Bank Capital Changes: What is the RBNZ Preparing For?

The New Zealand central bank is requiring New Zealand Banks to increase the amount of capital they hold.

Why would they want to do this?

Does the Reserve Bank of New Zealand (RBNZ) see some troubles looming on the horizon? Read on to find out…

IMF’s Dire Warning on Global Economy

In the Herald in December 2018, Liam Dann reported on a speech by David Lipton. First deputy managing director of the International Monetary Fund,  Lipton had a message that wasn’t so rosy:

“His message was clear.

History suggests we are due for another financial crisis and right now the world is no shape to cope with one.

“I see storm clouds building, and fear the work on crisis prevention is incomplete,” he told the Bloomberg Global Regulatory Forum in London last night.

With interest rates still low, central banks simply don’t have the firepower they did in 2008 to deal with a deep recession, he argued.

Trillions of dollars worth of quantitative easing cash (which central banks effectively printed to get though [sic] the GFC) has yet to be reabsorbed – limiting that option as an emergency response.

Meanwhile, public debt has been building in many countries – including the US – seriously limiting the option of using fiscal stimulus to deal with a crisis.

For two years, the IMF had called on governments to put in place policies aimed at just that goal—as we have put it, “fix the roof while the sun shines,” he said.

“It is essential they do what they can now to address vulnerabilities and avoid actions that exacerbate the next downturn,” he said.

…If there’s something positive for New Zealanders to take from all this it is that we have taken some steps to “fix the roof” since 2008.

Our past three finance ministers have stayed focused on reducing core crown debt.

While the Reserve Bank hasn’t made much progress on lifting interest rates it has overseen an improvement in financial stability.

Credit growth has eased (although private debt levels remain precarious) and local banks are funding much more of their debt locally than they did in 2008.

The official outlook for New Zealand’s economy remains solid with GDP growth expected to stay safely north of 2.5 per cent.

But these kind of forecasts will mean little if the world heads into a serious financial crisis.

This IMF speech is just the latest reminder that we may need to batten down the hatches in 2019.”

Source.

RBNZ: Banks Should Bear Greater Share of Financial Systems Risks

But it wasn’t the speech by the IMF guy that had us wondering about what the RBNZ sees coming down the road.

Rather it was this press release from the Reserve Bank [emphasis added is ours]:

Reserve Bank proposes that bank owners bear greater share of financial system’s risks

The Reserve Bank is consulting on a proposal to raise the level of capital that bank owners must contribute to their business.

“Insisting that bank shareholders have a meaningful stake in their bank provides a greater incentive to ensure it is well managed. Having shareholders able to absorb a greater share of losses if the company fails also provides stronger protection for depositors,” Deputy Governor and General Manager of Financial Stability Geoff Bascand said today.

The Reserve Bank has been reviewing bank capital rules since early 2017.

“Bank crises happen more often than many people care to remember, and the economic and social costs of bank failures can be very high and persistent. These proposals are designed to make bank failures less frequent. With these changes we estimate the banking system will be resilient to shocks that might occur only once every two hundred years,” Mr Bascand said.

The proposal would see banks’ capital levels increase materially. We are proposing to almost double the required amount of high quality capital that banks will have to hold. In practice, actual changes to the amount that they hold will be less than double and will vary. The increase will depend on their current levels of capital, how much extra they choose to hold above the required minimum, and whether they are a large or small bank. Generally, it will be an increase of between 20 and 60 percent. This represents about 70 percent of the banking sector’s expected profits over the transition period. We expect only a minor impact on borrowing rates for customers.

“While borrowing costs may increase a little, and bank shareholders may earn a lower return on their investment, we believe these impacts will be more than offset by having a safer banking system for all New Zealanders,” Mr Bascand said.”

What is Capital Adequacy?

This video from the RBNZ outlines what capital adequacy is.

Related: Problems with the RBNZ Bank Stress Tests

Banks Will Need to Fund Higher Capital From Profits

Of course the banks won’t be too happy about this proposed increase in banking capital. Why?

Because if banks are required to have more capital on hand “just in case”, it will have to come from their profits.

The RBNZ realises this too. Stating that the proposal will almost double the required amount of high quality capital that banks will have to hold.

“Generally, it will be an increase of between 20 and 60 percent. This represents about 70 percent of the banking sector’s expected profits over the five-year transition period.”

Not surprisingly the banks had an initial media blitz to get their opinion out. Here’s just a couple of news items that followed the RBNZ announcement:

RBNZ proposals will slow credit growth: Kiwibank

“Reserve Bank proposals for banks to hold significantly more cash on their balance sheets will lead to slower credit growth and rising interest rates, Kiwibank economists have warned.”

Source.

The ANZ Banking Group says ANZ NZ would need up to NZ$8 bln of new capital to meet RBNZ’s new bank capital proposals

Source.

Then more recently:

“The Reserve Bank’s new capital proposals could force Kiwis to pay $1.9 billion-$2.7 billion more for their mortgages each year, investment bank UBS has warned. Swiss investment giant UBS has taken aim at the proposals in a highly critical note. It believes New Zealand borrowers could be hit with rate hikes due to the costs associated with the new proposals, which were first mooted by the central bank last month.” 
Source.

The RBNZ have stated that interest rates may increase. Although not to the extent that the banks are warning. In a simple summary aimed at the everyday man or woman called “Safer banks = safer society” the RBNZ state:

“Interest rates (borrowing and lending) could change – but we don’t expect by much. Lending margins above borrowing cost are likely to expand by 20-40 points.”

Source.

The RBNZ also has a short 2 page “Non-technical summary: How much capital is enough?”.

This explains… 

“The Reserve Bank is proposing this change to reduce the chances of banks failing in New Zealand. If banks in New Zealand fail, some of us might lose money and some of us might lose jobs. However, there would also be indirect costs on all of society that may be harder to see that would negatively impact the well-being of all New Zealanders. In the end, we would all bear the cost of bank failures, in one way or another.

This is why we want to make the chances of this happening very small – so small that a banking crisis in New Zealand shouldn’t happen more than once every two hundred years.”

For more on this topic see: Bank Failure: Could it Happen in New Zealand?

What is the Reserve Bank Preparing For?

The likelihood is that higher capital requirements will lead to higher interest rates for New Zealanders.

But our thoughts are the biggest takeaway from this is not that bank profits will be hit, nor that interest rates may rise.

Rather the key takeaway is just what is the Reserve Bank preparing for?

You don’t have to read much between the lines to conclude that it is a pretty significant banking crisis. Quoting a recent speech by the RBNZ head honcho:

“In making this assessment, our recent work makes the explicit assumption that New Zealand is not prepared to tolerate a system-wide banking crisis more than once every 200 years.”

…”Bank failures also happen more often and can be more devastating than bank owners – and credit ratings agencies – tend to remember. The costs are spread across the public and through time.”

Source.

And also repeating from the earlier mentioned press release:

“Bank crises happen more often than many people care to remember, and the economic and social costs of bank failures can be very high and persistent. These proposals are designed to make bank failures less frequent. With these changes we estimate the banking system will be resilient to shocks that might occur only once every two hundred years,” Mr Bascand said.”

Did you get that? These changes are designed to make the financial system resilient to shocks that might occur only once every 200 years. Quite how the RBNZ can be sure of that we don’t know?

But given European New Zealand is not even 200 years old, this is quite an event the RBNZ seems to be getting prepared for!

Public Submissions on RBNZ Bank Capital Increases

On 1 July 2019 the RBNZ released submissions along with a Summary of Submissions (PDF 399 KB) on the latest consultation paper in its Capital Review: How much capital is enough?

The RBNZ stated:

“In general, submitters support the Reserve Bank’s objective to ensure that New Zealand’s financial system is safe, acknowledging the economic and well-being impacts of banking crises. Many submitters, particularly from the general public, support the proposed higher capital requirements for banks. A number of submitters observe that higher capital requirements could lead to higher borrowing costs for New Zealanders. Some submitters, in particular banks and business groups, question whether the proposed increases are too large and too costly.

Central to the measures proposed in the consultation paper are increases in regulatory capital buffers for locally incorporated banks. The changes include requiring bank shareholders to increase their stake so that they absorb a greater share of losses should their bank fail, improving the quality of capital, and ensuring banks more accurately measure their risk.

Increasing the amount and quality of capital can be reasonably expected to mean that banks can survive all but the most exceptional shocks, Mr Bascand says. “We think the costs of doing so are outweighed by the benefits – someone’s cost is for society’s broader benefit.”

The RBNZ will now release its response to these public submissions in November 2019.

Then the implementation of any new bank capital rules will start from April 2020. With a transition period of a number of years before banks are required to meet the new requirements.

Outcome of Public Submissions: RBNZ – “Higher bank capital means safer banking system for all New Zealanders”

Following the public submissions, on 5 December 2019, the RBNZ released its final decisions on the capital levels banks will be required to reach. Along with the time frames for these:

“The key decisions, which start to take effect from 1 July 2020, include banks’ total capital increasing from a minimum of 10.5% now, to 18% for the four large banks and 16% for the remaining smaller banks. The average level of capital currently held by banks is 14.1%.

Relative to the Reserve Bank’s initial proposals, the final decisions also include:

– More flexibility for banks on the use of specific capital instruments;

– A more cost-effective mix of funding options for banks;

– A lesser increase in capital for the smaller banks consistent with their more limited impact on society should they fail;

– A more level capital regime for all banks – with the four large banks having to measure the risks of their exposures (lending) more conservatively, more in line with the smaller banks; and

– More transparency in capital reporting.

The adjustments to the original proposals reflect our analysis and industry feedback over the past two years. All of these changes will be phased in over a seven-year period, rather than over five years as originally proposed, in order to reduce the economic impacts of these changes.”

What the Banks Say:

Despite the RBNZ making some changes from their initial proposals, the banks (not surprisingly!) still have some doubts. This is from ASB:

The RBNZ has confirmed increased capital requirements for NZ locally-incorporated banks.  The RBNZ has listened to feedback and eased some aspects of the original proposal. However, we note that some of the capital increases will be frontloaded for the large banks.

We still think the new capital regime would result in larger increases in bank funding costs (and customer borrowing interest rates) than the 20.5 basis points assumed by the RBNZ.  If interest rate impacts do turn out to be higher, the net benefits assumed by the RBNZ of higher capital may not be as strong and could even turn into a net cost.

As previously noted, the impacts will be uneven across sectors, with more significant impacts on sectors with higher capital requirements. There is also increased risk of financial disintermediation. 

The pending imposition of bank capital requirements is a key reason why we expect a prolonged period of very low OCR settings, including a 25bp cut in May 2020 and for the OCR to remain at 0.75% until 2022.

How Effective Will These Bank Capital Changes be in the Event of a Major Global Financial Crisis?

However, we wouldn’t rely on any banking capital changes ourselves.

Because increasing the capital banks are required to hold, from an average of 14.1% to 18%, does not change the underlying weakness of the global banking system.

That is the modern fractional reserve banking system. Where demand deposits and time deposits are no longer separated.

For more on this see: Why Fractional Reserve Banking is Not the Problem

The current fractional reserve banking system means that if an electronic or silent bank run were to occur, banks could be drained of funds in mere hours. (These silent bank runs were what led to the various US bank bail outs in the US and UK in the last financial crisis).

So an increase in capital might up the amount of funds the bank is required to hold. But it does not protect you from an electronic or silent bank run.

Instead become your own central bank and ensure you have some financial insurance in the form of gold or silver bullion.

Editors Note: This article was first published 19 December 2018. Updated 8 April 2019 to include new material released from the RBNZ. Updated again 1 July 2019 to include news of submissions by the public on capital changes. Last updated 18 December 2019 with final outcome of RBNZ review.