting together Financial Stability Reports, and the sort of narrow “my bank only” focus people talk about when they try to carve out macroprudential policy as something different from micro-prudential supervision never resembled the way the Reserve Bank dealt with these issues and risks.   Perhaps it happened to some extent at the level of an individual supervisor, but not at the institution level.  The starting assumption tends to be that the risks –  credit and funding –  are pretty similar in nature for all the big banks.  In fact, we see that illustrated in the way our Reserve Bank treats stress tests –  here is the focus is systemic whereas, for example, the Bank of England provides a high degree of individual institution detail (since banks fail individually, I think the BOE approach is preferable).    What also marks out New Zealand supervision/regulation, is that the statutory mandate is explicitly systemic in focus; there is no explicit depositor protection mandate.

So although Gai’s talk was avowedly focused on macroprudential functions, in the end most of what he had to say applies (at least here) to the full gamut of the Reserve Bank’s financial regulatory functions.  I think that conclusion is reinforced by the scepticism Gai expressed about the ability of central banks/regulators to do much effective to dampen credit/housing cycles, leaning against booms.  He sees the case for regulation as primarily about building the resilience of the financial system.

In passing, I would note that I also think he grossly overstates the cost of financial crises.  He put up a series of charts for various countries showing the path of actual GDP in comparison to what it might have been if the pre-2007 trends had continued, and asserted that the difference was the effect of financial crises (perhaps as much as 70 per cent of one year’s GDP).  I’ve disputed that sort of claim previously here (including here and here) and a few months ago I ran this chart  suggesting that another meaningful way of looking at the issue might involve comparing the path of GDP for a country at the epicentre of the crisis (the US in this case), with the paths for advanced countries that didn’t experience material domestic financial crises,

US vs NZ Can etc

But if the costs of financial crises are far smaller than people like Gai (or Andy Haldane) assert, they probably aren’t trivial either, especially in the short-term (one or two year horizons).  And much the damage isn’t done in the crisis itself, but in the misallocation of credit and real resources in the build-up to the crisis.

So I’m not arguing a case against supervision/regulation –  and have been recently arguing that we should, on second best grounds, introduce a deposit insurance scheme, which would only reinforce the case –  but I am more sceptical than many, perhaps including Gai, about how much value supervisors can really achieve, whether macro or micro focused.    There has been a great deal of  regulatory activity –  sound and fury –  in the few years since the last crisis, but that was precisely the period when banking systems were least likely to run into trouble anyway (managers, shareholders, rating agencies all remembered –  and were often scarred by –  the 2008/09 crisis, and actually demand for credit was generally pretty subdued too).  The test of supervision/regulation isn’t the difference it makes in times like the last 7 or 8 years, but the difference at makes at the height of the next systemic credit boom.  It isn’t obvious –  including from past cycles –  that regulators, and their political masters, will be much different from bankers next time round either.  Some regulators might well want to be different, but typically they will be marginalised, or just never (re)appointed to key positions in the first place.

But given that we have bank regulation/supervision, how should it best be organised and governed?     There is no one model, either in the academic literature or in the institutional design adopted in other advanced countries.  One of the question is how closely tied financial stability policy should be to monetary policy.   At one end there is  –  perhaps the practical majority  – view (including from Lars Svensson) that monetary policy and financial stability are two quite separate things, and should be run separately, possibly even in separate institutions.   At the other extreme, there is an academic view that monetary and financial stability are inextricably connected and policy needs to address both together.  A middle ground is perhaps a view associated with the BIS, seeing a role for monetary policy to lean against credit asset booms, with the advantage –  relative to regulatory measures –  that “interest rates get in all the cracks”.

In New Zealand, the Reserve Bank Act has since 1989 required the Bank to have regard to the soundness and efficiency of the financial system in its conduct of monetary policy (a requirement carried over in the PTA in 2012).  But no one really knows what it means – to the drafters in 1989 it seems to have meant something about avoiding direct controls –  but it sounds good –  motherhood-ish almost.   In practice, it has never meant much: successive Governors have, at times, anguished about housing markets and possible future risks, and on the odd occasion have tempered their OCR calls by those concerns.  But my observation suggested they’d have done so anyway.

So we are in the curious position where financial stability considerations don’t matter to any great extent to monetary policy, and yet we have single decisionmaker deciding policy in both areas with –  partly as a result –  little direct accountability.    The Minister of Finance has little effective involvement in the appointment of the decisionmaker, or in the specification of the goals of financial stability policy.   The Governor decides –  based on whim, rigour, or prejudice, but with little or no legitimacy or democratic mandate. Even the legislation grew like topsy, and the governance provisions never envisaged as active prudential policy as we’ve seen in recent years.

There is a range of different models, and Gai covered some of them in his talk.  In Sweden there is little or no integration between the central bank and the financial regulatory agency.  In the UK, all the functions are (now back) in the Bank of England, but there are statutorily separate committees (albeit with overlapping membersships), most of the members are appointed by the Chancellor, and all members are individually accountable for their views/votes.  In Australia, there are multiple agencies, a Council chaired  by the Reserve Bank, but also a strong role in policysetting for the Federal Treasury, representative of the Treasurer (and the Treasurer/government directly appoint the key players, including the Governor).  There are other countries –  for example, Norway –  where decisionmaking powers on systemic prudential interventions are reserved to the Minister of Finance.

Prasanna Gai wrapped up his talk arguing that there is a strong case for rethinking the governance model around systemic financial stability in New Zealand.     Specifically, he made the case for the Minister of Finance to be more directly involved.  As he had noted earlier in his talk, the sort of regulatory interventions like LVRs are almost inevitably highly political in nature (especially as they can be highly granular –  we saw a couple of years back regulatory distinctions between Auckland and non-Auckland, and we still have distinctions between types of purchasers, even if the collateral is identical), and that the more independent a central bank is around such interventions the more politicised the institution risks becoming.  Gai argued –  and I agree with him –  that we’ve seen this in New Zealand in the last few years.  He argues that wider participation in decisionmaking could help safeguard monetary policy credibility (and perhaps the Bank’s effective operational independence there).

Gai argues for the establishment of a statutory committee to be responsible for systemic financial regulatory matters that are currently the sole preserve of the Governor.  He didn’t spell out clearly what, if any, powers he would reserve to the Minister –  perhaps that is captured in establishing a mandate (backed by statute, not the goodwill/moral pressure of the current MOU).  But he envisages a model in which the members of the committee would be appointed by the Minister of Finance, and would be individually accountable (including to Parliament) –  presumably implying a considerable degree of transparency around minutes/voting records.  He argues –  correctly in my view –  that such a committee would not only provide access to more technical expertise but that it would provide greater “legitimacy” for the choices being made.

Mostly, Gai’s talk was very diplomatic.  But there was a bit of a dig at the current Reserve Bank, noting that there didn’t seem to be much turnover (“churn”) at the senior levels of the Reserve Bank, at least when compared to the experience of places like the RBA or the Bank of England, which –  he argued –  limited the scope for challenging “house views” or established orthodoxies.    Bringing in outsiders –  individually accountable – to a statutory committee could counteract those risks.    Personally I’m less sure that turnover (generally) is the issue –  and as compared to the RBA (most notably) the Reserve Bank of New Zealand has been weak at building internally capability (as a result, 1982 is still the last time a Reserve Bank Governor was appointed from within).  The issues at the Reserve Bank seem to be more about the capability of certain key individuals –  several of whom (Spencer, McDermott, Fiennes and Hodgetts) have been in their roles for a long time –  and the sort of culture fostered from the top in the Wheeler years in particular.     In a high-performing organisation, constantly opening itself to challenge, scrutiny and new ideas (from inside and outside) that stability might be a real strength.  In our Reserve Bank it has become a considerable weakness.  But an external committee, properly constructed, could be part of a process of change, and entrenching new and better behaviours.

Gai’s summary:

  • financial stability policy should be on an equal footing with monetary policy,
  • the focus of such policy should be on resilience of the system, not trying to fine-tune the credit cycle (just too ambitious),
  • politicians need to own the standards of resilience policy is working to maintain/manage, and be engaged more overtly in decisionmaking, and
  • because it will never be possible to establish very specific, short horizon, goals comparable to those in the PTA, the process of policy formulation and governance/accountability mechanisms take on an even greater importance for financial stability than for monetary policy.

I’d largely agree with him.

I hope these are issues that the Minister of Finance is going to take seriously as part of his (currently secretive) review of the Reserve Bank Act.    With central bankers who have a strong incentive to defend their patch and their powers –  including a new Governor with a reputation for fighting his corner, come what may –  if the Minister isn’t engaged it would be all too easy to end up with no material change, and far too much power still concentrated in the hands of one, less than excellent, institution and its single decisionmaker.     This is the opportunity for serious reform – bearing in mind Mervyn King’s injunction that legitimacy (the “battle for hearts and minds”) matters greatly –  and I hope the Minister is exposed to the advice Prasanna Gai offered the other day.  A Financial Stability Committee shouldn’t be dominated by academics, but the Minister could do worse, in establishing such a committee, than to appoint Prasanna as one of the founding members.

For anyone interested in these issues, there is also a presentation here given last year by David Archer – former Assistant Governor of the Reserve Bank, and now a senior official at the BIS. I meant to write about it at the time, but never did.  His title is “A coming crisis of legitimacy?”  and this from his first slide captures his concern

Make the case that many central banks are at risk of a crisis of legitimacy, with respect to new macro financial stability mandates. The issue is an inability to write clear objectives.

He highlights some similar issues to Gai, but is more strongly committed to keeping ministers out of regular decisionmaking, and so his approach is to supplement committees with a clear statutory specification of the issues, considerations etc that should be taken into account in using/adjusting systemic financial regulatory policy.

Transparency: Bank of England vs RBNZ

Open government –  or the lack of it –  has been getting a bit of attention in recent weeks.  The previous National-led government was pretty poor in that area, and if anything there now seems to be a risk that the current government could be worse.  But at least there is some debate around the issues.  Former Cabinet minister, and now Speaker, Trevor Mallard, had one promising suggestion in an article this morning

“Eventually getting some websites going which contain most of that material, for example, Cabinet papers two months after they’ve been to Cabinet automatically up unless there’s a good reason not to, just that sort of stuff would mean you’d have a lot of access to, actually quite boring information, but access to what’s going on.”

Easy to suggest, of course, when you are no longer a minister.  I hope the new Speaker will be as keen on extending the provisions of an (overhauled) Official Information Act to cover Parliament itself.

The Reserve Bank is one of the bodies that likes to claim that it is highly transparent.    There are plenty of counter-examples –  and occasional examples that might suggest that progress is actually being made –  but I stumbled across an interesting contrast this week between our central bank and the Bank of England, the central bank of the United Kingdom.  Recall that the British public sector was notoriously secretive for a very long time, and our Official Information Act was enacted many years before the UK’s comparable legislation.

In its Financial Stability Report this week, the Reserve Bank released a high-level summary of the results of its latest stress tests on the four major banks.  What they released was interesting enough but there wasn’t much of it; 850 words and a couple of charts.  There was, for example, no information on individual banks –  despite a disclosure-focused system –  and no detail on housing mortgage losses –  despite the active regulatory and rhetorical focus on those risks for the last five years.

Earlier in the week, the Bank of England released its Financial Stability Report, and as part of that they released their latest stress test results.  Their release –  on the stress tests alone –  was 64 pages, with a great deal of detail, on the test scenarios themselves, on the overall results, and on the results for individual banks.   It even has an interesting annex on how markets’ view of banks square with the stress test results.

To be sure, the UK banks are typically more complex than the New Zealand banks (some, such as HSBC, are primarily global banks with big international exposures), and there are more of them (seven in this test) so we might not expect 64 pages of results here.  But we really should be entitled to more than the Reserve Bank is giving us.  There is no obvious (good) reason for withholding the material –  including that at an individual bank level.  Disclosure statements are actually already supposed to disclose banks’ risks, and  stress tests are just shocks designed to test the circumstances under which those risks turn bad.  And, in the end, it is banks (individually) that fail, or not, not “banking systems”.

Sure, there is probably some cost to pulling all the material together and presenting it nicely, but those costs will be trivial compared to the costs the banks face in doing the stress tests, or even than the Reserve Bank faces in conducting them and writing them up for senior management and/or the Board.  Accountability provisions and openness do have direct costs –  and, for that reason among others, aren’t typically popular with bureaucrats – but we put them in place for good reason.  With such large and powerful governments we are long past the days when we could safely accept an approach of “trust us, we know what we are doing”, all the more so when it involves agencies – such as the Reserve Bank –  with huge power concentrated in one person’s hands and little direct effective accountability (we can’t vote him out).

I could, of course, lodge an Official Information Act request .  If I did they would probably release some more aggregated material.  But I wouldn’t get very far, as the Bank continues to shelter –  with the protection of the Ombudsman –  behind the egregious (or, more accurately, egregiously abused) section 105(1) of the Reserve Bank Act.  When the Reserve Bank Act is reviewed, doing something about that provision needs to be on the action list.

If the British can manage this high degree of openness around banking sector stress tests –  only a few years after they had to grapple with actual bank failures – surely so can we.

On the Reserve Bank FSR

There are some interesting things in the Reserve Bank’s Financial Stability Report, some questionable ones (including, at the mostly-trival end of the scale, Grant Spencer’s assertion that he is “Governor” when by law he is, at best, “acting Governor”) and some things that are missing altogether.

The Reserve Bank observes that banks have tightened their own (residential mortgage) lending standards

Banks have tightened lending standards, reducing the borrowing capacity of households. Typically, banks are using higher interest rates when assessing the ability of borrowers to service a new mortgage and their existing debt, restricting the use of foreign income in serviceability assessments, placing stricter requirements on interest-only lending, and ensuring that living expenses assumed in a loan assessment are reasonable given the borrower’s income.

If so, you have to wonder why the Reserve Bank is still intervening in such a heavy-handed way in the decisions banks would otherwise make about their mortgage lending.

But they go on to back their claim with an interesting, but on the face of it somewhat dubious, chart

The overall impact of the tightening in banks’ lending standards is illustrated by the Reserve Bank’s recent hypothetical borrower exercise,  which asked banks to calculate the maximum amount that they would lend to a range of hypothetical borrowers. This repeated an exercise that was conducted in 2014. The 2017 results suggest that maximum borrowing amounts have declined by around 5-10 percent since 2014 (figure 2.3).

max lending amounts

But it is hardly surprising that, with the same nominal income, banks would lend a little less now than they would have been willing to do so in 2014.  After all, there has been three years’ of inflation since then.   Even if the borrowers had declared the same monthly living expenses to their bank, banks use their own estimates/provisions for living expenses in deciding how much to lend.  Supervisors, indeed, encourage them to do so, and to be sure to leave adequate buffers.   An income of $120000 would comfortably support more debt in 2014 than the same income does in 2017  (the reduction in the maximum amount lent to owner-occupiers was 3.5 per cent in the chart).  It would probably be better to do all these comparisons using inflation-adjusted inputs.

In this FSR, the Reserve Bank reports the results of their latest set of bank stress tests.    This year’s macro stress test didn’t seem particularly demanding in some ways.

stress test.png

Previous scenarios have featured falls in house prices of more like 50 per cent (in Auckland) and 40 per cent nationwide, which seemed like suitably tough tests.  Previous test also featured an increase in the unemployment rate to 13 per cent (which was so implausible that I pointed out then that no floating exchange rate advanced country had ever experienced such a large sustained increase in its unemployment rate).

But there are several unrealistic things about this scenario

  • it is highly improbable that even a severe recession in another country would lower New Zealand house prices by 35 per cent.  A massive over-supply of houses here might do so, or even the end of a massive credit-driven speculative boom, but neither an Australian nor Chinese recession is going to have that sort of effect.  In the 2008/09 recession –  as severe a global event as we’d seen for many decades – we saw about a 10 per cent fall in nominal house prices in New Zealand.
  • it is also highly unlikely that house and farm prices would fall by much the same amount in this sort of scenario.  Why?  Because in this scenario it is all but certain that the exchange rate would fall a long way (helped by the fact that the Reserve Bank has more scope to cut interest rates than their peers in other countries), in which case the dairy payout (and any fall in farm prices) will also be buffered relative to the fall in prices of domestic-focused assets.
  • But perhaps most implausible of all was the requirement that “banks’ lending grows on average by 6 per cent over the course of the scenario”.   Governments of the day might, at the time, be keen for banks to keep taking on more credit exposures, but those private businesses –  amid a pretty severe shakeout –  are unlikely to be willing to do so.  And there wouldn’t be many potential borrowers. If the asset base was stable –  or even shrank a bit, as it would tend to do naturally with sharply lower asset prices –  a fixed stock of capital goes quite a bit further.

As it is, once again the stress tests suggests that on the lending practices banks have operated under over recent years –  and they can change –  our big banks are impressively resilient.   Here is the key chart.

buffer macro

The chart is presented to make the deterioration in banks’ capital positions look large (by being presented as a margin over the minimum regulatory capital, rather than an absolute capital ratio –  creditors lose money when banks run out of capital, not when they get to the regulatory minimum).   But even then, look at the results.   The blue line is the result if the banks do nothing in response.  Which bank would do that in the middle of a period of multi-year stress?  But even then, at worst, the banks in aggregate end up with a buffer of capital of 2 percentage points above their required minimum.  With mitigants –  the red line –  they never even dip into the capital conservation buffer (the margin over the minimum; if banks dip into that zone there are limits of their ability ot pay dividends).

It is good that the Reserve Bank does these stress tests.  It would be better if they provided more information on the results (eg in this scenario they tell us that half the credit losses come from farm lending and residential mortgage lending, but don’t provide the breakdown –  from previous tests’ results, I suspect the residential contribution is relatively small  –  and don’t give any hint where the other half of the losses is coming from (given that housing and farm lending get most of the coverage in FSRs).

It must surely be hard to justify onerous and distortionary controls on access to credit for one large sector of borrowers when year after year the results come back showing that the banks look pretty robust to pretty severe shocks.  And when the Bank also tells us that the prudential regime isn’t designed to avoid all failures.  In combination, could one mount an argument that banks aren’t being allowed to take enough risk?

Operating in a market economy, banks in New Zealand –  and those in Australia and Canada –  appear to have done a remarkably good job of managing their own risks and credit allocation choices.  It is, after all, more than a 100 years since a major privately-owned bank has failed in any of those three countries.  Things can go wrong –  and often have in heavily distorted financial systems (eg that of the United States) – and bank regulators are paid to be vigilant, but it might be nice –  just occasionally –  to hear senior Reserve Bankers pay credit to the competent (never perfect) management of the risks our banks take with their shareholders’ money.

I mentioned things that were missing entirely from the FSR.  

The Reserve Bank Act requires FSRs to be published

A financial stability report must—

(a) report on the soundness and efficiency of the financial system and other matters associated with the Bank’s statutory prudential purposes; and
(b) contain the information necessary to allow an assessment to be made of the activities undertaken by the Bank to achieve its statutory prudential purposes under this Act and any other enactment.

That second item is no less important than the first.  And when the Reserve Bank has, during the period under review, imposed significant regulatory sanctions on a major bank you might have supposed that in the next FSR there would be a substantial treatment of the issue (there is, after all, more space than in a press release).  It is, after all, an accountability document, designed to allow the public (and MPs) to evaluate the Reserve Bank’s handling of its responsibilities.

But in the case of the recent Westpac breach (operating unapproved capital models), which resulted in big temporary increases in Westpac’s minimum capital ratios and –  it appears –  a requirement that Westpac issue more capital over and above those minima you would be quite wrong.  I read the entire document yesterday and didn’t spot a single reference.  A proper search of the text revealed a single footnote, which simply noted that Westpac’s minimum capital ratios had been increased, with a link to last week’s Reserve Bank press release.

This really should be regarded –  by the Board, by MPs, by citizens and other stakeholders –  as unacceptable: an organisation, that despite its constant claims, seems to regard itself as above any sort of serious public accountability, despite the clear requirements imposed by Parliament.    You will recall that last week I noted that there was a range of unanswered questions about this whole episode (here and here).  The FSR answered none of them.  For example:

  • who discovered the error, and how?
  • how did it happen (both at the Westpac end, and at the Reserve Bank end)?,
  • what confidence can we have that there are not similar problems at other banks?,
  • what changes has the Reserve Bank made to its own procedures to reduce the risk of a repeat?
  • why was there no reference in the Reserve Bank statement to the failures of Westpac directors (even though director attestation is supposed to be central to the regulatory regime)?
  • did the Reserve Bank compel Westpac to raise new capital?
  • how much difference did the use of unauthorised models make to Westpac’s capital ratios?

Jenny Ruth of NBR (who covered the story in a column last week, noting that the Bank’s failure then to provide more information was “appalling”) asked some questions about the issue at press conference yesterday.     The answers weren’t particularly clear or helpful.

She asked why no directors were prosecuted (these were, after all, strict liability offences, and director attestations are a key part of the regime).  Grant Spencer basically refused to answer, just claiming that the steps they had taken were a “strong regulatory response”.

She asked about the other internal-ratings banks and whether there were such problems with them.  The first answer seemed to suggest that the Bank was confident, having checked, that there were not.  But as Spencer and Bascand went on, even that seemed to become less clear.  By the end it seemed to be a case of “we aren’t aware of any other problems and we are encouraged that some are having a look to check”.  It didn’t exactly seem like an aggressive pro-active response by the Reserve Bank, to a potential problem it has known about for more than a year (since the Westpac issues first came to light).  It turns out that ASB has had other problems around its capital calculations (apparently without penalty).

We learned one thing.  Asked who first uncovered the issue –  Ruth suggested she had heard that Westpac had uncovered the problem itself –  the Bank representatives responded that they had had their own suspicisions and had raised the matter with Westpac, who had then confirmed that there was a problem.   That was good to know, but it was only one small part of the questions that should be answered.

It is, perhaps, getting a bit repetitive to say so, but if the new government is at all serious about more open government –  and serious media outlets have raised questions about that in recent days –  then the Reserve Bank would be a good place to start.   The culture needs changing, and culture change is only likely to come from the (words and actions at the) top.    How the government can expect to find a Governor who would lead the Bank into a new era of openness and transparency when they are relying on the Board –  always emollient, always keen to have the Governor’s back, never revealing anything, never even documenting their meetings in accordance with the law,  – is a bit beyond me.  Sadly,a more probable conclusion is that the government doesn’t really care much, and that the repeated promises  by Labour, the Greens, and New Zealand First around the Reserve Bank were more about being seen to make legislative changes, rather than actually bringing about substantive change in the way this extraordinarily powerful, not very accountable, agency operates.  If so –  and I hope it isn’t –  that would be a shame.

 

Very slowly lifting LVR controls

It is a strange form of democracy in which an unlawfully appointed (and certainly unelected) bureaucrat, who faces little or no effective accountability, can descend from the mountain-top and decree new limits for how much different types of (potential) house buyers can borrow from banks.  But that is what Grant Spencer of the Reserve Bank did this morning with the release of the latest –  his one and only –  Financial Stability Report.  Our politicians seem to see nothing strange about this –  rabbiting on about “respecting Reserve Bank independence” in an area where there is no obvious reason for Reserve Bank independence at all.  If we have to live under the burden of regulation –  especially of the sort that directly affects ordinary citizens –  those controls should be imposed, or lifted, by politicians.  We can toss them out.  In this particular case, it is not as if there is even a clear statutory framework: the Reserve Bank is required to exercise its powers to promote “the soundness and efficiency of the financial system”, but neither they –  nor anyone else –  can really tell us what that means, or hence what limits, if any, it places on a Governor’s (or “acting Governor’s”) freedom of action. Arbitrary whims aren’t a good basis for government.

Don’t get me wrong.  I’m pleased to see the Reserve Bank making another start on easing the LVR controls (there was a partial easing a couple of years ago, but that didn’t last long).     The controls should never have been put on in the first place.   They started as a knee-jerk reaction from the previous Governor, without any good supporting analysis, and –  as so often happens with controls –  one control, originally sold as temporary, soon led to others, ever more onerous, with ill-founded exceptions.   As I summed up LVR restrictions a few months ago

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.

That discrimination?

We have direct controls on lending secured on housing, but none on lending secured on farms or property development –  even though the FSR notes that the dairy debt position still looks stretched, and recognises that internationally many of the losses in financial crises are on commercial property (especially development) loans.

We have much more onerous direct controls on potential owner-occupiers than on investors, even when the nature of the underlying collateral is identical.  Even if the investor borrower might, objectively, be a much better credit  (think of someone with a really secure job like a teacher or police officer buying a first investment property, and contrast then with a person (with the same income) with a job in a highly cyclical sector (thus at considerable risk of unemployment in the next recession) buying an owner-occupied dwelling).

And we have direct controls on housing lending by banks, but not by other lending institutions.

And, again as I noted earlier

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 books –  and those in other similar countries –  came through just fine.

The Reserve Bank has never seriously engaged with this sort of perspective, and never told us why we should be confident that they are better-placed to make credit allocation judgements than experienced bankers whose own shareholders’ money in on the line.

Some months ago the former Prime Minister called on the Bank to lay out clear and explicit markers that would see the LVR limits wound back and eventually removed.   Unfortunately we got nothing of the sort today (indeed, the idea that the restrictions will eventually go altogether –  and we can back to having banks making credit allocation decisions, at an individual and portfolio level –  got barely a mention in the FSR itself or in the subsequent press conference).    No doubt, the bureaucrats like having toys to play with.  They stress how hard it is  for them to lay down clear markers, but appear to put no weight at all on how hard it might be for citizens who have to make their own decisions against a backdrop of such regulatory uncertainty.  Sadly, there are few effective incentives to ensure that bureaucrats and politicians internalise those costs at all.   Politicians have to face re-election (and scrutiny in the House each day), but the Reserve Bank bosses face no such pressure.

Now, to be fair, this mess was primarily of Graeme Wheeler’s making, and Spencer and Bascand are left to tidy up the mess.  Since the LVRs were never grounded in good analysis in the first place, it is hard to set out analytically robust markers for lifting them.  But if analysis couldn’t offer much, perhaps there should have been a premium on predictability: the Bank could have laid out an expected numerical path under which over the next two years the LVR limits would be removed completely, with modest easing scheduled for each quarter.  Sure, they couldn’t have made binding commitments –  apart from anything else, some as-yet-unknown person will be calling the shots as Governor after March –  but indicative plans help provide certainty to banks, their competitors, to borrowers, and to other participants in the housing market.  And they create some hurdles that the Reserve Bank would need to get over before deviating from the announced path.    As it is, we have no idea –  no clues at all –  as to what pace the controls might be lifted at.

As a reminder, if the Reserve Bank is really concerned about the soundness of the financial system –  let alone the “efficiency” of the system, a key part of the mandate –  capital requirements (risk weights and required capital ratios) clearly dominate direct (and discriminatory) intervention in the credit allocation process.     That sort of insight was behind getting rid of direct controls back in the 1980s.

The Bank did attempt to lay out the criteria it would be using  in assessing whether and when to relax LVR limits further.  There were three.

  • Evidence that house price and credit growth have fallen to around the rate of household income growth.
  • A low risk of housing market resurgence once LVR restrictions are eased.
  • Confidence that an easing in policy will not undermine the resilience of the financial system.

The second and third aren’t specific at all, and provide little basis for citizens to hold the Bank to account.   But the second is also problematic, because the Bank has always claimed that its goal isn’t to eliminate, or even to materially dampen, house price cycles (the “acting Governor” this morning reiterated that there will always be housing cycles).  That second criterion only makes sense if there is evidence that house price cycles/increases are mostly caused by changes in bank lending standards, and the Bank has never produced any evidence for that in a New Zealand context.

The first criterion looks slightly more useful –  at least we can see the data for that.  But I’m not sure it is very robust.  First, why “household income”, when many of the houses are now bought by the small business sector –  nominal GDP growth might be as useful.  But, more importantly, the Bank’s criterion seems to cement in the current ratios of price and debt to income as some sort of equilibrium.   And they have absolutely no evidence at all for such a claim.  As they surely know, if land use is heavily-regulated then fresh shocks to demand –  from any source, including unexpected population growth –  will tend to raise debt and price to income ratios, with no particular reason to think that such movements raise financial stability concerns.  Lending standards are really what matter, not macroeconomic indicators.  And, of course, in floating exchange rate countries with a market-led allocation of housing credit, I’m not aware of a single case where housing loan losses have been central to systemic financial crises.

There was the customary self-congratulation this morning about the contribution the LVR controls have made.  The Bank keeps telling us LVR restrictions have “substantially improved” the resilience of the financial system.  It is another claim for which they advance no serious evidence.  They correctly note that the volume of high LVR loans is lower than otherwise (although a little footnote on page 6 suggests even that effect might have been quite modest), but they never ever explicitly recognise that if banks have fewer high-LVR loans they will be required to hold less capital than otherwise.  Or that since the incentive was now to lend lots of, say, 79.99 per cent LVRs –  not economically different from a loan of 80.01 per cent –  and yet capital requirements are typically materially lower on lower LVR loans, it is quite possible that the effective resilience of the banks has actually worsened a little.  As it is, their stress tests have told throughout that the banks are robust.

Two final points:

The first is that in some respects today’s moves further increase the regulatory wedge imposed between access to credit for investors, and that for owner-occupiers.  In essence, no one (or almost no one) can borrow from a bank to buy a residential rental property using a mortgage of more than 65 per cent of the value of the property.  (There is provision for up to 5 per cent of such loans to be above 65 per cent, but given the larger buffers banks operate to ensure that they don’t breach conditions of registration, it is effectively a near-zero limit).  That isn’t a decision of a professional credit-manager.  It is regulatory fiat, from people with little or no experience in credit allocation.  By contrast, 15 per cent of owner-occupied housing loans can now be to borrowers with LVRs in excess of 80 per cent.  If banks judge it prudent –  and it might well be, depending on the borrower and the overall portfolio –  some owner-occupiers will be able to borrow perhaps well above 90 per cent.    The Reserve Bank has not produced a shred of evidence –  in the past or today –  for such a huge gap, on identical collateral.   Recall my example earlier: lending an 82 per cent LVR loan to the police officer buying an investment property is likely to be materially safer than lending to, say, a person on the same salary buying a first home, but working in a highly-cyclical sector (eg construction or tourism).  Banks can make those sorts of distinctions – they get to know and evaluate their customers –  but the Reserve Bank can’t. Instead, we get crude controls slapped on and maintained for years.  It looks and feels a lot more like politicised credit preferences – owner-occupiers favoured over investors.  When politicians do it it might be odious and undesirable but….they are politicians, and they have to face the voters.  When bureaucrats do it, it is highly inappropriate.

As I noted in my housing post yesterday, in some ways it is a bit odd for the Reserve Bank to be starting to declare victory now.  For the last few years there has been little or no prospect of any material oversupply of physical dwellings (or urban land).  There was little effective liberalisation and huge population pressures, and much of the new building has been on a pretty small scale, done by the private sector.   But now net immigration looks as if it may have turned a corner, easing some of the demand pressures.  A series of tax and regulatory changes will also dampen demand, at least temporarily, a little.     And the government is talking up “build, build, build”, in a government-led process designed to generate a huge number of new houses in the next decade  You might be sceptical, as I am.  But it is explicit government policy.  And government-led investment projects face considerably weaker market disciplines –  and often operate on a considerably larger scale –  than private sector ones.    Government interventions in the housing finance market were a big part of what went wrong in the United States. Physical oversupply was a big issue in Spain, Ireland and (parts of) the United States.   How confident can the Reserve Bank be that if Kiwibuild really gets going at the scale envisaged that the risks can be effectively managed?   It is, after all, almost certain there will be at least one recession  –  wich won’t be foreseen – in the 10-year horizon of Kiwibuild.     I’m not using this as an argument for keeping LVR restrictions on –  they aren’t fit for purpose, and in any case the Bank bowed to political pressure to exclude loans for building new houses (the riskiest sort of housing loans) from the LVR controls altogether.  But I think they are wrong if they believe, as they stated this morning, that risks are now easing.  And capital standards are a better, less intrusive, way to manage any risks.

The sooner the LVR controls are behind us the better,  Sadly, unless the right Governor is chosen, that day doesn’t seem likely to be soon.

I’ll have some comments tomorrow on some other aspects of the FSR.

Revisiting Westpac and the Reserve Bank

Last week I wrote a post about the Reserve Bank’s announcement that it had increased Westpac New Zealand Limited’s minimum capital requirements –  by quite significant amounts – “after it failed to comply with regulatory obligations relating to its status as an internal models bank”.

Two things in particular annoyed me last week:

  • the complete lack of any serious explanation, from either the Reserve Bank or Westpac, as to what had gone on and why, how and by whom the errors were uncovered, what remedial steps had been taken (in both institutions), how we could be sure similar problems didn’t exist in other banks, and
  • the absence from both statements (Reserve Bank and Westpac) of any reference to Westpac’s directors, even though under our system of bank regulation and supervision, the directors have primary responsibility for attesting to the accuracy of disclosure statements, and face potential civil and criminal penalties for (strict liability) offences for publishing false information.

One can understand why Westpac would not want to say anything more, even if (for example) they thought the Reserve Bank had overreacted: don’t upset the regulator is one of the watchwords of the banks, because even if your concern might be justified on one point, the Reserve Bank has many other ways to get back at you on other issues (where, eg, approvals are needed) if you make life difficult.

The Reserve Bank’s stance is more disconcerting.  It is, after all, a government regulatory agency, responsible to the public for the exercise of its statutory powers, and for the management of its own operations.    And yet, as so often with monetary policy, they seem to think it is up to them to decide how much they will graciously tell us, rather than to be accountable and answer the questions that people have.  I gather they are refusing to explain themselves further at all.  If, as it says it is, the government is serious about increasing the transparency of the Reserve Bank, this is just another example of why reform –  and a new culture –  is needed.

When I wrote last week, there were several things I didn’t notice.

First, I noticed the lack of any sign of contrition in the Westpac statement, but didn’t go on to draw the obvious conclusion that lack of any sign of contrition –  even feigned for the public – might suggest that they felt they were being rather unjustly dealt with in this matter.    Had they been caught out doing seriously bad stuff, you’d have expected them to, if anything, overdo the public contrition (mea culpa, mea culpa, mea maxima culpa and all that).

Second, the Reserve Bank’s statement was clearly designed to have us believe that there had been systematic problems for nine years now, ever since Westpac was first accredited to use internal models.  Why do I say that?  This is what they said.

The report found that Westpac:

  • currently operates 17 (out of 35) unapproved capital models;
  • has used 21 (out of 32) additional unapproved capital models since it was accredited as an internal models bank in 2008;

But someone pointed out to me Westpac’s initial disclosure of the problems in its September 2016 disclosure statement.   In that statement (page 9) Westpac disclosed a couple of trivial errors dating back to 2008 (in sum, lifting risk-weighted assets by $44 million on a balance sheet of $86 billion).  And what about the model approvals errors?  Well, this is what the directors’ disclosure says:

“The Bank has identified that it has been operating versions of the following capital models without obtaining the Reserve Bank’s prior approval as required under the revised version of the Reserve Bank’s Capital Adequacy Framework (Internal Models Based Approach)(BS2B) that came into effect on 1 July 2014”

If it is correct that prior to July 2014 internal models banks did not require Reserve Bank approvals for specific models (and I have now have vague recollections of internal discussions on exactly this point in 2013/14, and an earlier version of BS2B does not have the requirement) that would put a rather different light on Westpac’s errors than was implied in the Reserve Bank statement.    Transition problems associated with a pretty new requirement look rather different than a failure that had run for nine years since the inception of the Basle II regime.

The original conception of allowing banks to use internal models to calculate risk-weighted assets (for capital adequacy purposes) had not been to have the Reserve Bank micromanaging the process, but rather reaching an overall judgement about the ability of banks to responsibly use such models, while imposing supervisory overlays where the Reserve Bank thought the models were producing insufficiently cautious results (as we did from day one in respect of housing mortgage exposures).  Over the years, the Reserve Bank grew less confident in the internal models approach, culminating (apparently) in the 2014 requirement that all models have prior Reserve Bank approval.

As the situation stands now

Registered banks may only use approved internal models for the calculation of their regulatory capital adequacy requirement. Banks must advise the Reserve Bank of all proposed changes to their estimates and models before implementing them.

There are specific requirements laid down about the information banks have to submit to the Reserve Bank when seeking such approvals. I’ve been told that the Reserve Bank can then take up to 18 months to work through the process of approving any change (there are, after all, 32 models for Westpac alone, and four internal-models banks).

The Reserve Bank also requires that

A bank that has been accredited to use the IRB approach must maintain a compendium of approved models with the Reserve Bank. This compendium has to be agreed to by the Reserve Bank and only models listed in that compendium may be used for regulatory capital purposes. The compendium is to be reviewed and relevant sections are to be updated at least once a year. The compendium must be updated as soon as practicable after a model change has been approved by the Reserve Bank. The compendium lists basic model-related information such as version number, approval date, risk drivers, key parameters, as well as information from the most recent annual validation report on RWA, EAD, validation date and model outlook, and any other model-related information required by the Reserve Bank.

All of which sounds sensible enough, but it raises some obvious questions.  If this was a new requirement in 2014 (but in fact whenever the requirement was introduced), surely the Reserve Bank would have insisted on a compendium from each bank of the models that bank was using at the time, and then would have put in place a process to (a) monitor any changes it was approving, and (b) ensure, whether by directors’ attestation or whatever, that any changes to the models banks were using actually had prior Reserve Bank approval.  But did any of this happen?

Since we don’t have anything in the way of a good explanation from either Westpac or the Reserve Bank we can only guess at what must have happened.  I’m pretty sure Westpac didn’t consciously set out to deceive the Reserve Bank –  the banks are gun-shy, terrified of breaching conditions of registration –  and the Reserve Bank’s own statement seems to accept that story.

Perhaps there is a clue in this line from the Reserve Bank statement as to what the independent investigation found.  Westpac New Zealand

failed to put in place the systems and controls an internal models bank is required to have under its conditions of registration.

Most or all of the risk modelling work is likely to have been being done in Sydney (by the parent bank) and not by Westpac New Zealand at all.   Quite possibly, people on this side of the Tasman only ever see the bottom line numbers, and pay no attention to the modelling or (small?) changes in it.    Perhaps Sydney went on refining risk models, including updating the models for changes in data composition (as the composition of individual loan portfolios changes), and just didn’t know that they were now (unlike the first few years as an IRB bank) required to notify and get Reserve Bank approval for each and every change?   If so, it is still a system failure –  and potentially of concern for the way it highlights how things could go more seriously wrong –  and shouldn’t have been allowed to happen, but it doesn’t seem like the most serious failing in the world.  Did the Reserve Bank see Westpac’s model compendium in 2015, and if so did they confirm with the Westpac risk people in Sydney (presumably who they are primarily dealing with) that the models in the compendium, and only those models, were being used?  If so, why it did it take another year to uncover the problems.  And if not, why not?

Without a proper explanation, we don’t know if this is the story.   But depositors and creditors should be owed an explanation by Westpac, and the public are owed one by our regulator, the Reserve Bank.

The third thing I didn’t pay much attention to last week was the statement that Westpac now had a total capital ratio (share of risk-weighted assets) of 16.1 per cent.  It seemed surprisingly high, but it was higher than the (temporarily increased) regulatory minima, and than the level Westpac had undertaken to maintain, so I passed over it quickly, and I shouldn’t have.

Here are Westpac New Zealand’s capital ratios (common equity tier one, and total capital) for the last couple of years.  The data are taken from disclosure statements and, for September 2017, from Westpac’s press release last week.

wpac capital ratios

I couldn’t find any reference anywhere to Westpac New Zealand Limited having issued any capital instruments on market in the September 2017 quarter.    But the Westpac New Zealand branch did issue $US1.25 billion of perpetual subordinated contingent convertible notes in September.  Those instruments would qualify as Tier One capital (though, of course, not as common equity).  Since we don’t yet have the September disclosure statement, we can’t be sure what went on, but it looks as though the proceeds of that issue might have been used to subscribe to (eg) a private placement of similar securities by Westpac New Zealand to its parent.  Whatever the story,  it seems unlikely that the sudden increase in Westpac New Zealand’s capital ratio had nothing to do with the fight they were then no doubt in with the Reserve Bank about the appropriate response to the model-approvals issue.

Again, we deserve a better explanation from the Reserve Bank (and Westpac) as to what actually went on.  For example, did the Reserve Bank insist that Westpac take on more capital, even beyond the temporarily increased regulatory minima, and then let Westpac raise the additional capital before letting the public (and depositors/creditors) in on what was going on?  Perhaps not, but the alternative –  in which Westpac New Zealand just happened to decide to raise more capital just before the regulatory sanction was announced  –  seems a bit implausible.  The news coverage would have been at least subtly different if last week’s announcement of the model approvals errors had been accompanied by the statement that Westpac New Zealand would need now to take steps to increase its level of capital (as distinct from just glossing over a fait accompli).

Which also brings us back to the unanswered questions?   We don’t know how much difference the use of unapproved models actually made to Westpac’s risk-weighted assets –  in fact, we don’t even know if the Reserve Bank knows.   And we don’t know if the Reserve Bank insisted on this new capital –  although it seems likely given that they noted that

In addition, the Reserve Bank has accepted an undertaking by Westpac to maintain its total capital ratio above 15.1 percent until all existing issues have been resolved.

when 15.1 per cent is well above even the temporarily higher regulatory minima for Westpac.

But if so, is the penalty proportionate to the offence?  It is impossible to tell, on the information the Reserve Bank has so far made available, and that isn’t a good state of affairs –  no basis for holding this (weakly-accountable) regulator to account.

And, to return to one of the questions I posed last week, why wouldn’t prosecution of the directors have been a more appropriate penalty, and one better-aligned with the design of the regulatory framework?  I’m not suggesting anyone should have gone to prison, but if what actually went on here was a governance design failure, surely it is an obvious case for trying out the penalty regime designed to ensure that directors do their job (of, among other things, ensuring that management do their job)?  A fine on each director –  for what are, after all, strict liability offences –  looks as though it could have been a more appropriate penalty.    But if such prosecutions had been contested, that might have forced the Reserve Bank to disclose more, including about their own system failures, than perhaps they would have been comfortable with?   Bureaucrats protect themselves, and their bureau.

As I said last week, I hope journalists use the opportunity of the Financial Stability Report press conference next week to pose some of these questions to the “acting Governor” and Geoff Bascand, the new Head of Financial Stability.  They can’t force the Reserve Bank to answer questions, but if the Bank continues to stonewall, in the face of repeated questions from multiple journalists, in a news conference that is live-streamed, it won’t be a good look for the Reserve Bank (or for Geoff Bascand personally, if he is still in the race to become the next Governor).

 

 

Growth in debt, but barely at all in New Zealand

I’m a bit tied up for the next couple of days, and so posting might be light and insubstantial  My share in the stewardship of a financial entity that has now operated for decades without appropriate authorisations and approvals is somewhat time-consuming (thank goodness we have a Reserve Bank to deal with cases where major commercial banks don’t follow the rules).

But for today, I’m just going to leave you with a simple chart. presumably constructed by Moody’s from BIS data, that I found in a newsletter last night.  It shows the change in the ratio of business and household debt to GDP between 2007 (just prior to the recession and financial crisis) and 2017 for 41 advanced and emerging countries.

household and corporate debt

In some quarters you hear a lot about high and rising debt in New Zealand.  I’ve pointed out previously that the “rising” bit is mostly wrong –  and that levels comparison across countries are difficult to do meaningfully, because of issues such as the tax treatment of debt.  Despite the surge in house prices in the last few years, household debt as a share of GDP isn’t much higher now than it was in 2007.

What this chart highlights is that New Zealand is towards the end of the spectrum with the least increases in private debt as a share of GDP.   Of these 41 countries, only five advanced economies and two emerging ones had less of an increase (more of a fall) than New Zealand.

And here is a slightly more detailed chart on the specific New Zealand data, showing credit for each of the three sectors the Reserve Bank reports, as a share of GDP.

credit

In the years leading up to 2007 we did, indeed, see a big increase in private sector indebtedness (as a share of GDP), across households, farms, and non-farm business.  In the crisis-prediction literature it was a classic warning sign –  taking on lots of new loans very quickly is often associated with a serious deterioration in credit standards.    But it didn’t come to anything much, at least outside the (small) finance company sector.

Sure, we had a serious recession in 2008/09 –  as most other countries did (it was largely a global phenomenon, with roots in the US in particular) –  but our core financial sector came through the recession unscathed.  Banks weren’t perfect by any means (they are run by humans in a world of imperfect information so that is hardly surprising) and of course there was some increase in loan losses and provisions.  But nothing to threaten the soundness of any major institution or the system as a whole.

There probably are some serious questions to ask about what has gone on, and what might yet happen, in some of the countries in the chart that have had big recent increases in debt to GDP ratios –   China most notably –  but as was the case pre-2007, a big increase in debt is unlikely to be any sort of safe predictor of future financial sector problems.

And whatever the situation abroad, New Zealand at present doesn’t look like one of those places where anyone should be concerned about financial system risks.  Yes, our house prices are cruelly high, but the structural policy failings that took them there don’t show any sign of being sustainably fixed.  And there just hasn’t been much new debt taken out for other purposes.

All this is, of course, backed up by successive waves of stress tests undertaken by the Reserve Bank.   Which does leave you wondering why we now have such a regulatorily-distorted and suppressed market in housing credit.

 

More questions than answers

When a Reserve Bank press release turned up yesterday afternoon, announcing that the Reserve Bank had temporarily increased the minimum capital requirements for Westpac’s New Zealand subsidiary, after breaches had been discovered in Westpac’s compliance with its conditions of registration, my initial reaction was a slightly flippant one.  It must, I thought, be nice for the Reserve Bank to be able to impose penalties when banks don’t do as they should, but it is a shame that there is no effective penalty operating in reverse.   When the Reserve Bank misses its inflation target, imposes new controls with threadbare justification, flouts the principles of the Official Information Act, allows OCR decisions to leak, or attempts to silence a leading critic what happens?  Well, nothing really.

But as I reflected on the Reserve Bank’s statement and the Westpac New Zealand, both reproduced here, I became increasingly uneasy.

This is what we know from the Reserve Bank

Westpac New Zealand Limited (Westpac) has had its minimum regulatory capital requirements increased after it failed to comply with regulatory obligations relating to its status as an internal models bank.

Internal models banks are accredited by the Reserve Bank to use approved risk models to calculate how much regulatory capital they need to hold. Westpac used a number of models that had not been approved by the Reserve Bank, and materially failed to meet requirements around model governance, processes and documentation.

The Reserve Bank required Westpac to commission an independent report into its compliance with internal models regulatory requirements. The report found that Westpac:
·currently operates 17 (out of 35) unapproved capital models;
·has used 21 (out of 32) additional unapproved capital models since it was accredited as an internal models bank in 2008; and
·failed to put in place the systems and controls an internal models bank is required to have under its conditions of registration.

The Reserve Bank has decided that Westpac’s conditions of registration should be amended to increase its minimum capital levels until the shortcomings and
non-compliance identified in the independent report have been remedied.  …..

In addition, the Reserve Bank has accepted an undertaking by Westpac to maintain its total capital ratio above 15.1 percent until all existing issues have been resolved.  The Reserve Bank has given Westpac 18 months to satisfy the Reserve Bank that it has sufficiently addressed those issues or it risks losing accreditation to operate as an internal models bank.

There is nothing additional in the Westpac statement, but they don’t appear to dispute either the Reserve Bank’s findings or its response.

There are a few things to clear away.  First, the temporary increase in the minimum capital requirements for Westpac New Zealand does not constitute a financial penalty at all.    Arguably that might be true even if it increased the actual amount of capital Westpac had to hold (Modigliani-Miller and all that), but this measure does not do that.    The Reserve Bank statement tells us that as 30 September, Westpac’s total capital ratio was 16.1 per cent.

That doesn’t mean it is no penalty at all.   I’m sure there has been a great deal of very uncomfortable anguishing in recent months both among Westpac New Zealand directors and senior management, and at head office (and the main board) in Sydney.  APRA is likely to have taken a very dim view of this sort of mismanagement by an Australian bank’s subsidiary.  And, of course, a lot of scarce staff time is now going to have be devoted to sorting these issues out over the next 18 months.  That resource has an opportunity cost –  other things those people could have been used for, which might have boosted the bank’s earnings.

But what I found more striking was how little either the Reserve Bank or Westpac statements said about breaches of conditions of registration which appear to go to the heart of our system of prudential supervision.

There is, for example, nothing at all in the Westpac statement about how these errors happened (use of numerous unathorised models, dating back to 2008), and not much contrition either.  The closest they come is this

WNZL is disappointed not to have met the RBNZ’s requirements in this area.

And our system of banking supervision is supposed to, at least in principle and in law, rely very heavily on attestations from each individual director that the bank they are directors of is fully in compliance with the conditions of registration (which includes provisions around calculation of minimum capital requirements and associated models).  But there is no apology from the directors, and no sign that any director has lost his or her job.   Potential heavy civil and criminal penalties –  including potential imprisonment –  are supposed to sufficiently focus the attention of directors that depositors and other creditors can rely on the information banks publish.  Westpac’s clearly haven’t been able to rely on their disclosure statements for almost a decade.  And yet there is no specific mention of the directors in the Reserve Bank’s statement either.

There is also nothing in either statement (Reserve Bank or Westpac) about the quantitative significance of the errors.   The Reserve Bank tells us that they accept that Westpac did not deliberately set out to reduce its regulatory capital, but intent and effect are two different things.    These problems appear to have been known about for more than a year –  Westpac tells us they first reported them in their September 2016 Disclosure Statement.  But was the effect, over the years since 2008, to reduce the amount of capital Westpac had to hold relative to what it would have been if they’d been using Reserve Bank approved models?  Or does no one –  at the Reserve Bank or Westpac –  yet know?   When the issues are sorted out will Westpac New Zealand be required to restate its capital ratios for the whole period since 2008?

The Reserve Bank’s own processes also seem lax at best.    And this comes closer to home for me, since I sat for a long time on the Bank’s internal Financial System Oversight committee.  The precise mandate of that committee was never fully clear –  in a sense, it was to provide advice on whatever issues the Governor wanted advice on –  and we didn’t typically do individual bank issues at this level of detail.  But that Committee provided advice to the then Governor to go forward with Basle II and, in particular (back in 2008), to allow the big banks to use internal-models based approaches to calculating regulatory capital requirements.    I don’t recall if anyone ever asked how we –  the Reserve Bank –  could be confident, on an ongoing basis, that an internal-models bank was actually using approved models.  But had anyone done so, I’m pretty sure the answer would have been along the lines of “director attestations” and the stiff potential civil and criminal penalties directors could face for what are, after all, strict liability offences (directors don’t have to be shown to have intended to mislead –  it is enough that their statements were subsequently found to be false.)

For a long time the concern was that any questions we (the Bank) asked of bank management would weaken the incentive on directors to get things right –  they might, after all, claim they had relied on us.   But that mentality had been changing in the last decade –  eg the Reserve Bank started collecting private information that creditors don’t have access to.     But where were the questions around Westpac’s models?  After all, it wasn’t a single model where someone overloooked getting Reserve Bank sign-off, but roughly half of all the models, stretching back years.

If there is nothing in the Reserve Bank statement about steps the Bank may have taken to improve its own monitoring and recordkeeping (given that they had to grant approval, how did they not know that so many models were being used and had had no approval?), there is also nothing about any steps they may have taken to assure themselves that there are not similar problems in any of the other IRB banks.   Have they even asked the question?  Surely, one would think, but mightn’t we expect to be told?

As I noted, there was no mention of the directors in the Reserve Bank statement.  But did the Reserve Bank consider taking prosecutions against Westpac’s directors, who signed false disclosure statements over the years from 2008 to 2016?  If not, why not?  If the directors believed (as presumably they did) that the statements they were signed were correct, did they have reasonable grounds for that belief?  What procedures or inquiries had they instituted over eight years that (a) they had confidence in, and (b) still proved wrong?  The Reserve Bank insists on independent directors: those on the Westpac NZ board look quite impressive, but what were they doing all those years?

If the Reserve Bank has lost confidence in a system of rather condign punishment of directors, perhaps it should tell us so, and seek legislative changes.  But if it really still believes that director attestations have a central role in the framework, surely this is as good an episode, and time, to make an example of someone as there is ever likely to be?  After all, it was about a core aspect of the regulatory framework (capital requirements), and comes at times when there are no jitters around the health of the financial system.  If there is no penalty for directors, no doubt directors of other banks will take note.

And then there is the question of the other (apparent) breaches of the conditions of registration. I don’t make a habit of reading Disclosure Statements (and don’t bank with Westpac anyway –  although, come to think of it, the Reserve Bank Superannuation scheme, that the “acting Governor” is a trustee of, does).  But I had a quick look at the latest Westpac statement.  On page 2, there is half page of disclosures of things Westpac NZ is not compliant with.  Several appear to be dealt with by yesterday’s announcement, but another five don’t.   Perhaps they are all pretty small matters –  they look that way to this lay reader – but banks are supposed to be fully compliant.   It is the law.

From the Reserve Bank’s side, the press statement went out in the name of Deputy Governor (and new Head of Financial Stability) Geoff Bascand.  But he has been in the role for less than two months now.  By contrast, “acting Governor” Grant Spencer was head of financial stability from 2007 to 2017, spanning the entire period of the use of internal models, and one of his direct reports, the head of prudential supervision, has also been in his role that entire time.    One would hope that the Reserve Bank’s Board is now asking some pretty serious questions about just what went on, about how the Reserve Bank has handled these issues over the last decade, and about how much confidence New Zealanders can have in an avowedly hands-off system.

Most probably, the empirical significance of this protracted breach of the rules will prove to have been small.  For that small mercy, we should of course be grateful.  But it is also small comfort because the fact that such breaches could go on for so long –  and the statements aren’t even clear how they came to light – leaves one wondering about what other gaps we (or the Reserve Bank, or Westpac or other IRB banks) might not yet know about.  Often enough, such problems only come to light when it is too late.   In many other central banks and regulatory agencies, if they hear about this episiode, there will be tut-tutting along the lines of “well, that is what you get when you don’t have on-site supervision of banks”.  Personally I wouldn’t want to see New Zealand go that way, but my confidence in our approach has taken a blow in the last 24 hours.

The Reserve Bank has a review of capital requirements underway at present.  I hope final decisions are not going to be made before a new Governor is in place.   There is plenty of unease around the use of internal-models for calculating capital requirements –  especially for rather vanilla banks such as those operating here.  Personally, I’d be comfortable moving away from that system, back to a standardised model for calculating capital (which would, among other things, put Kiwibank –  somewhat put upon by the Reserve Bank – and TSB on the same footing as the large banks).  But, for now, the law is the law, and needs to be seen to be enforced.  A breach of this sort, with little serious direct penalty, risks undermining confidence in our system.

And, of course, there is the small matter of openness.  Not every aspect of the Reserve Bank’s dealing with an individual bank can be published, but there are a lot of questions –  including about the Reserve Bank itself –  to which we really should be entitled to more answers than the Bank has yet given us.

I hope some journalists are willing to pursue the matter further.  Questions could be directed to David McLean, the well-regarded Westpac NZ CEO, to the Board members past and present (especially the independents), perhaps to the parent bank in Sydney, and –  of course –  to Grant Spencer and Geoff Bascand –  if not before then at their next (financial stability) press conference, which is now only a couple of weeks away.