By Martien Lubberink*
The current prudential regulation renders the New Zealand financial system vulnerable to the impact of significant shocks.
The Reserve Bank of New Zealand relies on self-discipline and market discipline. Compared to other supervisors, the New Zealand Reserve Bank takes a rudimentary, almost Spartanic approach to bank supervision. Pillar 1 dominates, there is no Pillar 2 to speak of.
Because of a fear of moral hazard, supervision was not meant to be intrusive. There is no deposit insurance system. Thus far, this has had no adverse impact on the financial system. I guess we have been lucky. However, the current approach to supervision is out of date and unsustainable in its current form.
In some way, New Zealand banking can be compared to cycling in the Netherlands. Since the 1970’s the Netherlands has created a very safe cycling infrastructure. As a result, cycling in Holland has been very safe. If you have visited Amsterdam, you must have noticed that there is hardly any traffic enforcement. Dutch cycling also relies on self-discipline and on monitoring (other cyclists, cars, pedestrians).
However, this system is now starting to show cracks. The number of bicycle casualties is on the rise, for two reasons. First is the ageing population: vision loss and hearing loss do affect older adults, impairing their ability to monitor traffic. Second is technological advancements: battery-powered bicycles have become increasingly popular. Combined, these two factors make cycling in the Netherlands today more lethal than driving cars, which was never the case.
The New Zealand approach to prudential supervision, shaped by a reliance on self-discipline and market discipline, has become an anachronism. The GFC demonstrated the limits of market discipline and depositor monitoring. The post-GFC era shows the limits of self-discipline: poor conduct is a growing problem. In light of these developments, the RBNZ approach to prudential supervision increasingly reflects a set it and forget it attitude. Like cycling in the Netherlands, the New Zealand financial system, once deemed very safe (see Calomiris and Haber (2014)*, has become vulnerable.
Breaches of capital requirements will become visible quickly. The prize-winning Financial Strength Dashboard allows the New Zealand public to identify weak banks and act accordingly. Prompted by social media, retail investors fearing the Open Bank Resolution haircut will move money abroad, to well-managed and resilient European, Far East, or North American banks. Money that was deemed to be sticky in the past has become hot.
Meanwhile, new risks are emerging. They affect the resilience of the New Zealand financial system. Operational risk has become much more important: examples are cyber security risk, the risks associated with money laundering, and other conduct risk, such as Libor related scandals, as well as scandals that led to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. A recent article in the Financial Times showed that banks’ risks managers are most concerned about cyber security risk, and that the attention for operational risk had increased by seven percentage points over the last year. Quoting Paul Sharma: “There is definitely more of a focus on conduct rather than capital.”
No simple solutions in banking
Andrew Haldane some years ago championed the virtues of the Leverage Ratio. He claimed that the Leverage Ratio would be a ‘simple ratio’, thus rendering it superior to the risk-based ratio. However, Haldane failed to acknowledge the era of accounting scandals. About 10 years before his speech, companies like Enron and WorldCom demonstrated that the simplicity of accounting is deceptive. Enron kept information off-balance sheet, which rendered the reported values of assets and leverage unreliable.
In other words, the idea that there exists a simple measure of solvency is misleading. The same applies to the different ways of calculating Risk Weighted Assets. Metrobank, the UK contender bank, which lost a whopping 75% of its market value because it did not get banking regulations right, demonstrates that the Standardised Approach is not a panacea for small banks that are encouraged to compete against established rivals. Likewise, the idea of a “wall of equity” suffers from the same problem.
Deutsche Bank in February 2016 demonstrated that investors will get very nervous once a bank approaches a breach of its capital requirements. It is not obvious that requirements of 4%, 8%, or 18% will calm investors once they anticipate a breach.
The Nordic banks have recently demonstrated that high levels of capital will not prevent a bank from getting into trouble. Dankse Bank, plagued by money laundering problems that wiped out half of its market value, may have suffered from a supervisor who applied a set it and forget it approach.
Lastly, regarding the writing down or writing off of CoCo capital, the RBNZ prefers a high trigger. However, the idea that a high CoCo trigger will contribute to financial stability may suffer from the same keep it simple, set it and forget it mindset.
The 4th Capital Review Paper: more of the same
Against this backdrop of an increasingly vulnerable banking system, emerging risks, supervisory complacency, and the longing for the simple world of yesteryear, the RBNZ presents a proposal that can be best characterised as more of the same.
Briefly summarised the main elements of the 4th Capital Review Paper are:
Tier 1 capital requirements at 15% of Risk Weighted Assets (RWAs),
a 1% surcharge for systemically important banks,
a structure of regulatory capital where Common Equity Tier 1 (CET1) dominates,
a more prominent role for a conservation buffer, which comprises solely of CET1,
a significantly diminished role for non-equity capital,
a more prominent role of the Standardised approach of calculating risk weights, and
a significantly diminished role for the Internal Ratings Based approach of calculating risk weights.
More: Total capital ratios for New Zealand banks will be 17% overall, and 18% for systemically important banks, up from 10.5%. The main capital component driving this increase is the conservation buffer, which adds 5% to the current buffer of 2.5%. The D-SIB (Domestic Systemically Important Bank) and Countercyclical Buffer contribute 2.5% to the increase in capital.
The same: As under the current rules, these are all Pillar 1 requirements, meant to cover credit risk, market risk, and operational risk.
However, the RBNZ proposal fails to acknowledge the vulnerabilities of the current system: i) better-informed and more savvy retail investors and depositors; ii) the growing importance of operational risks, iii) the complexities of banking and the naive belief in simple solutions. Instead of acknowledging operational risk and liquidity risk, the Reserve Bank focuses on a risk that is largely under control: credit risk.
More of the same is hardly an improvement, it leaves the current financial system vulnerable to the impact of significant shocks. The governance of own funds regulation at the Reserve Bank is such that a next official may dial the ratio requirements down to levels that are comparable to other countries. I doubt if such a move will contribute to safety and stability, hence my submission.
My comments [submission on the RBNZ capital proposals] therefore will focus on the structure of capital. The RBNZ should let go of the idea of the “wall of equity” and accept layers instead. Layers in the form of, for example, contingent convertible capital. But also “layered” degrees of capital disclosures, thus following the example of Europe’s Pillar 2 framework, which is now split into two parts, of which the “guidance” part allows the supervisor to do its job: supervise. This instead of the current approach which seems to be inspired by Madame de Pompadour’s famous adage: Après nous, le déluge.
* Calomiris, C. W. and S. H. Haber (2014). Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. 41 William Street Princeton, New Jersey 08540 USA: Princeton University Press.
*Martien Lubberink is an Associate Professor at the School of Accounting and Commercial Law at Victoria University. He previously worked for the central bank of the Netherlands where he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide including Europe (Basel III and CRD IV respectively).