A resilient banking system

I just read Gareth Vaughan’s opinion in today’s interest.co.nz. Though most of his contributions are spot on and relevant, on the topic of bank capital I have seen Gareth once in a while making things up as he writes.

For example, his idea that the Standardised Approach (SA) for risk weight calculations, as opposed to the Internal Ratings Based approaches (IRB), promotes competition between banks is debatable. It is an odd idea, like promoting competition between marathon runners by forcing them to carry an anvil. Moreover, support for the idea that there is a problematic gap between both approaches is waning. Early studies, the ones that got published, showed such a gap. But many of these studies used data from years before 2013, when supervisors did not really pay attention to weaknesses of the IRB approach. In more recent years supervisors have deployed measures to manage banks’ use of the IRB approach, e.g. the ECB TRIM initiative. And then there is Wayne Byers, head of the Australian prudential authority, who recently played down the harm the IRB approach can do: “When looked at holistically, we think any gap [between IRB and SA] is small.

The opinion of the day

Today, Gareth surprised me with this paragraph: “It was just a few short months ago, with the Reserve Bank proposing to increase their regulatory capital requirements, that New Zealand banks were telling us how strong they were. The Reserve Bank’s risk appetite was too conservative, their lobby group the New Zealand Bankers’ Association said. … Boy how things have changed and how quickly too. Over recent days banks have received so many different forms of government and central bank assistance, in order to keep their credit / debt conveyor belt flowing, that it’s hard to keep track of them all.

This dig is entirely off the mark, for three reasons. Firstly, the current perilous situation is not the result of past efforts of the New Zealand banking association, of course not. It is also not the case that our banks are being bailed out by the Reserve Bank.

Banks will always oppose higher capital requirements. But ultimately, bank regulators and bank supervisors decide. The quality of a banking system is a responsibility banks share with their supervisor.

Secondly, the Reserve Bank is making a solid attempt to stabilize the financial system. It rightly does so. As I pointed out in my previous blog post, prudential supervisors and bank regulators worldwide have stepped up their efforts to protect financial stability. Keeping our financial system stable is the RB’s top priority now, moral hazard is of secondary importance.

Thirdly, research provides compelling evidence that bank capital cannot lower the probability of a crisis, see research by Jorda, Richter, Schularick and Taylor (2017) as well as the Basel Committee in working paper No. 37: The costs and benefits of bank capital – a review of the literature.

A resilient banking system

Nevertheless, comments like these and recent press-releases and media appearances of Reserve Bank officials prompt questions about the resilience of New Zealand Banks.

The short answer is: our financial system is resilient. There is ample evidence to support that answer.

First is a study by professors Charles Calomiris and Stephen Haber, who examined many countries and discovered only seven crisis-free countries where credit flows normally: Singapore, Malta, Hong Kong, China, Cyprus, Australia, Canada, and … drum roll … New Zealand. (Their presentation shows why there are so few countries with stable financial systems).

Second is the 2019 report from the World Economic Forum that ranks New Zealand number 9 (out of 141 countries) on Soundness of banks. New Zealand scores 6.1 out of a maximum score of 7. That is great!

Third is the volume of capital available to absorb losses. New Zealand’s aggregate Tier 1 capital ratio stands at 13.5%. This is higher than the sweet spot of 10-12 percent identified by several authoritative studies. For example, the Basel Committee working paper #37 shows that the contribution of bank capital to reducing the probability of a crisis rapidly diminishes once capital ratios exceed the 10 percent mark. A recent ECB study shows that the cost of senior bonds is the lowest at a 12 percent CET1 ratio, which is close to the New Zealand CET1 ratio of 11.53 percent.

Fourth are New Zealand’s conservative risk weights, which bias capital ratios downward. It is unfortunate that the RBNZ does not present data that we can use to compare New Zealand bank risk-weights with those of international banks. We have to rely on guesstimates. This PwC study shows that capital ratios, after adjusting for the conservative risk-weights, should be at least 6 percentage points higher. Former RBNZ official Grant Spencer, in his speech of March 2017, offers a more moderate estimate. He thinks the ratios should be one to two percent higher.

Our banks are also resilient if we look at the (unweighted) leverage ratios. These are significantly higher than, say, European leverage ratios: 8.0 percent versus 5.4 percent reported in the most recent EBA transparency exercise.

Lastly, banks are sufficiently liquid. Funding and mismatch ratios meet requirements. Yesterday the RBNZ offered headroom: it has decided to reduce the core funding ratio requirement from 75 percent to 50 percent.

In all, there is ample evidence to support the answer that the New Zealand banking system is resilient.

What should the RBNZ do now?

Regarding bank capital, the Reserve Bank mentions that banks can use buffers. However, communication about capital relief is vague. “We also gave the banks a clear go-ahead to use the capital they have stored for rough times. We estimate this gives banks an extra $47 billion of lending capability to assist New Zealanders. They have a similar amount again to lend if needed without reaching their minimum capital reserves. In normal times this is about three years of borrowing demand.

I agree with the spirit of the capital relief decision: use those buffers! However, there is no clear explanation of the $47 billion extra lending capacity. Neither is there a clear explanation of the buffers the RBNZ refers to. Is this the conservation buffer, or is it bank’s own buffers? What about any capital penalties imposed on naughty banks?

Investors want to know the headroom offered by the RBNZ capital relief decision – my research shows that headroom matters, even if capital ratios are high.

The RBNZ could follow the Nederlandsche Bank, which clearly explains the buffers that can be used and supports that with relevant numbers: “The systemic buffers will be lowered, from its current 3% of global risk-weighted exposures to 2.5% for ING, 2% for Rabobank and 1.5% for ABN Amro.”

This line explains how much headroom the Nederlandsche Bank created: “these measures will free up EUR 8 billion in capital.”

The RBNZ should also explain that buffers are meant to absorb losses and continue lending, but not to pay dividends or bonuses. The European Banking Authority puts it like this: “Banks should also follow prudent dividend and other distribution policies, including variable remuneration.

Regarding the denominator, the RBNZ could quantify the difference between New Zealand Risk-weighted assets and those of international banks to improve the transparency, comparability of the RBNZ capital framework. Our like-for-like ratios are bound to be higher than those of many international banks. This APRA discussion paper can serve as an example.

Lastly, the RBNZ could clarify its position on non-performing loans and the IFRS forward-looking provisioning model. See an excellent comment by Nicolas Véron on this nerdy, but important topic.