Towards an engaging Governor

There won’t be a post here on Monday, but yesterday something caught my eye in the email inbox (and I’m not very much of a rugby fan).

This was the advisory from the Reserve Bank

Text of a speech by Head of Communications and Board Secretary, Mike Hannah, entitled “Engaging with our stakeholders to promote understanding, accountability and dialogue” will be published on the Reserve Bank website at 8:30am on Tuesday 27 June

It reminded me of an earlier piece by Hannah a couple of years ago.  It was a Bulletin  article published in May 2015 under the title Being an engaging central bank.  It didn’t seem to attract much attention at the time, although I wrote about it.  Hannah used the article as, among other things, a platform to highlight how active its engagement was and how transparent it was.  I highlighted then some of the many areas in which the Reserve Bank is well off the pace in respect of transparency, particularly around monetary policy.

When Hannah wrote his previous article things must have seemed to be going quite well for the Bank, at around the half-way mark of the Governor’s five year term.   The article presented and drew on a survey of external stakeholders about the Bank’s external engagement, that had been done in the second half of 2014.    The OCR increases were then well underway, and they and most of the people they regarded as domestic stakeholders still probably thought the Bank was doing the right thing.  The Bank used the article to talk up a more active programme of public speaking.   And just a couple of months previously Central Banking magazine had named the Reserve Bank of New Zealand as central bank of the year, citing various things to their credit including having been “the first advanced economy central bank to raise interest rates in the current cycle”.   (Oops)   Graeme Wheeler must have been feeling rather pleased.  According to the survey, most “stakeholders” were also reasonably happy with the Reserve Bank’s communication.

It will be interesting to see what Hannah has to say on Tuesday.  But it is a little surprising that he is doing such an on-the-record speech when the Governor has less than three months to run on his term.  It can’t, one would think, be outlining a new approach  – surely anything of that sort would be a matter for the new permanent Governor next year?   So we can only assume it will be an explanation and defence of the current approach.  If so, given the embattled state of the Bank it is a bit of a surprise that they leave it to a relatively junior member of the senior management group to make the case rather than, say, Hannah’s boss Deputy Governor Geoff Bascand, or indeed the Governor himself.

However they choose to engage, speeches clearly seem to have gone out of fashion again.  The Governor gave five on-the-record speeches in 2013, and seven in 2014.  Things seemed to be going well then.    But in 2015 and 2016 he gave only three on-the-record speeches each year, and in the first half of this year (ending next week) he will have given only one speech.    The pattern is pretty similar for his Deputy Chief Executive, Grant Spencer who is being appointed (questionably legally) Acting Governor for six months after Wheeler leaves.  He has also given only a single speech this year.

What is a relevant comparative benchmark?   Well, Phil Lowe, Governor of the Reserve Bank of Australia will have given six on-the-record speeches in the first half of this year.  His deputy, Guy Debelle, who is particularly active on international foreign exchange regulatory matters, will have given eleven speeches in the first half of this year.    The Reserve Bank of Australia, it will be recalled, covers a lot less ground than our central bank, not being responsible for the supervisions of banks, non-bank deposit-takers or insurance companies.    For most of the RBA senior management speeches, there is also a webcast or audio/video material, something our Reserve Bank doesn’t do.

Here are the numbers for the Governor of each of the other Anglo country central banks, and those of two other small inflation targeters.  Of those central banks, only the Bank of England has at least as wide a range of responsibilities as our central bank,

Governor speeches, first half 2017
UK 8
Ireland 8
Norway 7
USA 5
Canada 4
Sweden 2

What is striking in some of these central banks is the number, and range, of the speeches done by other senior managers.   Our central bank – smaller than most of course – will have done four on-the-record speeches in total in the first half of this year.

However the Reserve Bank engages, it isn’t through media interviews either.  The Governor now seems to give a soft interview to the Herald the day after a Monetary Policy Statement, but that seems to be it.  In almost five years he has given not a single searching interview to any media outlet.  Perhaps that is not so unusual internationally, but the Governor here wields personally an unusually large amount of power, and the Bank has been rather active (interest rates up and down, and more and more regulatory interventions) in the last few years.  Doing citizens the courtesy of a sustained interview once in a while –  an interview that is more than advertorial – would seem the least a Governor could do.  The Governor is said to be uncomfortable with the media.  In a role such as his that should really be disqualifying.

Of course, we now know that the Governor doesn’t much like criticism either.  In fact, one of the ways he engages (was that to promote “understanding”, “accountability” or “dialogue”?) is to send his senior managers out to try to whip critics into submission.  And when that doesn’t work, he sends threatening letters to the chief executive of a bank he regulates, calling for the critic concerned to be censored, to end the risk of upset to the Governor.  Perhaps Hannah will be able to offer some statistics on the frequency of “engagements” of this sort?   Perhaps he could offer some thoughts on the legitimacy of such engagements (after all, the Governor hasn’t been willing to front up in public)?  And on the effectiveness of them?  Does he judge that they have enhanced the Bank’s standing, and public/stakeholder confidence in the institution?

We also know another way the Reserve Bank was engaging, but is no longer.  Under Hannah’s stewardship the Reserve Bank was for years running lock-ups for journalists and analysts just prior to the release of MPSs and FSRs.  Unfortunately, they took that engagement so far that the procedures they used were so lax that people in the lock-ups could simply email highly confidential market sensitive stuff back to their offices (or indeed to anyone else).   That came to a crunching end when, somewhat by accident, I became aware that something of the sort seemed to have actually happened: MediaWorks staff in the lockup had been emailing things back to their office (who knows how many times before?) and on this occasion someone in their office passed the early information on to me (I was to be a guest on their show later that day).    In response, the Governor’s idea of engagement was to (a) largely whitewash MediaWorks, while (b) attacking me as irresponsible, even though I was the person who had brought to their attention what turned out to be both an actual leak and a serious weakness in their procedures.  Perhaps there will be some reflections on that sort of engagement?   Probably not though.

We’ll see what Hannah has to say on Tuesday. But in many respects it doesn’t much matter now.  The embattled Wheeler will be gone in three months, and Spencer  – probably not really the problem –  will be gone in nine.   The challenge for the new permanent Governor –  and something the Board and the Minister should be looking for in identifying potential appointees –  is to move towards much greater openness and effective open engagement.   There are so many fronts on which reform is overdue that it could make a post in itself.

So many other central banks are now so much further ahead of our central bank in this area (as well as others).  In most of them the whole institution has rather less power in the whole institution than is here concentrated in a single individual.  It is a shame, as the Reserve Bank could once reasonably have been said to be in the forefront of openness, transparency and honest engagement.  Now it is quite a laggard in this and other areas, with pre-existing institutional weaknesses reinforced by the problems of a thin-skinned insular and embattled Governor.  An engaging Governor would be a huge step forward towards a more engaging, open and accountable and central bank.  Whoever is Minister of Finance when the appointment is made should insist on it.

 

Leadership and accountability

I’d been going to write just a short post on the contrast, that I’ve been trying to make sense of over the past week, between the very public calls for the head of the Director-General of the Ministry of Health, and the near complete silence around the conduct of the Governor of the Reserve Bank.   Perhaps there are just more votes in health than in the Reserve Bank?

Chai Chuah seems to lead a not entirely well functioning ministry –  in time presumably the SSC PIF report will reveal more –  but he has little or no direct control over anything beyond his own agency.  And the latest calls for his head –  or at very least for severe reprimand –  appear to relate to errors in putting together the Budget.  The mistakes were made by people down the organisation, and while chief executives have to take responsibility for everything in their agency, it doesn’t look as though the direct mistakes were made by Chuah himself.   And even the mistake affected expected flows of money between various government agencies (the various DHBs), with little or no apparent consequences for the public.   But the Minister was openly embarrassed by the mistake.  And there has been plenty of public and media comment, and even comment from politicians –  so much so that the State Services Commissioner has (rather unconvincingly) sought to suggest public service chief executives shouldn’t be openly criticised by the Opposition.

Contrast that situation with Graeme Wheeler, Governor of the Reserve Bank.  He is an extremely powerful indepedent public servant, who makes policy himself and regulates financial institutions, with relatively few checks and balances.   Upset by comments on his policies by the BNZ’s economist, he engaged in a sustained campaign to “silence” (materially alter the tone and/or content of) a leading critic.  It wasn’t a matter of a single upset phone call, but a sustained campaign over weeks (at least) involving not just the Governor, but each of his three other most senior managers, a meeting with the BNZ chief executive, and finally (that we know of) a letter to the BNZ chief executive, urging that Stephen Toplis be censored.   The Governor, recall, is a key regulator of the BNZ’s business.

And what was the response?   Pretty muted to say the very least.  Lots of people were pretty appalled by the behaviour, but hardly anyone was willing to say so openly.  As Reuters put it in a story

To write such a letter was an unusual move for the head of an independent central bank in an advanced economy, particularly one that directly regulates banks.
The fact the letter did not cause more controversy indicated the central bank’s power, analysts said.

Whether it is really the central bank’s power that was the issue I’m not sure.  For some no doubt it was (some people directly associated with banks made that point to me).   But for many others, with no current involvement in banks, it must have been something else. Perhaps it was partly because Wheeler is leaving shortly anyway?  Perhaps an ingrained willingness to turn a blind eye to egregious conduct when it involves establishment institutions?  The sort of practical indifference that, in turn, enabled the Minister of Finance to get away with abdicating his responsibilities (for the Governor and the Bank) and breezily dismissing the issue as nothing whatever to do with him.   A silence that risks leaving the impression that such conduct –  active attempts by senior public officials to silence a prominent (and annoying) critic –  is acceptable is modern New Zealand.

Then again, look at the example set by our current head of government.

I’m not party political at all.  If any readers think they can work out who I’ll vote for they are doing better than me.  But I’m probably the sort of pro-market conservative that might in times past have been most naturally comfortable supporting National.  And I’ve always had some regard for Bill English.  He was Minister of Finance when I spent some time at The Treasury and if he wasn’t willing to be very ambitious about doing stuff, at least he seemed to recognise – and care about – many of the underlying issues.    And in this very secular age, there was also something reassuring about a conservative practising Catholic as Prime Minister.   He seemed to be a person of decency and integrity, the sort of person any Cabinet would be fortunate to have.

Which is probably why what has emerged this week is so profoundly troubling.

I don’t care greatly about Todd Barclay himself.  What bothers me is Bill English, long-serving Minister of Finance, now Prime Minister, about to seek election to a full term as Prime Minister in his own right.   They are roles in which we should be looking for leadership with integrity.  What is on display this week doesn’t look remotely like that  –  not much leadership, not much integrity.

I’m sure plenty of politicians in the past have had guilty secrets – things that were either never widely known, or never able to be reported.       Had they become known, perhaps some other political reputations would have been severely damaged.    But we are dealing with this specific episode, which has become public, and this specific election.  In the process, the standards of the man who seeks to keep leading our country seem to be laid bare pretty starkly.  Not, I hope, the standards he would sign up to in the abstract, but the way that, under pressure, he actually chose to operate.

From his comments this week it is clear that:

  • Bill English knew not just that a financial settlement had been made in the dispute that had arisen over the employment relationship between Todd Barclay and his former staffer, but that (a) part of the settlement had been funded from the National Party leaders’ fund (not a problem in itself). and (b) that the payment had been larger than usual because of the “privacy issues”
  • Bill English knew that Todd Barclay had taped some of (her end of) his employee’s phone calls (as he noted in his statement to the Police that Barclay had told him so)
  • Bill English knew there was a Police investigation into a complaint around the taping (approached by the Police, he made a statement to them),
  • Bill English knew that  –  as was public knowledge – that Todd Barclay had refused to cooperate with the Police investigation.
  • Bill English knew that when an OIA release was made on these matters, his statement to the Police (with the report of Barclay acknowledging the taping), was deliberately and consciously withheld.

If it didn’t initially occur to him, when Barclay first mentioned the matter, that taping someone else’s phone calls could be a criminal offence, the possibility must have been clear by the time he was making his statement to the Police a couple of months later.

Bill English wasn’t Prime Minister when all this was going on, but he was both Deputy Prime Minister and the former electorate MP for Clutha-Southland.  He knew all those involved in a way that, presumably, John Key didn’t.  And can anyone really doubt that, in a matter with these specifics, if Bill English had insisted to John Key on a higher standard being adopted, it would have been done?

What might a high standard of integrity have involved in this case?

I’d have thought it was as simple as this.

Once it became clear that there was a Police investigation into these matters, English (and Key) should have insisted that Barclay co-operate with the Police inquiry –  first made that insistence known privately, and then (if that failed) publicly.  There was no legal obligation on Barclay to cooperate with Police, but this is about politics and acceptable standards in public life.    Insisting on co-operation with Police isn’t an asssement of guilt, or innocence, just the sort of minimum acceptable standard we should expect in those holding high public office (in this case under the National Party banner) –  especially when you as leader or deputy know stuff (per the English statement) that, at least on the surface, looks questionable.

And if Barclay had refused?   Suspension from Caucus would presumably have been an option, followed by expulsion from Caucus if necessary.   Richard Prebble did that as leader of ACT when the Donna Awatere case arose.

English –  and Key and the National Party Board –  could also have made clear that if Barclay refused to cooperate that under no circumstances would he be a National Party candidate at the 2017 election.

And Mr English could have released his Police statement.

No doubt, well before any of this happened, Barclay would have quietly bowed to the inevitable and either resigned or cooperated with the Police investigation.    But he isn’t the issue here; the conduct of the National Party leadership (and that of Bill English in particular) is.

Might it have been uncomfortable for English and the National Party?  Quite possibly –  and over something that they had had no effective control initially.  But doing the right thing often is uncomfortable.   But it is also why we all drum into our kids that “you’d get in less trouble if you’d fronted up straight away”.    Dealt with effectively 15 months ago (a) this would largely be forgotten by now, and (b) as much of any memory would have been about the willingness of the Prime Minister and Deputy Prime Minister to act decisively to uphold standards.

Instead, none of this was done, and presumably the hope was that none of it would ever come out.  As late as Tuesday morning –  after the Newsroom story came out –  the Prime Minister was still trying to claim he didn’t know much about what had gone on.

It is pretty shameful conduct from the Prime Minister.  And pretty feeble leadership even now.  There is no sign of contrition.  There has been no apology.  Even now, Barclay is still not indicating that he will be cooperating with the Police, still not apologising.  And yet he still sits in the National caucus.    Meanwhile, media seem to find it impossible to get the President of the National Party to face the media on the issue –  even though if the Prime Minister told him otherwise he’d surely be available almost instantly.  (In fact, I heard one National Party MP on Morning Report this morning bemoaning how unfortunate it was that “internal party stuff” had become public.  It suggests they still don’t get it.  Police investigations into possible criminal conduct aren’t just “internal party stuff”. )

Where was the leadership with integrity last year?  Where is it today?

Perhaps the spin is right that the public don’t care.  Time will tell.  But I reckon we should expect, and demand, better from those who hold, or seek, high office.  In a sense, we are fortunate that so much detail emerged on this episode –  that, for example, the Police got Mr English’s text with the comment about taping.  The standards  apparent in the stuff we do see is our best predictor for how our leaders handle other difficult stuff.  On the evidence of how Bill English (and John Key) have handled this episode, from the beginning to today,  those standards look pretty deeply disquieting.

As readers will know, I have written here more than once about a tendency that has crept into this government as the years have gone, and the problems of underperformance have become more apparent, to just make stuff up.  Perhaps it is the pretence that the economy is doing wonderfully, better than most of our peers (when in fact productivity growth is non-existent, the tradables sector is in relative decline, and the unemployment rate still disconcertingly high etc), or the proposition that New Zealand came through the 2008/09 recession better than most, or the laughable (and worse) attempt to pass off extraordinarily high house prices as a “quality problem” or mark of success, it has become all too pervasive.    Frustrating as that sort of thing is, at least anyone who looks for themselves can see that it is largely made-up lines.

The lack of leadership, and attempts to keep things from the public, apparent over the Barclay affair seems to me an order of magnitude more serious.   But perhaps one sort of spin eventually corrodes in other areas the standards these people would surely once have set for themselves, and allows them to lose sight of just how unacceptable the continued failure of leadership now on display really is.  Flourishing free and open democracies need better than that.

 

A few scattered thoughts prompted by the OCR

Once again, I largely agree with the Governor’s bottom line –  OCR unchanged, and no great sense of urgency about future changes in either direction.   And I have quite a few other things on my plate over the next few days.  So here are just a few scattered thoughts prompted by the OCR statement this morning.

At a fairly trivial level, I was a bit surprised, on two counts, to see this line “Recent changes announced in Budget 2017 should support the outlook for growth.”   First, aren’t the bulk of the Budget announcement changes conditional on the current government being re-elected?   That is hardly in the nature of a sure thing I’d have thought.   And second, the comment could be read as something of an endorsement for the government’s spending plans, which doesn’t really seem appropriate for an independent apolitical Reserve Bank.  Why do I say that?  Because the observation isn’t just that increased government spending will provide a boost to demand in the near-term, but that it will increase the “outlook for growth” –  generally regarded as “a good thing”.  Perhaps I’m being a little picky, but it would be surprising if the sorts of initiatives announced in the Budget do anything to lift potential growth.

I wonder too if the Reserve Bank ever gets uncomfortable with the implications of this line “Monetary policy will remain accommodative for a considerable period”?  On their reckoning, presumably, monetary policy has been “accommodative” for probably eight and half, getting on for nine, years, now.   And they expect it to remain “accommodative” for a considerable period ahead.  In total, on their reckoning, at least a decade.     And yet throughout the whole of that period unemployment has been or is projected to be above the NAIRU.   And inflation (core) has been persistently low.  It isn’t even as if that can be ascribed to a series of positive supply shocks –  in fact, productivity growth (not something the RB has any real influence over) has been shockingly bad in recent years.    So where, specifically, is the evidence of the “accommodation”?  Interest rates are certainly low, but that is potentially a quite different thing.    There is an old line about the evidence of leadership being the existence of people actually following.  Perhaps the evidence of monetary “accommodation” should be some sustained resurgence in inflation and pressure on the economy’s available labour?  We still haven’t seen it.

Does it matter?   Perhaps, it could be argued, it is only words.  What matters is actions.    I think it does matter.  The Reserve Bank has twice started what it saw as sustained tightening cycles, only to have to reverse itself quite quickly.   And even though they are no longer champing at the bit to raise the OCR, the mindset still seems to be on the gap between actual and (their estimate of) neutral interest rates.   That increases the likelihood that they will miss, or downplay, downside risks.     In fairness to the Reserve Bank, I suspect it is a problem shared with many of their peers in other advanced country central banks –  there is plenty of talk of a hankering for “normalisation” in the United States – but most are perhaps more subtle and less dogmatic about their phraseology.   In the RBA latest statement, for example, there is no attempt to comment on the gap between the actual cash rate and (estimates of) the neutral cash rate.

And, finally, the Governor repeats his common line that “Longer-term inflation expectations remain well-anchored at around 2 percent”.   Perhaps that is what economists tell survey-takers  (and in a welcome development the Reserve Bank is just about to add such a question to its own survey of expectations).   In fact, we know very little about what (implicit or explicit) assumptions about medium-term future inflation that firms and households are basing their decisions on.   Perhaps, in most cases, they don’t even need to give it much thought –  most interest rates and most wage contracts reprice at least every year or two, and most selling prices can be reset or reviewed at least that frequently.

But we do have one set of indications about what people putting real money on the line might be thinking.    That is the gap between the yield on conventional government bonds and the yield on inflation-indexed government bonds.  That difference isn’t a pure measure of inflation expectations –  there probably are no such things anywhere – and it can be affected by the relative supply of the various instruments, and changing attitudes towards risk.  Try to sell too many indexed bonds, for example, and the yield on them will rise compared to yields on conventional bonds.  That isn’t a change in inflation expectations.   Indexed bonds are often less liquid than conventional bonds.  But then again, for many purposes an indexed bond is a more natural hedge (and thus a more valuable asset) than a conventional bond.   Some of the issues around indexed bonds were covered, long ago, in a Reserve Bank Bulletin article.

There is also a problem that indexed and conventional bonds rarely have the same maturity dates.   Here is the chart of the differences (the “breakevens”) for New Zealand for the last few years.  I’ve used the Reserve Bank’s benchmark 10 year conventional bond yield (the actual bond they are using moves through time), and the indexed bonds maturing in 2025 and 2030.   Throughout the whole period shown, the 2025 bond was closest to 10 years away, but by the end of the period (now) it has only little over eight years to run, and can start to get thrown around by short-term CPI fluctuations (eg oil price changes).

breakevens NZ

There was a big rebound in these “breakevens” (or implied inflation expectations) from the lows in the middle of last year.  But it hasn’t really come to much.  Take the average of last observations from those two series, and the 10 year breakeven –  where people are placing actual money –  is 1.15 per cent.   That is a long way from the 2 per cent target midpoint that the Governor has been required to focus monetary policy on throughout his term.  It has now been at least two years since the breakevens were averaging even as high as 1.5 per cent.

As readers who are closer to markets will no doubt be drumming their fingers and telling themselves, it isn’t just a New Zealand issue.   What about the US and Australia?  Well, here is the same chart for the United States (using the constant-maturity series for both indexed and conventional bonds).

breakevens US

There has been quite a fall off in the last few days, but at least until then the picture looked less disquieting that the New Zealand one does.   If the breakevens weren’t averaging around 2 per cent, perhaps you could say that at around 1.8 per cent they weren’t too far away.  For those defending the Fed’s interest rate increases –  I’m not fully convinced of the case myself –  it might have been some comfort.

And here is a similar chart for Australia, using data from the RBA website (for which the data are only available since the start of 2016).

breakevens aus

Australia’s inflation target is centred on 2.5 per cent annual inflation.  Averaging these two series, implied inflation expectations for the next 10 years are currently only around 1.75 per cent.  The gap in Australia, between the breakeven inflation rate and the midpoint of the target, is almost as large in Australia as in New Zealand.

Perhaps there are compelling market-based reasons why such breakeven inflation rates should be completely discounted, as currently telling us nothing relevant to monetary policy.  But if so, perhaps the respective central banks could explain the reasons why they think there is no meaningful information, rather than (as it seems) simply ignoring the information.  Curiously, twenty years ago –  when Graeme Wheeler was still head of the Treasury’s Debt Management Office – the Reserve Bank was dead-keen on having inflation-indexed bonds, as one read on inflation expectations.  Treasury themselves were never that keen –  they just thought it would be expensive funding.    But at the moment it looks as though markets are telling us that Graeme Wheeler will finish his term as Governor without any widespread investor confidence that things are well-positioned for inflation to average near 2 per cent over the next 10 years.  On the face of it, that should disquiet the Bank, and those charged with holding them to account.

In conclusion, and in passing, one of my repeated themes has been the persistently large gap between New Zealand real interest rates and those in other advanced countries.  When our OCR is 1.75 per cent and the Australian cash rate is 1.5 per cent, it is easy to gloss over that point.  But bear in mind that the Australian inflation target is 0.5 per cent per annum higher than New Zealand’s, so that even at the short end there is still a material real interest rate gap.   And what about the very long-term indexed bond yields?   Both governments have indexed bonds maturing in 2035.  Ours was at 1.94 per cent earlier this week, and Australia’s was yielding 0.91 per cent.  Those are really big differences –  think how much they cumulate to over almost 20 years –  and not supported at all by productivity growth differentials in New Zealand’s favour.     The US yield on a 20 year indexed bond is similar to Australia’s at 0.8 per cent.   The gap is, amomg other things, one marker as to how overvalued our real exchange rate is.   That has been a constant theme of the Governor’s during his term.  The policy things that might make a difference to that outcome are in the government’s hands rather than the Governor’s.  And sadly, they don’t seem very interested.

 

The OECD Survey process

The OECD’s biennial report on the New Zealand economy was out yesterday.

I noticed that Treasury has put out a blog post on the late phases of the process, in which New Zealand officials go to Paris to engage with other countries’ representatives on the analysis and recommendations, and to haggle over the numerous differences the authorities and staff will have.

I participated in this phase of the process on perhaps half a dozen occasions over almost 25 years.  In anticipation of the 2015 survey, I wrote a post along similar lines.

Being public servants, who have to keeping dealing with the OECD, the Treasury piece errs occasionally on the side of gush.

Every two years the Treasury assists some of the world’s best economists and policy analysts from the OECD with their study of New Zealand.

I, being of a more sceptical, perhaps contrarian disposition, and not any longer being a public servant, emphasised some questions.

It is, in other words, quite a political process. And that, of course, is also how these OECD Surveys are used.  Opposition parties have liked calls for, say, capital gains taxes.  The Reserve Bank likes references to overvalued exchange rates.  The government likes positive comments on fiscal consolidation.  And so on.  The Reserve Bank doesn’t much like references to leverage ratios, or the Treasury references to fiscal councils, but then no one much cares either.

What is the quality of the Surveys like?  I’m somewhat sceptical.  The OECD does have some fairly unparalleled databases, and quite a knack for compiling and presenting interesting charts.  I’m a data junkie, and I find those cross-country data comparisons fascinating, and labour-saving.  But the quality of the policy analysis and recommendations is rather more questionable.  I’ve looked at draft reports for New Zealand and for other countries over the years, and often found the argumentation quite unpersuasive, even in areas where I lay no claim to being a specialist or an expert.  These days there is a strong tendency to favour what I’d call “smart active government” solutions, and a disinclination to put much weight on markets and market processes.  That isn’t the image the OECD has often had in New Zealand – the late Roger Kerr often used to cite “OECD orthodoxy” to back his own arguments about what should be done in New Zealand.  But a few years back, I pointed out to the head of the Country Studies Division that the OECD could probably be best characterised as the technocratic wing of the more market-oriented strands of European social democratic movement.   He looked askance, and then somewhat reluctantly acknowledged my point.    Reasonable people will differ on how to read the evidence on the appropriate role of government, but OECD papers aren’t inclined to put much weight on questions of why governments fail so often and how policy should be shaped in the light of that.

All of which is by way of saying that no one should put too much weight on anything in any particular OECD survey.  Sometimes they will be right on the mark –  out of interest I went back last night and read the 1983 Survey and thought that they had done a very good job of highlighting the microeconomic and macroeconomic challenges then facing New Zealand, without any sense of imminent crisis.  At other times, they will be missing the mark, or adopting a particular recommendation based on not much more than institutional priors and the preferences of a few staffers.  As the OECD acknowledges, they have consistently failed to come to grips with why the New Zealand economy has not performed better over the last 25 years.  Without a good story about that it is hard to nest their individual recommendations in an overall narrative of what needs to be done.

Read together they’ll probably give you a reasonable sense of how these things come together.   I do hope the New Zealand Ambassador still offers as fine a lunch as ever.

Market rents

In the aftermath of the London fire, in some ways my heart isn’t in writing much about housing.  Disasters don’t often get to me, but this one has.

Nonetheless, the Dominion-Post led with housing this morning, and when I saw that the first word in the entire article was “greedy”  (followed by that other emotive term “landlords”) it wasn’t promising.    Just because people scoff when Fox News talks of being “fair and balanced” doesn’t mean the rest of media should abandon the aspiration.

Faced with rising demand for rental accommodation –  in a city where central and local government have again combined to make housing supply not very responsive to changes in demands –  owners (or their agents) of residential rental services businesses have faced excess demand for the limited stock available.  The typical response you might expect would be for rents to rise.

There are different sorts of pricing structures used for different goods and services.  Typical dry goods in a supermarket will have a fixed price, and occasionally the supermarket runs out of stock –  which can be mildly annoying to you or me, but is presumably easier to manage for them.  The value of New Zealand dollar (the exchange rate) is constantly changing, typically by quite small amounts, as pressures from potential buyers and sellers ebb and flow.   Even at a retail level, petrol prices now change very frequently.   There are whole literatures on the reasons why different structures are adopted in different markets (and I’m certainly not expert in that field).

Housing is typically nearer the variable pricing end of the spectrum.  In the market for actual house purchases, fixed price adverts, “buyer enquiry over”, tenders, and auctions all co-exist.   In the last two, the seller can reconcile supply (one house) to demand, simply by using the amounts bid.  In a fixed price advert, if there is more than one interested party, the seller might have to use some other decision criterion (although I imagine that typically even then one bidder will offer more).

It is, as I understand it –  not owning rental property, and not having rented one in this country for many decades –  customary to advertise rental properties with a fixed rental price.  Holiday home websites operate that way too –  and, in effect, they just operate on a “first come, first served” basis.    In a normal market, it probably often works quite well –  if there are plenty of people offering rentals, and plenty of potential tenants, even if one misses out on one property, there is another not far away.  If the property owners sets his or her price too high, they find there is little or no interest in renting their property, and eventually have to re-evaluate and revise the fixed asking price.

But the current situation seems to be one where lots of people are enquiring eagerly about almost any rental property on offer.  Fixed asking prices are, in that sense, too low to clear the market.   Over time you’d expect that those fixed asking prices would rise –  and thus take care of that particular element of the problem –  but that doesn’t deal with the property owner’s issue on the day: when 20 people want one rental.

Wellington Central MP Grant Robertson knew of two cases of renting tenders in Wellington – both from around the start of the year when students were returning to the capital.
“I think it is barely legal,” he said.
At one, would-be renters turned up to view a flat with an advertised price. “When they got to the property they were asked, ‘how much are you prepared to pay?'”

At the other there was no advertised price and would-be renters were simply asked how much they were prepared to pay.
“I think it is abhorrent. It is exploiting the fact we have a real shortage of rental homes in Wellington at the moment – exploiting people in vulnerable positions.”

So how is the property owner or agent supposed to respond?  Just ignore the excess demand and draw straws to determine who should get the flat at the –  evidently –  too low advertised price?  It is a market, and the property owners aren’t running charities for the homeless, but private businesses.

As is noted in the Dom-Post article, auctions aren’t always an ideal mechanism –  as an owner you are likely to care about the quality of the tenant as well.   But simply drawing straws doesn’t seem to have any particular merit –  moral or practical  – in this climate.

Don’t get me wrong.  The housing market in New Zealand is, in many, respects a scandal, and the problems flow largely from the choices of successive waves of central and local governments.  Since we are talking about right now, in this case it means the National-led central government, and the Labour-dominanted Wellington City Council.   But attacking a symptom –  rising rents, and alternative techniques to reconcile supply and demand –  isn’t a particularly meaningful response.   Owners of rental properties are, in many respects, the last people who should be being blamed here.

But I also learned something new from the article.    The journalists approached, and got some comment from one of their officials

Ministry of Business, Innovation and Employment national manager tenancy compliance and investigation Steve Watson said the practice was allowable under the Residential Tenancies Act.

“Any party who feels that they are being asked to pay rent that exceeds ‘market rent’ has the ability to apply to the Tenancy Tribunal who can review and determine the appropriate amount of rent for a residential property,” Watson said.

Really?   I know there has been centuries of philsophical and theological debate around concepts of “just prices”, but have we (or rather our Parliament) really legislated to provide for cases where some arbitrarily determined “market price” differs from a price being paid in….well…the market.  It seems that our politicians had done just that.

Here are the relevant bits of section 25 of the Residential Tenancies Act

25 Market rent

(1)  On an application made to it at any time by the tenant, the Tribunal may, in accordance with the succeeding provisions of this section, on being satisfied that the rent payable or to become payable for the tenancy exceeds the market rent by a substantial amount, make an order reducing the rent to an amount, to be specified in the order, that is in line with the market rent.

(2) Notwithstanding anything in subsection (1), no application may be made under that subsection in respect of the rent payable under a fixed-term tenancy later than 3 months after—

(a)  the date of the commencement of the tenancy or (in the case of a tenancy that was subsisting immediately before commencement of this Act) the date of the commencement of this Act; or

(b)  the date of the last review of rent,—

whichever is the later.

(2A) …..

 (3)  For the purposes of this Act, the market rent for any tenancy shall be the rent that, without regard to the personal circumstances of the landlord or the tenant, a willing landlord might reasonably expect to receive and a willing tenant might reasonably expect to pay for the tenancy, taking into consideration the general level of rents (other than income-related rents within the meaning of section 2(1) of the Housing Restructuring and Tenancy Matters Act 1992) for comparable tenancies of comparable premises in the locality or in similar localities and such other matters as the Tribunal considers relevant.

Initially I wondered if this might be some historical provision to deal with, say, a situation in the Great Depression where there was a long-term fixed rent, and the general price (and wage) level fell sharply.  But that can’t be –  at least for fixed term tenancies these provisions can only be used within three momths of the tenant taking up the tenancy, or of the most recent rent review.

It just looks like an extraordinary piece of “feel good” law.     The standard (in 25(3)) is the rent that “without regard to the personal circumstances of the landlord or tenant, a willing landlord might reasonably expect to receive and a willing tenant might reasonably expect to pay, for the tenancy, having regard to the general level of rents”.

It isn’t clear at all why the “personal circumstances” should be irrelevant.  If someone desperately wants to live on a particular street, because they want to be close to aged parents (say) why shouldn’t that be something that can reflected in the price they pay for a rental tenancy?    One bag of flour might be much the same as the next one.  But except perhaps in high-rise blocks, almost every rental property is different from the others, even if only by location –  and location preferences are often quite idiosyncratic and personal.

I have no idea how often this provision is used –  perhaps more often now  having been highlighted on the front page of a major daily paper.  Various readers have a lot of exposure to running rental businesses, and I’d be interested in any perspectives they can offer.     But you also have to wonder why the MBIE official felt it appropriate to add in this information when he commented.  After all, the one common element, agreed (it would seem) by all parties in the story, is that the rental market in Wellington is very tight.  The general level of rents is presumably rising.        (And if, perchance, someone does agree to pay a level of rent “above the market rent”, it was a contract voluntarily –  even if grudgingly –  entered into: not great perhaps, but better –  for the renter –  in their own assessment, than the alternative.)

I was interested to see Grant Robertson stating that Labour will soon be announcing a package to “strengthen renters’ right”.  There may well be merit in some of that.   But the best way to protect the position of renters, and all others coming into the accommodation market (whether as renters or buyer) is surely to fix up the land use and housing supply markets.  Abundant responsive supply in the face of  changes in demand is the best assurance of genuinely affordable and secure accommodation.

(On which note, a reader sent me a link the other day to a stimulating piece on housing and land markets from a UK academic. I don’t agree with everything in it, but for those interested in the debate –  and in recognising the similar issues in other countries –  it is worth reading.)

 

 

An astonishing illustration of unfitness for public office

I wasn’t planning to write anything today, but I was flicking through the NBR website when I found a story that both shocks and appals me.  I suggest reading it first, before reading my take on it.

After my experiences with the Reserve Bank over the last couple of years, I thought I was beyond the possibility of being shocked by the Governor.  Clearly, naive optimist that I must really be, I was wrong.

Somehow the media got hold of a story that Graeme Wheeler had lodged an official protest with BNZ over something their head of economics, Stephen Toplis, had written.  So an Official Information Act request was lodged and the Bank has apparently responded by releasing both Wheeler’s letter to BNZ chief executive Anthony Healy and Healy’s response.  The Bank hasn’t put those documents with the other OIA releases on their website, so I have asked for a copy.

I should add that Toplis is not some close friend of mine.  I always find his commentaries stimulating, but we usually disagree on the substance of monetary policy.  In fact, when I was in the gun from the Governor last year, Toplis was sending the Bank snarky comments about me (that he no doubt didn’t expect to be published).  But no one should be treated, by a top public servant, the way he has now been treated by Graeme Wheeler.

What is Wheeler’s complaint?    Apparently, he was upset with the preview of the latest Monetary Policy Statement that Toplis had written.

Mr Wheeler, who is to step down as governor on September 26, wrote to Mr Healy on May 11, the day the MPS was released, saying a preview written by BNZ head of research Stephen Toplis called into question the Reserve Bank’s integrity by saying it would be “negligent” not to admit it had a tightening bias, expressed “through an explicit expression of rate increase(s) in its published OCR track.” 

For some context, here is what Toplis actually wrote

So why do we think the RBNZ will sit pat this week? Simply because it said it would. When it released its March OCR review, the Bank reaffirmed that not only did it expect interest rates to stay where they were for the foreseeable future but it went on to reiterate that it thought there was equal chance that the next move could be a cut as a hike. To hike this week would leave the Bank with egg splattered all over its face, a prospect it couldn’t abide.

But surely, at the very least, the Bank will be forced to admit that it now has a tightening bias? Equally, it would be negligent not to express this through an explicit expression of rate increase(s) in its published OCR track. The biggest questions should revolve around how early the Bank is prepared to poke in a first rate increase and how quickly (if at all) rates rise thereafter.

Toplis seemed to be trying to strike a middle path.   Hawks, he argued, would be foolish to think Wheeler would raise the OCR in May, whatever they thought the data showed.  And doves who might expect a flat (OCR) track forever were also likely to be mistaken.    In Toplis’s view –  given the data he had seen –  it would be “negligent” of the Bank not to show some rate increases in the published OCR track.

And, as it happens, the Bank largely agreed.  The actual OCR track released in the May MPS wasn’t  anywhere near aggressive enough for BNZ’s liking  (I agreed with the Bank this time), but it did show some increases in the OCR eventually.    Presumably they thought it would be wrong –  inconsistent with their obligations under the PTA – not to have done so.

So quite what was the Governor’s problem?

Monetary policy is one of those areas of considerable uncertainty.  Reasonable people can and will differ quite materially on what the best approach is.  But the power –  very considerable power over the way the economy develops in the short to medium term –  is vested only in the Reserve Bank.  More specifically, it is vested in a single individual, the Governor.  It is one of the unfortunate aspects of the single decisionmaker model that any criticism of the Bank’s decisions is inevitably a criticism of an individual’s actions/choices.   For a thick-skinned and self-confident individual on the receiving end, that just shouldn’t be a problem.  After all, the Governor took on the job voluntarily, knowing that he would be making key decisions in an area where (a) almost inevitably there would be mistakes (almost the nature of uncertainty) and (b) where he would subject to a lot of scrutiny from smart people, in political and economic spheres, here and abroad.  He gets paid a great deal of money (by New Zealand public sector standards)  to make the decisions and be accountable for them.   A self-confident Governor might either (a) let disagreements wash over him, or (b) pick up the phone and invite the critic in for coffee and an open exchange of views.   But Wheeler is notoriously thin-skinned –  and unwilling to engage.

Here is how NBR continued the story

Mr Wheeler’s letter describes a back story, suggesting he reached out to Mr Healy after failing to bring Mr Toplis to heel. It says Mr Wheeler’s deputy governors had individually approached someone (the name is redacted) “to convey their concern at the personal nature of the criticism being expressed by the BNZ in its written publications.”

“When this failed to address the situation I met with you and passed on examples of the material,” Wheeler wrote. “I mentioned that the BNZ approach was damaging to the Reserve Bank and the New Zealand financial market, and the personal nature of its tone was contrary to that of other banks.”

Clearly, Wheeler’s concern was more than just the particular pre-MPS commentary.  And certainly, more than most other bank economists, Toplis is willing to quite openly disagree with the Governor and the Bank, sometimes with a vigorous style.   But there is nothing “personal” in that preview, and even if there were, the Governor personally exercises the power.

Personally, I wish there were more like Toplis willing to openly question and challenge the Bank.  The Bank –  the Governor –  after all wields huge power, not just in monetary policy but in regulatory matters, with rather little effective accountability.  Banks in particular are very reluctant to openly call out the Reserve Bank –  journalists have told me how difficult it is to get anyone to go on the record.

What bothers the Governor?   Apparently, he thinks the Reserve Bank is damaged by criticism.   It isn’t clear how or why, unless the Bank is operating in a way that leads people who read the criticism, and think about it, to conclude “yes, that’s right”.  High-performing organisation shouldn’t need to worry about criticisms,  And insular, low-performing organisations, need the criticism –  and need to be willing to learn from it.   Even more important, when it is a troubled public sector organisation,  the public need the criticised body to learn from and respond constructively to criticism by lifting its game.

Perhaps even more oddly, the Governor thinks that Toplis’s commentary is “damaging the New Zealand financial market”.  Who knows what he means by that?    There is a competitive market in commentary.   If Toplis’s criticism are wrong (on average over time) presumably that reflects badly on Toplis and the BNZ.  If they right, perhaps it reflects badly on the Governor himself, but that doesn’t harm the New Zealand markets or economy.  People having less faith in the Governor might, in principle, be a bad thing, but not if the criticisms are well-founded.  And if they aren’t well-founded, the sort of observers who matter will go elsewhere for their commentary.

Wheeler clearly doesn’t see it that way

In his letter to Mr Healy, Mr Wheeler said it was “unacceptable” to question the Reserve Bank’s integrity while “fundamentally misrepresenting” how it sets monetary policy.

“I would also expect that the editorial quality assurance process (and any legal sign-off involved) would have identified that an accusation of negligence is inappropriate in a public document distributed by BNZ.”

 

Perhaps there is something in the Governor’s concern that I’m missing, but nothing in that quote above from the MPS preview questions the Bank’s integrity.  It sets out some hypotheticals, and suggests the Reserve Bank would be not doing its job –  “negligent”  –  if it didn’t do something Toplis favoured.    But it did do it –  there were rate hikes put into the OCR forward track.  And even if the Bank has disagreed altogether –  and run with a dead flat OCR track –  the BNZ claim was “negligence”, it wasn’t a comment on integrity at all.   When people suggest the Reserve Bank isn’t running monetary policy well, that is a judgement on their competence or their diligence (or just a disagreement about the data), but it isn’t a reflection on anyone’s integrity.  It is disconcerting that the Governor doesn’t seem able to tell the difference.  Nor, apparently, were the Bank’s Deputy and Assistant Governors.

The whole thing is extraordinary.  I’ve never worked in a bank economics team, but I’ve never supposed that they had their daily or weekly economics commentaries signed off by in-house lawyers (or indeed by anyone much).   It is chilling to have the Governor of the Reserve Bank writing to the chief executive of a major bank in effect urging such tight control.   What is it, one can only wonder, that the Governor is afraid of?   And isn’t this, after all, the Governor who regularly claims that the Bank is highly accountable, partly because of the scrutiny financial market participants and commentators provide?

All this would be quite bad enough if the Reserve Bank was simply a monetary policy body.  Some central banks are.   Such central banks influence the economy and the rate of inflation, but have little or no direct regulatory influence over private financial institutions.  Access might still be valuable, but the central bank just doesn’t have that much leverage.  Nor should it.

But that isn’t the model in New Zealand.  Here, the Reserve Bank –  the Governor personally –  not only sets monetary policy, and sets prudential policy, but is also responsible for a wide range of detailed regulatory approvals that banks and financial institutions need to keep operating in this market.  Mr Healy himself will have needed the Governor’s approval to take up his current position.  So will all his direct reports.  And approval of individuals is just the least of it.   That is a huge amount of power, and all vested in one person.  In this case, it appears, an extremely thin-skinned and reactive one.

Banks are typically pretty scared of the regulator –  whether here or abroad –  and unwilling to take them on over regulatory matters.  That is bad enough.    What is worse is when the Governor of the Reserve Bank openly –  directly and through his deputies –  attempts to coerce banks to just keep quiet, to say only stuff that the Reserve Bank likes to be said.  We might expect that in Singapore, Russia, or other semi-authoritarian states.  We shouldn’t tolerate it in a free and democratic society, governed by the rule of law not the whims of powerful men, like New Zealand.   It would be bad enough from an elected politician –  and I’m sure it goes on there to some extent (we saw recently the Alfred Ngaro comments) –  but it is far far worse in an unelected, and exceptionally powerful, public servant.

As far as we can tell, the BNZ hasn’t been cowed by Wheeler’s approach.   Perhaps they just think “there he goes again, and thank goodness he’ll be gone in another three months or so”.  But even if they aren’t (this time), it is a chilling example that people in other organisations will take note of.  Some of them will be more cautious, more risk averse, and the message will go down “be careful what you say; don’t upset the central bank”.  We’ll be poorer for it.  And actually, over time, the quality of our Reserve Bank would be poorer for it to, if the extent of robust scrutiny of this powerful institution was even less than it is now.

The fault here is clearly primarily with Graeme Wheeler, who reveals himself to be manifestly unfit to hold his current high office.   But there are other people who need to take some responsibility:

  • where, for example, in all this were Grant Spencer, Geoff Bascand, and John McDermott, the deputy and assistant governors.   Wheeler has tried to tell us that that group makes all the Bank’s major decisions collectively, whatever the legal position.  The NBR article implies that they too were making calls to the BNZ to get pressure put on Toplis to alter his commentary.  Were any of them willing to stand up to Wheeler and tell him that he appeared to have lost all sense of perspective, and that if he went ahead with these actions it would only leave him and the Bank looking worse (even before this OIA, I gather the story was pretty widely known)?  If not, why not?  If not, why we would we suppose that any of them was fit to hold the office of Governor –  Spencer will be acting for six months, and Bascand is widely expected to be a leading contender for the permanent role?   Do any of them know what is, and isn’t fit behaviour for a regulator?  You would hope so given that Spencer is now Head of Financial Stability, and Bascand will assume that role in September.
  • where is the Bank’s Board in all this?  They exist to monitor the performance of the Governor, and the chair has often seen his role as a bit of a confidential sounding board for the Governor.  They were totally supine over the OCR leak last year, backing the Governor to the hilt?   Will it be different this time –  when the Annual Report comes out in a few months?  If not, how could we possibly consider that these individuals are fit to take the lead responsibility for choosing a new Governor?
  • What does the Minister of Finance make of this?   He appoints, and can dismiss, the Governor. I hope some journalists are willing to ask hard questions of the Minister, and not allow themselves to be fobbed off, about whether this sort of conduct is acceptable from a New Zealand public servant?
  • And what of the Finance and Expenditure Committee?  Are they willing to call Wheeler before them to answer openly for his conduct in this matter?  If not, what use are they to citizens?

I noticed that one commenter on the NBR article observed that if this is what Wheeler made of Toplis’s comments

“This is insane. Can you ask for Wheeler’s correspondence with Michael Reddell?”

There is no such correspondence.    The difference is that Graeme Wheeler has no leverage over me.   Stephen Toplis, by contrast, works for a bank over which the Reserve Bank has extensive regulatory clout.   It shouldn’t make a difference –  views are views and should stand or fall on their own merits –  but in Graeme Wheeler’s Reserve Bank, sadly, it appears to.  That is simply unacceptable.

He might only have three months left in office, but it is now three months too long.  The words of Oliver Cromwell to the Rump Parliament –  or Leo Amery to Neville Chamberlain in May 1940 –  come to mind

You have sat too long for any good you have been doing lately … Depart, I say; and let us have done with you. In the name of God, go!

 

 

 

Bank capital: some thoughts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here is the gist of their argument

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

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

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

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

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

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

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

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

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

popular co-co

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

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