By Gareth Vaughan
Cast your mind back to events in global financial markets during 2008. The news was dominated by tales of woe involving US sub-prime mortgages, falling share markets, collateralised debt obligations, worthless AAA credit ratings, a global credit crunch, failing financial institutions and taxpayer funded bailouts in events that became known as the Global Financial Crisis (GFC).
Thus 2008 appears to have been a particularly bad year for bank capital rules to have been liberalised. But that is exactly what happened in New Zealand. Although to be fair to the Reserve Bank, which approved this liberalisation, the timing was the result of a long running international process.
From 2008 the Reserve Bank accredited NZ's big four banks - ANZ, ASB, BNZ and Westpac to use what's known as the internal models approach under the Basel II bank capital adequacy regime. These international bank capital rules were imported via the Basel Committee on Banking Supervision, a Swiss-based group established by the central bank governors of the Group of Ten countries in 1974.
What this 2008 move means is NZ's four Australian owned banks, which today control 88% of NZ banking system assets, are allowed to set their own models for measuring credit risk exposure which they must then get approved by the Reserve Bank. In contrast all other local retail banks, including Kiwibank and TSB, use what's known as the standardised approach where the banks have their credit risk exposure prescribed by the Reserve Bank.
A key result of this is the Aussie owned banks are able to hold less capital, notably against the key lending area of housing loans than their NZ owned counterparts, thus boosting their profitability. But more on that later.
Although the Basel Committee doesn't have formal supervisory authority, it has encouraged convergence towards common supervisory approaches and standards for bank regulation. In 1998 it developed the Basel Capital Accord, or Basel I, to align the capital adequacy requirements applicable to internationally active banks. Prior to this there had been no uniform international regulatory standard for setting bank capital requirements. Subsequently Basel I was updated with the Basel II framework released in 2004, and Basel III in late 2010 in response to the GFC, which left the internal models approach intact.
Why capital matters
Coming with Basel II, the internal models approach was a move away from a one-size-fits-all approach to global bank capital rules. But before delving into the internal models approach, let's remind ourselves why bank capital matters.
As then-Deputy Governor and Head of Financial Stability Grant Spencer put it when kicking off the Reserve Bank's biggest ever review of bank capital requirements in March 2017, which is ongoing, bank capital is an important cushion for the financial system.
"It is the form of funding that stands first in line to absorb any losses that banks may incur. Having sufficient capital promotes financial stability by reducing the likelihood of bank insolvency and moderating the effect of credit cycles," Spencer said.
Bank capital includes ordinary shares, retained earnings, capital instruments issued by a bank that are continuous given there's no fixed maturity date such as preferred shares, and long-dated subordinated debt, such as bonds, issued by a bank.
Previewing the then-imminent release of the Reserve Bank's December consultation paper on bank capital, in late November 2018 Reserve Bank Governor Adrian Orr made some strong comments on bank capital at the central bank's bi-annual Financial Stability Report press conference.
"Bank capital ratios have declined continuously in the last 30 plus years even though bank crises have been as frequent as they ever have," Orr said.
"Bank capital is the number one safety valve for citizens of a country because that allows us to absorb losses before it becomes taxpayers' losses and/or future generations' losses. People forget losses are not just borne by the current taxpayer, but by the lost output now and for many years to come. And this is the framework we're bringing together to talk about bank capital," Orr added. "We will be expecting [banks to hold] more capital and ... good quality capital."
Orr didn't specifically mention bank depositors. At last count households had $175.311 billion deposited with banks and this is also protected by bank capital.
It's important to remember that banking crises have happened right here in NZ. Most recently BNZ needed to be recapitalised twice, in 1989 and again in 1990. After a $648 million annual loss, the 87% government owned BNZ was bailed out by a recapitalisation worth $610 million that diluted the government's shareholding to 52%.
This first recapitalisation involved a government underwritten rights issue of new shares worth $405 million, where the government gave up its rights to the new shares to Fay Richwhite's Capital Markets Equity Ltd. The recapitalisation also involved the issue of preference shares worth $205 million to Japanese investors. The government also provided bridging finance of $200 million.
Then, in 1990 after BNZ's $124 million profit turned out to be overstated due to creative accounting, BNZ was recapitalised with $200 million of taxpayers' money and $50 million from Capital Markets Equity. Current owner National Australia Bank bought BNZ in 1992.
More recently, at the onset of the GFC, NZ banks received taxpayer sponsored bolstering via the Crown retail deposit guarantee scheme, and the Crown wholesale funding guarantee scheme covering overseas bank borrowing, in which taxpayer liability peaked at $10.7 billion in November 2009. The wholesale scheme was used by ANZ, BNZ, Westpac and Kiwibank. Across the Tasman Aussie banks benefited from the same GFC backstops.
'Basing their minimum capital requirements on their own economic-capital models and systems'
Now back to the internal models approach.
As a Reserve Bank Bulletin article from 2005 put it; "Over the past decade banks have invested heavily in economic capital models and systems that can better help them identify, measure and manage the key risks that they face. The capability of modelling techniques has improved to the point that banks use them increasingly to determine internal capital targets, feed in to pricing strategies, assess risks, determine economic value added, and contribute to executive remuneration...Banks that apply the Internal Ratings Based [internal models] approaches will base their minimum capital requirements on their own economic-capital models and systems."
Regulators like the Reserve Bank view the internal models approach as being about balancing the incentives on banks to try and minimise capital against the outcomes of allowing banks to model their own capital, which has been seen as increasing the sensitivity of capital requirements to key bank risks.
In a 2009 article the Reserve Bank noted the NZ banks accredited to use internal models are all Australian owned, with parents accredited to use internal models by the Australian Prudential Regulation Authority. The NZ banks generally base their internal models on those used by their parents, the Reserve Bank added.
How capital requirements work
Let's now look at how capital requirements work in practice. Here we need to introduce the concept of risk-weighted assets. These are used to work out the minimum amount of regulatory capital a bank must hold. The capital requirement is based on a risk assessment for each type of bank asset.
Here's an example. A housing loan valued at $1,000 with a risk weight of 30% means risk weighted assets are worth $300. The capital requirement is then determined by multiplying risk-weighted assets by 8%. For our example this gives a minimum capital requirement of $24 for that $1,000 mortgage.
Based on the most recent Reserve Bank figures, housing lending comprises $257.484 billion, or 57%, of NZ financial institutions' lending. Thus it's the key area of bank lending exposure. And as the Reserve Bank chart below shows, housing's share of overall lending has grown over the past 20 years.
Parts II and III
In part two of this series we'll look at what allowing the big four banks to use the internal models approach means in practice, specifically in terms of the capital held against their hundreds of billions of dollars worth of housing loan exposure, and how and why this gives ANZ, ASB, BNZ and Westpac an advantage over their NZ owned rivals. We'll also look at how the Reserve Bank is proposing to change this.
Then in part three we'll look at how the owners of NZ's big four banks have fared over the past decade, and how the Reserve Bank's proposal to increase bank capital requirements could impact this, and what it may mean for bank customers. We'll also look at a couple of other key aspects of the Reserve Bank's proposed changes to bank capital requirements.
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