The international financial institution that the RBNZ ignored

Yesterday, the RBNZ announced the release of submissions on the last capital review paper. A whopping 161 submitters shared their views on the Reserve Bank’s capital proposals. This is significant for sure. It also confirms how interesting bank capital regulation is! I quickly found my own contributions. Three this time, but I wonder why the Reserve Bank counts an email to Susan Guthrie, who I congratulated for her efforts and her team’s achievement shortly before Christmas, as a submission. Apparently anything counts.

Ciao to an Italian job

The Reserve Bank’s release announcement is unambiguous. New Zealand banks will have to satisfy higher capital requirements. The submissions are largely in support.

It is encouraging to see the Reserve Bank moving away from the idea that a 4.5 percent requirement for Common Equity Tier 1 is realistic or acceptable – today. The 4.5 percent was the result of a deal made at a Basel Committee meeting in the fall of 2010. The idea was to have 8 or 6 percent Common, but then Italy threw a tantrum.

I wondered if the Reserve Bank was aware of this “Italian Job.” It was always funny to see Financial Stability Reports referring to 4.5% as the minimum requirement. I mean, the 4.5 percent was an Italian minimum, not a globally acceptable standard. Of course, New Zealand is not Italy, so yes, it can do much better. A predictable question ensued: how much better can New Zealand do?

The ‘how much capital is enough‘ question kept the folks at the Reserve Bank busy for many months. Unfortunately, that question has not been answered convincingly or justifiably. Even now there are international financial institutions that express concerns about the RBNZ capital plans.

More interestingly, however, is a recent study from one international financial institution that makes an important contribution to the debate on bank capital.

And yet, in its most recent public communication on bank capital, the RBNZ does not refer to that study.

Support from two international financial institutions

Yesterday’s release announcement claims that the Organisation for Economic Co-operation and Development’s (OECD) and the International Monetary Fund support (IMF) support the Reserve Bank’s capital plans.

Not so fast, I would say. The OECD’s support comes with important warnings. The Reserve Bank should to not take the benefits of more capital for granted: “High bank capital requirements reduce the costs from financial crises, but might also dampen economic activity through higher lending rates. On balance and notwithstanding considerable uncertainty increases in bank capital are likely to have net benefits, but the impacts should be carefully monitored.”

As for the IMF, it is true that a recent statement of the Fund mentions that the Review of the Capital Adequacy Framework should provide for a welcome further strengthening of the resilience of the financial system and regulatory framework. So far so good.

However, the IMF statement also criticizes the capital plans for its weird structure. The buffer for domestic systemically important banks (D-SIB buffer) is too low, and the capital conservation buffer is too high. Moreover, probably referring to the 2017 FSAP, the IMF warns the Reserve Bank to strengthen its supervision regime, else the higher capital requirements will likely lack their desired effect.

The IMF statement is hardly surprising. Dovetailing with my own submission, the Fund encourages the Reserve Bank to conform to international standards, i.e. Basel III, something the Reserve Bank appears to have struggled with for considerable time.

What about support from the Basel Committee?

It is unfortunate that yesterday’s release announcement does not refer to a recent study from the Basel Committee: Working paper No. 37: The costs and benefits of bank capital – a review of the literature.

The study is interesting and highly relevant because it basically replicates the work of the Reserve Bank. Working paper #37 reviews more or less the same academic studies that the Reserve Bank examined.

The conclusions of the Basel Committee study, however, are different. They are much more modest than the findings of the RBNZ. Agreed, the main conclusion favors higher capital because of the positive net macroeconomic benefits it brings. However, these benefits accrue over a wide range of capital levels – not only once banks meet a 17 percent requirement.

But there is more. First, the Basel Committee study rightly informs the reader that conclusions from studies on bank capital are sensitive to a range of assumptions. Assumptions on, for example, “the efficacy of post crisis reforms – such as liquidity regulations and bank resolution regimes – in reducing the probability and costs of future banking crisis.” In other words, other policy tools can lessen the need for high bank capital requirements.

Second, confirming a pet peeve of mine: one cannot really compare studies on bank capital. Estimates of existing studies rely on capital ratios that are measured in different units. Some academics cannot tell the difference between Equity, Total Capital, Common Equity Tier 1, or Tier 1. Others do not know the difference between the Tier 1 ratio and the Leverage Ratio. Then, there are studies that rely on data produced under U.S. accounting standards, whereas other studies rely on IFRS accounting. The implication is that studies on bank capital are more quicksand than a sound foundation for policy recommendations.

Third is that the Basel Committee study shows that the contribution of bank capital to reducing the probability of a crisis rapidly diminishes once capital ratios exceed the 10 percent mark. Still, there is a wide range of “optimal” capital ratios:

As for the contribution of capital to the economy: the marginal benefits are positive all the way, unlike the RBNZ suggests:

In all, Working Paper #37 is a must-read for anyone interested in bank capital regulation. Moreover, it also presents a great replica of Jorda, Richter, Schularick and Taylor (2017). On the lower probability of a crisis, it shows bank capital is impotent, whereas loan growth does have an effect:

As for the RBNZ, it invited three academics to comment on the process of the calibration of the capital review, see terms of reference here. The three wise men are James Cummings (senior lecturer at Macquarie University), Ross Levine and David Miles. Levine works with Barth, who, according to the upper graph of this post, is confident of the power of capital to reduce the probability of a crisis. Miles, according to Working Paper #37, documents the lowest cost of higher capital requirements. It is interesting to see if the three wise men take this Basel study on board in their assessment.

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