Are the Reserve Bank capital plans really about conduct risk?

Today, I submitted my comments on our Reserve Bank’s 4th capital consultation paper. The RBNZ wants banks to meet stiff new capital requirements. For common equity, the ratio requirement will increase by a whopping 5 percent, with a 1.5 percent countercyclical buffer requirement on top. Total capital requirements will be 17 percent. There will be a surcharge of 1 percent for systemically important banks.

18 percent total capital! That is a clear departure from the current requirements, which want New Zealand banks to meet a 10.5 percent total capital ratio.

The amount of capital involved is large. According to my own calculations, New Zealand’s banks need to raise $25 billion fresh equity capital. To give you an idea: $25bn is the amount of capital supporting UK’s Nationwide Building Society. In other words, if you have $25bn to spare, you can start an entire new bank.

Why my submission? That wall of equity.

I submitted my comments for three reasons. First is the focus on equity only. How will New Zealand banks fund a $25bn “wall” of equity? It’s just very unpractical. My advice: keep it simple and follow Basel III. Let Additional Tier 1, Tier 2, or Senior Non-preferred capital contribute to higher capital requirements.

Second is the poor governance of the process. I have yet to see a bank supervisor that turns a policy consultation into custard: there is no proper cost-benefit analysis, the limited and watered-down quantitative impact study performed by the RBNZ lacks the clarity, visibility, or accessibility of the one offered by the Basel Committee, the consultation paper had to be revised because of typos, and the choice of studies supporting the consultation paper looks biased. Also, the consultation deadline was postponed because the Reserve Bank wanted to meet with investment banks to discuss the feasibility of the plans. The poor governance may affect investors’ and depositors’ confidence in the Reserve Bank. Who says that a next RBNZ official will continue to support the out-sized capital proposals?

Third is that I doubt if the New Zealand financial system will be safe and sound if a next RBNZ official decides to dial the ratio requirements down to levels that are in line with other countries. However high or low the ratio requirements, the capital proposals rely heavily on publicly known requirements (Pillar 1). There is little room for supervisory discretion, i.e. for Pillar 2. This creates vulnerabilities: only when it is too late, the public will discover that the RBNZ relied too much on self-discipline and market discipline.

Do as I say – Basel II revisited

A clearly noticeable aspect of the 4th capital consultation paper is that it is based on an obscure pre-crisis Basel Committee document: “An Explanatory Note on the Basel II IRB Risk Weight Functions.” I mean, the RBNZ goes the extra mile to discourage banks using internal ratings. However, for the calibration of the capital plans, the Reserve Bank relies on just these. You cannot make this up!

What about new risks: operational risk, liquidity risk?

It is unsettling to know that the Reserve Bank relies on that explanatory note – as it only addresses credit risk. It is not about market risk. It is not about liquidity risk. Neither is it about operational risk or conduct risk. Remember Libor scandals, recent money laundering scandals, and the Royal Commission into Misconduct in the Banking industry? These scandals are about conduct risk or, in Basel-speak “operational risk” or “OpRisk.”

Lessons learned since the GFC: credit risk is largely under control, liquidity risk and operational risk are important. A recent article in the Financial Times showed that banks’ risks managers are most concerned about cyber security risk, and that the attention for operational risk had increased by seven percentage points over the last year.

And yet, the Reserve Bank seems to act as if it is 2005, the calibration of the capital revamp is predicated on credit risk only: “We adopted the assumption that the current quantum of capital held against operational and market risks is appropriate going forward, and thus focused, in the quantitative modeling, solely on credit-related losses.” (See the Background paper of 3 April 2019).

Again, the RBNZ capital plans are not about operational risk.

In a bizarre move, the Reserve Bank today posted a note on its website informing us that it revoked ANZ’s accreditation to model its own operational risk capital requirement. It did so on a sunny afternoon, during trading hours, at lunch time. It beggars belief.

More worrying is this line: “ANZ’s directors have attested to compliance despite the approved model not being used since 2014. The fact that this issue was not identified for so long highlights a persistent weakness with ANZ’s assurance process.” I doubt if this line of reasoning has been made in good faith. The quality of the banking system as perceived by the public, investors, and depositors is a joint responsibility of the banks and the supervisor/regulator.

Shifting responsibility to the supervisee hardly exonerates a supervisor. The supervisor should see these issues coming: super-visor (from Latin super “above, over, beyond” respectively visus “a look, vision”).

Today’s revocation announcement prompts some important questions. Has the RBNZ been sitting on this bad news to release it just four hours before the capital plans submission deadline? What else does the RBNZ have in store for us? Will other banks follow? How does this announcement contribute to financial stability?

Outright bizarre is that the Reserve Bank links the Friday lunchtime announcement to its capital plans: “The Reserve Bank is currently consulting on its capital framework for banks. Among the many decisions to be made, and in part due to proven weaknesses with the internal models approach, it is proposing that all banks adopt a new standardised approach for calculating operational risk capital.”

I beg to differ. The RBNZ will consult on operation risk in 2020. Apart from that, my submission, as well as a previous blog post document that the RBNZ struggles with operational risk: “Conduct risk and customer outcomes are less easily quantified than credit risk or market risk, and are not easily controlled by standard compliance tools.” Because of that struggle, the Reserve Bank applies an unimaginative approach to operational risk. Presenting that as an own proposal is a stretch. The RBNZ decided to follow “Basel IV”, which, if my mind serves me right, uses past accounting data to deal with operational risk. How that will contribute to financial stability, notably in the absence of a Pillar 2 framework, mystifies me.