Murray Jackson previews the RBNZ review of banks’ regulatory capital requirements, arguing NZ banks should hold capital equivalent to 19% of their total assets

By Murray Jackson* 

The Reserve Bank of New Zealand is set to commence a process seeking stakeholders’ views on three broad areas of capital adequacy in banks:

● what sort of capital instruments should qualify as capital;
● how risk exposures of assets should be measured;
● and minimum capital ratios and buffers. 

The Reserve Bank says in its announcement of the process that:: “Higher levels of capital would improve the soundness of the financial system by reducing the likelihood of bank failures. However, the capital regime could reduce the efficiency of financial intermediation if ratios are pushed too high or standards are made overly complex. An appropriate capital regime will ensure a very high level of confidence in the solvency of the banking system, while avoiding unnecessary inefficiencies.” 

As a layman’s contribution to the discussion, I provide some perspectives that might be of interest when reading the Reserve Bank’s forthcoming discussion paper. The review comes at a critical time; New Zealand is now at a point where household claims to private debt to household income ratio now exceeds 160%. That this level is high is confirmed by the IMF. Unfortunately recent performance is far worse than this ratio implies, the ratio of incremental household claims to incremental household income over the last five year has been over 250%. 

With current alarming debt-to-income trends it is apparent that credit is being created for transactions that do not contribute to New Zealand’s GDP. International experience can tell us if New Zealand allows its credit creation performance to deteriorate further it will not be sustainable. Surely it would be better to curtail the excess credit growth now than having curtailment imposed on New Zealand through crisis and stagnation. In the context of the high private debt levels and consequent risk to financial stability, the IMF has advised New Zealand to aim for “ adequacy ratios for New Zealand’s large banks that are somewhat higher than the Australian Prudential Regulation Authority’s (APRA’s) “unquestionably strong” capital targets for the large Australian banks.”

Process objectives

Bank equity capital has several important roles. However, in the Reserve Bank’s announcement in March, it seems the bank is focused on only one: the funding of a bank that is available as a buffer to absorb financial losses that a bank may suffer. 

There is another role that is not addressed by the Reserve Bank, and that is how the amount of capital acts to regulate the rate of return to bank equity. The rate of return to equity matters because the level of return directly affects the rate of credit growth that the bank can support. In New Zealand, with bank equity capital at around 13% of total assets, the banks have enjoyed rates of return to their equity of around 18% before tax. This high rate of return allows the banks to fund credit growth at more than 8% per annum while still at the same time allowing dividend returns greater than any deposit they offer to their customers. A perspective on the magnitude of the excess returns is indicated by the price-to-book ratio of listed banks (being the market capitalisation divided by balance sheet equity): a ratio of 1.5 would suggest that the rate of return to equity of banks is about 50% higher than the cost of capital (e.g. see Fig. 3.11 here and below). 

It is widely viewed that rapid credit expansion is the most significant predictor of future instability and economic loss. This is because it is not only the quantity of credit created by banks that is important for the economy and for financial sector stability. It is also important that credit creation is preferentially directed or incentivised to improving or increasing productivity and economic efficiency. A prolonged disparity between credit creation and income is a sure sign that much investment in New Zealand has been unproductive. 

It would be unfortunate if the Reserve Bank did not look at how the level of bank capital is a key regulator of such excess credit growth relative to income. The Reserve Bank is seeking to achieve “a very high level of confidence” in the solvency of New Zealand’s banks. We might note that APRA has recently set the goal that capital ratios of Australian deposit-takers should be ‘unquestionably strong’. Both regulators are looking to make such judgments in the context of the Basel framework and by comparison to international practice. 

It seems that APRA is taking into account the particular circumstances of Australia in making such a comparison. For example, the high degree of lending to housing, and the elevated prices of houses to incomes. We might hope that the Reserve Bank is doing the same in New Zealand. 

In particular, it would seem appropriate comparisons should also take into account the Reserve Bank’s unique position in respect to deposit insurance: “New Zealand does not have a deposit insurance scheme and the Reserve Bank does not favour compulsory deposit insurance; it is difficult to price and can blunt incentives for both financial institutions and depositors to monitor and manage risks properly. Nor is there any policyholder protection scheme for insurance firm customers. The combination of a credible non-zero failure regime and the realistic prospect of creditors incurring a financial loss in a failure should give them ample incentives to monitor the profitability and risk-taking behaviour of the institutions in which they invest.” 

In the context of such a position, and for creditors to do their part in respect of monitoring individual bank risks, the Reserve Bank must do its part in respect of ensuring system integrity: - to design the regulated capital requirements such that they are not only adequate as a buffer to each individual bank, but also that the capital requirements should be at a sufficient level to not create financial instability and inefficiency for the New Zealand economy. Surely this dual consideration is appropriate in the circumstance where the ordinary creditors of banks in New Zealand have no deposit insurance?

Basel - 'spurious sophistication?' 

The specification of adequate regulatory rules in regard to capital requirements for banks is Pillar I of the Reserve Bank’s three pillar foundation for its regulation of banks. Pillar II relates to reliance on risk management by self governance by the banks, and Pillar III seeks to achieve market discipline through disclosure; 

For Pillar III to be effective then the design of Pillar I must be simple and transparent. Unfortunately that is not the case. Under Pillar I, the current approach to formulating capital requirements based on Basel III is neither simple nor transparent. This might be acceptable if the foundations of the approach to risk management was clearly robust, but that is not all apparent either whether one looks at the base assumptions or actual performance of the approach during the GFC.

As Andrew Haldane of the Bank of England opines in his article Capital Discipline (2011), the output of capital calculations under Pillar I are “no longer easily verifiable or transparent. They are as much an article of faith as fact, as much art as science. This weakens both Pillars II and III. For what the market cannot observe, it is unlikely to be able to exercise discipline over. And what the regulator cannot verify, it is unlikely to be able to exercise supervision over.“ He reminds us of Hayek’s caution regarding the “pretence in the minds of risk managers and regulators” as to their understanding the dynamics of complex systems. He warns that policy predicated on such pretence risks catastrophic error. 

Even the Reserve Bank has acknowledged in relation to Pillar I : “Critics of the Basel framework maintain that ever-increasing risk granularity has led to a spurious sense of sophistication and that the pendulum should swing back to simpler, more objective measures of risk”.

Contrasting with the “spurious sophistication” of the Basel approach we should be aware that there are simpler approaches that could be adopted. For example:

● Admati has advocated that equity requirements be set at 30 percent of total assets with a conservation buffer between 20 and 30 percent (see “The Missed Opportunity and Challenge of Capital Regulation”, Anat R. Admati)
● Under the Swiss proposals, their large domestic banks may be required to hold capital equivalent to around 19% of assets. 

The Reserve Bank seems to be suggesting that Basel III will continue to be at the centre of its capital adequacy considerations, but in the New Zealand context, should Basel III be given a primary role?

'Efficiency of financial intermediation' 

The Reserve Bank has stated in its March note that of its primary concerns is the “efficiency of financial intermediation”. One might reasonably assume that “intermediation” as concept is meaningful in the New Zealand context, and that the efficiency of it can be readily measured so as to be optimised. Unfortunately neither might be the case for the reasons set out in a Bank of England paper. Intermediation, to the extent the concept involves the "matching" of lenders with savings to borrowers would seem to give an erroneous impression of how banks actually operate. 

Generally, when a deposit is transferred to a bank it is simply the transfer of a liability between banks. Deposits are simply the accounting record of the bank’s liabilities arising from previous money creation, and because they are liabilities; it is obvious that deposits cannot be lent out. As summarised by the Bank of England in 2014: "Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits"

The choice of analysis framework for banking is a critical one. If New Zealand fails to adopt an appropriate analysis framework, will it also fail to provide adequate measures to prevent inefficiency, instability, and financial crises?

Calculation of the optimal level of Tier 1 Capital 

The Reserve Bank said in its March note that: “Capital is a more expensive form of funding for the banks and so higher capital ratios can potentially increase the overall cost of funding the system as well as improving its soundness.” 

The inference may be taken that the Reserve Bank seems to be setting up an assessment that will be similar to the assessment it carried out in in 2012. (see: Regulatory impact assessment of Basel III capital requirements). At the core of its approach at that time the Reserve Bank showed how it arrived at its assessed optimum by balancing the following factors:

“The key benefit of higher capital ratios is the reduced probability that there will be a financial crisis. We have also taken into account that higher capital ratios will increase the New Zealand Inland Revenue share of foreign banks global tax payments and reduce expected government payments to foreigners in a bank bailout scenario.”
“On the cost side, we have allowed for the possibility that bank lending rates may increase in the short-term as banks seek to maintain their return on capital. However we have assumed this effect will be temporary (i.e. it will reduce to zero after 10 years). “ 

The Reserve Bank outlined how its model: “....calculates the benefits of higher capital by estimating the expected fall in the probability of a financial crisis from an increase in capital held by the banking system. This number is then multiplied by an estimate of the cost of a crisis to generate the expected benefit to the economy.“ There are multiple points of interest in this approach, the main ones being:

1) The apparent assumption that financial crises are assumed to occur on some Gaussian-like probability frequency, thus excluding “fat tail” events that seem to be more typical of financial crises;

2) The assumptions that crises are external events occurring at random but predictable frequencies, and that the frequency of such events is not related to the capital ratios themselves. These assumptions seem to be in contrast to the experience of the GFC where highly leveraged banks showed their capacity to induce system crises by themselves;  

3) The assumption that, as the share of a bank’s assets financed by capital rises, there is only limited and delayed reduction of the banks’ required rate of return arising from the reduction in risk due to the reduction in leverage. (Contrary to the Miller Modigliani theorem (MM theorem)). 

While each of these points is of interest and significant, the most remarkable assumption is the third. It is clear that in order to believe that an optimal capital ratio exists at all, the MM theorem must be assumed to be invalid to some extent or else there would be no cost or inefficiency in requiring higher capital ratios. From contemporaneous publications, the Reserve Bank indicates that the reason for departure from the MM theorem is “information asymmetry” stating that: “without informational asymmetries between a bank and its shareholders it would probably not be necessary to have a Basel type regulation in the first place, as high capital ratios would not be that costly”. 

It is odd that the apparent reason given for the Reserve Bank to assume the MM theorem is of limited validity is “information asymmetry” given that the information asymmetry exists in favour of the banks which are the beneficiaries of this assumption. It is striking that the Reserve Bank arrived at the conclusion in 2012 that the optimal result for New Zealand was that its banks (which are predominantly overseas owned) could continue to enjoy an extraordinarily high rate of return on capital for the reason they had market power, to the cost of its domestic creditors in terms of higher risks of bank failure. 

Perhaps New Zealand needs to find a market mechanism whereby the banks and its creditors are incentivised to arrive at optimal level of capital without the Reserve Bank having to make dubious assumptions and calculations in seeking to determine such an optimum?

A way forward? 

It is clearly going to be difficult for the Reserve Bank to identify optimal capital requirements that would be satisfactory to all stakeholders. On the one hand, New Zealand needs simple and transparent rules for establishing capital requirements that can quickly assure the average everyday bank depositor that the risk of financial loss bank through bank failure is low risk. On the other hand, the Reserve Bank wants creditors of the banks, under Pillar III, to play their part in monitoring the risk profile and performance of banks and influencing their behaviour (through the prices they demand for supplying funds). 

These two somewhat conflicting requirements can be resolved by first observing that New Zealand already has various classes of credit that can contribute to bank funding between the owners of bank equity and the ordinary bank creditor or depositor. An example is subordinated debt that operates as Tier 2 capital and has some of the attributes of equity (Tier 1) capital in that it can absorb losses ahead of an ordinary depositor in the circumstance of bank failure. The holder of subordinated debt can be assumed to be a sophisticated investor who is equipped to negotiate a fair rate of return for the risks to which he is exposed. So a solution may be to set up a situation where the subordinated bond creditors and equity holders are both incentivised via the financial markets to negotiate the optimal level of bank equity (see also Herring “The Capital Conundrum”). 

To do this, and to be in accord with the suggestion by the IMF that the capital requirements standard for New Zealand banks should be “somewhat higher” than “exceptionally strong”, perhaps the Reserve Bank should be considering adopting minimum capital requirements of at least 19% of total assets (Tier 1 plus Tier 2). (Note that the reference here is to total assets rather than risk-weighted assets because current risk weightings simply cannot be taken seriously, particularly in relation to housing. e.g. see here). 

Setting minimum Tier 1 plus Tier 2 capital at 19% of assets would constrain the ability of banks to continue funding excessive credit growth relative to income that has put New Zealand’s financial stability at risk. Within that constraint, the banks and their Tier 2 creditors can then each choose what proportion of each category of capital is optimal for them. To the extent that they choose to leverage with subordinated debt as Tier Two capital, it will change the dynamics of money creation: because banks will need to obtain such debt by borrowing on commercial terms on the financial market, as opposed to creating it by lending as they do at present.

*Murray Jackson is a commercial advisor working in Wellington in the oil and gas industry.

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"New Zealand private debt to household income ratio now exceeds 160%..... recent performance is far worse than this ratio implies, the ratio of incremental household claims to incremental household income over the last five year has been over 250%."
Nothing to worry about here. Just cut interest rates a tad more, and that will solve all our problems!

And this incremental ratio seems to be understated!
On the basis of RBNZ file C21 - Key household balance statistics
from 2011 until 2016 increase in household disposable income = $22.35B, and the increase in household financial liabilities was $65.40B
A ratio of 292%

The only reason the regulations were complicated was to suit the large investment banks who claim to understand risk. This is, of course, inaccurate as most or all banks around the world are unable to carry out risk analysis. They do not have the expertise or competence. Further to that the regulators lack the capability to assess the risk models so the process is a complete farce.

The simple idea is that banks must have a certain percentage of capital. In New Zealand it's supposed to be 8% (very roughly for residential mortgages) but the current figure is actually 2.26%. This means a small financial hiccup could be leveraged into a financial collapse. There's no reason for us to take on this risk expressly for the purpose of leveraging bank profits.

The capital requirements should be moved at least to 20% or even 30%. This takes away most of the real risk of having to bail out greedy banks. Who suffers with higher capital requirements? Only the banks, and if they don't like it they can turn in their banking license and become a finance company. The banking license is a privilege to print money not to farm the citizens for private profits and socialised risk.

Don't understand risk????

But if they drive their company into bankruptcy the tax payer will bail them out. Brilliant risk management in my book.

The Depositor will bail them out, and pay bonuses more than likely.

All pretty good, but is anybody listening out there??