Has the reserve bank become too philosophical about bank capital?

“You guys are little bit philosophical: the Netherlands and France are the only two countries in Europe that haven’t taken a position on capital requirements.” That was Emil from Nomura, who, in early 2012, queried me about the Dutch position on minimal capital requirements. The Swedish bank authorities had just announced that capital ratios should be at least 10% Common Equity over RWA. The Brits expressed a desire to follow suit, Germany had made up its mind. But France and the Netherlands were … philosophical.  

Obviously Nomura wanted to do business. Help banks issuing capital. And rightly so, banks will only issue capital when the supervisor offers clarity. Remember Elvis’ adage: a little less conversation, a little more action please. Prolonged inaction will harm financial stability.

There are reasons to believe that the Reserve Bank has become  philosophical on bank capital too. 

That speech

First is a recent speech of Deputy Governor Geoff Bascand on Financial stability. The speech did not draw a lot of media attention. However, the section on bank capital is disquieting. Discussing the pros and cons of bank capital, Bascand highlights the private interests of banks: “There is a debate as to how high that price [the price of higher capital requirements] really is. And we need to weigh those private costs against the social costs of a crisis.”

This is remarkable, because the Reserve Bank has always claimed to protect the financial system, not the private interests of banks. 

More importantly is this. Ten years after the GFC, Bascand’s speech shows that the Reserve Bank has still not taken a position on bank capital. The speech is littered with dovish philosophical capital claims. For example, it mentions: “The literature is therefore helpful in pointing to the direction that regulatory capital should travel, but not the destination.” Perhaps. But statements like these set the RBNZ apart from its Australian counterparts. APRA and RBA have no problems pointing out the destination of bank capital. It’s called ‘unquestionably strong’.

It’s not only words

Second is the recent outcome of the 2018 EBA stress test. The EBA publishes all the relevant data, also on capital ratios. So, we can compare New Zealand bank capital ratios (using the Dashboard) with those of EU countries. 

Adjusting for size, the average CET1 capital ratio of New Zealand banks is 11.35%, with the big banks not at all meeting that average:  

Compare this to CET1 ratios of EU banks, which are 14.22% on average.[1]  Most European banks sport CET1 ratios higher than 11.35%:

The difference in CET1 ratios between Europe and New Zealand is 2.87% (14.22-11.35). Adjusting this by 2% to reflect conservative risk-weights, the average ratio is still 87 basis points below that of the European average.

Also this study from the U.S. Federal Reserve shows that optimal bank capital levels range from just over 13% to just over 26%. New Zealand dwells at the lower boundary of that range. 

Moreover, European banks have increased average CET1 capital by more than 700 basis points since June 2011. But New Zealand CET1 ratios have increased by only 107 basis points since 2013 when the RBNZ started measuring CET1 capital ratios.[2]  

Buffers, buffers, and a pinch of Pillar 2

Just in case you wonder why the European ratios are so high; Europe implemented the full Basel III tool-box. This includes an array of buffers. There is a conservation buffer, a buffer for systematically important banks, a buffer that kicks in when lending grows too quickly. These buffers can augment CET1 ratios to about 13%. Then there are Pillar 2 requirements, which allow a supervisor to augment regulatory capital of individual banks. This to cover risks that are not covered by the main regulatory requirements. Some European banks are required to hold 10% additional Pillar 2 capital.

It all stacks up! And it stacks up because of that comprehensive tool-box called Basel III.

You need a hammer

Third is the joint FMA and RBNZ report on conduct and culture. This also contains interesting dovish statements on capital. 

Just in case you wonder what bank capital has to do with conduct and culture, here’s an illustration. Banks need to hold capital for Operational Risk (as well as for credit risk and market risk). The text below, from the Credit Suisse annual report, shows how it works: 

Credit Suisse got itself into trouble by mis-selling RMBS before the global financial crisis. The U.S. Department of Justice found out and fined Credit Suisse. Then FINMA, the Swiss Market Supervisory Authority stepped in and made Credit Suisse change its way of measuring risks. This led to a CHF 9.0 bn increase of Risk Weighted Assets – and with it a CHF 1.125 bn increase in bank capital.

This is the way to go. Capital is a great hammer tool for disciplining banks. 

Abandoning that important tool?

The combined FMA and RBNZ conduct and culture report, however, does not mention regulatory capital. There is a hand-waving remark about the difficulty of quantifying conduct and culture risk. A cop-out. This is remarkable, given that the Reserve Bank not so long ago required Westpac New Zealand to hold an additional 200 basis points of regulatory capital because of poor conduct.

Has the Reserve Bank abandoned a potent tool to discipline banks? 

To answer that questions, lets look at the policy initiatives on Operational Risk. I mean, perhaps the RBNZ contemplates the introduction of a new operational risk framework to deal with matters of conduct and culture. Unfortunately, here too it looks like the capital philosophers are gaining ground. For example, last year’s consultation report on the Review of the Capital Adequacy Framework offered the following options:

The third option could potentially deal with culture and conduct.

Alas, looking at the response to the consultation, the RBNZ appears to favor the second option: All banks will calculate the RWA arising from operational risk in the same way, using the Basel Standardised Measurement Approach.

Again, this makes me wonder: has, under Adrian Orr the RBNZ become too philosophical about bank capital?

[1]: These ratios are on a fully-loaded basis, which are conservatively low. They apply the full Basel III  deductions to capital. 

[2]: I weighed the Common equity tier 1 ratios from the RBNZ statistics tables by total assets.