New Zealand’s Commerce Commission plea for lower bank capital to bolster bank competition – what could possibly go wrong?

On 21 March, the New Zealand Commerce Commission published a study of the domestic personal banking services market. For those who are unfamiliar with the Commerce Commission, it is New Zealand’s leading agency for promoting competition, ensuring fair trade, and protecting consumer rights, dedicated to keeping markets fair and informed.

The study finds that the New Zealand retail banking market is not as competitive as many of us would like it to be. The Commerce Commission attributes the lack of competition to a two-tier system, where the four Big Australian banks (ANZ, ASB, BNZ, Westpac) do not face strong competition and the smaller banks hardy pose a threat. The study documents that the Big 4 are highly profitable compared to other New Zealand banks and foreign banks. I have written about this before.

The Commerce Commission’s draft proposals are set to shake up New Zealand’s banking landscape. At their core, the recommendations aim to level the playing field for smaller banks and Kiwibank, making capital more accessible and turning them into formidable competitors. They are pushing for a rapid rollout of open banking, cutting through red tape to spark innovation and ease fintech’s entry into the market. On the regulatory front, there is a call for a more competition-focused approach, ensuring decisions bolster rather than hinder market dynamics. Lastly, the study is championing consumer empowerment – making it easier for Kiwis to switch banks and access essential banking services. It is a bold step towards a more competitive, inclusive, and innovative banking sector.

The Commerce Commission should be commended for this study, it is comprehensive, thought-provoking even. It should lead to changes that improve the experience of retail banking customers. And rightly so, New Zealand’s banks do not treat their customers very well. A simple example: Ours is one of the two OECD countries without real-time payments.

The lure of déjà vu capital requirements

On bank capital, however, the study offers some concerning recommendations. For example, the Commerce Commission proposes to recapitalise mid-sized Kiwibank so that it can compete more fiercely. Kiwibank is a state-owned bank that was only recently bailed out by the government because the owners wanted to run from it. At the time, the finance minister expected Kiwibank to become a disrupter. However, since the bailout, the bank has underperformed and relied on an accounting trick to prevent its CET1 ratio from becoming the lowest of all New Zealand’s banks. It is now second lowest, after having lost capital since 2018, while other banks managed to increase their capital ratios because of RBNZ’s new capital regime.

Adding billions of bank capital will likely create moral-hazard problems. Kiwibank’s management, pressured by expectations of turning the bank into a genuine disrupter, could engage in excessive risk-taking, thus gambling with the bank in the knowledge the government will support the bank. This is not the type of disruption we need.

Another concern is the lack of knowledge of capital requirements. The study makes some sweeping statements on that topic: “Bank prudential capital requirements in particular have limited competition by constraining entry and expansion.”, “Capital requirements reduce the level of retained earnings available to banks to fund growth and have had the unintended effect of constraining the growth of smaller banks relative to the major banks during a period of strong demand for lending.” and “Capital requirements are a key constraint on competition, particularly for smaller banks“.

Statements like these are generally voiced by bankers, while there is overwhelming empirical evidence to the contrary. See this well-cited study by top banking academics Allen Berger and Christa Bouwman, which documents that “capital helps small banks to increase their probability of survival and market share at all times (during banking crises, market crises, and normal times).” [Emphasis added, see a free copy via this link.]

From a financial stability point of view, the purpose of capital is loss absorption, which the Commerce Commission mentions. But then again, the primacy of loss absorption seems to be poorly understood. The theme of the study’s chapter on capital is that it is a hindrance more than a help, especially for smaller banks. This is straight from the songbook of bank lobbyists, despite reams of empirical studies demonstrating the virtues of capital and a year after the fall of nonsystemically important, mid-sized, Silicon Valley Bank.

It is tempting to empathize with smaller banks and apply regulation more proportional: stringent rules for big bank and looser rules for smaller banks. However, prudential regulators do not fully embrace proportionality; see for example this speech from Fernando Restoy, Chairman of the Financial Stability Institute: “… the political argument is based on the assumption that large institutions are less able or willing than smaller banks to offer credit and other services to retail customers or small businesses in local communities. However, to my knowledge, there is no compelling evidence that access to credit in concentrated banking systems (like those of France, Canada or the Netherlands) is generally more cumbersome than in countries with a more diversified banking industry (such as that of Germany).

Regarding competition, Restoy expresses concerns that small banks hinder innovation and competition, a viewpoint starkly contrasting with the Commerce Commission: “Yet, there is always a risk that the principle of proportionality could be misused to give a significant regulatory advantage to small institutions. As we have seen, this may not only be unwarranted from a prudential point of view but could also distort competition and prevent a necessary restructuring of the industry. Arguably, the latter effect may become particularly relevant when technological innovation is likely to disrupt the market …”

Tinkering with risk weights

The Commerce Commission study reinforces the widely held belief that the four Australian-owned banks enjoy an unfair advantage due to the system of risk weights. The Big 4 use the Internal Ratings-Based (IRB) approach to calculate risk weights, whereas other banks rely on the one-size-fits-all Standardised Approach (SA). The IRB approach allows banks to use internal models to match risk weights against their loan books, theoretically optimising risk management and capital use to … promote competition. However, the reputation of the IRB approach suffered after the global financial crisis, leading regulators to tighten qualifications for its use and limit its scope with so called ‘floors.’ This may be seen as regulatory overreach, especially in light of nuanced studies on internal models, such as this report by the European Banking Authority. But here we are.

Today, the use of the IRB approach is tightly regulated, complete with safeguarding floors. Against this background, it is concerning to see the Commerce Commission proposing to make it easier to acquire IRB accreditation.

Due to the use of floors, the differences between the risk weights under the IRB and the SA approach have now decreased significantly. So much so that the Australian prudential regulator, APRA, in a recent studyestimates that the average pricing differential for housing lending due to differences in IRB and standardised capital requirements is 5 basis points“. That is negligible: Five basis points is 5 percent of one percent, which is clearly less than the current rate of inflation and the interest rate rises that mortgage holders face due to poorly managed inflation.

Unfortunately, the Commerce Commission uses an awkward method to quantify the differences between IRB and SA. In Table 7.1, the study shows the impact of the SA and the IRB approach on the amount of capital required for a one million dollar home loan, for banks before the RBNZ capital review. Using historical data on risk weighs assigned to SA and IRB portfolios (37%, respectively 28%) and a Common Equity Tier 1 requirement of 7%, the study shows that banks should hold $25,900 of CET1 capital using the SA approach, and $19,600 under the IRB approach, a difference of $6,300, which is 63 basispoints of the loan.

Table 7.2 then shows the current situation, featuring the 85% RBNZ floor. Using the post-capital review CET1 requirement of 11.5%, the study shows that banks should hold $42,550 of CET1 capital using SA, and $36,167.50 under the IRB approach with floor, a difference of $6,382.50. This is 64 basis points of the loan. The study then concludes that the floor has not changed a lot: namely 1 basis point (64 – 63 basis points, or $82.50 on a one million dollar loan).

There are some odd choices with the calculations in Tables 7.1 and 7.2. For example, they use CET1 requirements, but more relevant is the Total Capital Ratio requirement, which is 16% for non-systemically important banks (Non-D-SIBs) and 18% for systemically important banks (D-SIBs). See the table below.

Furthermore, the RBNZ also applies an IRB scalar, which multpies the value of IRB loans by a factor of 1.2. The applicable risk weight then is the higher of credit risk RWA calculated under the IRB approach (incorporating the IRB scalar, 31.7% in the study), and credit risk RWA under SA multiplied by the floor of 85%, which is 31.45 (85% of 37%). See these percentages in the lower panel of the table above.

Following the logic of the study and the fully implemented RBNZ capital rules, the applicable IRB percentage is therefore 31.7%: the higher of 31.45% and 31.7%. Using the Total Capital Ratio requirements, total capital required is one million dollars times 5.92% for SA banks (16% x 37%) and 5.71% for IRB banks (18% x 31.7%). The difference is $2,140 ($59,200 – $57,060), or 0.214%. This is 21.4 basis points (A in the table). That difference is significantly smaller than the 64 basis points shown in the study ($6,382.50). In other words, the combination of floor and scalar with the 16 and 18 percent Total Capital ratio requirements for small respectively large banks, leads to a smaller difference in capital requirements for SA and IRB banks. The post-GFC strenghened governance around the use of the IRB approach seems to work! (Note that these numbers are all estimations using data oberved by the Commerce Commision, and the calculations are likely different in reality using the applicable Basel II and Basel III formulae and modifications thereof, see for example the APRA study Demystifying credit risk capital requirements for housing loans.)

The purpose of bank capital

Lastly, the study makes some brave statements about the purpose of capital requirements: “it ensures that the owners of a bank have a meaningful stake in the business. The more its owners are exposed to bank losses, the more carefully they will manage the bank;”

Again, this statement deserves more nuance. As pointed out by Ross Levine in his comments on the RBNZ capital review, the role of capital in bank governance depends, for example, on the way banks executive are compensated: “Focusing more on incentives might also enhance the analyses of the comparative impact of the proposed capital regulations on the IRB and standardized banks. For example, to the extent the IRB banks are run primarily by executives who have a large part of their compensation in the form of options-type bonuses linked to ROE, this implies that (a) risk-taking incentives are especially strong, (b) capital regulations are unlikely to reduce, and might even increases risk-taking, suggesting that the capital cushions must be especially large. Moreover, under this example, complementing capital regulatory reforms with reforms of executive compensation schemes would be especially beneficial.


In all, given the importance the Commerce Commission gives to the availability of capital, it is concerning to see the study pushing an agenda that is reminiscent of the interests of bank-advocacy groups. With the fall of mid-sized Silicon Valley Bank fresh in our minds, it is worrying to see the Commerce Commission proposing solutions that may negatively affect financial stability.

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