Social impacts of banking crises a relevant consideration for bank capital policy, RBNZ background paper on proposals to increase bank capital requirements says

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By Gareth Vaughan

The Reserve Bank’s proposals for increased bank capital requirements include consideration of the social impacts of banking crises, a paper released by the Reserve Bank says.

“While the Reserve Bank’s explicit mandate does not make reference to societal well-being, the social impacts of crises are a relevant consideration for society and society’s attitudes towards the risk of harm from crises that we seek to represent in our capital policy. The idea that economic policies, and by association, financial regulations, should be set after considering outcomes in the broadest sense is not novel,” the Reserve Bank says.

This comment comes in a Reserve Bank capital review background paper entitled An outline of the analysis supporting the risk appetite framework. Released on Wednesday, the paper is authored by Susan Guthrie, a Reserve Bank adviser on financial system policy and analysis. Guthrie was also co-author, alongside Gareth Morgan, of the book The Big Kahuna: Turning Tax and Welfare on Its Head in New Zealand.

Guthrie’s highlighting of well-being issues comes after Reserve Bank Deputy Governor and General Manager for Financial Stability Geoff Bascand used “well-being” eight times, including in the title, in a February speech on the capital proposals. Finance Minister Grant Robertson is due to unveil the Government’s first well-being budget on May 30.

The Reserve Bank’s capital proposals make the explicit assumption that New Zealand is not prepared to tolerate a system-wide banking crisis more than once every 200 years, although Guthrie notes the absence of a systemic banking crisis in NZ’s modern history. (There’s a Reserve Bank paper on NZ banking failures here). She says a decision was made to define the policy goal as the banking system having sufficient capital to retain the confidence of the market when faced with losses as large as, but not larger than, losses that might arise once every 200 years.

“We don’t have evidence about New Zealanders’ tolerance for banking crises, and we hope that as a result of the consultative process we might become better informed. However for the purposes of arriving at a capital proposal we needed a starting assumption, and that became 1/200,” Guthrie writes.

She says failure probability rates are common in similar regulatory frameworks.

“For example, internationally, some insurance regulators administer solvency standards that specify a probability of ‘ruin’ that is not greater than 1/200 years. In New Zealand, non-life insurers are subject to a solvency requirement of 1/1000 years in relation to earthquake risks and 1/250 for other non-life catastrophes.” 

“In the US in 2017, analysts at the Federal Deposit Insurance Corporation used a risk tolerance of 1/500 years in their modelling work related to setting the reserve ratio for the US deposit insurance fund. A risk tolerance is also embedded in the capital equation specified in the Basel III standards and used by banks permitted to model their risk weights. A ‘confidence level’ of 99.9% is specified, this translates to a risk tolerance of 1/1000 years,” says Guthrie. 

How tolerant should the Reserve Bank be to the risk of a banking crisis?

Says Guthrie; “There are thus a range of risk tolerances evident in financial sector regulation around the world and in New Zealand. The risk tolerances used in other areas of financial regulation provided context for the decision to adopt 1/200 when setting minimum bank capital requirements.”

“More fundamentally, though, in order to set a risk tolerance for policy purposes it was necessary to consider the adverse economic and social impacts of banking crises. Acting as an agent for society, how tolerant should the Reserve Bank be of the risk of a banking crisis, given the available evidence about the impacts of such a crisis?” Asks Guthrie.

She goes on to acknowledge the Reserve Bank’s mandate does not explicitly make reference to societal well-being. Nonetheless she argues the social impacts of crises are a relevant consideration for society, and for the Reserve Bank to consider in its bank capital policy.

“It is essential that Governments take into account the likely social implications of their economic policies. It has been shown, time and again, that economic policies considered in isolation from their social outcomes can have dire consequences for poverty, employment, nutrition, health and education, which in turn, adversely affect long-term sustainable development,” the paper says sourcing this to the United Nations.

“There is a large literature about the economic and social impacts of deep and prolonged recessions, such as are likely to arise in the event of a banking crises. A common theme in the literature is the harm to mental and physical health, family cohesion and community connectedness caused by the economic stress induced by a severe downturn – through unemployment, falling incomes, reduced savings and/or declining asset values. There is evidence of these impacts in both developed and developing countries although local circumstances can act to mitigate the effects.”

Again sourcing the UN, she says that whilst systemic data’s not available, there’s growing evidence that a crisis has significant impacts on individuals, families and communities in terms of wellness, cohesion and conflict. This can include increases to rates of mental illness, substance abuse and suicide.

‘Enduring effects on society as a whole’

Guthrie argues evidence should be considered in detail, providing insight into why the likes of the World Health Organisation, the World Bank and the United Nations see the societal impacts of financial crises as being long-lived.  

“The break-up of families, ill-health, reduced spending on healthcare and nutrition and societal unrest can all be expected to have enduring effects on society as a whole.”

Below is detail from Guthrie’s paper on these perceived impacts.

Impacts on physical health:
 Public health impacts from prolonged recessions – such as increased mortality due to heart disease and illnesses such as liver cirrhosis related to increased alcoholism – have been long documented.

“Adverse health effects are mostly found among the “lower socio-economic classes” without economic security. The lack of economic security is often stressful: social and family structures break down and habits harmful to health are adopted. These effects may be manifested in a psychopathological event, such as suicide, or, after a time lag of a few years, in chronic diseases.” 

Impacts on mental health:
 “A recent study of 26 countries in the European Union found that for every one percent increase in unemployment, the suicide rate for people under 65 years of age went up by 0.8 percent.” 

 “During the Asian crisis, overall poverty rose from 11 percent to 18 percent in Indonesia, and urban poverty doubled to 18 percent in Korea. Previous studies also point to increased inequality associated with financial crises in a panel of advanced and emerging market countries during 1988-2010, with the impact rising along with severity of recessions. Research also shows that the average rise in income inequality during recessions tends to be larger than the fall during booms, suggesting that the poor tend to get a bigger share of the pain than the prosperity.” 

 “Economic crises also coincide with a deterioration in social cohesion. During the Great Depression in 1929-32, for example, there was a 40 percent increase in suicide rates and a 10 percent increase in deaths from all causes in the United States. Similarly, there was a 39 percent increase in suicide rates among males in Japan during the Asian crisis, a 44 percent increase in Hong Kong SAR, China, and a 45 percent rise in Korea and Thailand.” 

Impacts on family cohesion:
 “Economic stress is a major source of family tension and a leading cause of family breakups. A study of housing prices and marital dissolution in the United Kingdom in the period 1991 to 2004 found that a 10 percent fall in housing prices was associated with an additional 5 percent of couples breaking up.” 

 “Although data are scarce, some countries have seen an increase in cases of domestic violence linked to the crisis. For instance, a survey of 630 domestic violence shelters in the United States reported a 75 percent increase in the number of requests for services since the onset of the crisis…The survey also found that abuse had become more severe…”

Impacts on the wellbeing of children and youth:
 “Recent reports by UNICEF, for example, point to a significant deterioration in child well-being in a number of advanced countries, based on measures of material well-being, health and safety, education, behaviours and risks, and housing and environment….Similarly, the UN composite Human Development Index, computed as a function of measures of life expectancy at birth, access to knowledge, and a decent standard of living, declined between 2007 and 2012 for a number of middle and high income countries in the Middle East and Europe as well as for small island states.” 

 “The youth have been particularly hit hard by the crisis….The jump in the youth unemployment rate has been most pronounced in advanced economies, rising from 12.5 percent in 2007 to an estimated average of 17.9 percent in 2012. The rate has reached alarming levels in the peripheral Euro Area countries, to 59 percent in Greece and 56 percent in Spain, compared with an average rate for the Euro Area at 24 percent in mid-2013 and 7.5 percent in Germany.” 

Impacts on community connectedness:
 “We study the implications of the Great Recession for voting for anti-establishment parties, as well as for general trust and political attitudes, using regional data across Europe… We compare the regions that greatly suffered from the crisis with those that weathered the crisis relatively well – controlling or pan-European and country-specific time trends… We show that the differential [regional] impact of the crisis explains the rise of anti-establishment, often populist, parties, and also the respective drop in trust towards political parties and the European Union….” 

 “The World Health Organisation has recently highlighted the negative psychological effects of financial crises as well as the increase in crime that these typically bring.” 

Impact on vulnerable people.
“While everyone is vulnerable to their adverse consequences, financial crises hurt disproportionately the poor, as with natural disasters, contagious diseases, or climate change, given that the poor have limited capacity and instruments to insulate themselves from the shock and recover from the impact of the crisis….In any given country, crises hit particularly hard the most vulnerable – the young, the old, women and the ill. A severe financial crisis can morph into a social crisis if it is poorly handled…” 

Guthrie says the Reserve Bank believes such impacts as those detailed above are likely to lead to society being relatively intolerant of banking crises.

“However, one aim of the consultation is to generate a public conversation, and prompt feedback, about this important issue,” she writes.

She says the 1/200 assumption was “accepted as being a reasonable approximation, in the absence of any information to the contrary,” as to what society might consider an appropriate risk tolerance.

Full cost-benefit assessment for a Regulatory Impact Statement to come

Meanwhile, Guthrie notes her paper isn’t intended to provide a cost-benefit assessment of the capital proposals. Instead she says the Reserve Bank will carry out a full cost-benefit assessment for a Regulatory Impact Statement. Nonetheless she says the concepts discussed in her paper will be an important component of that cost-benefit assessment.

“The full assessment will also consider any submissions received during the consultation period, as well as looking at alternative scenarios to look at risks around estimates of costs and benefits.”

Additionally she notes other impacts of bank capital such as impacts on tax revenues.

“Where a tax regime treats interest payments by banks as a tax deductible expense, as New Zealand’s does, the more a bank substitutes debt funding for capital funding, the less tax it pays, all else equal. While an increased tax payment would be an expense to the bank, from a societal perspective it is simply a transfer and not a cost. The only cost of capital from a societal perspective is the output impact of higher lending rates,” writes Guthrie.

What the RBNZ is proposing

NZ banks must currently meet a minimum total capital ratio of 10.5% of their risk weighted assets (RWA). The Reserve Bank is proposing to increase this to 18% for banks identified as ‘systemically important’, ANZ, ASB, BNZ and Westpac, and 17% for all other banks. 

“After adopting a risk tolerance of 1/200, weighing up the available evidence and considering soundness and efficiency, the decision was made to propose an increase in minimum Tier 1 capital requirements such that the minimum requirement would exceed current Tier 1 system-wide capital by $20 billion. The final proposal was expressed as capital relative to RWA, not unweighted assets, and reflected proposed changes to the calculation of RWA by the large four banks,” says Guthrie.

“The final proposal equates to capital equal to 9.3% of unweighted assets, measured as total exposure at default or ‘EAD’. Assuming banks hold a voluntary buffer of 0.5% of EAD means the proposal will deliver capital equal to 9.8% of unweighted assets.”

The deadline for submissions on the Reserve Bank proposals is Friday, May 3. The Reserve Bank then expects to publish final decisions in the third quarter of 2019. 

*For full details on just what the Reserve Bank is proposing for bank capital, see interest.co.nz’s three-part series here, here, and here. You can also see a video interview with Reserve Bank governor Adrian Orr on bank capital here.

*This article was first published in our email for paying subscribers early on Thursday morning. See here for more details and how to subscribe.

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