New Zealand's Reserve Bank (RB) is proposing to increase the total minimum capital requirement from the current 10.5 per cent to 18 per cent for banks that are identified as 'systemically important' (essentially the big four subsidiaries of Australian parent banks) and 17 per cent for all other banks.
The current minimum of 10.5 per cent is consistent with international standards for minimum capital requirements.
The New Zealand Institute of Finance Professionals Inc (INFINZ) is considering the proposals, which are attracting a lot of attention not just from the banks themselves but also from business more widely.
INFINZ represents a broad cross-section of participants in our capital markets, including industrial, service and agricultural businesses. We are keen to ensure that changes to the financial landscape do not hinder New Zealand's economic performance.
The RB believes that, while the proposed increase may look dramatic, the actual increase for banks would not be quite as high because banks are currently operating well above the existing 8.5 per cent minimum requirement for high quality capital: on average, banks in New Zealand are operating with more than 12 per cent of such capital.
Nonetheless, the proposals are significant. To comply with these new minimum capital requirements, the RB estimates that four major New Zealand's banks may need to raise $20 billion of new capital. This would equate to an increase of 53 per cent on their current positions. The RB suggests that this could be done by the banks collectively retaining 70 per cent of their earnings as capital over the proposed 5-year phase-in period.
If adopted, these new minimum capital requirements for banks operating in New Zealand – after taking into account the conservatism built into capital standards in New Zealand – will be the most stringent in the world.
The RB believes that the level of capital required of the banking sector should be sufficient to ensure banks can retain creditor confidence when subject to an extreme shock. In other words, the banks should be able to meet their obligations and remain solvent when faced with large unexpected losses, for example arising from a financial crisis. This is despite empirical research showing that higher capital ratios are unlikely to prevent a financial crisis.
Furthermore, the RB has a core principle that the capital requirements of New Zealand banks should be conservative relative to those of international peers, reflecting the risks inherent in the New Zealand financial system.
The RB has proposed a capital requirement that would ensure that the banking system
could cover losses so large that they occur very infrequently: specifically, once every 200 years.
This one in 200-year assumption contrasts with the approach used by international standard-setters, which is based on a one in 100-year crisis. The RB believes society would trade off higher output for minimising the risk of 'rare disasters'.
The proposal will come at a cost to New Zealanders. Will we be paying an insurance premium that we can ill-afford, the impact of which might be more damaging over time than the risk we're trying to protect against?
A sweep of the past one hundred years would take in the Great Depression, the share market crash of 1987 and the ensuing collapse of a large part of corporate New Zealand, and the GFC and recession in 2008 and 2009.
Does the one in 100-year approach not adequately cover off these risks?
The potential costs are clear. If you are a borrower, you can expect to pay more for your loans, whether to finance your home or your business. If you are a saver, you can expect to earn less on your deposits.
If you are a bank shareholder, directly or through your Kiwisaver fund, you can expect lower returns over time, and most noticeably over the next five years as banks look to build their capital base.
And overall, the economy can be expected to grow at a slower rate as it absorbs the higher cost of borrowing and lower returns for depositors.
The RB acknowledges that the increasing capital requirement is expected to result in an increase in banks' average funding costs. It believes that this will be partly offset by reduced return expectations from shareholders, depositors, and other creditors as the banks will be safer.
It expects that the banks will try to pass on higher costs through higher lending rates and lower deposit rates, but that competitive pressures may limit the banks' ability to fully pass these costs on.
By the RB's calculations, the increase in lending margins (the difference between bank lending and borrowing rates) arising from their proposals will be in the vicinity of 0.2 per cent and 0.4 per cent. This represents a combination of interest rates on deposits and other bank liabilities falling to make up some of this margin, with lending rates for borrowers rising to make up the remainder.
Will higher borrowing costs mean lower economic activity? The answer is that this is highly likely if the past is any guide. By what quantum is debatable; the RB cites international literature implying that the cumulative impact of an increase in lending rates of less than half of one percent could be equivalent to a one-off reduction in the long-run level of output of around the same amount (i.e., also less than half a percent).
International investment bank UBS have looked carefully at the RB's proposals. Their conclusions are somewhat more alarming than the costs and penalties assessed by the RB.
UBS says that it fundamentally disagrees with the RB on its premise that this significant increase in New Zealand bank capital requirements will only have a minimal impact on customers' borrowing costs.
It estimates New Zealanders could end up paying between NZ$1.9b and $2.7bn more on their home loans each year.
Households and businesses will see the interest rates on their loans rise by between 0.86 per cent and 1.22 per cent.
"This is materially higher than the ~0.35 per cent in mortgage repricing implied in the RBNZ's analysis", UBS says.
For a home-owner with a $400,000 mortgage, this would mean that the interest cost of that mortgage would rise substantially, by between $3,440 and $4,480 per year.
And if the banks can't generate the returns they require to meet the additional costs from having a higher level of capital, then they may look to ration credit. This would reduce the flow of capital to New Zealand and have a materially adverse impact on the economy.
Home mortgages are typically seen as less risky and attract a lower capital charge than business lending, for instance, so it's the productive part of the economy that could suffer the most.
Thus far, no comprehensive and independent cost-benefit analysis has been done which is surprising.
INFINZ believes that this is something the Productivity Commission would be well placed to undertake.
Key questions to be addressed are: do the benefits outweigh the costs? Does the country really need to go so far out on a limb to prepare for future financial shocks? Could other policies be implemented which would ensure the continued sound operation of our financial system without such a hefty increase in costs?
Without such independent analysis and clear demonstration of the benefits outweighing the costs, New Zealand should not embark on these significant reforms.
- Louise Tong is Chair of INFINZ.