David Chaston says regulation of bank capital levels is in a sorry state when commentators call for banks to grow their margins out of RBNZ OCR cuts

David Chaston says regulation of bank capital levels is in a sorry state when commentators call for banks to grow their margins out of RBNZ OCR cuts

By David Chaston

Everyone wants a strong and stable banking sector.

It is the Reserve Bank's role to regulate for financial stability.

However, we are now at a point where the definition of "strong and stable" is more to do with bank profitability than bank capital support. And the RBNZ has to take a fair bit of responsibility for that.

Banks currently argue that their 'high profits' are a necessary component of banking stability. They say a fall in profits will indicate weaker banks. Protecting those profits, especially as measured by the NIM (net interest margin) has unfortunately become a core goal, a core indicator of bank strength, of our banks' ability to withstand an economic setback.

But this is false reasoning.

Strong banks require a strong capital base more than large profits.

Under economic stress, it is the bank shareholders who should be supplying the resilience, not their customers. Under economic stress it will be the bank's customers who first show this stress; relying on them to supply the resilience is asking for trouble.

Shareholders in banks make their investment in the hope of profiting in the good times, but also in the knowledge that they will be the first to be required to back up their institution in the bad times. They are not suitable as shareholders if they don't sign up for this role.

Banks are special enterprises.

They are given a privileged position in the economic life of our economy. They are regulated separately.

And they are allowed to run the business on a highly leveraged way. (Ironically, the leverage in a bank is at levels that if a normal business presented their accounts to them on that basis, they wouldn't even contemplate lending them money. They would declare the business as 'too risky to bank'.)

Regulation is one way to contain the risk of high bank leverage. But regulation is failing us.

The banks have 'conspired' through their international influence to set up a system that allows them to run with very high leverage. And central bank regulators have gone along with this twist. And that includes the RBNZ.

The Bank of International Settlements set up a system of 'capital adequacy'. This is a system where each of the items in a bank balance sheet (on the 'asset' side) is assessed for risk, and a minimum level of capital is required for those risks. This is what 'tier 1' and 'tier 2' capital levels are all about.

But banks have gamed the system.

In fact, they have gamed it to such an extreme degree that now even regulators are worried.

It is an intricate process working out 'risk-adjusted capital' and just about everyone's eyes glaze over when you try to describe it. But the easiest way to understand it is to start with what happened before 2008.

Capital required is based on risk-adjusted levels, not the face value. Most 'cash' had a risk weighting of 5%. Most 'securities' had a risk weighting of about 20%. Most 'loans' had a risk weighting of 100%, except for residential mortgages which had a risk weighting of 50%.

The theory being that banks could liquidate these easily by selling the underlying home in a highly liquid real estate market. That is true in a normally functioning market, but not so true in time of stress.

However, banks were only required to keep half the capital they needed compared with a business loan. With a half-requirement, ROE (return on equity) was twice the level it was for business loans. It should be no surprise that this incentive turned ordinary trading banks into 'mortgage banks' (or even more like 'building societies').

In New Zealand ASB and Kiwibank are more like mortgage banks, and recently ANZ and Westpac have shown a drift to this definition. Even the BNZ, which I think has the best balance sheet of any local bank, has recently declared they 'want more mortgage market share' - which is code for a drive to become more like their rivals.

But in 2008, things changed. The BIS adopted new rules to allow banks to set their own 'risk weightings'. And the RBNZ went along with that. (There is irony here because these rules were adopted in the middle of the Global Financial Crisis when banks in general were under capital stress.)

Banks have taken on the new rules with gusto.

The have essentially self-regulated themselves to say they only need a 30% - or often much less - risk weighting for residential mortgages.

The effect has been to make their existing capital support fast growing mortgage loan books. The loans grew very much faster than the capital underpinning them. All this has happened over a relatively short time span.

Now, the regulator can't put things right easily because the capital demands on shareholders are huge.

And we are starting to see beggar-thy-neighbour pressures.

The Australian prudential regulator is worried about how out of hand things have become and pressing hard for their banks to shore up inadequate capital positions.

One way this is happening is that the four pillar Aussie banks are raiding their New Zealand subsidiaries for some of that capital requirement. Our regulator has been too slow, and stands by while this happens. Bank management in New Zealand fears the APRA rules much more than the RBNZ rules. Cash and capital is flowing faster across the ditch.

The banks claim that they need high profits is now self fulfilling.

They need it to pay off the APRA demands, and to hold their own capital levels in the state they are now.

But what should be happening is that our bank's shareholders should be required to stump up adequate (proper) capital.

Many years ago, (and before Basel III) I called for a simpler way to set adequate bank capital, one based on an overall leverage ratio. I have little influence and no one took any notice.

I think the minimum level should be set at 7 times. That is, for $100 of loans, bank shareholders should be required to back these up with $15 of capital.

Today, our least-leveraged big bank backs its loans up with just $8.20 of capital (BNZ), most other Aussie-owned banks with slightly less, and Kiwibank backs them up with only $5.65 (which is especially dangerous and only works because 'everyone believes' the taxpayer will come to the rescue).

But, realistically, no-one but me thinks we should adopt an overall leverage ratio. I made the proposal because I thought the pre 2008 50% risk weighting for mortgages was dangerous.

The best we could hope for now however is to return to that 50% risk weighting.

The implication on our banks will be huge however.

The problem has mushroomed enormously since we have let them have the ability to set ridiculously low risk weightings. They now have us over a barrel. They now say, if we go back to that 50% level they will need to just stop lending until profits build up the capital base again. But this should be completely unacceptable.

What should happen is that the shareholders should be required to recapitalise the bank to the necessary level. And a lot of capital is involved. If ANZ went back to a 50% minimum risk weighting for residential mortgages, they would need an additional $1.5 bln in capital. This is based on Note 12 in their latest accounts, here.

ANZ has $69.6 bln in residential mortgages risk-weighted to just $16.5 bln (23.8%). That allows them to hold just $1.3 bln in capital for those mortgages.

But going back to a 50% risk weighting, would mean they would have to have $2.782 bln of capital backing them up, an increase of $1.46 bln.

To put that into perspective, that would require almost all of their $1.65 bln in annual tax paid profit and certainly not allow any dividends to be paid back to Australia. (They paid their Aussie owners $1.745 in the prior financial year - and yes, that is more than their earnings).

Similar corrections will be needed at all the main banks. And that bill may total about $4 bln in additional capital and as much as 1.6% of NZ's GDP.

So you can see why our bankers insist they need these current high profits. But the requirement is entirely one of their own making.

And they need to be restrained from such risky settings.

A safer, stronger banking system would result if the shareholders played their role properly.

Bernard Hickey wouldn't need to call for banks to enhance their profits from an OCR cut.

And I could go back to calling for a simple leverage ratio of 7x with its requirement for even more capital (which everyone will still ignore).

We have a public policy imperative to get them back into line before their irresponsible capital rort hurts us severely. And we must do it now, "in the good times". Waiting for financial system stress to wake us up to the need will make it even harder.

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Well, that is telling it how it is - congratulations. Will RBNZ regulatory officers take notice and act, I guess not - too busy nursing their salaries to rock any boat?

Second that one!

Banks haven't just gamed the system until regulators are worried, they've gamed the system until the banks themselves are worried.

And their shareholders - ANZ

Well said David. A special bank tax would also seem to be in order, an excise duty at 1% of their loan book per annum would seem like a fair price for the privilege they enjoy. It would do wonders for our current account balance, not to mention making houses more affordable.

How?
Where do we see the elasticity to support the notion that the banks would ride the charge of the tax?

We have a public policy imperative to get them back into line before their irresponsible capital rort hurts us severely. And we must do it now, "in the good times". Waiting for financial system stress to wake us up to the need will make it even harder.

hah, amen to that. Great article. Some god damn honest truth!

Totally agree. Well done DC.

David Chaston is a national hero for crafting this piece.

Bravo my thoughts exactly !!!

Sounds like the regulators should be sacked for stupidity for allowing the banks to essentially self regulate and reduce their capital requirements after GFC. Seriously what were they thinking.

Did the banks pay Benard to write that article calling for higher profits for banks ?

Straight out of the Muppets' show! Good laugh!! Thanks.
Poor Bern...

Dare I say, that's an explicit caricature for financial stability. That fellow is going nowhere!

Easy to grandly declare that ‘shareholders should be required to stump up adequate (proper) capital’. They would by that stage have already taken a severe share price haircut on their investment and unlikely to volunteer for a second flogging.

In a country like NZ with only 4 main banks, they are already TBTF, whether they make enough profits or not and whether they have enough capital or not....

this was the rbnz goal. they pulled the carpet from under the finance company sector believing that it was easier to regulate and control the banks. the reality is that they are no different. Rather than providing some added competition, and spreading the risk, we now have a concentration of credit risk split between 4 TBTF banks.

This doesn’t appear to be rational behaviour considering the GFC crisis was caused by housing loans essentially so to allow banks to reduce their capital for this category seems mine boggling.

If anything this should have been strengthened post GFC not reduced.

These same banks are the banks that needed government guarantees at the time of GFC otherwise they would probably be out of business.

The sad part is that tax payers will end up bailing them out should their be another crisis and by reducing the capital required the amount of that bailout will only increase.

If you are the CEO and con them into $5 million a year salary, why would you be interested in your banks stability. Best thing is to maximise profit and cashflow to the shareholders - keep the suckers happy for now. If you can keep up the illusion for just a year that"s all you need. It doesn't matter if the bank goes bust, or they sack you, you are away laughing. Probably you will get away with it for five years. Magic.

House prices better not fall, aye.

Is there any suggestion that the same asset is being used as capital support on both sides of the ditch?

Thanks David. Your idea of a simple unweighted ratio makes eminent sense. As we found out in 2008 the risk weightings are all very fine while there are no problems, but when the proverbial hits the fan the effects manifest themselves everywhere at once. (sorry about the analogy) Hence all the the CDOs with their sub prime debts, amalgamated and attributed high security status through a similar risk weighting process went belly up. In a crash all the borrowers had problems simultaneously and did not behave in accordance with the risk weighting algorithms. I think that the fault in that case was that they seemed to be assuming that just because they had a whole bunch of risky bonds with say a 10% risk of default that the chances that they would all fail concurrently was very low. Therefore the combination of these bonds was attributed a much lower chance of failure. Well that just wasn't so and as I said above the crash affected everybody at the same time so the security of the whole population was probably no better than any one bond and because these CDOs were highly leveraged they failed totally. What I have suspected, and I think your article confirms is the bank capital structure is very similar. It is indeed extremely worrying. Interestingly I meet a chap a while ago who was working in Europe trying to implement the latest Basel accord in a large merchant bank. His comments were very similar and he could not believe how quickly they had forgotten the lessons of the GFC and the were scrambling for every loophole to get back to the same crazy behaviour.

Drawing risk weighting parallels between the CDO/non-recourse loan environment that contributed to the GFC and the NZ/AUS current context, is flawed. Our current down under world is a very different one to 2007. It’s preposterous to insist shareholders alone should shoulder the burden of shoring up bank balance sheets in the face of rising risk. Banks increasing their margin is a logical response. Insurers and other businesses do this (capital supply cost/competitive market pressures permitting) when they get their capital adequacy calculations wrong or are hit by a disaster but somehow banks are expected to behave differently. The collapse in bank shareholder support that would be the consequence of David Chaston’s ‘tap the shareholders’ proposal would deliver a more adverse long term consequence for bank customers than an incremental diversion of profits to achieve lower risk weightings.

The Australian regulators are doing just that to the Australian banks and in response the banks are de capitalising the New Zealand banks to fill the capital requirement. Why should we stand by and do nothing and allow the risk to NZ depositors increase as outlined in David's article to the benefit of Australian depositors. The Reserve Bank should enforce the capital margins more firmly which would mean that the banks would have to either get more capital from the shareholders and or increase the lending margins to generate the cash shortfall. The latter would not be a bad thing, as it would tend to depress both deposit interest rates and the currency while applying upward pressure on loan interest rates and tend to depress asset bubbles. Both stated objectives of the Reserve Bank. How could the banks complain as their profits would temporarily soar until the capital requirements are met and the asset value for the shareholders would increase, they might even be persuaded to tip in some money themselves.

Capital and profit stripping from NZ branches to over seas parents is common practice. 'Head office' service charges, manipulated cost of capital, elevated debt gearing of subsidiaries, all the usual suspects. Some techniques border on transfer pricing. We are whistling into the wind if we think that can be fixed by govt decree to banks. Enforcing more demanding bank capital adequacy ratios however could and should be done, given rising risks.

David's arguments echo those of Lord KIng,who as Mervyn King was Governor of the BOE from 2003-13. He has written an excellent book; "The End of Alchemy", Money,Banking and the Future of the Global Economy. He believes that as things stand,another crisis is inevitable and risk-weighting different classes of assets does not work He recommends replacing the lender of last resort with the Pawnbroker For All Seasons(PFAS). As he writes; "The aim of the PFAS is threefold. First, to ensure that all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the centralk bank. Second, to ensure that the provision of liquidity insurance is mandatory and paid for upfront.. Third, to design a system which in effect imposes a tax on the degree of alchemy in our financial system.

Something certainly needs to be changed. Not quite sure how though.
It seems to me that the banking/economic systems as it is currently structured requires endless and ever increasing debt. They rely on permanent positive inflation which is totally conflicts with increasing productivity and improving technology and the price reductions that result. This is leading to increasing wealth disparity, over easy credit, asset bubbles and increasing economic instability.
The OBR system that the government has implemented is a shocking construct that undermines depositors confidence in the banking system and puts the consequences of failure in the wrong place. At the very least the ownership of the bank should rest in the hands of the depositors if the bank fails, because leaving it in the hands of politicians makes the process open to all sorts of abuses as we have seen in the past.

Time they settle on a new name for 'Banking' in this Century.

If they could have a simple single ratio for weighing all risks, then why do we need those grandiose economists and analysts at all Banks and Central Banks..The current regime is a self-perpetuating one, to the detriment of the general public. But to the advantage of the One Percent...Go figure.

Great, knowledgable article David, well done. Is there a way to get more traction with your views to the government ?

Risk weights are fine if the bottom rate is 100% and then you move up from that point. i.e. Cash is 100%, mortgages are 150% Personal loans are 200% for illustrative purposes. This will ensure that weightings do not dilute the absolute capital, but we also then need a capital ratio, say 15%.

Echo the words on the quality of this opinion piece, well done David. Excellent report. You could have added the little tit bit about those profits including all depositors funds.