Some days ago, our minister of finance, Grant Robertson, spoke at an INFINZ workshop. This was the same day that he was asked to explain the size of the hole in his budget. Perhaps because of this, Grant’s presentation was modest and a bit shy, but still formidable. Against this background, the audience—students and financial industry workers—kept the questions civil and high-level. One question was about what advice he would give students. His answer: “You have to learn to work with people that you do not necessarily like.” Another was about regrets. He had a few.

Mine was the last question. I asked him about the systemic crisis that affects our universities. At first, he quipped that I should ask the vice chancellors. But after prompting from my side, Grant admitted that there is a systemic problem, but also that our universities are well capitalized, with fortress balance sheets and solid operational cash flows. He then referred to the ongoing review of university funding, which would see light by year-end. I guess he is willing to leave important decisions about the tertiary education sector to the next government. Unfortunately, there are few signs that a National-led government will come to the rescue. Why would it? It is not an issue that worries voters.

Are universities like banks?

Robertson’s answer made me think: there is a systemic crisis, there was a bailout of sorts, fortress balance sheets. It looks like universities and banks have something in common. I will not bore you with a long list of similarities between banks and universities, but there are many. Their main assets are intangibles, they are strongly regulated; they cannot set all their prices freely; their profits are volatile; they have a public function (payments, education); they compete for staff and customers in international markets; and so on.

Despite many similarities, there are some important differences. For instance, if a big bank fails, it has a direct and strong effect on our economy. But, if a large university fails, it may affect our economy maybe in the long term. Another difference: Banks can impose their risks on shareholders, who can diversify risks, while universities have less loss-absorbing capacity. They feel forced to impose losses on employees who cannot diversify that risk.

A more significant difference is the way universities and banks are supervised. Since the Global Financial Crisis (GFC), supervision, especially in the EU, has become much more assertive and powerful. Bank regulation has also grown considerably. It would not surprise me if the number of pages of regulation that banks face exceeds 100,000. But note, bank regulation is largely the result of due process and ongoing interactions between banks, governments, and regulators. The process is fairly transparent, thanks in part to the financial press. Then again, despite the reams of regulation, the main metric for effective bank supervision is capital.

Compared to banks, universities face less intense regulation. However, the governance of university regulation is different. This may affect the quality of regulation. It is hard to say, yet, because …

It’s complicated

Take, for instance, the way our central university overseer, the Tertiary Education Commission (TEC), monitors the resilience of our universities. My understanding is that the TEC traditionally relied on an elaborate framework of financial metrics. This is the Financial Monitoring Framework from 2016, when Labour was in opposition. According to the Framework, the TEC uses it “to monitor your institution’s financial performance. We developed this framework, together with the sector, to assist in our monitoring obligations.”

To assist the TEC in its monitoring role, the Framework features metrics such as Operating Surplus (Net income), Cash flow for operations, Quick ratio, Debt equity ratio (a measure of capitalization), and some nonfinancial metrics. In all, there are about a dozen of these, which look like targets, plus five weightings. These are then combined into an overall risk rating.

I was nonplussed when I learned about this Framework, as it resembles Robert Altman’s 1968 Z-score methodology, but without empirical calibration. The weights assigned to the metrics appear to be the result of ad hoc decisions, potentially the result of negotiations with the sector. The level of understanding of financials reflected by the metrics seems limited. It almost looks as if an intern developed it, without a deep understanding of the Z-score and its well-documented caveats. It does not look like any back-testng was done.

The complexity of the Framework is not helpful, which, in an email to me, the TEC more or less admitted. “[F]ollowing the arrival of COVID-19, [the TEC] stepped away from completing formal FMF assessments. It adopted a more holistic approach to its financial monitoring.” A holistic approach can have varying interpretations and is subjective in nature. In practice, it is often a euphemism for “We know we do something, but we struggle to explain what”.

Less is more

The problem is that, according to a TEC official, the universities still abide by the framework. My understanding of university discussions and documents then is that the new, holistic, approach results in a strong focus on getting profitability back in black quickly. Fair enough, but why?

In banking, profits, or better, the lack thereof, are regarded as a risk factor (see this speech by former ECB head of prudential supervision, Sabine Lautenschläger). Profitability, therefore, should be managed accordingly, not hurriedly targeted.

Instead of using multiple metrics, the TEC should focus on a few only. My suggestion is to focus on an adequate level of capital. Which brings me back to my Q&A with Grant Robertson: New Zealand’s universities have fortress balance sheets that can absorb losses without the imminent risk of failure or associated bailouts. This gives the sector time to recover without unnecessary disruption and unnecessarily imposing losses on employees.

The TEC may be concerned that focusing on a few metrics, such as capital adequacy, might cause universities to behave financially irresponsibly. However, the graphs below suggest that these worries are not well-founded.

The two graphs show distributions of profitability: one for US banks and one for New Zealand universities. The first graph shows the quarterly return on assets for US banks from 2000 to 2023 (in basis points). Over 80,000 observations of thousands of banks. As you can see, most of the observations are positive.

It shows that banks aim to avoid losses, despite the absence of prescriptive profit targets. Bank managers know all too well that losses diminish capital, and therefore, they try to avoid losses. They carefully manage the headroom of capital over the requirement, as my Max Headroom paper shows. And, as the graph shows, some banks make losses, generally due to poor risk management, but these are a minority.

Below is a very similar graph from annual observations of New Zealand universities since 2004:

Again, despite the convoluted or perhaps dysfunctional Financial Monitoring Framework, universities achieve a similar result. Less (metrics) is more.

The advantage of a focus on capital adequacy is that it is transparent for all and, therefore, easier to monitor and manage than the current approach, be it holistic or based on multiple metrics. Another advantage is that it gives our universities time to increase or restore capital ratios in a less disruptive way.

How much capital is enough?

This, of course, is an important question, and it was asked in by the RBNZ when they revised their capital framework. Alas, there is no definitive answer. It depends. However, the graph below offers some guidance. It shows the capital adequacy of our universities over time, measured as the amount of equity over total assets. The ratios are trending up, and it looks like a minimum leverage ratio requirement of 75 percent (which is way higher than that of banks) is acceptable. Of course, the TEC can follow the example of the RBNZ and impose higher requirements. That is fine as long as the new requirements are clearly communicated and phased-in gradually, like in 7 years. Remember, bank regulation is all about (financial) stability. This should appeal to universities too.