Shaky groundwork

The Reserve Bank released its six-monthly Financial Stability Report this morning, followed a bit later by the Governor’s press conference.  The FSR seemed to be mostly about laying the defensive groundwork for next Thursday’s announcement of the Governor’s final decision on minimum bank capital requirements.  And the press conference was mostly pretty tame, the Governor having announced that he wouldn’t answer any questions on bank capital issues, and the assembled journalists having come quietly and not asked any.  The Governor himself was mostly on his best behaviour again.    It is to be hoped that the journalists get an opportunity to question the Governor seriously, and in an informed and open way, when the capital decisions have been announced and the year-overdue cost-benefit analysis has finally been released.

There was some discussion at the press conference about the Bank’s staffing for supervision.  We were told that they now have 38 staff in that area, up by five, although they avoided answering the question of how many people they have assigned to each main bank.   Asked about plans for further staffing increases, the Governor indicated they were planning on 30 more people, but he had to be hauled into line by his deputy who stressed that it was all contingent on how much the government agrees to allow them to spend in the forthcoming Funding Agreement.  Count me just a little sceptical that there would be much marginal value, in terms of system soundness gains, from the 30th additional person, especially if (as we must) we assume the Governor is pushing ahead undaunted with his capital plans.    It was one of the Governor’s own vaunted “independent experts” who wrote recently.

The RBNZ has adopted a principle of being conservative as regards bank capital to offset possible risks from its light-handed approach to supervision. That is a choice and one partly based on the view that having very large resources devoted to intrusive oversight of banks is not the most efficient road to go down. That is a conclusion that engineers and safety experts often apply when dealing with the design of structures. There is a choice between building bridges many times stronger than you expect them to need to be OR you having large teams of inspectors who pay frequent visits to examine all bridges and monitor flows of traffic over them.  It is clear that nearly all countries follow the first strategy.

That may be a useful guide for bank supervision.

“Belt and braces” springs to mind.

The Governor told us he hadn’t been “particularly close” to easing the LVR limits, those restrictions first put in place –  as avowedly “temporary” – more than six years ago.  Now that the central bank has been delivered into the hands of enthusiasts for direct controls, facilitated by a government with not much belief in indirect instruments or markets, we must assume it would take something really rather severe to see the LVR controls lifted again.  It has always reminded me of exchange controls –  imposed in a hurry in 1938, finally fully lifted in 1984.   But again, no one seems to have thought to ask whether there would not be an element of “belt and braces” about having binding LVR controls in place at the same time as – the already resilient (Governor’s words) banking system is facing a near-doubling of its minimum capital requirements.    I guess enthusiasm for regulation begets enthusiasm for yet more regulation.

Remarkably, in the FSR the Bank claimed that there had been a “gradual reduction in housing market imbalances”.    It wasn’t fully clear what they had in mind, but since those words appeared in the same (short) paragraph that featured a link to this chart, it appeared to be something about price to income ratios.

imbalances

The price to income ratio might have fallen back in Auckland, but it has been continuing to increase in the rest of the country (taken together) and for the country as a whole a current ratio (estimated) of 6.64 is immaterially different from the peak of 6.78.    Whether these are really “imbalances” –  as distinct from equilibrium outcomes given land use restrictions –  is another question.

The Bank itself persists in minimising the importance of these fundamental regulatory distortions.  In the FSR there is a box which attempts to address the question “How have lower long-term interest rates affected housing valuations?”    It is an attempt to argue that low(er) interest rates themselves are a big part of what has gone on.

This is their main chart (in which it is a little puzzling why they start from 2009 –  the depths of the recession/crisis –  rather than, say, take a peak to peak approach).

house prices FSR

Focus on the left-hand panel, for the entire country.   (In these charts, blue bars are positive contributions and red bars negative ones.)   It isn’t very satisfactory that they appear to have modelled nominal house prices rather than real house prices. It isn’t clear why they have done so, but (at very least) it appears to be convenient for them, enabling them to (claim to) show that lower interest rates are a big part of what explains house prices rises, when lower inflation expectations –  an offsetting factor (in red) –  would be expected to be fully reflected in lower nominal interest rates over a 10 year horizon.  Taken together, the effect of real interest rates looks quite small.

Similarly, this highly reduced-form approach tends to imply that rents are an exogenous explanatory factor in house prices, and using nominal (rather than real) rents only compounds the problem.  As I’ve pointed out here on various occasions, the sharp fall in real long-term interest rates should have been markedly lowering real rents over the decade –  real rents should be more affordable than ever.  Almost certainly it is the supply restrictions, interacting with unexpected population surges, that has driven up house prices, in turn driving up rents.    Interest rates are, at most, a second order issue: had the OCR not been lowered in line with the fall in neutral rates then –  all else equal – house/land prices would be lower, and the entire economy weaker.

Perhaps an easier way to see the point is this chart, showing the BIS measure of real house prices for the advanced economies in aggregate.

real house prices BIS 19.png

Real and nominal interest rates have fallen a lot almost everywhere in the advanced world since 2007 (Japan excepted) and yet real house prices are barely higher now than they were in 2007.    Lower interest rates do not explain high house prices, rising rents certainly don’t.  The culprit here (and in Australia) is tight planning restrictions, the effects of which are exacerbated by rapid population growth.

There were a couple of other significant points in the document that caught my eye, consistent with my description of the document earlier as laying the defences for the capital requirement increases next week.

The first related to credit conditions.    You will recall that the Bank recently released the results of its credit conditions survey. I wrote about them here.   Across the various classes of business lending, actual credit conditions were reported to have tightened quite a bit, and conditions were expected to tighten further over the coming six months.  And why?   Well, this was the chart –  from their own data.

credit 4

“Regulatory changes” is explicitly identified as the biggest single factor –  surely mostly the bank capital proposals –  closely followed by “balance sheet constraints” and “your bank’s risk tolerance”, both which one would expect to be directly influenced by the expected change in capital requirements.  And yet not a word of this made it into today’s FSR, presumably because it would have been a bit awkward or uncomfortable to have confronted it directly.    (There were a couple of mentions of credit conditions, but none of the role their own policy proposals appear to have played.)

And then there were stress tests.  One of the highly unsatisfactory elements of the way the Bank has tried to spin the case for much higher capital requirements is their reluctance to engage seriously with the results of various stress tests done this decade, all of which – no matter the shock – suggest that the banks come through in pretty good shape, in turn suggesting that (a) banks have plenty of capital and (b) bank lending standards in recent years haven’t been that bad at all.  Typically the Bank waves its hands, suggests the stress tests might not capture things perfectly, and hurries on to another issue.   But in this FSR they’ve come up with a new argument –  not previously seen, at least as I recall it, in a year of consultation.

While the stress tests are calibrated to a severe downturn event, the Reserve Bank is seeking to ensure that the system will be resilient to even larger shocks.

Well perhaps, but the scenarios they’ve already tested seemed plenty demanding (and appropriately so).  For example, a 4 per cent fall in GDP, a 40 per cent fall in house prices (and a 50-55 per cent in Auckland house prices) and an increase in the unemployment rate to 13 per cent.  It is the interaction between lower house prices and higher unemployment rates that creates large mortgage losses.

There are few examples anywhere of house prices falling more than that (including in the crises –  typically in fixed exchange rate countries –  people like to quote), and as for the unemployment rate, I devoted a whole post to that a few years back, where I concluded that there was not a single example, across the entire OECD, where a floating exchange rate advanced economy had experienced an increase in its unemployment rate as large as was implied by the Bank’s stress test in the entire post-war era (now 75 years, across perhaps 25 market-based countries).   The Bank seems to be wanting to prepare for a Greek crisis, or for a rerun of the Great Depression, without taking account of the stabilisation role monetary policy and a floating exchange rate now play in countries like New Zealand.   Without a lot more open engagement on the sorts of risks they see, it is pretty tawdry stuff.

In the course of his press conference, the Governor took the opportunity to wrap himself around the recent reports of the foreign academics he’d hired to provide some comments on the Bank’s capital proposals, lamenting only that these “excellent”, “very positive”, “wholly independent of us” reports hadn’t had much local media attention “unlike some other views” (it wasn’t quite clear who he was having a dig at there, but perhaps Kate McNamara’s stories are still leaving a sting).   Victoria University academic, and bank capital expert, Martien Lubberink was live-tweeting the Governor’s press conference and was moved to observe of these reports

I wrote about those reports in a post a few weeks ago, summarising

As I said at the start, for handpicked reviewers, chosen at a time when the Governor had already put his stake in the ground, the reports were much what one should have expected.   The Bank seems to have taken the reports as reassuring support –  but that is why they hired these particular people, known for particular predispositions –  but I suggest you don’t.  Many of the bigger picture questions simply haven’t been engaged with, adequately or at all.

(many of those bigger picture questions were rehearsed in the post)

and went on to conclude that there was a surprising absence from the reports (and from any Reserve Bank papers on the issue)

And, somewhat to my surprise, I didn’t see any mention at all of the paper that came out three months ago, from a working group of major central banks, looking at issues around appropriate minimum capital requirements, working within the academic framework these reviewers are comfortable with.   I discussed that paper here and  highlighted this chart and these issues

On my reading, this is the bottom line chart in the BCBS paper.

bcbs chart.png

They report the net marginal economic benefit (slightly lower GDP each year, offset against savings from a less serious crisis decades hence) from higher bank capital ratios, drawn from a series of studies.    On these models there were really big gains in lifting capital ratios, up to around to around 9-10 per cent.  If there are gains at all –  and they don’t report margins of error around these estimates –  they are looking extremely small beyond about 13 per cent.    Perhaps that doesn’t sound too far from the 16 per cent number the Reserve Bank is proposing for the big banks but (among other limitations, many made inevitable by data limitations):

  • this modelling is done on actual capital ratios, not regulatory minima (a 16 per cent minimum ratio is likely to see banks aim for something between 17 and 18 per cent actual ratio), and
  • none of this modelling takes account of differences in accounting and regulatory treatment across countries: conventional wisdom, (backed by estimates done by PWC) suggest that effective capital ratios in New Zealand (and Australia) would be far higher if things were measured the same way they were done in various other advanced countries, and
  • none of it takes account of the regulatory floor in how risk-weighted assets are calculated.  As the Bank is quite open about, a significant part of what is proposing is that in calculating risk-weighted assets, the big banks will have a floor of 90 per cent of what the standardised rules would generate (the more normal floor is, as I understand it, about 72 per cent).  A 17.5 per cent headline actual capital ratio would, on RB proposed rules, be akin to something like 20 per cent in the sort of framework the BCBS authors are looking at.

Nothing in this paper suggests any reason for confidence that effective capital ratios of, say, 20 per cent of risk-weighted assets would be generating net economic benefits, even on the (overly pessimistic) macro assumptions the authors are using.  But that is what the Reserve Bank claims to believe.  The onus, surely, is on them to show us, and to engage on their assumptions and analysis – in open dialogue – well before decisions are made.

Neither in todays report nor in the press conference was a rigorous, open, accountable, excellent central bank of the sort we should expect on display.     Perhaps it is too easy to become accustomed to this mediocrity.  Perhaps that accounts for the not-very-searching questions at the press conference –  nothing at all for example about the recent very public concerns about the Governor’s conduct over the bank capital proposals.

Next week all will be revealed. No one seems to expect any material departure from the initial proposal, even if there are a few cosmetic modifications, or adjustments to the transitional arrangements.  Perhaps then we will get all the answers: really good and convincing cost-benefit (and associated sensitivity) analysis, serious engagement with the serious analytical points raised in submissions (rather than attempts to treat submissions as akin to a public opinion poll), a sustained narrative around transitional paths and risks in allowing material tightening in credit conditions when conventional monetary policy is almost exhausted, and so on.

Perhaps.

A run on the bank (well, building society)

Being a bit early for an appointment yesterday, I ducked into a secondhand bookshop and emerged with a history of Countrywide Bank (by Tony Farrington, published in 1997), to add to my pile of histories of New Zealand financial institutions and major corporates.   For younger readers, perhaps unfamiliar with the name, Countrywide grew up from the building society movement, became a bank in the late 1980s after deregulation, and was taken over by the National Bank (itself later taken over by ANZ) in the late 1990s.

As I idly flicked through the book, I came across the account of one of those little episodes in financial history that (as far as I know) are not that well documented: the run on the building society, in April 1985.  Literal physical retail bank runs –  people queuing in bank branches and out onto the street – just aren’t that common.   When there was a run on Northern Rock in the UK at the start of what become the widespread financial crisis of 2008/09, the story was told that it was the first retail run in the UK for 140 years.  I am not sure if that is strictly true, but (fortunately) such runs are rare.   Deposit insurance supposedly contributes to that, but so do well-managed banks.

In April 1985, it was still the very early days of the comprehensive new wave of financial liberalisation that had begun when the Labour Party had taken office the previous July.  And it was only six weeks since the exchange rate had been floated, and five weeks or so since the extreme pressure on liquidity had seen overnight interest rates trade up towards 1000 per cent.  One-month bank bill rates peaked at about 70 per cent, and three-month rates peaked at around 35 per cent before the Reserve Bank intervened to stabilise the situation.  The overall level of interest rates had risen enormously (even post liquidity stabilisation) and anyone left sitting on (say) long-term government bonds faced very substantial mark-to-market losses.   There was a great deal of uncertainty about who might flourish, and who not, in the new environment.  And the newly-floated exchange rate was not exactly stable.

According to the Countrywide history’s account, in early April there had been rumours circulating for several days about the viability of Countrywide, which crystallised on Wednesday 10 April when an Auckland radio station ran a comment from one of their journalists that “there is no truth in the rumour that Countrywide is in financial difficulty”, which seems to have made the rumour much more widely known than it had been.

Countrywide protested to the radio station (perhaps reasonably so, but inevitably it was futile –  what was done was done), and they prepared a media release supposed to highlight their strength, but it took several days to get this in daily newspapers.  Reading the release now, with 34 years hindsight, I’m not sure that as a nervous depositor I’d have been reassured by it –  indeed when financial institutions boast about how rapidly they had been growing (in a climate of big changes in relative prices, and a great deal of uncertainty) it is probably reason for increased unease.

By this time, deposit withdrawals were already increasing significantly, and management was at pains to ensure that no branch was in danger of running out of cash even briefly.    And by this time, management had tracked down how the rumours seem to have started –  in the failure of a totally unrelated trucking company Countrywide Transport Systems Limited.  By then, the knowledge wasn’t much use to them.  They’d planned a press release explaining where the rumour had come from, but before it could run they had to deal with a development completely from left field: a Social Credit (monetary reformers) MP had issued a press statement referring to “widespread rumours about the impending collapse of a major building society” (by this time there were only two majors).

Countrywide called in the Reserve Bank and the then Governor, Spencer Russell, managed to get hold of the MP concerned –  at Wellington airport –  within 45 minutes of the statement being issued.  Morrison retracted the statement, but it was too late. As the history records “hundreds of depositors demanded their money”.

The run seems to have been focused in Wellington (and Hamilton), with queues outside several branches – 50 metres down the street outside the main Lambton Quay branch.   By the end of the day, customers had pulled out $10 million of deposits (Countrywide’s total assets then were about $445 million).  The next day, Thursday, they lost another $9 milliom in deposits (not just “mums and dads”, with withdrawals by solicitors being particularly evident.

The powers that be engaged in a significant (and successful) effort to staunch the run, with statements from the Associate Minister of Finance, the Governor of the Reserve Bank and the chief executive of the National Bank all reassured the public that Countrywide was sound.  By the Friday, it was estimated only $1 million of panic withdrawals occurred.

(These numbers don’t fully add up but) the history records that total deposit losses over the period of the run were around $30 million –  a far from insignificant share of total deposits.  Countrywide estimated that the run had involved a  direct P&L hit of around $1m, arising from the need to liquidate assets (government stock) in a rush, and additional staff, advertising, and communications costs.

And then the money flooded back –  it is recorded at times there were long queues to deposit the funds that had been withdrawn just a few days previously.   And the history mentions –  without comment –  that people were often depositing the same cheque they had taken from Countrywide only a few days previously.  I don’t really remember the run –  I was a junior Reserve Bank economist doing monetary policy stuff, and yet there is no mention of the run in my diary at all –  but that factoid was grist to the mill in debates about financial stability for years to come.  If you were so concerned about the health of your bank (building society) as to run on the bank, spend an hour in a queue, forfeit your place in the queue for mortgage eligibility (this was a thing still in 1985), why would you (a) take a cheque from the very bank you were concerned about (the danger of mugged on Lambton Quay had to be small, for example), and (b) why would you then not bank it straight away and pay for expedited clearing?  I still don’t claim to fully understand the answer to either question.

Eligibility for mortgage lending was still an issue in early-mid 1985.  Banks and building societies had been liability-constrained, and thus the practice grew up of having to have a suitable “savings record” with a specific lender to get a (first) mortgage (at least if you didn’t work for a bank, an insurance company, or the Reserve Bank).  The lender was doing you a favour not (as now to a great extent) the other way around.   Pulling your money out of the financial institution you might want to borrow from really was a big issue. Of course, better to lose your place in the mortgage queue than to lose your deposit (had it come to that), but it was a hurdle many depositors faced then that they would not face now.

As it happened, times were a changing, and the history records that Countrywide eventually “relented” (their words) and restored to their place in the mortgage queue those who had pulled their money out in the run.  Before very long, those depositors would have found other lenders competing to lend to them.

There are quite a number of unanswered questions in the Countrywide history (unsurprisingly –  geeky monetary economists weren’t the target market for the book), and I had a look at various other books on my shelves to see if I could find any other angles.  There was nothing in Roger Douglas’s book or in the biography of (then Deputy Governor) Roderick Deane, but there was a brief mention in the history of the Reserve Bank published in 2006.   Here is the relevant text.

countrywide.png

But, of course, that passage only raises further questions, including ones about how the Governor (or the Associate Minister) could be confident in their assertions about the soundness of Countrywide.  Whatever the substantive health of the institutions, were their statements well-founded in verified and verifiable data, or were the statements to some extent a confidence-trick: well-motivated, but actually based on little or no more information than the public had?    (There are readers of this blog who would pose similar questions about the style of bank supervision adopted by the Reserve Bank to this day.)   The Bank’s files may offer some answers (or maybe not).  And was the statement of support from the National Bank chief executive supported by offers on unsecured liquidity assistance (that would be a clear signal of confidence that might have encouraged the Reserve Bank).

Perhaps  the authorities made a relatively safe call –  after all, resurgent inflation meant that the value of Countrywide’s loan collateral was rising. On the other hand, like all regulated entities in those days, Countrywide had had to hold significant amounts of government securities, and government security interest rates had risen sharply.    Many institutions –  notably the trustee savings banks –  had taken big mark to market losses, and there was a strong sense that the viability of some of them would have been in jeopardy, especially if there had been timely and clear mark-to-market reporting.  Add in the high and very variable wholesale funding costs (probably only a small proportion of Countrywide’s funding) and one is left wondering how robust an analysis lay behind the official statements of support.  There was another building society run –  on competitor United –  a few years later, and the Reserve Bank history records that that time United took the view that official statements of support (Governor and Prime Minister) were tardy.    What sort of rethinking went on internally after the Countrywide episode?

I’m not playing any sort of gotcha here.  If anything, it is more a plaintive appeal for some economic and financial historian to undertake a systematic treatment of the New Zealand banking and financial sector through the liberalisation period.    There were all manner of small crises and near-crises during this period (PSIS, the devaluation “crisis”, Countrywide, United, RSL, the DFC, NZI Bank, the BNZ (twice) and probably others that don’t spring immediately to mind.  There are serious scholarly treatments of the experience in the Nordic countries with liberalisation at about the same time, but surprisingly little about New Zealand.

Not, I suppose, that historians will be able to help answer the question of why panicking depositors took their money in a cheque and then, it appears, in many cases didn’t even rush to get the cheque cleared, or to bank it at all.

I’m sure there are readers who were involved to some extent in these matters, whether at the Reserve Bank or elsewhere. I’d welcome any perspectives or insights in comments.

An embattled Orr

Still catching up, but noticing some concerning newspaper stories about how the Governor was handling things, yesterday I finally got round to reading the Reserve Bank’s Financial Stability Report and watching the Governor’s press conference.

Of the former, probably the less said the better.  It is a disappointingly lightweight effort, clearly designed to sound a bit more worried about New Zealand financial system risks – to support (belatedly) the Governor’s capital proposals – even while offering no evidence to suggest that such risks were (a) significant, or (b) worsening.       There were statements of the blindingly obvious –  “some” households and farms are overindebted, as if that has not always been the case –  and alarmist conclusions (about the threat banks could face if lots of borrowers default) made without any reference to the Bank’s own repeated stress tests.

And then there was the press conference.   I’ve seen some pretty poor performances from Governors over the years –  early ones by Alan Bollard were often awkward, and as Graeme Wheeler became more embattled the defensive introvert, never comfortable with the media, took over.     But this one was the worst I’ve seen, and from someone who has many talents in communications.  But just not, so it is confirmed again, in coping with challenge, disagreement, or finding himself on the back foot.  I doubt a senior politician would have got away with it, and it isn’t obvious why an unelected bureaucrat, uncomfortable at facing serious scrutiny, should do so.

The Governor and Deputy Governor faced several questions about the possible impact of the Bank’s capital proposals on farm lending –  various commentators have suggested such borrowers will be among the hardest hit.  The Bank attempted to push back claiming that any sectoral impacts were nothing to do with them, and all about banks’ own choices.  But they seemed blind to the fact that banks will have more ability to pass on the additional costs of the higher capital requirements to some sectors, some borrowers, than others.  And that is because of a point the Bank never addresses: their capital requirements don’t apply to all lenders.

They don’t apply to banks operating here that aren’t locally incorporated, they don’t apply to banks operating abroad in respect of loans to New Zealand entities, they don’t apply to local non-bank institutional lenders (deposit-takers, who have their own capital regime, or others), and they don’t apply to bond markets.   So some borrowers (think large corporates in particular) have a variety of alternative options and others don’t.  Almost inevitably the costs of the Bank’s capital proposals would bear most heavily on those with the fewest options, and farm borrowers are foremost among that group (there isn’t a big appetite from new entrants to build farm loan books, and farm lending is information-intensive and quite property-specific).   The Reserve Bank’s failure to openly and honestly address these sorts of issues –  none of them have been touched on in any of the consultative documents –  reflects poorly on them.   Whether it is because they simply never recognised the issue, or are trying to play blame games and shift responsibility etc, isn’t clear, but since the issues have been raised here (and elsewhere) for months, there is an increasingly likelihood that they know exactly what they are doing, not playing straight with the New Zealand public.

The Governor came across as embattled from start to finish –  embattled at best, at times prickly, rude, and behaving in a manner quite inappropriate for a senior unelected public official exercising a great deal of discretionary power, with few formal checks and balances.   BusinessDesk’s Jenny Ruth – who often asks particularly pointed questions about the exercise of the Bank’s regulatory powers, and the lack of transparency around its use of those powers – was the particular target of his ire, and at one point he tried to refuse to take further questions from her.

It isn’t always clear that the Governor hears the way he sounds: he goes out of his way to state that it is a genuine and open consultation, only to then conclude “but we are going to have more and better capital” –  in other words, no true consultation at all, as he has already made up his mind on the big picture.  Asked by another journalist what had changed in recent years that made further big increases in capital requirements warranted now, he fell back on spin –  no substantive answer, but “not enough has changed since 2008”, which isn’t a serious answer at all, especially in view of (a) the resilience of Australasian bank loan books in 2008/09, (b) repeated stress tests since, and (c) that aggregagate debt to income ratios are little different now than they were 10 years ago.   At one point, he actively misrepresented a prominent submitter’s submission.

Not all the awkward questioning was about the new capital proposals.  Some was about the recently-discovered failure of ANZ to use approved models in calculating capital requirements for operational risk, in the course of which it was revealed –  belatedly –  that the  Reserve Bank had told banks  (but not the public) that it is no longer approving any changes they would like to make to their internal models.    Under pressure –  this is after all the Reserve Bank’s day job –  the Governor moaned that the Bank hadn’t been adequately funded and that they had to prioritise. It was a shame no one asked about why the $1 million on the Governor’s Maori strategy, his tree god spin, and the endless talk about climate change –  at best peripheral to the Bank’s responsibilities – is being prioritised over proper adminstration of the bank capital regime.  Someone still should (after all, recently they had the money to send two staff to Paris for a climate change shindig).

The press conference deterioriated further as it got towards the end.  Without specific further prompting, the Governor noted a certain frostiness in the room, and then launched off again in his own defence.  The Bank was very transparent –  he asserted, even though it took months to get the full capital proposal documentation out, and we still have no cost-benefit analysis –  and it was very open-minded (except that, as he told us, he was closed minded on the needed for more and better capital).  He went on to note that he needed to rely on facts, and he would welcome decent questionings but (and I paraphrase) “I will be short with people when I see continuous mis-statements from journalists and others with vested interests”, all while – he told us –  he was trying to serve the interests of the people of New Zealand.

It should become a case-study for official agencies in how not to do things.

But it appears that Orr wasn’t finished, and didn’t go back to his office, reflect that that hadn’t gone well, listen to some sage counsel from his senior managers or Board, and re-engage in that sunny upbeat way the Governor at his best can manage much better than most.

A couple of articles in the Herald in recent days tells us some more of the story.   The first was from Liam Dann, who has in the past provided a trusty outlet for the views of successive Governors, and the second was a column from Pattrick Smellie, under the heading “Bunker mentality returns to the RBNZ?”, evoking unwelcome memories of the Wheeler governorship.

Dann’s article draws from a media lunch at which Orr had apparently been speaking.  There was, it appears, no hint of emollience, no suggestion of welcoming all the thoughtful work and analysis that had gone into the many submissions the Bank had received.  That is what a normal person would do and say (whatever they felt privately).  But not Orr.  He’s all in.  People either don’t understand, or they choose not to understand because –  on the Governor’s telling – they are all self-interested, part of the financial sector, while he –  and he alone it appears –  is looking out for the future of New Zealand.   If you think I’m caricaturing, read the article for yourself (I’m reluctant to excerpt extensively something behind a paywall).   But here are two extracts.

Orr said he had expected the strong critical response from the banks because he was aware of “the capability and resource” within the industry to lobby for the status quo.

“It is a very, very powerful industry.”

But he said he had been surprised by the personal attacks and “the underlying venom” that had come from the broader financial sector – including bloggers, think tanks and some sections of the media.

The noble Governor –  alone equipped to assess the public interest –  as the Three Hundred at Thermopylae facing down the amassed hordes of bankers (and “bloggers, think tanks and some sections of the media”).

Not only is there nothing about the substance of the arguments and evidence submitters and commenters have made (at length over many months) but note the attempt to imply that anyone criticising his proposals (and the very weak process around them) was part of the “financial sector”.   No doubt my views don’t count for much, but I’ve articulated numerous questions and criticisms here (and in my submission), and have never once taken a cent from the “financial sector”.  My former colleague Ian Harrison has extensively critiqued the Bank’s proposals and supporting documents, and I know for a fact it was entirely a labour of love (well, voluntary and unremunerated anyway).  And even if affected industries have made submissions –  shouldn’t we want them to? –  the onus should still be on the Governor and his staff to address issues and criticisms in a constructive way, not to engage in some sort of Trumpy politics of slur (no need to engage, because you are  – great evil –  banks).  It actually got worse at FEC (at least according to the Smellie column): questioned about why his “independent experts” (appointed belatedly) were all from abroad, he couldn’t stick to a moderate line that (say) most New Zealand residents who knew much about the issue had already weighed in in one form or another, but had to resort to the (frankly slanderous) suggestions that any New Zealand experts “had already been ‘bought’ by the trading banks”.

In the Dann article there was further illustration of how the Governor plays politics and spin, rather than engaging on substance.    We get this

Orr described the notion that the major banks “sailed through the GFC” as a popular myth that had taken hold with the general public.

In fact sailing through had involved a $133 billion overnight guarantee, an $8b direct asset purchase by the Reserve Bank to provide liquidity, a $10b wholesale underwrite and a drop of the OCR by 5.75 per cent.

I know Orr was not in the core public sector at the time (he was trading the markets at NZSF), but this is a highly misleading attempt to play distraction.   First, as the Governor very well knows, the big banks did not want to participate in the retail deposit guarantee scheme (the Minister of Finance compelled them to, as a condition of the limited wholesale guarantees).  Second, as the Governor equally well knows, every wholesale funding market in the world dried up for a time (and for reasons –  as all the contemporary documentation makes clear –  that had nothing to do with the specifics of Australasian banks).  Third, it is a core role of the Reserve Bank to provide liquidity support when demand for liquidity rises.  Fourth, as regards banks, all those operations were profitable for the Crown.    Fifth, the scale of the OCR adjustment is totally irrelevant to questions of bank soundness or otherwise –  there was a severe recession, partly domestic, partly foreign –  and adjusting the OCR as it did was just the Reserve Bank doing its day job (a little slowly as it happens).  And finally –  and really the only point of relevance to the capital debate  – bank losses (and NPLs) remained impressively moderate through that nasty recession and slow recovery.  Capital was never impaired.

On my reading, even Pattrick Smellie’s column is too willing to defend Orr’s conduct –  last week, and more generally.    He sticks up for his use of the Bank to pursue climate change agendas that have no grounding in statute (translations of the Bank’s self-chosen Maori name signify precisely nothing), of the tree god nonsense and the costly Maori strategy (even defending Orr’s claim that criticism of him on this is somehow “racist”).  And he buys into the Orr propaganda line that the Bank is “now more open and transparent” (it just isn’t so –  the capital review is only the latest example, but nothing material has changed about monetary policy, we’ve had no serious speeeches from the Governor on his core responsibilities, and they play OIA games just as much as ever), but this really should worry the Board (albeit they are usually in the Governor’s pocket), The Treasury (other distractions I suppose), and the Minister of Finance.

Ebullient, rambunctious, prone to Shane Jones-ian turns of phrase, Orr is the antithesis of his prickly predecessor, Graeme Wheeler. The RBNZ is now more open and transparent.

However, Orr and members of his senior team are starting to exhibit some of the same bunker mentality as beset Wheeler,

Orr very much needs to be pulled into line, for his own sake and that of the country (as single decisionmaker he still wields huge untrammelled power).  At present, he is displaying none of the qualities that we should expect to find in powerful unelected official –  nothing calm, nothing judicious, nothing open and engaging, just embattled, defensive, aggressive, playing the man rather than the ball, all around troubles of his own making (poor process around radical proposals made without any robust shared analysis, all while he is prosecutor, judge, and jury in his own case).

It is a sad week for New Zealand when the heads of our two main economic agencies –  The Treasury and the Reserve Bank –  are so much, and so deservedly, under intense scrutiny, and when we have no idea who will even be Secretary to the Treasury –  lead economic adviser to the government –  three weeks from now.

 

 

The tree god again

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

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

partridge 1

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

And thus the Governor begins

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

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

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

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

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

Te hunga tiaki

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

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

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

The statement goes on

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

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

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

RBNZ-Relationships-Charter

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

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

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

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

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

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

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

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

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

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

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

And then there is the final paragraph

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

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

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

And then there is that bold final claim

Outcomes will be superior and better understood and owned by society

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

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

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

 

 

 

Bank capital proposals: a few initial comments

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

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

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

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

capital requirements

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

These were the other comments I was reported as making

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

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

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

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

Many KiwiSaver funds own shares in the Australian banks.

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

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

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

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

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

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

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

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

Don’t legislate depositor preference

The government has underway a fairly comprehensive review of the Reserve Bank Act.  The first phase –  around monetary policy –  was pretty narrow in scope, rushed, and has resulted in not very good provisions now about to be legislated by Parliament.  I was always a bit sceptical about Phase 2, partly because of the way Phase 1 was handled and partly because the Minister of Finance had never displayed any particular interest in the issues.

But, for the moment anyway, I’m willing to revise my judgement.  Earlier last month a 100 page consultative document was released, the first of three as the Treasury and the Bank (aided by a somewhat questionable, secretive, independent advisory panel) work their way through the numerous issues involved in overhauling the Reserve Bank legislation and institutional design.

Yesterday, I attended a consultative meeting at The Treasury on the issues in the current document.  It was an interesting group of people and quite a good discussion, although even 2.5 hours is barely enough to do much more than scratch the surface on the wide range of issues in the document –  everything from the role of the Board to regulatory perimeter issues (including whether banks and non-bank deposit-takers should be subject to the same regulatory regime – most people seemed to think so).  Truly keen people can spend their summer preparing written submissions (due in late January).

What was striking –  part of what leads me to provisionally revise my view –  is just how much official resource is being put into this one review.  At yesterday’s meeting there were six members of the review team, and that wasn’t all of them –  and even they only report to their masters in the Reserve Bank and Treasury, many of whom will probably engage quite extensively on the issues. And the process has at least another year to run.  Despite having long championed the cause of reforming the Reserve Bank, I couldn’t help wishing that the same level of resource was being devoted to getting to the bottom of the causes, and compelling remedies, for New Zealand’s astonishingly poor long-term productivity performance.    There is little sign The Treasury has any resources devoted to that issue, the one that has the potential to make a huge difference to the lives of all New Zealanders.

But in this post I wanted to touch on just one specific issue that came up yesterday which surprised quite a bit and worried me quite a lot.   Chapter 4 of the document is devoted to the question of “Should there be depositor protection in New Zealand?”.  Of course, to the extent it adds in value at all, prudential regulation does help the position of depositors (reducing the probability of failure, and limiting the potential chaos if a major failure happens), but New Zealand’s legislation is unusual in that there is no explicit depositor protection mandate (the legislative goals are about the financial system, not individual institutions or their creditors).  Linked to that, we are now very unusual among advanced economies in having no system of deposit insurance.

I wrote about some of these issues, in response to a journalist’s queries, when the consultative document first came out.  But my focus then was on deposit insurance, and in particular on the realpolitik case I see for instituting deposit insurance, to give us the best chance that when a bank gets into serious trouble it will be allowed to fail, and its wholesale creditors –  the ones who really should know what they are doing –  can be allowed to lose their money.   Without deposit insurance, my view is that big banks will always be bailed out.  Perhaps they will even with deposit insurance, but by separating the interests of retail creditors from others, at least political options are opened.

But in focusing on deposit insurance, one thing I hadn’t really noticed in the chapter was the idea of providing depositors with additional protection by legislating depositor preference.  Depositor claims on the assets of a bank rank ahead of those of any other creditors.   Such a provision exists in the Australian legislation –  for Australian depositors.  It was a big part of the reason why New Zealand eventually insisted that Westpac’s retail business in New Zealand be locally incorporated (ie conducted through a New Zealand subsidiary).

To the extent I’d noticed the discussion of the depositor preference option, I’d assumed it was a bit of a straw man, there for completeness perhaps.  Surely, I thought, no one would seriously suggest that New Zealand adopt such a legislative preference.   But, going by the discussion at yesterday’s meeting, it seemed I was wrong and that officials are actually seriously considering this option.   They seem to see it as a complement to a deposit insurance scheme.  I think it would be quite wrongheaded.

In my incomprehension, I asked why  –  starting with a clean sheet of paper – anyone would think legislated depositor preference was a sensible route to consider.  The response seemed to be that it would be a way of reducing the cost of deposit insurance, and increasing the credibility of a deposit insurance scheme.  Both seem weak arguments, especially in the New Zealand context.

One argument sometimes advanced against deposit insurance is that in the event of a systemic financial crisis the cost could be so overwhelming that it would either over-burden public debt, potentially triggering a fiscal crisis, or lead to governments retrospectively walking away from the insurance commitment (simply legislating to not pay out).  In fact, we know that for reasonably governed countries that practical limits on the ability to take on new public debt are not very binding at all.   And we know that New Zealand has (a) very low levels of net public debt by advanced country standards, and (b) a banking system of only moderate size (relative to GDP) by advanced country standards.    Total household deposits with all registered banks are about $175 billion.  Not all of those would be covered by a deposit insurance scheme, even one that capped cover at a relatively high $200000.

Now lets assume something really really bad happens: banks lend so badly over multiple years that when the eventual reckoning happens loan losses are so large that 30 per cent of all bank assets are written off.   This would be absolutely huge –  far far beyond anything in Reserve Bank stress test, for beyond advanced country experience for retail-oriented banks.  But one can’t rule out by assumption utter disasters.  30 per cent of bank assets is currently about $175 billion as well.  There is about $40 billion of equity to run through, and then the creditors start bearing the losses.  Household deposits are about a third of non-equity liabilities, so in this extreme scenario the deposit insurer (and residual Crown underwriter) would face bills of up to perhaps $50 billion (a generous third of $135 billion of losses to be distributed across creditors and insurers).    And remember how extreme this scenario is: it assumes every bank in the system fails, and fails dramatically (not just slightly underwater), and that every household deposit is fully covered by deposit insurance.  In this really really bad, highly implausible scenario the bill presented to the depositor insurer is equal to less than 20 per cent of GDP.

Reasonable people can, of course, differ on whether deposit insurance is a good idea at all, just better than the likely alternative (my view), or something to be eschewed at all costs.  But in no plausible world would even a commitment of 20 per cent GDP overwhelm New Zealand public finances, or cast doubt on the ability of the New Zealand government to honour its obligations.   And none of this takes into account the likelihood that any deposit insurance scheme would be set up funded by insurance levies  Levy depositors, say, 20 basis points a year and you’ll be collecting (and setting aside) $350 million a year.  As I recall it, prudential policy (bank capital requirements) are currently set with a view to expecting systemic crises no more than once in a hundred years (the Governor the other day talked of extending that to once in 200 years).    If the really really bad systemic crisis hits in year 1, the government needs to borrow more upfront (recouped over time by the annual insurance fees).  If the really really bad crisis hits in year 150, there is a large pool of money standing ready, accumulated from those same annual insurance fees.

(Of course, in any scenario in which banks have lent so badly –  and regulators regulated so poorly –  that 30 per cent of all assets are written off, the economy is likely to be performing very badly for a while, and the public finances will be under some pressure anyway.  But those problems are there regardless of the resolution method chosen.)

The other argument I heard advanced for a legislated depositor preference is that it would reduce the cost of deposit insurance.    That might look like a superficially plausible argument, but it is almost certainly wrong in any economically meaningful sense.   Sure, if your bank is funded 50/50 by retail depositors on the one hand and wholesale creditors on the other, the chances that a deposit insurance fund will ever have to pay out to the depositors of that bank, in the presence of legislative preference, is very small (roughly speaking, losses would have to exceed 50 per cent of all the assets for depositors to be exposed to loss –  and thus the deposit insurer).    But if you don’t pay for your insurance one way you will pay for it another way.   If depositors have first claim on bank assets and all other creditors are legislatively subordinated, over time depositors are likely to earn lower interest rates than otherwise (less risk to compensate for) and other creditors more).   It might be hard to show this effect in the case, say, of the big Australian banks, but then no one seriously thinks the Australian government would do anything other than bail out those banks in the event of a crisis.  But we can see the pricing on existing subordinated debt issued by banks around the world – it yields, as you would expect, more than deposits.  It is much riskier.

Of course, it is true that legislating a depositor preference largely shifts the problem from the Crown balance sheet (underwriting the deposit insurer) to those of banks and their creditors.  That might look like a smart thing to do  –  internalising the issue and all that –  but in fact it is a subterfuge: trying to meet a public policy priority (depositor protection) by forcing banks to change their entire business model.  Much better to do things in a direct and transparent way: if you want deposit insurance, charge for it directly, and allow banks to determine how they operate their businesses (funding structures etc) given the insurance levies they face, and the market opportunities.  Doing so also operates more fairly – and efficiently – across different types of banks.  Depositor preference accomplishes nothing at all  in a bank that is 100 per cent deposit-funded, and such institutions should be competing on a competitively neutral basis with other banks with different mixes of funding.

In the consultative document, and again in the discussion yesterday, officials seemed to see a model in which wholesale creditors are exposed to more risk as a “good thing”, conducive to effective market discipline.  I’m with them on that point in so far as people -especially wholesale creditors –  who lend to banks should face a real risk of losing their money.  But depositor preference in effect says that the only way non-depositors can lend to banks is through instruments on which the losses mount extremely rapidly if anything goes wrong.  There is no good case for that (even if, as some do, you think it is reasonable to require banks to issue some tranche of subordinated or convertible debt).   It is a doubly surprising argument to hear mounted in New Zealand where for years –  and especially since 2008 –  we have been repeatedly reminded of the heavy exposure of our banks to offshore wholesale funding markets.   None of those holders has to take on exposure to New Zealand or New Zealand banks.   Legislate depositor preference and what you will do is to significantly increase the risk of those funding markets, for New Zealand, freezing, and yields on secondary market instruments going sky-high, at the first sign of any trouble, or even just nervousness.    Retail runs are one issue to think about, but as we saw globally in 2008 wholesale runs can be just as real, and perhaps more threatening (and lightning fast) –  I discussed the Lehmans story here.

I hope the legislated depositor preference option is taken off the table quickly.  It has the feel of clever wheeze intended to ease the path for deposit insurance.  Much better to make the case –  and there is a sound one –  for a properly funded deposit insurance scheme on its own merits.

On a totally different subject there was a surprising article in the Herald yesterday in which a former MPI official was discussing openly concerns held in 2008/09 about the potential financial health of Fonterra.   I was involved in this work at the time, working at The Treasury, and have always been a bit surprised that there wasn’t more open analysis of the issue at the time.  Just drawing on public information, the combination of:

  • a quite highly indebted cooperative,
  • largely frozen international credit markets (not just for banks),
  • highly-indebted farmer shareholders,
  • a model in which shareholder farmers could redeem their shares in Fonterra when their production dropped,
  • a drought the previous year (reducing production) and
  • low product prices, encouraging some farmers to further reduce production, and
  • the potential for some highly-indebted farmers to be sold up by their banks

was a pretty obvious basis for some vulnerability.    Fortunately, the particular extreme combination of risks never really crystallised.   One aspect of the 2008/09 crisis that was always interesting was –  in the words of one investment bank CEO at the time –  “one of the few markets that remain open is the New Zealand corporate bond market”.  That was because it was, and always has been, primarily a retail market, different from the situation in many other countries (reflecting regulatory differences).  In early 2009 Fonterra was able to run a highly successful domestic retail bond issue.  Subsequent changes to the Fonterra capital structure mean that in future serious downturns, redemption risk is no longer a consideration.  That, however, leaves more of the (liquidity) risk on farmers themselves.

What?

In the press release for last week’s Reserve Bank Financial Stability Report, the Governor commented that

Our preliminary view is that higher capital requirements are necessary, so that the banking system can be sufficiently resilient whilst remaining efficient. We will release a final consultation paper on bank capital requirements in December.

In commenting briefly on that, I observed

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

There wasn’t much more in the body of the document (and, as I gather it, there wasn’t anything much at the FEC hearing later in the day), so I was happy to wait and see the consultative document.

But the Governor apparently wasn’t.  At 12.25pm on Friday a “speech advisory” turned up telling

The Reserve Bank will release an excerpt from an address by Governor Adrian Orr on the importance of bank capital for New Zealand society.

It was to be released at 2 pm.   The decision to release this material must have been a rushed and last minute one –  not only was the formal advisory last minute, but there had been no suggestion of such a speech when the FSR was released a couple of days previously.

And, perhaps most importantly, what they did release was a pretty shoddy effort.    We still haven’t had a proper speech text from the Governor on either of his main areas of responsibility (monetary policy or financial regulation/supervision) but we do now have 700 words of unsubstantiated (without analysis or evidence) jottings on a very important forthcoming policy issue. which could have really big financial implications for some of the largest businesses in New Zealand and possibly for the economy as a whole.

The broad framework probably isn’t too objectionable.  All else equal, higher capital requirements on banks will reduce the probability of bank failures, and so it probably makes sense to think about the appropriate capital requirements relative to some norm about how (in)frequently one might be willing to see the banking system run into problems in which creditors (as distinct from shareholders) lose money.  At the extreme, require banks to lend only from equity and no deposit or bondholder will ever lose money (there won’t be any).

But what is also relevant is the tendency of politicians to bail out banks.  Not only does the possibility of them doing so create incentives for bank shareholders to run more risks than otherwise (since creditors won’t penalise higher risk to the same extent as otherwise), but there is a potential for –  at times quite large –  fiscal transfers when the failures happen.  Politicians have more of an incentive to impose high capital requirements on banks when they acknowledge their own tendencies to bail out those banks.  If, by contrast, they could resist those temptations –  or even manage them, in say a model with retail deposit insurance, but wholesale creditors left to their own devices –  it would also be more realistic to leave the question of capital structure to the market –  in just the same way that the capital structure of most other types of companies is a mattter for the market (shareholders interacting with lenders, customers, ratings agencies and so on).

But nothing like this appears in the Governor’s jottings.  Instead, we have the evil banks, the put-upon public and the courageous Reserve Bank fighting our corner.   I’d like to think the Governor’s analysis is more sophisticated than that, and one can’t say everything in 700 words, but…..it was his choice, entirely his, to give us 700 words of jottings and no supporting analysis, no testing and challenging of his assumptions etc.

There are all manner of weak claims.  For example

We know one thing for sure, the public’s risk tolerance will be less than bank owners’ risk tolerance. 

I think the point he is trying to make is about systemic banking crises –  when large chunks of the entire banking system run into trouble.  There is an arguable case –  but only arguable –  for his claim in that situation, but (a) it isn’t the case he makes, and (b) I really hope that (say) the shareholders of TSB or Heartland Bank have a lower risk tolerance around their business than I do, because I just don’t care much at all if they fail (or succeed).  Their failures  –  should such events occur –  should be, almost entirely, a matter for their shareholders and their creditors, with little or no wider public perspective.

There are other odd arguments

Banks also hold more capital than their regulatory minimums, to achieve a credit rating to do business. The ratings agencies are fallible however, given they operate with as much ‘art’ as ‘science’.

Bank failures also happen more often and can be more devastating than bank owners – and credit ratings agencies – tend to remember.

And central banks and regulators don’t operate “with as much ‘art’ as ‘science'”?   Yeah right.   And the second argument conflates too quite separate points.  Some bank failures may be “devastating” –  although not all by any means (remember Barings) –  but the impact of a bank failure isn’t an issue for ratings agencies, the probability of failure is.   And I do hope that when he gets beyond jottings the Governor will address the experience of countries like New Zealand, Australia, and Canada where –  over more than a century –  the experience of (major) bank failure is almost non-existent.

The Governor tries to explain why public and private interests can diverge (emphasis added)

First, there is cost associated with holding capital, being what the capital could earn if it was invested elsewhere. Second, bank owners can earn a greater return on their investment by using less of their own money and borrowing more – leverage. And, the most a bank owner can lose is their capital. The wider public loses a lot more (see Figure 2).

But what is Figure 2?

figure 2

Which probably looks –  as it is intended to –  a little scary, but actually (a) I was impressed by how small many of these numbers are (bearing in mind that financial crises don’t come round every year), and (b) more importantly, as the Governor surely knows, fiscal costs are not social costs.  Fiscal costs are just transfers –  mostly from one lots of citizens (public as a whole) to others.  I’m not defending bank bailouts, but they don’t make a country poorer, all they do is have the losses (which have arisen anyway) redistributed around the citizenry.  If the Governor is going to make a serious case, he needs to tackle –  seriously and analytically –  the alleged social costs of bank failures and systemic financial crises.  So far there is no sign he has done so.  But we await the consultative document.

There is a suggestion something more substantive is coming

We have been reassessing the capital level in the banking sector that minimises the cost to society of a bank failure, while ensuring the banking system remains profitable.

The stylised diagram in Figure 3 highlights where we have got to. Our assessment is that we can improve the soundness of the New Zealand banking system with additional capital with no trade-off to efficiency.

and this is Figure 3

capital chart

It is a stylised chart to be sure, but people choose their stylisation to make their rhetorical point, and in this one the Governor is trying to suggest that we can be big gains (much greater financial stability, and higher levels (discounted present values presumably) of output) by increasing capital requirements on banks.

I don’t doubt that the Bank can construct and calibrate a model that produces such results.  One can construct and calibrate models to produce almost any result the commissioning official wants.  The test will be one of how robust and plausible the particular specifications are.  We don’t know, because the Governor is sounding off but not (yet) showing us the analysis.  Frankly, I find the implied claim quite implausible.   Probably higher capital requirements could reduce the incidence of financial crises.  But the frequency of such events is already extremely low in well-governed countries where the state minimises its interventions in the financial system, so I don’t see the gains on that front as likely to be large.    And, as I’ve outlined here in various previous posts I don’t think that the evidence is that persuasive that financial crises themselves are as costly as the regulators (champing at the bit for more power) claim.  And many of the costs there are, arise from bad borrowing and lending, misallocation of investment resources, which are likely to happen from time to time no matter how well-capitalised the banks are.

There are nuanced arguments here, about which reasonable people can disagree. But not in the Governor’s world apparently.

He comes to his concluding paragraph, the first half of which is this

A word of caution. Output or GDP are glib proxies for economic wellbeing – the end goal of our economic policy purpose. When confronted with widespread unemployment, falling wages, collapsing house prices, and many other manifestations of a banking crisis, wellbeing is threatened. Much recent literature suggests a loss of confidence is one cause of societal ills such as poor mental and physical health, and a loss of social cohesion.

Oh, come on.  “Glib proxies”……..    No one has ever claimed that GDP is the be-all and end-all of everything, but it is a serious effort at measurement, which enables comparisons across time and across countries.  Which is in stark contrast to the unmeasureable, unmanageable, will-o-wisp that the Governor (and Treasury and the Minister of Finance) are so keen on today.

As for the rest, sometimes financial stresses can exacerbate unemployment and the like,  but the financial crises typically arise and deepen in the context of common events or shocks that lead to both: people default on their residential mortgages when they’ve lost their jobs and house prices have fallen, but those events don’t occur in a vacuum.  And anyone (and Governor) who wants to suggest that mental health crises and a decline in social cohesion can be substantially prevented by higher levels of bank capital is either dreaming, or just making up stuff that sounds good on a first lay read.

The Governor ends with this sentence

If we believe we can tolerate bank system failures more frequently than once-every-200 years, then this must be an explicit decision made with full understanding of the consequences.

As if his, finger in the dark, once-every-200 years is now the benchmark, and if not adopted we face serious consequences.   Let’s see the evidence and analysis first.  Including recognition that systemic banking crises don’t just happen because of larger than usual random shocks –  the isimplest scenario in which higher capital requirements “work” –  but mostly from quite rare and infrequent bursts of craziness, not caused by banks in isolation, but by some combination of banks and (widely spread) borrowers, often precipitated by some ill-judged or ill-managed policy intervention chosen by a government.   Higher capital ratios just aren’t much protection against the gross misallocations that arise in the process –  in which much of any waste/loss is already in train (masked by the boom times) before any financial institution runs into trouble (the current Chinese situation is yet another example).

Perhaps as importantly, under the current (deeply flawed) Reserve Bank Act the choice about capital is one the Governor is empowered to make.  But his deputy, responsible for financial stability functions, had some comments to make on this point in a recent speech (emphasis added)

And Phase 2 of the Government’s review is an opportunity for all New Zealanders to consider the Reserve Bank’s mandate, its powers, governance and independence. The capital review gives us all an opportunity to think again about our risk tolerance – how safe we want our banking system to be; how we balance soundness and efficiency; what gains we can make, both in terms of financial stability and output; and how we allocate private and social costs.

It may be that the legislation underpinning our mandate can be enhanced, for example, by formal guidance from government or another governance body, on the level of risk of a financial crisis that society is willing to tolerate.

These are choices that should be made by politicians, who are accountable to us, not by a single unelected and largely unaccountable (certainly to citizenry) official.  We need officials and experts to offer analysis and advice, not to be able to impose their personal ideological perspectives or pet peeves on the entire economy and society.

We must hope that the forthcoming consultative document is a serious well-considered and well-documented piece of analysis, and that having issued it the Governor will be open to serious consideration of alternative perspectives.  But what was released last Friday –  700 words of unsupported jottings –  wasn’t promising.

(I should add that I have shifted my view on bank capital somewhat over the years, partly I suspect as a result of no longer being inside the Bank. It is somewhat surprising how –  for all one knows it in theory –  things look different depending on where one happens to be sitting.  But my big concern at present is not that it would necessarily wrong to raise required bank capital, but that the standard of argumentation from a immensely powerful public official seems –  for now – so threadbare.)