Geof Mortlock argues the RBNZ’s proposals to increase bank capital are poorly thought through and unsupported by analysis

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The RBNZ as the Tāne Mahuta of NZ’s financial system.

By Geof Mortlock*

In December, the Reserve Bank released a consultation paper (Capital Review Paper 4: How much capital is enough?), in which it has proposed a major increase in the capital requirements for banks in New Zealand.  The proposed increase in capital ratios for banks puts the Reserve Bank’s proposals well out of line with international norms.

While there is certainly a need to consider the question of what the appropriate minimum capital ratio requirement should be for banks, the Reserve Bank’s consultation paper falls well short of the quality of analysis that is needed to answer this question. 

Despite its length (59 pages), the paper contains little substantive argumentation to support the very high capital ratios proposed.  It also contains very little cost/benefit analysis.  For a central bank that is portrayed by its CEO as a ‘god’ of the ‘financial forest’ (tane mahuta), the quality of analysis is simply not good enough – and certainly falls well short of the mark expected of such a deity.

What has the Reserve Bank proposed?

Before assessing the Reserve Bank’s capital proposals for banks, let’s recap what they have proposed.  In brief, the Reserve Bank proposes to:

  • set a tier 1 capital requirement (consisting of a minimum requirement of 6% and prudential capital buffer of 9-10%) equal to 16% of risk-weighted assets (RWA) for banks deemed systemically important (the so-called ‘D-SIBs’), and 15% for all other banks; and
  • limit the extent to which capital requirements differ between the Internal Ratings Based (IRB) approach and the Standardised approach, by re-calibrating the IRB approach and applying a floor linked to the Standardised outcomes, raising the average RWA for the four IRB-accredited banks to approximately 90% of what would be calculated under the Standardised approach.

The Reserve Bank’s proposal represents a very substantial increase in bank capital requirements relative to current requirements.  Currently, banks are required to have a total capital ratio of at least 10.5% of RWA (of which 6% must be in the form of tier 1 capital (essentially issued shares plus retained earnings), 2% in tier 2 capital (such as perpetual or term subordinated debt) and 2.5% as a capital conservation buffer.  Under the Reserve Bank’s proposals, the large banks (D-SIBs) will have to meet a prudential capital buffer of 10% of RWA in the form of tier 1 capital, lifting their minimum common equity capital ratio to 14.5% and total tier 1 capital ratio to at least 16% of RWA.  Smaller banks will have their tier 1 capital ratios hiked to at least 15%.

How does this compare internationally?

These are extremely high tier 1 capital ratios by international standards.  The international norm is for tier 1 capital to be no more than around half of these figures, with some countries then imposing additional capital requirements in the form of additional loss-absorbing capital (often in the form of fixed term or perpetual debt instruments that convert to equity upon a defined non-viability trigger).  The Reserve Bank’s proposed capital ratios are considerably higher than those recently proposed by the Australian Prudential Regulation Authority (APRA), which would raise the common equity tier 1 ratio for the four major banks in Australia to a minimum of 10.5% of RWA.  APRA has proposed no increase in capital for the smaller banks in Australia unless resolution planning reveals a need to do so.

The Reserve Bank’s proposal to limit the gap between average risk weights under the IRB framework (which applies currently to the four major banks) and the average risk weight under the standardised framework (which applies to all other banks) is arbitrary and is also penal by reference to some international norms.  It will increase the average RWA calculation of IRB banks to 90% of the outcome under the standardised approach, which is considerably higher than the 72.5% RWA floor finalised by the Basel Committee (the international standard-setter for banking supervision) in December 2017.  This will have the effect of further increasing the capital burden on the four IRB accredited banks.

Is the capital increase justified?

The main justification given by the Reserve Bank for increasing the capital ratio requirements for banks is to minimise the damage to the economy and financial system that could result from a bank failure by reducing the probability of bank failure.  They have indicated a desire to achieve a probability of bank failure equivalent to around 1 in 200 years.

It is certainly appropriate to be seeking to ensure that banks maintain capital ratios that enable them to survive severe economic and financial shocks, such that bank failures are rare events.  That is especially important for the systemically important banks (the D-SIBs), given that their failure could have a major impact on the financial system and economy, and would doubtless involve a substantial amount of resolution funding from the taxpayer if the Australian parent banks were not able or willing to provide the capital funding needed. 

However, what is missing in the Reserve Bank’s analysis is any in-depth assessment of the magnitude of shock needed to cause the major banks to fail.  The Reserve Bank’s own stress tests indicate that banks come nowhere near to the point of failure under very severe stress scenarios.  That being the case, why is a major increase in capital needed? 

If they think that the stress tests they have applied are not severe enough, then why do they not recalibrate the tests to even more severe impacts (e.g. through higher and longer contractions in GDP, steeper falls in asset prices and higher and more sustained increases in the rate of unemployment)?  Indeed, one would think that, in order to develop capital proposals of the nature contemplated, the Reserve Bank would have undertaken ‘reverse stress tests’.  These are used by some foreign supervisory authorities to assess the level of economic and financial shock needed to generate a bank failure.  They provide helpful information in assessing how large the economic and financial shock would need to be to cause one or more of the big banks to fail. 

It would then be possible to assess the probability of such a magnitude of shock actually occurring.  Yet there is no substantive analysis of this in the Reserve Bank’s discussion paper.  They appear to have done no reverse stress testing at all.  Nor, it seems, has the Reserve Bank asked the banks to undertake reverse stress tests.

All the Reserve Bank do in their paper is draw on international literature that provides high-level (and frankly quite challengeable) data on the level of probability of bank failure associated with given levels of bank capital ratios.  That is interesting information.  But it tells us little about the magnitude of shock needed in the New Zealand economy to generate bank failures at current levels of capital or the probability of such a severe magnitude of shock occurring. 

Moreover, because the data they refer to covers a span of time that includes pre-GFC periods, it does not adequately take into account the strengthening of bank risk management frameworks and governance arrangements that have been part of the post-GFC regulatory environment.  These developments would arguably reduce the probability of bank failure for any given capital ratio.

Another deficiency in the Reserve Bank’s analysis is their failure to adequately differentiate between the systemic and economic consequences of a large bank failure from a small bank failure.  The failure of a D-SIB (e.g. any of the four largest banks in New Zealand) would have a much greater impact on the economy and financial system (depending on how it is resolved) than would the failure of a small or medium-sized bank. 

Yet the Reserve Bank largely ignores this in its capital proposals.  It is suggesting that small banks should hold almost as much capital as the D-SIBs, despite the reality that their failure would cause barely a ripple to the financial system (in terms of contagion risk) or economy (in terms of impact on credit channels and adverse wealth effects).  In contrast, most other supervisory authorities draw a major distinction between the impacts of D-SIB failure and the impact of small bank failure, and they logically impose considerably lower capital ratio requirements on small banks than on large ones.

A further failing in the Reserve Bank’s analysis is that they take no account at all of the means by which bank failure resolution planning can reduce the economic and financial impact of bank failure and reduce the amount of taxpayer funding that might be needed as part of the resolution process. 

Other countries – including Australia and the United Kingdom – have explicitly taken this into account.  They have concluded that, with effective bank resolution planning (something the Reserve Bank has largely ignored to date, aside from its ill-conceived Open Bank Resolution policy), small to medium-sized banks that fail can be resolved without the need for high levels of capitalisation.  This can be achieved through various techniques, such as ‘purchase and assumption’, merger and bridge bank solutions.  That is why most jurisdictions do not impose capital ratios at as high a level on small banks as they do on the systemic banks.  Yet the Reserve Bank has completely ignored this reality.  It is largely silent on resolution options and the linkage to capital requirement calibration.

The Reserve Bank also ignores the role that deposit insurance plays in a bank failure.  Deposit insurance insulates small depositors from loss and provides them with prompt access to their insured deposits.  This markedly reduces the adverse impacts of small bank failure.  Yet the Reserve Bank paper is silent on the matter.  That is probably not surprising given their (largely irrational) opposition to deposit insurance. 

However, if a sensibly structured and funded deposit insurance scheme were established in New Zealand – which it should be – then this would significantly reduce the adverse impact of small to medium-sized bank failures.  All else equal, it would provide an argument for lower capital ratios for small banks than for larger banks, subject of course to bank levies being calibrated on the basis of their risk profile.

Another failure in the Reserve Bank’s analysis is the importance of bank risk appetite settings, risk management and governance arrangements in influencing the probability of failure.  They ignore it completely.  Instead, the Reserve Bank places 100% emphasis on the role of capital in minimising the probability of bank failure.  In reality, many factors come into play in influencing a bank’s probability of failure, including capital, liquidity, credit exposure concentration, funding concentration, quality of lending, risk appetite, quality of risk management systems and controls, and governance arrangements. 

That is why a professional supervisory authority, such as APRA or Canada’s OSFI, put such emphasis on comprehensive requirements for governance and risk management frameworks, risk appetite settings and the like.  It is also why these supervisory authorities invest the time, resource and expertise in on-site bank assessments, benchmarking analysis between banks, and comprehensive preventive and corrective action frameworks. 

In contrast, the Reserve Bank still keeps its head in the sand on these matters.  It is content to be a ‘light touch’ ‘reluctant regulator’ on all of these matters that so heavily influence the probability of bank failure.  And yet they now seem to be the ‘rogue and reckless regulator’ when it comes to seeking to put all of the financial system soundness eggs in the capital basket and to increase tier 1 capital ratios to levels unseen in most countries.  Where is the balance in this?  It seems that the Reserve Bank is happy to impose a very large tax on banks (and bank customers) in order to continue to enable it to continue to be the reluctant regulator and supervisor it is in respect of the details of bank risk assessment.

A further piece of the jigsaw puzzle missing in the Reserve Bank’s paper is the absence of any discussion of bank recovery planning.  Internationally, most OECD supervisory authorities have, since around 2010/11, required banks to develop, maintain and regularly test recovery plans.  These are comprehensive plans that set out the means by which banks would restore themselves to financial soundness in the face of a capital or liquidity shock.  They are an essential element in the risk management framework of any bank.  All else equal, the more comprehensive and reliable is a bank’s recovery capacity, the lower is the risk of bank failure. 

Yet, unlike other supervisors, the Reserve Bank has done nothing to require banks to establish, maintain and test comprehensive recovery plans and to link them to their risk management frameworks.  All their focus has been on ‘separation plans’ to enable a New Zealand subsidiary of an Australian parent bank to be separated from the parent bank in a failure situation, which merely reflects the continuing irrational paranoia the Reserve Bank has about the Australian authorities in a bank failure scenario. 

If comprehensive recovery planning requirements were introduced for all banks in New Zealand, that would achieve at least two things.  It would shed light on each bank’s capability of restoring themselves to financial soundness from an impaired capital position (and hence the amount of capital needed).  And it would strengthen their recovery capability and thereby lower the probability of failure (without necessarily increasing capital ratios).

The Reserve Bank’s paper is also very light in its justification for requiring IRB banks to have an average risk weight of not less than 90% of the average risk weight under the Standardised model.  This is a significant proposal and one that could impose significant capital costs on the D-SIBs with flow-on effects to borrowers and depositors alike.  It is perfectly reasonably for the Reserve Bank to rigorously assess the analysis underpinning banks’ IRB calculations of risk.  The Bank should be doing this as part of its supervisory approach.  However, imposing an arbitrary floor on IRB risk weights is a costly and inefficient approach to achieving the goal of ensuring that IRB outcomes reflect risk accurately.  Much more analysis is needed by the Reserve Bank on this matter, especially if they are proposing a risk weight floor that is more conservative (penal in impact) than in other comparable countries.

Finally, the Reserve Bank’s paper is incredibly light on cost/benefit analysis.  It notes in a sentence or two that higher capital ratios might lead to higher interest rates and reduced credit availability, but dismisses this as insignificant.  Yet there is no quantification of these impacts.  They should undertake a substantive cost/benefit assessment of the effect of higher capital ratios on lending rates and deposit rates, on bank risk appetite and on the likely effect on credit availability.  This is essential if we are to meaningfully assess the impact of the proposals on the economy and bank customers.

Likewise, there is no mention of the impact of the capital proposals on the contestability of the banking system – i.e. whether introducing one of the highest capital ratio requirements in the world would make it less attractive for new entrants (domestic or foreign) to enter the banking system, with reduced competitiveness and efficiency for the financial system and economy.  And there is next to no analysis of the impact on competitive neutrality in the proposals – i.e. whether this would impose competitive burdens on small banks relative to large banks (given that the failure of a small bank is systemically insignificant) or the competitive non-neutrality vis a vis non-bank deposit-takers.  Given that efficiency of the financial system is one of the implied objectives of the Reserve Bank, one could reasonably expect much more comprehensive analysis of the financial system efficiency issues that arise from the proposals.

All in all, the Reserve Bank’s proposals are poorly thought through and unsupported by analysis.  The Reserve Bank needs to fundamentally reassess what is being proposed and provide much stronger argumentation and facts to support it, backed by a comprehensive cost/benefit assessment.  Treasury needs to step up here too.  They need to independently review what the Reserve Bank is proposing, either themselves or by commissioning a report from an independent expert. 

New Zealanders can reasonably expect a lot more from its banking regulator, in terms of quality of analysis, than it is getting.

(You can see interest.co.nz’s three part series on the Reserve Bank capital proposals here, here and here).


*Geof Mortlock, of Mortlock Consultants Limited, is an international financial consultant who undertakes extensive assignments for the International Monetary Fund, World Bank and other organisations globally, dealing with a wide range of financial sector policy issues. He formerly worked at senior levels in the Australian Prudential Regulation Authority and Reserve Bank of New Zealand.

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