More questions for the RBNZ

Michael Reddell’s blog post of today reminded me that RBNZ governor Adrian Orr is scheduled to appear before the Parliament’s Epidemic Response Committee (PERC) tomorrow.

The appearance will be an interesting event for sure, because it is difficult to challenge the Governor, ask him important or prickly questions in the flesh. In testing times like these, one would also expect our folksy Governor to engage with the public, hold a press conference once in a while, take questions and answer them without losing his temper.

Communicating effectively, what Jacinda Adern, Ashley Bloomfield, and Grant Robertson can do so well, should be a minimum requirement for anyone occupying a top job. This also applies to Adrian Orr. And yet, what we have seen from the RBNZ Governor does not inspire confidence: a weird op-ed in Stuff and a video conference with reporter talk-show host Liam Dann motivated perhaps by a misguided fear of having to administer emergency liquidity assistance in the wake of unsettling reports from the Australian bank supervisor. No important questions asked or addressed, just convenient spin, except of course the absurd and patronising encouragement to imagine “the role you can and will play in the vibrant, refreshed sustainable, inclusive New Zealand economy.”

As an aside, if you want an illustration of proper communication skills of an official in charge of bank supervision, feel free to compare Orr’s mid-March press conference performance (defensive, nervous, inauthentic) against a recent press conference by Andrea Enria, ECB’s head of supervision, held on 28 January this year. You don’t have to watch the full video, as I did, but the Q&A between Enria and the press, specifically the Reuters reporter at 34″50′ is just magnificent; note the highlight around 36’50”.

Anyways, I don’t want to digress too much. If I were to ask questions at the PERC tomorrow, then I would ask Adrian about capital matters, specifically about i) the decision to postpone the recently agreed capital plans and ii) the role of bank capital requirements during times of stress.

Restarting the capital plans, when?

The controversial bank capital plans, announced only four months ago, have been postponed until 1 July 2021 initially – with a restart conditional upon future conditions. What criteria does the RBNZ apply to restart its delayed capital plans?

I am aware that a year in bank regulation is short, so let’s, for now, assume a two-year delay. In the months ahead, the New Zealand economy will take a hit. The IMF projects a drop in GDP of 7.2 percent, which is significant by all means.

The expected economic abeyance will affect bank capital ratios: capital may drop because of lower profitability and expected and materializing loan losses. The denominator of the ratio will grow because of increasing risk-weights.

According to a recent research report from Macquarie Wealth Management, the capital ratio impact will last until at least 2022. By that time, banks will start restoring capital ratios to return to pre-lockdown levels. This may take another three years. (Of course, banks can increase capital ratios more quickly, but this will be at the expense of SME’s, farmers, and economic growth. Less haste is more speed.)

Meanwhile, the RBNZ may conclude every year that “now is not the right time” to reignite its capital plans. Or it may declare it is the right time, but do so at the wrong moment, e.g. to not lose face. Though I’d love to see the back of the RBNZ capital plans, it is poor policy-making to leave important decisions to the future. Can the RBNZ explain what conditions need to be met before the capital plans recommence? And if the plans recommence, will the same phase-in period apply?

There are no rainy day capital stores

According to Adrian Orr at the 16 March press conference and the press release of 30 April, the RBNZ encourages banks to dip into their rainy day capital stores, and it opens up “an additional $47 billion of credit availability, with the same again available before reaching regulatory minimums.”

I have commented on this initiative before, mainly because there is no documentation that I can find, to support or explain the newly created headroom of $47bn × 2. The only quantitative evidence about the strength of our banks that I have originates from the Bank Financial Strenght Dashboard, which sports data from December 2019. That data looks like ancient history to me.

More importantly, however, is that the RBNZ appears to allow banks to lower their capital ratios until Common Equity Tier 1 capital drops to 4.5 percent or Total Capital reaches 8 percent of risk-weighted assets.

This, of course, is delusional, as, in practice, the headroom is much more limited. Banks may struggle once CET1 ratios dip below 10 percent, their viability is at risk once CET1 ratios drop down to 7.5 percent.

Can the RBNZ explain more clearly what headroom is realistic? The idea that banks can use buffers until CET1 ratios hit the absolute bottom requirement of 4.5 percent is fantasy. By that time banks are in resolution and our financial system, if it concerns systemic banks, will be in tatters.

The press release statement on capital is problematic for another reason. This has been pointed out by former FDIC head Sheila Bair: banks should be banned from ‘consuming’ capital during a ‘rainy day.’ Instead, capital should be preserved as much as possible. There is ample academic research that shows that banks with low capital ratios are weak. These banks will struggle to survive a crisis, their funding cost are higher, they lend less, their valuations are low, and they are in a weak competitive position.

I can see merit in decisions of the Reserve Banks to temporarily apply some flexibility regarding capital requirements, but the decisions seem open-ended. It looks like the RBNZ assumes that the current perilous state of the economy will end sometime soon and that normalcy recommences “once this is all over”. In practice, crises like the current one are long-lasting. Just watch Larry Summers’ majestic speech on the zero-lower bound. He correctly points out that it ain’t over until it’s over. That speech was in 2014, it is 2020 now.

The idea that banks can use capital for a rainy day is wrong for many reasons and sets a tricky precedent – it incentivises moral hazard behaviour.

My questions therefore, are:

  • Can the Reserve Bank show evidence supporting the $47bn headroom × 2?
  • Why does our financial system, in the absence of a deposit insurance system, offer investors and depositors outdated dashboard data? Can this be updated and disclosed on a fortnightly basis? If so, please do.
  • What are the projected losses and capital ratios for our banks in the next three years?
  • What criteria does the RBNZ use to define that ‘rainy day’?
  • How long does the RBNZ expect the ‘rain’ to continue?
  • In the presence of reams to studies demonstrating the benefits of double-digit capital ratios, why does the RBNZ suggest that banks can dip into capital until (single-digit) regulatory minimums are reached?
  • While important bank risks are covered by the government and other prudential supervisors urge banks to limit variable pay to preserve capital, why are New Zealand banks allowed to continue to pay bonuses?