A one-in-200 year event

A lesson that I learned from the Global Financial Crisis is that the “one in the many years” events materialise much quicker than expected. The thing is, these models never rule out that the event will happen tomorrow.

The RBNZ predicated its recent capital plans on a 1-in-200 year chance of a financial crisis. The plans will be phased in over the next years, in the expectation that, by the end of the phase-period, our banks are stronger than ever before.

So here we are, that 1-in-200 year event is probably now, and the banks have barely started to reinforce capital.

During the last ten to four years, the RBNZ failed to use its time wisely. Instead of following Basel or the Australian prudential supervisor, the RB tried to reinvent the wheel. It chose to design its own capital framework, a waste of resources. While the clock kept ticking and an unhelpful governor turned capital into a vanity project, other prudential supervisors managed to increase bank capital.

Sad and depressing as this is, the RB could take a leaf from the ECB playbook. European banks are well-capitalized, with about 15 percent Common Equity Tier 1. This is well over the primary capital requirements.

Much of the higher capital in Europe is due to an array of buffers. See the picture below. The 15 percent is also significantly higher than the 11.5 percent CET1 capital ratio currently reported by New Zealand banks.

Because of the relatively strong capitalization of European banks, last week the ECB decided to ‘waive’ some buffer requirements. Specifically:

  • Banks can fully use capital and liquidity buffers, including Pillar 2 Guidance
  • Banks will benefit from relief in the composition of capital for Pillar 2 Requirements
  • ECB to consider operational flexibility in the implementation of bank-specific supervisory measures

In all, the waived capital buffers amount to 4 percent of risk-weighted assets. This is massive and allows banks to absorb losses.

Unfortunately, the RBNZ has only one buffer it can waive, the conservation buffer. Moreover, with 11.5 percent capital today, a waiver of 4 percent will make banks look very vulnerable, but it should be done.

Banks should be able to absorb the upcoming losses.

The reason to cut these ratios is that investors become very nervous once capital approaches a (buffer) requirement. Look at the results of some research I did over the weekend: I measured the effect of the Corona price shock on various capital components of European banks. One of the components is the amount of discretionary capital. This is the cushion of own capital that banks hold over the requirements.

My results show that banks with lower own-capital cushions suffer more from a severe price shock than banks with big own-buffers. See the top-line of the table (Discretionary Buffers).

By eliminating buffer requirements, the cushions of discretionary capital increase, enabling banks to breathe a bit – and stop depositors or investors from panicking.