Gareth Vaughan argues Westpac's capital stuff-up demonstrates why the combination of a hands-off bank regulator and the internal models approach to regulatory capital requirements is a bad one

Gareth Vaughan argues Westpac's capital stuff-up demonstrates why the combination of a hands-off bank regulator and the internal models approach to regulatory capital requirements is a bad one
There should be red faces at both the RBNZ & Westpac NZ.

By Gareth Vaughan

News last week that the Reserve Bank has given Westpac 18 months to get its capital in order after using a series of unapproved capital models, demonstrates a hands-off prudential regulator allowing banks to use the internal models approach to capital is a bad combination.

Here we have one of the country's big four banks using unapproved capital models since it was accredited as an internal models bank nine years ago. Additionally Westpac failed to put in place the systems and controls an internal models bank is required to have under its conditions of banking registration.

In the world of banking prudential regulation this is serious stuff. There should be faces matching their brand colour at Westpac. And faces should be just as red at the Reserve Bank. That's even though - according to Westpac - the Reserve Bank has acknowledged Westpac's capital has remained above required regulatory minimums. 

So what's Westpac's punishment for this indiscretion? The bank has 18 months to satisfy its regulator that it has cleaned up its act or it risks losing accreditation to operate as an internal models bank.

The use of the internal models approach allows ANZ, ASB, BNZ and Westpac to develop their own models to quantify their required capital for credit risk and then get these approved by the Reserve Bank. All other NZ banks use what's known as the standardised approach where the Reserve Bank prescribes their credit risk measurements. The upshot of this is banks using the internal models approach can hold less capital than they would be required to do under the standardised approach, and stretch their capital further boosting profitability. 

Until it gets its house in order Westpac has to maintain a total capital ratio above 15.1% versus the standard requirement for other banks of 10.5%. Under the Reserve Bank Act there was potential for a fine of up to $2 million. However, Westpac isn't being fined.

Earlier this year the International Monetary Fund (IMF), in its first Financial Sector Assessment Program report on New Zealand since 2004, gave a useful helicopter view of NZ regulation. In terms of the Reserve Bank, this very much painted a picture of a bank regulator that's hands-off having adopted an idiosyncratic and dogmatic light handed regulatory approach. One point made by the IMF is that the Reserve Bank does not undertake inspections or on-site visits of NZ banks.

"Overall, the lack of first-hand independent verification of prudential returns and assessment of banks’ risk management practices prevents the RBNZ from having a thorough understanding of the banks," the IMF said.

Three things offer an opportunity for change.

Firstly, the Reserve Bank is currently undertaking its broadest ever review of bank capital adequacy requirements. Secondly, the new government is reviewing the Reserve Bank Act. And thirdly, a new as yet unnamed Governor is due to take the reins at the central bank in March.

The capital review offers the opportunity to ditch the internal models approach currently used by the big four banks. As I argued last week one reason for doing so is to level the capital playing field with the rest of NZ's banks. Another reason is to avoid the potential for more scenarios like this Westpac situation. And then there's bolstering the confidence of bank depositors given NZ is an OECD outlier in not having deposit insurance.

The Reserve Bank Act review and appointment of a new Governor offer the opportunity for the Reserve Bank to become more proactive in its regulatory oversight of this country's banks. Heck, Reserve Bank staff could even make a few on-site visits.

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This appears to be a good example of wanting to have the authority without taking any responsibility. Oversees the insurance industry in similar manner.


The problem is far, far worse than that. We have a problem of gross capital misallocation towards housing. I think the hidden defect is the smoke and mirrors of all the models and the weightings they give to different types of lending. So, as I understand it, the banks only have to put 25% "weighting" on mortgage loans, but 100% on business loans. This means they can lend at least four times as much for household borrowing as for business lending for a given amount of reserves. Surely this is a massive and deceptive sleight of hand?

This wouldn't matter so much if the excess capital didn't jack up the price of housing in this country to 2 or three times what it would otherwise cost. The pushing up of the price of existing housing stock is a classic sign of excess capital misallocated to low productivity assets.

The RBNZ are a fine bunch of chaps but the result of their weakness in identifying the effects of their deranged ideas is rather shocking to me. Yes, yes, I know, they are only doing what other bankers are doing, but the whole of academia in the US and elsewhere seems in thrall to the banking sector.

Productive businesses are the base upon which society is built. Banking is a great technology when it supports the development of productive businesses, and that should be our focus. The house price saga is a clear sign that this is not the case.

The RBNZ operates under the delusional idea that the market is inherently self-regulating, and believe that regulation is a distortion of the free market, that regulation is only necessary because of externalities and imperfections. They simply do not see that issues you mention create endogeneous instability, and so see instability as only caused by external shocks.
Their paradigm is chock full of deranged ideas..

I met a modelling economist who used to work for Treasury but had to quit due to worsening schizophrenia. He described himself as a "laissez-faire economist". I just about got a concussion from the face palm. I honestly think they screen for this mindset when they are hiring, it's a vestige of the neoliberal mindset from the '80's. Our governing bodies need to wake up to the world around them, the experiment has played out and failed.

Why the face palm?

Either you don't understand what a modelling economist does, or you have some righteous belief that professional economists aren't allowed a different (let's face it, probably better informed) economic ideology to yourself..

Thanks Gareth, you did a fine job of filling in the details there. The point I was trying to make is that monetary policy and the function of the RBNZ is a mess. On the surface all seems well, but capital misallocation is rampant and the RBNZ do not seem to be facing up to the real issues but burying themselves in the operational details instead.

They have created a banker friendly system that steadily weakens the country. Rampant house price inflation coupled with a current account deficit is what you get when monetary policy is disfunctional. We are setting ourselves up for a re-run of the 1970s where "inflation appears from nowhere" but no-one saw it coming.

And under whose administration was this application implemented? George Frazis, who is now in line to run CBA in Australia; a bank already suffering from past misdemeanours. But, hey. You use the rules offered to you, right? Not a good look CBA, not a good look....

(PS: Herald 2016 - "George Frazis brought what the New Zealand Herald described as a "colourful and free-spending style" to main street banking during his time at the top....In 2010, Frazis stunned staff by whipping his shirt off at the end of a Christmas party.....The party was reportedly so wild that it was closed down by noise control officers.....he was surprised by accounts he had heard of "unusual excesses" that seemed "very 1980s"." Cool, Geroge, really cool.....Real CEO of a Big 4 type stuff...)

NZ is "the" training ground for training Australian Bank CEO's. Here's where they learn how to fiddle the system, ignore the Central Banker, pay big-bucks to the NZBA and get the PM on their speed-dial

Ralph Norris, Ian Narev, George Frazis

And all CBA! To be fair, NAB seems to have done ok with 'our' offspring Clyne and Thorburn


the worst part is the OBR and the reserve banks contention that those that deposit with banks are investors and should be well aware of the risks of investing in such vehicles.
i dont know how many conversations i have had with people who have no idea what the OBR is
and who class their money as savings not investments and
who think banks and their deposits are save.

I suggest that if OBR were ever activated it would have unintended consequences. It could trigger further runs and send capital offshore to safer Government guaranteed banks. I have seen posts whereas its assumed because of the Canterbury Finance bailout then there would be more! Spreading cash amongst several banks is probably safer in an effort to reduce any impact of haircuts under OBR. Banks overreliance on property as a basis of security will prove to be all folly in retrospect.


The purpose of a central bank is to provide lending of last resort to the country's banks, but the RBNZ has developed the OBR which has the purpose of directing all losses to hapless depositors. It has regulated itself out of its primary purpose.

Hardly savings given the one sided means of fabrication and subsequent dilution of value.

What banks do is to simply reclassify their accounts payable items arising from the act of lending as ‘customer deposits’, and the general public, when receiving payment in the form of a transfer of bank deposits, believes that a form of money had been paid into the bank.

No balance is drawn down to make a payment to the borrower.

The bank does not actually make any money available to the borrower: No transfer of funds from anywhere to the customer or indeed the customer’s account takes place. There is no equal reduction in the balance of another account to defray the borrower. Instead, the bank simply re-classified its liabilities, changing the ‘accounts payable’ obligation arising from the bank loan contract to another liability category called ‘customer deposits’.

While the borrower is given the impression that the bank had transferred money from its capital, reserves or other accounts to the borrower’s account (as indeed major theories of banking, the financial intermediation and fractional reserve theories, erroneously claim), in reality this is not the case. Neither the bank nor the customer deposited any money, nor were any funds from anywhere outside the bank utilised to make the deposit in the borrower’s account. Indeed, there was no depositing of any funds.

The bank’s liability is simply re-named a ‘bank deposit’.

Banks create money when they grant a loan: they invent a fictitious customer deposit, which the central bank and all users of our monetary system, consider to be ‘money’, indistinguishable from ‘real’ deposits not newly invented by the banks. Thus banks do not just grant credit, they create credit, and simultaneously they create money. [emphasis added] Read more

The BoE went to the trouble of explaining this in a very good article:

Money creation from lending for the purchase of existing assets is not necessarily bad, but to avoid instability there has to be a significant level of saving to support the lending, i.e. the lending must not be much more than 50% of the asset value (e.g. equivalent to an LVR limit of 50%). Beyond that the money creation becomes a problem, providing windfalls to the sellers of those existing assets, downgrading the value of money, and leading to significant social issues as we continue to see.

NZ's major banks are TBTF. They don't need to keep aside any capital at all. They got the economy by its throat. They have to be rescued, if anything goes wrong. History is on their side.

Westpac stuffed up ? Really ? I would be convinced if the so called stuff up had been more expensive to them and led them to hold more capital than they really needed to. But that's not what happened. They 'accidently' did something to their advantage.