"You'll hardly feel a thing" is the message the Reserve Bank seems keen to send the public as it makes the case for requiring the big four banks to stump up $20 billion for the seismic strengthening of their balance sheets.

"Oh yes you will" is likely to be the banks' message when they respond to the consultation paper on capital adequacy the Reserve Bank issued a couple of months ago.

The $20b cost, spread over five years, would be the combined effect of requiring the banks to finance more of their lending from shareholders' funds and tightening the rules for risk-weighting their lending.


Risk-weighting different categories of lending determines the denominator of the capital ratio.

The current rules, the Reserve Bank believes, give too much of a competitive advantage to the big four banks, which are allowed to use their own internal modelling, over the smaller banks, which have to apply a one-size-fits-all approach.

Currently, the big four collectively fund 12 per cent of their risk-weighted assets from shareholders' equity, even though the regulatory minimum required is 8.5 per cent; the Reserve Bank wants to raise that to 16 per cent.

The banks also have to have an additional capital buffer in the form of "Tier 2" capital, which is debt in normal circumstances, but would turn into equity if a bank got into trouble.

The Reserve Bank indicates that there might be a case for dropping that requirement if the move to 16 per cent "high quality" capital is adopted.

The essential point is that, because equity is more expensive than debt, this will raise the banks' cost of funds.

As the banks are unlikely to meekly absorb that extra cost as a hit to their bottom lines, it will widen their interest margins.

That margin is the spread between the interest rates they pay depositors and others they borrow from, on the one hand, and the rates they charge the households and businesses they lend to, on the other.


The question is how much will that spread widen?

Before getting into those weeds, a couple of general observations come to mind.

One is that insurance costs money. It is natural to look grumpily at that bill and contemplate the opportunity cost — things you would rather have spent that money on — until the day comes when you are grateful for the cover.

With any luck, that day never comes. But in a complicated and perilous world it is idle to suggest that stress tests or banks' internal modelling can accurately quantify the probability and magnitude of a major economic shock that could threaten the solvency of banks. Or even forecast the nature of the shock: another global financial crisis, perhaps?

The last one inflicted the deepest recession New Zealand had suffered since the 1970s.

A pandemic against which we are pharmacologically defenceless? It's 100 years since the Spanish flu killed more people than WWI.


International hostilities breaking out in some surreptitiously weaponised but systemically vital realm of cyberspace?

Or a more conventional geopolitical conflict? The current crop of world leaders do not inspire confidence.

Whatever, you do not want your bank lying low in the water if the seas get that high.

The other general observation is that governor Adrian Orr has a point when he argues that internationally there has been a tendency for banks to privatise the gains and socialise the losses.

The more equity skin in the game a bank's owners have, the less likely they are to take undue risks (the moral hazard argument) and the less likely it is that the cost of injudicious lending will ultimately be borne by depositors or taxpayers.

The Reserve Bank estimates its proposals would widen interest margins by between 20 and 40 basis points.


Given that the debt-funded portion of the banks' combined loan book is around $400b, that would be between $800 million and $1.6b.

Other estimates are higher. ASB's economists, for example, reckon the higher capital requirements would directly increase bank funding costs by at least 50 basis points.

Now either that tightening would be warranted by broader economic conditions at the time, in which case the official cash rate would not have to be raised as much, or it would not be warranted, in which case the Reserve Bank would be expected to cut the OCR to compensate.

So we can't assume that the wider margin would necessarily or entirely flow through to, say, mortgage rates.

But if not, it would be depositors who took the hit, and the real after-tax returns they receive are pretty meagre already.

However it is split between borrowers and depositors, the wider interest margin imposes a cost.


One of the assumptions the Reserve Bank is making in arriving at its 20 to 40 basis points estimate is that banks' shareholders will be prepared to accept a lower return on equity (as well as stumping up more of it) to reflect the lower risk of investing in a safer and sounder bank.

So how much less like bandits does it expect the banks' owners to make out? A couple of percentage points, deputy governor Geoff Bascand says.

Well maybe. To calibrate the scale, the big four banks' average return on equity in the September 2018 quarter was an annualised 15.2 per cent, up 2 percentage points on the March quarter. One might think 15.2 per cent is a pretty plump return for what should be a safe, utility-like investment class.

But there is some risk the other way. The Australian parents of our big four banks are in bad regulatory odour at home following the Royal Commission and they also face falling house prices in some key markets. They might seek to sweat their New Zealand assets even harder than they already do.

Similarly, the Reserve Bank also expects that the international capital markets which the banks tap for a good deal of their debt funding — roughly one dollar in four, based on Statistics New Zealand's numbers for their net foreign liabilities — will demand a lower risk premium if the capital ratio is raised as proposed.

The Reserve Bank is also making an important assumption about the extent to which something called the Modigliani-Miller theorem applies. Economists might enjoy debating that; the rest of us could only roll our eyes.


So we are left trying to weigh a highly debatable but significant cost against an incalculable benefit.