Tomorrow at noon, the RBNZ will reveal its bank capital plans. After many years, the RBNZ will likely decide to increase capital requirements to 17 percent for all banks, with a 1 percent add-on for systemically important banks.
Having contributed to capital rules for the Basel Committee and the European Union, for me, most of the discussions on New Zealand bank capital are déja vu all over again. The regulator persists, the bank resists. But rest assured, once the final decision has been made, banks will move on.
Which makes me wonder, … why has this process taken so long? The Basel Committee started actively working on capital rules after the G20 of April 2009. By the fall of 2010, Basel III was a reality. That’s about one and a half year.
What happened to Ctrl-C, Ctrl-V?
Instead of copying and pasting the Basel III rules text into the Banking Supervision Handbook, the RBNZ decided to reinvent the wheel. With an off-the-shelf solution available, I doubt if this is money well spent.
It is also unlikely that the final result will differ very much from Basel III. The main differences, i) non-eligibility of Additional Tier 1 capital, ii) the floors, and iii) the levels of 17-18 percent can all be achieved within the Basel III framework. For example, the Netherlands decided to stop the tax deductibility of interest paid on Additional Tier 1 capital instruments. As a result, Dutch banks lost appetite for these risky instruments. The New Zealand government could make a similar decision, which would save the RBNZ valuable time and resources.
The elevated capital ratios that the RBNZ so eagerly wants can also be achieved under Basel III rules. See the picture below, which shows capital ratios for European banks in 2018. The left bar shows the ratio requirements that European supervisors can impose on banks, with a max of 18 percent, excluding Pillar 2 capital. The right bar shows that European banks report Total Capital ratios of 19.36 percent, even though on average, the ratio requirements are about 12.5%. The big blue block is the amount of capital that EU banks voluntarily hold.
In short, the justification for a long and drawn-out capital review is weak, if not absent. Why did the RBNZ decide to go it alone?
Best friends forever
But there is more the RBNZ has to answer for. For example, there is a well-resourced supervisor across the Tasman. A pragmatic Governor would be keen to collaborate with (and piggyback on) APRA. However, it does not look like the RBNZ and APRA are gelling. Last week’s Financial Stability Report press-conference made it clear that APRA informed the Reserve Bank late about Westpac’s money laundering problems. The Reserve Bank also negotiated poorly with the APRA regarding the amount Australian banks can invest in New Zealand subsidiaries. As I explained in my column for interest.co.nz, largely credit to the poorly communicated and poorly coordinated capital plans, our country now runs the risk that the largest banks will surrender business to banks that are supervised by lesser Gods than APRA.
Wouldn’t a better relationship with APRA contribute to financial stability and thus lower the need for more capital? Why didn’t our Governor make the relationship with APRA a top priority?
Spoiler: the New Zealand financial system is fine
On the current and future levels of capital, the RBNZ presents a narrative that current capital levels are too low and that banks need more capital to fend off a crisis, a crisis that imposes costs on future generations.
The media perpetuates this flaky narrative. In doing so they short-change the New Zealand public. Yesterday, Rod Oram on Nine to Noon fooled the nation by uncritically chiming in with the RBNZ. He painted a bleak picture of our financial system: our banks are poorly capitalised, there will be a crisis, the crisis will cost the taxpayer money. Perhaps, but Rod, it is not 2008, it is almost 2020. Since the onset of the GFC, the RBNZ has implemented measures to improve bank capital and bank resilience. There is a resolution framework, the RBNZ has implemented macro-prudential polices, etc. The idea that bank failures will be borne by taxpayers looks less likely than before.
Oram even belies his audience. Referring to the WEF Global Competitiveness Report, he wants us to believe that New Zealand banks are in a poor state. Oram explains that our banks rank 119 on capitalisation. However, that same report informs us that our banks score number 9 on Soundness of banks with a score of 6.1 out of 7, see the picture below. For so blatantly selecting the information that fits his opinion Oram should spend considerable time in the naughty corner.
Unfortunately, RNZ is not alone. Interest.co.nz’s David Chaston also over-eggs the case for high capital. He uses colourful language to sound the alarm on low bank capital. Why? Where is the evidence?
Fortunately, World Bank data shows a far less bleak picture. It places New Zealand’s capital ratios close to those of Australia. Total Capital Ratios are 13.70 percent for our country and 13.80 percent for Oz (2016). These are risk-weighted ratios, which are likely deflated by relatively high risk weights.
Our banks look even better if we look at the (unweighted) Leverage Ratios of New Zealand’s banks. These are significantly higher than, say, European Leverage ratios: 7.9 percent, versus 5.38 percent reported in last week’s EBA transparency exercise.
But there is more. In “Fragile by Design: The Political Origins of Banking Crises and Scarce Credit“, Charles Calomiris (Columbia Business School) and Stephen Haber (Stanford) show that New Zealand is among the few nations that never experienced a full-blown financial crisis.
Then there is the Basel Committee that recently demonstrated that the benefits of capital diminish once capital ratios reach about twelve percent. More importantly, that Basel Committee report also demonstrated that bank capital will not lower the probability of a crisis.
In short, where is the evidence that the public of New Zealand will benefit from capital ratios that are on par with those of Iceland, to name a country that experienced a massive banking crisis? Where is the evidence that current capital ratios put our financial system at risk? Why also aren’t banks told to disclose capital ratios that allow us to make a proper international comparison? If APRA can do this, then the RBNZ should follow suit. It would certainly facilitate discussions on the state of our banking system.
High capital and the Tinbergen Rule
Gareth Vaughan this week informed us that the Reserve Bank capital proposals will level the playing field between the Aussie-owned banks and the rest. According to Gareth, by limiting the use of the Internal Ratings Based approach, the RBNZ somehow levels the playing field.
I always found this a strange narrative. It is like asking Usain Bolt to wear an anvil around his neck – to create a level playing field. Why? The IRB approach, if properly governed, allows banks to optimally match risks and capital. Using the IRB approach to foster competition does not make sense because it so obviously violates the Tinbergen rule. Named after Nobel laureate Jan Tinbergen, his rule of thumb says that a policy tool, to be effective, can only be used for one policy objective. The IRB approach and the SA approach are not meant to optimise the allocation of risk and capital and solve market concentration problems at the same time. Competition problems are best dealt with by the Commerce Commission.
Admittedly, there is evidence of incorrect use of the IRB approach, but that is a problem of poor governance, which the Reserve Bank could help mitigate by focusing on conduct and operational risk, not by limiting the use of the IRB approach.
Evidence published in the Journal of Banking and Finance shows that “IRB banks were able to curb the increase in credit risk driven by the macroeconomic slowdown better than banks under the standardized approach. This suggests that the introduction of the internal ratings based approach by Basel II has promoted the adoption of stronger risk management practices among banks, as meant by the regulators.”
Lastly, APRA’s Wayne Byres, in a recent speech pours more cold water on the idea that there is large difference between the IRB and Standardised Approaches: “any gap is small.” See quote below:
Poor Conduct is the new black
Last month, the ECB’s Financial Stability Review presented some interesting facts that demonstrate the growing headache caused by misconduct: “Past misconduct by banks has weighed on global bank profitability and equity positions over the last decade, with the related costs amounting to over USD 350 billion or 15% of total bank equity. European banks have been more exposed since 2015 (see Chart A, left panel), … misconduct costs related to sanction violations, money laundering and tax evasion have picked up more recently (see Chart A, left panel). Euro area banks’ net income could have been one-third higher over the same period without these misconduct costs, potentially helping strengthen capital buffers, if earnings were retained.” (Emphasis added)
With the perturbations at BNZ and Westpac fresh in our minds (and the fallout of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry) the RBNZ ideally should take notice and focus much more on preventing conduct problems than on capital; which prompts the question why the Council of Financial Regulators delegated Conduct to the FMA.
Capital and conduct
More importantly, increasing capital ratios can prompt poor behaviour if governance does not keep up. That increasing capital ratios can reduce profitability has now been documented by many studies (See for example De Marco and Wieladek, 2015; Jensen, 2015; and Gropp et al, 2016).
Ross Levine, in his expert report on the RBNZ plans, then points out that the combination of high capital, poor profitability and weak governance can induce risk taking i.e. foster poor behaviour.
This is not just a pie-in-the sky theory. Examples, abound, specifically the highly capitalised banks of the Nordics. These banks once sported stellar bank capital ratios, now they struggle with conduct problems. Another example is Dutch bank ABN AMRO. Sporting a CET1 capital ratio of 18.2%, this poorly governed bank is now embroiled in money laundering problems.
High capital has merits for sure, but be careful what you wish for.
What to look for in Thursday’s publication?
As the graph of the capital stack at the top of this post shows, the European capital stack has many layers, there is a Pillar 2 buffer, which is bank-specific. In the RBNZ proposal, the Capital Conservation Buffer dominates. It occupies 7.5 percent of the stack. Under Basel III rules, this is only 2.5 percent. At the same time, last year’s RBNZ proposal looks unfinished when it comes to specifying the management of this buffer. As explained in my previous post, there is a risk that the buffer becomes politicised. It would thus be interesting to see how the RBNZ rules on this buffer.
The other thing to look for is the eligibility of Additional Tier 1 and Tier 2. My preference goes out to accepting both, in line with Basel III. However, instead of Tier 2, banks in Europe increasingly issue Senior Non Preferred capital. SNP is cheaper than Pillar 2 capital but a good substitute. Given that Australian banks are meant to be issuing lots of Tier 2 capital and the ECB now allows Tier 2 capital to contribute to Pillar 2 requirements, the RBNZ could accept SNP capital to cover gone-concern capital requirements.